Examination of Witnesses (Questions 280-299)
ENGINEERING EMPLOYERS
FEDERATION
25 JANUARY 2005
Q280 Mr Hoyle: What I am saying is that
the manufacturing industry have had other raw materials where
there has been sudden volatility where the market goes up and
then comes back down. If they can cope with it in manufacturing
why can they not cope with it in the energy price?
Mr Temple: The main element here
is market differentials.
Mr Radley: To set the scene, we
have seen a recovery in manufacturing after a very severe recession.
Unfortunately, so far we have only seen a limited recovery in
profitability compared with previous recoveries. This very much
reflects the changing world market, that competition is much more
intense and that it is much harder for companies to raise prices.
With regard to the specific instances you were talking about there
it is true to say that metals are a larger proportion of manufacturers'
costs. They have gone up by more than energy has, but the point
is that metals price increases are a worldwide trend so, although
there are problems in passing on costs, particularly if you are
at the sharp end of the supply chain, it is not something that
is particularly eroding your competitive advantage. The other
thing is that although the increase in metals prices was unwelcome
it was largely predictable and explained by market factors, the
fact that we had seen rapid industrialisation in countries such
as China creating huge demand for metals and that was pushing
up the prices. If we look at energy there are two differences.
First, if we look at what has happened in UK markets we have seen
a loss of competitive advantage. We have gone from a period when
our prices were sometimes considerably lower than the rest of
continental Europe to a period now where, particularly if you
look at forward prices, our markets are round about 20-25% higher
than central and western Europe. The other key point, as my colleagues
have already explained, is that the rise in energy prices was
less predictable, less explainable. If the rise in prices is predictable
and explainable then sensible companies can take sensible market
strategies. They can to some extent avoid the worst increases
in the prices. They can take hedging strategies, things like that.
If you do not understand what is happening in the market because
odd events are happening it is far more difficult for companies
to adopt strategies to cope with it.
Q281 Mr Hoyle: Do you feel there is a
bit of a cartel operating in the way the price increases came?
Mr Temple: If you have a market
that suddenly changes direction and nobody can adequately explain
it then somebody ought to be asking some very tough questions.
We believe that somebody should be doing that. We think that the
DTI probably have not been asking tough enough questions of the
gas producers. A lot of it still remains unexplained and I think
there probably is a case for somebody neutral who looks at it
in every facet, including the competitive aspect, to understand
better why those hikes took place.
Q282 Sir Robert Smith: You mentioned
earlier that for some time with the liberalised market in the
UK and the different market on mainland Europe your members have
benefited from lower prices. In a sense now as our market gets
tight (there could be other things as well), especially in the
potentially extreme winters, then obviously as our market is closed
prices will go up to some extent. Obviously you have concerns
that they have gone up much more in the forward market than you
would expect. An inevitable consequence of the different markets
is that our prices could go up now. Would you prefer to have the
European model where you did not get the lower prices in the earlier
years in return for the stability that the European competitors
seem to have in not seeing prices jump?
Mr Temple: No. We were absolute
supporters of liberalisation of the market. We still steadfastly
believe in that and we believe that in all of this we should let
it be a market driven scenario; there is no doubt about that whatsoever.
That is why we were so concerned, and comment has already been
made, that the market did not seem to be working in a natural
way and that is a real problem when you are, if you like, operating
in a free market. Therefore, what we would much prefer to see
is, first of all, that we find out why it was different in the
context of gas, but, more in particular, as a Government, we get
them to push for the extension of that liberalisation of Europe.
There are many directives already in place that people have signed
up to; it is just that they are not being put into action. We
just want that to be the driver rather than to take a retrograde
step.
Q283 Sir Robert Smith: In your evidence
you talk, in point 28, about how also, in mainland Europe, the
Emissions Trading Scheme does not seem to be feeding through to
energy prices in the way that it is in the UK. Is that something
you can expand on?
Mr Temple: Yes, we can. This was
one of the very early questions that a lot of people kept saying:
"Why, in Heaven's name—when apparently the same drivers
are applying, say, on emissions trading, in particular, on the
UK and Europe—is it that we end up with a very different
outcome from this: prices running 20-25% higher as a consequence?"
That is why we brought Trevor in, to analyse this for us. I shall
therefore ask him to do it as simply as possible. This is stunningly
complicated, and I know you have had a long day, so I am not going
to push him to give you all the whys and wherefores. If there
is a simple explanation, Trevor, can you give it?
Mr Sikorski: Yes. When we talk
about energy, I guess we are talking about power prices, and so
the question is why, when we looked at the forward markets for
the year, did we see prices stepping up in the UK to an extent
you could not explain by looking at the fuels, but this was not
happening in continental forward prices? So we did the report
and what we came to, as a conclusion, was that in the UK power
producers are looking at CO2 as an opportunity cost. So they are
basically saying to the market now: "If you want us to turn
on and generate you have to pay us enough for gas and you have
to pay us the opportunity cost of our CO2." So this is just
an efficient power market working. There is nothing wrong with
this but it is just saying: "You need to compensate me for
the opportunity cost of, let us say, my input to production."
Why is this not happening on the continent? The reason it is not
happening on the continent is it is very, very hard to have an
opportunity cost on gas because you cannot do anything with your
gas; there is no gas market to sell your gas into. So the threat
of saying to the power market "I am not going to turn on
and I am going to sell my gas and sell my CO2 and make more money"
just is not in there on the continent. What we tend to see now,
I think, is we are seeing continental generators saying: "I
will pass through any incurred costs on CO2" and, as we know,
the incurred costs of CO2 in the first place are almost nothing
because everybody got these things for free, whereas in the UK
we are seeing these generators pass through everything because
they are saying: "I have got an opportunity cost. There is
a market value for these permits, I will sell these permits and
realise that value if you are not paying me enough to generate."
Q284 Sir Robert Smith: So it is really
vital to get the European mainland and the UK markets in some
kind of sync in terms of liberalisation?
Mr Temple: Absolutely.
Mr Sikorski: I think that the
key outcome of the report was to say that the lack of liberalisation
of gas markets on the continent, particularly the German gas market,
is having all kinds of effects on UK markets, both on UK gas but,
since the introduction of the CO2 market, UK power as well.
Mr Temple: The concept of emissions
trading is something we support; we think it is a proper way to
go about containing these sorts of emissions, but actually by
introducing it it is likely to dissuade many of the European countries
to liberalise because it will slightly worsen their position in
this regard. It is going to be an interesting debate in persuading
this to be pushed forward in terms of the agenda.
Q285 Chairman: There are a number of
countries within Europe which have liberalised markets as we have.
Most of the northern European countries, apart from the Federal
Republic, of the old 15—Sweden, Denmark, places like that—they
have fairly liberalised markets, but they do not seem to have
been subject to the kind of spiking that we have had.
Mr Temple: It comes down to the
structure of the energy supply markets—for example, hydropower
and things like that. Again, Trevor has an explanation for that.
Mr Sikorski: I agree that there
are liberalised markets around Europe, and that is a good thing.
The main one, I guess, that is more fully liberalised in power
is called Nord Pool, which is all the Nordic countries, and that
is very heavily influenced by non-gas based forms of generation,
so hydro and nuclear. What that means is that those markets have
been far less exposed to changes in the gas price, changes in
the coal price and changes in carbon, which have all affected
UK prices in the last year.
Q286 Chairman: We are going to be taking
this up; we are getting the Director General of Competition from
the Commission to come and see us.
Mr Sikorski: The other thing is
there are no real gas markets anywhere else in Europe. Even if
you have a gas plant it is not that easy to optimise it.
Q287 Mr Clapham: Just looking at your
submission, you cite the experience of your members for the evidence
on increased gas prices, yet we have other contributors, who have
put submissions in and we have heard today, who argue that gas
prices in the UK, by and large, are not that great when compared
with continental prices. In other words, the continental prices
have followed a similar trend. Can you suggest why there may be
these big differences between the analysis done by yourselves
and the analysis, for example, of Shell?
Mr Temple: I think that in all
these matters we are talking about a complex scenario. It depends
precisely which company you are. Therefore, if you take relative
prices, domestic prices here are typically cheaper than Europe.
If you take industrial prices of energy, it depends where you
are in this debate. Let us just take gas for a moment. Essentially,
the nearer you are to the gas wholesale market then the more likely
you are to be paying a premium. Typically today, that is now 20-25%.
No matter what people say, there is that premium today. We have
a premium over Europe. As you move down the spectrum to the smaller
users of gas, then the price itself may go up because there are
different issues coming into the equation, but in that context
the relative price differential with Europe starts moderating.
This is why, depending on who you talk to, they will pick which
part of that debate suits their argument, but there is no doubt
that the nearer the wholesale market the bigger the price difference,
and it exists. Then, of course, it is those big guys who actually
have the big problem but can actually pass on some of that cost.
So I am afraid this starts coming down through the supply chain.
If you take electricity, those prices were pretty low, historically,
but they did bounce back, and we are now operating in broadly
the same scenario; that is, the nearer you are to the wholesale
market the bigger the price differential. There is a real one
there—it is 20-25% higher—and, again, as you go in
the chain, it changes a little. I think, therefore, the argument
goes all ways, and this is where you do see, if you like, different
people giving different answers to you.
Q288 Mr Clapham: In terms of the evidence
that you have collected from your members, is it beginning to
show through in, for example, a lack of competitiveness? Are there
areas or sectors where the Europeans, because of their lower gas
prices and lower energy prices generally, are showing themselves
to be more competitive?
Mr Temple: Probably I should just
comment, actually, in answer to your previous question, that those
people who contracted, by the way, during October when, surprise,
surprise, that gas hike went very high indeed—which is when
most of us were doing our next range of contracts—those
contracts are the ones that are driving through into the market
as well; those are gradually coming in more and more. So the comments
I made about nearest to the wholesale market will start creeping
down through that spectrum as well, as that starts passing through
the system. Are these prices impacting in terms of competitiveness?
I will hand over to you, Stephen, and let you pick that one up.
Mr Radley: It is not even a case
necessarily of just looking at different sectors but looking at
different types of companies. What we are tending to find is that
the larger international companies, particularly those that are
in energy-intensive sectors but not necessarily just restricted
to those, are taking the view that, if you look at what is happening
to costs, particularly if you feel it is going to persist, this
is contributing to a loss of competitiveness. The sorts of decisions
they are making are to say: "Look, it is becoming more expensive
to source energy in the UK; we will actually load our production
towards our other sites in other parts of Europe or, possibly,
outside Europe." The concern there is that if these trends
persist, eventually companies will make decisions about actually
making the next major investment outside the UK or moving production
facilities out of the UK. If you look at some of the smaller companies,
I think the issues there are, firstly, that it is more difficult
for them to actually adopt hedging strategies to avoid the worst
of the cost increases, and also that these tend to be the companies
that are at the sharper end of the supply chain, so they will
find it difficult to raise prices and pass on the cost to customers.
They are also likely to be the customers that face paying higher
prices from the producers that are in energy-intensive sectors,
so they will be paying more for products such as steel, building
products, aluminium. So they will have a double blow: both energy
going up and, also, some of their other costs going up, but an
inability to raise prices.
Mr Temple: A common misconception,
actually, is that there is some cataclysmic event suddenly, in
the context of these things, and everybody thinks, "Wow,
that's it." In fact, if you take those that have most immediately
been hit, as we said earlier, there are probably those energy-intensive
ones nearer the wholesale market (though we said it is feeding
through) but these are very often international companies. They
do not suddenly close down a massive great plant overnight just
because of this; there is a drift. This is a loading issue; these
are not board decisions, these are decisions taken within the
context of business against budgets, against loading, where you
start loading your lowest cost route, and that is why they play
the plants around Europe, or wherever. So you see a drift taking
place, and when that drift takes place other people invest in
the stability of the market which they are in. That is what we
have in the UK at the moment; we have an unstable picture around
energy, a lack of clarity around gas supply. Why did it shift?
We do not know—lack of clarity. Where do these companies
drift to? They drift to a more predictable market scenario where,
currently, prices are somewhat lower, and that is where we lose
the impetus and that is, eventually, where we lose the investment.
Q289 Mr Clapham: Could I look at one
of the points Mr Radley made regarding some of your smaller producers?
We know the forward gas prices were very high in 2004 but they
have fallen away significantly. In terms of some of your smaller
producers, has there been any thought about, for example, entering
into a purchasing co-operative to be able to access the spot market?
Mr Temple: Trevor, is that possible
and does it exist? We certainly have not come across that as happening.
That is the answer in that respect. Is it possible? Is it sensible?
I do not know whether we have a response. Trevor?
Mr Sikorski: I guess my immediate
feeling is that it just depends on your view of risk. I do not
think most small producers would want to take the kind of price
risk that being exposed to spot prices has. Most of them want
a very certain cost structure so they can budget and know what
costs they are facing. If you are taking spot price exposure you
are taking risk on what that is going to be rather than fixing
ahead. Some people would take a premium just to fix that price.
Mr Temple: Typically, the bigger
the company, the closer you are, again, to the wholesale market,
the more options and more knowledge you have; the further you
go down the chain, frankly, the more limited your opportunities
are.
Q290 Mr Clapham: Is there any evidence
of any of the larger manufacturers going on to the spot market
for their energy?
Mr Temple: Yes, we have seen that.
A number of people were doing that actually in the period over
the hike last year. Some were choosing to do that. It was very
unclear whether that was a good idea to do or not—we have
touched on it already—because nobody quite understood why
the market was behaving like that, so it is very difficult to
make a sensible decision. On reflection, those that bought spot
at that time probably did the right thing, even though a lot of
people were criticising them for it. You do have to think again,
though, to the point I made earlier about the ownership of these
companies. Here you have a major plant (because that will be the
people doing it) in a UK market, perhaps part of an international
company, actually putting themselves in a dramatically unclear,
short-term scenario around a very key input cost like energy.
That is not going to lead to confidence at having that operation
in the UK and loading it to the maximum. We saw that very short-term
view on energy a very worrying one in terms of how we would be
perceived as a base for some of these big businesses. That was
our concern. I think that still remains the same. What you want
is people contracting long term because they have a long-term
view of the future here.
Q291 Mr Clapham: So your view would be
that even if we had a larger manufacturer who accessed the spot
market to take advantage of the cheaper energy, because of the
lack of stability within the spot market, over a medium period
of time, it would undermine confidence?
Mr Temple: It is their option.
We are just saying you feel more comfortable, do you not, if you
see companies putting themselves into contracts for a long-term
future? That was very much plain short-termism. In the event,
for those playing spot it was a good decision.
Q292 Sir Robert Smith: In a cold winter
it might have been worse.
Mr Temple: It might be different
then. It depends where they are today, is the debate.
Q293 Mr Berry: A long-term contract eliminates
uncertainty over that period. So, in one sense, I understand what
you mean by saying there is clearly a risk involved in going for
the spot price, but the risk in going for a long-term contract
is that you end up paying more. There is a downside to it. You
are making a gamble that if you have a long-term contract, yes
you know it is certain and what the price will be, but the risk
is that your costs could be far greater than if you played spot
for a while.
Mr Temple: You are quite right,
and that is what happened. Those people that had contracted last
year at the price hike are now paying a premium price over the
rest of Europe—20-25%—but at the time people were
wondering whether or not they should. This is the essence of this
debate.
Q294 Mr Berry: The reason Mr Sikorski
gave for people not purchasing spot was the risk, and I am simply
making the obvious point that, yes, there is the uncertainty about
the price but the risk of long-term contracts is that you commit
yourself to a price that is disadvantageous compared to playing
the spot for a period. That is all.
Mr Sikorski: It is an issue of
certainty. If you have a reasonably fixed income stream and you
fix your costs level, you are fixing your profit margin. That
profit margin, in the event, could turn out to be bigger, or it
could turn out to be smaller, but you fix that. Most companies
prefer to have that degree of certainty and hedge that price rather
than taking the risk that prices will be lower or will be higher.
That is the spot price risk. The spot price risk is not all up-side,
some of it is that those prices could be lower. So that point
is absolutely taken, but it is all about certainty in fixing your
margins, which is what most people prefer to do.
Mr Temple: That is why it is so
important for those markets to work, if you like, in a correct
market way, so that at least you can read whether it is good,
in your estimate, to go spot or long-term.
Q295 Mr Berry: Why is it that so many
contracts fall to be renewed at the end of September or beginning
of October?
Mr Temple: I do not know. It happens
to be the case. Do we have any knowledge as to why it is happening
that way?
Q296 Mr Berry: It is a bit like this
place. "Why do we do this" (some plainly absurd thing)?
The answer is, "We've always done it that way." There
is tradition and democracy of the dead. I thought entrepreneurs
were much more vigorous, get-up-and-go and risk-taking—entrepreneurial,
as it were! I am staggered to find this sort of "We do it
this way because we have always done it this way." Is that
really the case?
Mr Temple: I do not know that
it is actually done because of that, I think it just so happens.
Q297 Mr Berry: We have been told by other
witnesses it is primarily for historic reasons.
Mr Temple: I think it is—that
is when the last contracts came round. I am afraid we do not have
a brilliant answer for you, and one feels as though we should.
We did wonder, if we got people to start changing their contract
period, would that be beneficial—ie when prices are meant
to be low? (Normally, one would one say in summer but, for some
reason, this year it did not work out that way.) You then say:
"Would the market then start shifting in anticipation of
that?" That is certainly an option we have been discussing,
as to what would happen if we got people to start changing the
contract period.
Q298 Mr Berry: Do you think the market
is more competitive if contracts all come up at about the same
time, or is it more competitive if they are staggered through
the year?
Mr Temple: We do not know.
Q299 Mr Berry: If you do not know, who
does?
Mr Temple: This is just very complicated.
You have got to actually go away and think about this, really,
because if you suddenly press a button here it pops up over there.
I do not feel ashamed not knowing, I just think it is one of these
areas that is very hard to—
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