Examination of Witnesses (Questions 520-538)
MR ALISTAIR
BUCHANAN AND
MR STEVE
SMITH
16 NOVEMBER 2005
Q520 Mark Pritchard: I agree, and in
practice it is clouded by the nuclear issue which is a headline
in all of this climate change debate, sadly, and there is a lot
more to the debate, as members know. Perhaps there is a public
education campaign need. Moving on, if I may, the evidence presented
in your memorandum suggests that nobody is ready to invest in
new generating plant at the moment and I just wondered, why do
you think this is?
Mr Buchanan: If I can start, and
Steve can sweep up, perhaps, on the longer term. On the near term,
the situation that we have got is that we have this reserve margin
of 21%. Basically, looking at this winter, you have got 75 gigawatts
of power plant, your model winter usage is 60 gigawatts, your
peak moment on a peak bad winter's day is 65 gigawatts. Incidentally,
that 75 gigawatts is not including the 3.2 gigawatts of mothballed
plant, at least over half of which can be called up at quite short
notice. There is quite a cushion currently, which goes back to
my horrible analogy of a Scooby-Doo sandwich; you have got to
have a lot of plant, having a lot of problems at the same time,
which could happen but frankly it would be most improbable to
happen, to see that occurring. If we are looking forward, one
of the encouraging things that I sense within the market place
is that we are seeing a range of plans being developed. RWE has
announced that it is looking to re-convert its 2 gigawatts of
oil powered plant at Pembroke into a modern plant. Isle of Grain
is 2 gigawatts of plant of potential commission. Bear in mind
that 60 gigawatts that I mentioned earlier is usage in a normal
winter's day in the UK. RWE is looking at Staythorpe, for a new
plant. EON is looking at Drakelow, Centrica is looking at Langage
in Plymouth. The ESB has started to develop its position at Marchwood.
So there are a whole range of plants in the consenting, planning
and developing phase. It is not just a blank piece of paper. The
next question which you or somebody else could quite rightly ask
me is, "What is going to convert that to build?" I think
part of the answer is going to be looking at the reserve margin
currently and looking at the spark spread price which is the price
that industry looks at. You would anticipate that price would
have to improve for a gas fired plant before the developers said
"Right. We have got the consent. We have got the sites. We
are ready to build. We have got the gas and the National Grid
connections. We are ready to go." I am quite encouraged that
we have got the plant portfolio there with a range of interested
parties and therefore looking forward, candidly, I ended up slightly
scratching my head when Dieter was talking, because if you were
listening to Dieter's view of the world—and he has to put
some balance in here, you would say, "We need a revolution
right now." In networks, where we have just awarded a 48%
increase in capex on the electricity network companies, now we
are getting evolution and where the regulator is involved they
can see that. On the market side, in gas we have got £6 billion-worth
of infrastructure investment going in. That is 100 billion cubic
metres (bcm) going in, in the next two to three years. We use
in a year about 120 bcm. Massive investment is being put in on
the gas market and you have got, potentially, coming back to my
list of power plants, exactly the same that is going to happen
in electricity, so I was quite keen to get a bit of balance and
colour into what Dieter has suggested because you might have thought,
"Nothing has been built, the end of the world is nigh!".
Q521 Mark Pritchard: Do you think that
energy supply would be helped or hindered by more competition
in the market place?
Mr Buchanan: What we look for
is evidence of behaviour, behaviour patterns. We basically look
for new investment, new players, new products, new prices. If
they start to dry up, I think you start to ask some quite uncomfortable
questions and, rightly, I think, a number of your colleagues have
raised liquidity; is this the death knell of the market? If we
look across those other criteria, just take the gas market but
we could take the retail market if you wanted to, or the electricity
market, we are seeing new infrastructure, massive infrastructure,
being invested and we are seeing new players, the Danes, through
DONG, Gaz de France, Gazprom, Sonatrach, they are all major players
wanting to come into the UK market. Not only as infrastructure
owners but also as traders. We are seeing a range of products
and prices being offered as well. It would appear to us that,
when we look for the behavioural instincts of a market, they are
there and that I think is quite intelligent.
Mr Smith: I think it goes back
to the point you are making, the existing players are willing
to invest in new plant and there are other new players willing
to invest either in existing plant: you can see at the moment
the Drax plant, for example, is attracting interest from the US
and other funds, so as Alistair said, you look at all of the metrics
about whether competition is healthy, is there new entry? Are
there people interested in coming into the market? Are the existing
players willing to invest in new products and new plant? They
are all there at the moment.
Q522 Mr Ellwood: It is very interesting
to hear the scope of build that is in the planning stages from
Ofgem's perspective. That is the ability to generate, which I
do not think is really being challenged here. What is the concern
is the source of power itself. If we become a net importer of
coal, gas and oil it goes against the grain of cultural change,
that Britain and other countries are undergoing, where we no longer
want to have to resort to importing these goods, whether they
come from Africa, whether they come from China or other places.
Are we, from a climate change perspective, not going to solve
the global problems that we face? Of course we will be able to
keep the lights on, but at a detrimental cost to other countries.
Mr Buchanan: I am very alive to
the issues that you have raised and I think there is a combination
of issues here which is, are we happy with our future fuel mix
and are we happy with the sources of that future fuel mix? On
the sources issue, I take comfort—but in a way I am going
to caveat that quite quickly because you might say, "If the
regulator believes the market he should not take comfort or otherwise"—from
the fact that 20% of our future gas load is going to come from
Norway, that one of the major facilities that is being built at
Milford Haven has locked into Qatar LNG. We have a major pipeline
development with Holland, gas there may come from Dutch reserves,
Norwegian reserves or from Russia or Africa. I do not know where
the resource of that is going to be. I think one of the concerns
has been that simply we are going to be focused potentially, which
has been mentioned many times, completely reliant on Russian gas
and Russian gas through one pipeline through the Ukraine and Belarus
up through Czech. I do not see that, candidly, as being the picture
going forward. I think our gas sources are going to come from
many different places around the world, so you might get some
comfort there in terms of portfolio management. The reason that
I gave the caveat is that Ofgem has to be very careful in these
areas, because we do not make forward comments about fuel mix;
we do not make forward comments about prices. That really is for
the market to devise, unless the Government want to do something
else. That is entirely up to the Government to do.
Q523 Dr Turner: Do you accept that there
is a problem in what the UK market has very short-term?
Mr Buchanan: It sounds a slightly
glib answer: I do not want it to sound a glib answer but £6
billion-worth of investment, virtually a complete regeneration
of our gas infrastructure, is a huge investment, therefore I do
not believe that those providers of capital, those involved in
that, are being short-term. The issue—and I was asked this
question at a Parliamentary Energy Meeting last night—is
that we are in a `neck' year and do something now. Slightly uncomfortably,
my answer last night was, the thing we have to do now is try and
learn the lesson of what maybe we should have had in the last
three or four years, because to develop this kind of infrastructure,
it is all long-term infrastructure, takes a long time. I think
the key issue for us is that of information. Information is the
key for players in the market place and only in the last 18 months
have the UK Off-shore Association and players agreed with the
DTI to provide, on a voluntary basis, a much higher level of information
to everybody else, including ourselves. Consequently, if you go
back three or four years—when, for my sins, I was a City
analyst—my numbers (it may just have been that I was not
a very good one) but my numbers were much higher for North Sea
gas for this year than they are now. Had we had more information—much
more information which we have got now—I feel more confident
that perhaps we might have been able to see the issues that are
now happening in this net year for gas supply.
Q524 Dr Turner: I think your £6
billion of investment in gas infrastructure may be accounted for
by quite different reasons, and in any case I am more concerned
with the short-term nature of the electricity market which is
a disincentive to long-term investment, certainly in newer technologies.
It is obvious why people are involved in gas; that is the easy
option at the moment, it is the cheapest plant option, it has
all sorts of things going for it. I am much more concerned with
developing renewables and the market is much less friendly to
renewables, is it not?
Mr Buchanan: I am going to ask
Steve to talk, as I think you are getting bored with me.
Mr Smith: To start with, is electricity
short-term? If you look at the history of what the markets delivered,
because that is what the economics dictated over the last ten
or 15 years it is about 30 gigawatts of new power stations, so
the question is, will it continue to do that in the future? If
you go and talk to any of the big generators, they are making
significant commitments to invest both in renewable generations
and all of them have big plans and big investment programmes for
wind, but also seeking to look at the opportunities for conventional
generation. I think what they would say to you is their big issue
and the thing that is stopping them taking a long-term view is
some of the uncertainties over some of the big environmental questions
that Dieter was referring to, and in particular things like LCPD
and the fact that if you have got a coal station you do not yet
quite understand how the rules are going to work for you from
2008. In terms of CO2 you do not know what your CO2 targets or
allowances are going to be beyond the next three or four years.
I think if you got any of the Big 6 or the big power companies
in and asked the Chief Executive, "What is the thing that
is stopping you making long-term decisions at the moment?"
they would say, "If we got clarity on that framework, whether
it is long-term carbon credits or simply just tell us what the
overall UK framework is going to be, we would make the investment".
There is certainly no unwillingness to make investment; they just
want to know the rules of the game.
Q525 Dr Turner: But the rules of the
game are such that they do not foster the pull-through of new
technologies.
Mr Smith: I think that is possibly
true historically, but that is precisely because the carbon cost
of different technologies has not been something that any company
has had to face, so I think the launch of the Emissions Trading
Scheme has led to a fundamental shift in the way generators think
about their business. Previously you looked at the lowest cost
and cost was measured only in terms of fuel cost, you took no
account of any environmental damage you were doing. You cannot
do that any more; we have carbon pricing, we are going to have
sulphur dioxide pricing for coal generators as well and they can
then trade their sulphur allowances. So I think that may be true
historically, but emissions trading has fundamentally changed
the nature of the decisions they take.
Q526 Dr Turner: Yes, but all the evidence
is that the price of carbon emerging from emission trading at
the moment is not enough to trigger various important sorts of
investments, like in marine technologies which are totally non-carbon,
or like in carbon capture and storage.
Mr Smith: That again comes back
to the timing issue which is, if the Government were to put some
backing behind its carbon targets, it would be clear that the
kinds of prices that were likely to emerge in three, four, five,
six or seven years' time, you could not deal with those carbon
reductions just by switching coal to gas or other mechanisms,
so it would encourage that investment. I echo what Dieter said,
which is at the moment the short-term nature of emissions trading
has just made some generators think, "What can we do with
the existing stock of assets we have to minimise carbon?",
not think the bolder thoughts about "What new things could
we do?"
Q527 Dr Turner: You have given us assurance
that the market itself can guarantee security of supply, so why
is it that you and the DTI jointly operate this animal, JESS?
Why do you need it?
Mr Smith: There is a simple answer,
which is we were asked to do that by Parliament. We are a creature
of statute. If you look at the last Energy Act that went through,
there was much debate about who was responsible for security of
supply and Parliament coming out of that process said they would
like us and the Secretary of State to produce an annual report
that assessed the outlook. We are simply creatures of statute
and do what we are asked to do. I think given the importance of
energy as a product, even though we have that confidence in the
market it is understandable people want to have that information
and have that understanding that the market is delivering, so
it is providing people with that certainty. If those long-term
indicators started to suggest that the market was not delivering,
it gives us plenty of time to do something about it. We are not
blind to those issues; it just gives us an early warning.
Q528 Dr Turner: Can you tell me what
difference your relatively new obligation resulting from the Energy
Act to have regard to sustainable energy has made? How has that
altered your behaviour as a regulator?
Mr Buchanan: I think it has altered
our behaviour both internally and externally. Internally, we now
ensure that every IA that we do, before we set out on a major
policy or project, includes an environmental step where we have
to judge what the environmental issues and consequences are. We
have also changed the shape of our environmental team internally,
so that the environment is now very much part of Steve's Markets
division, so that everything we do within the markets has an environmental
viewpoint, so that we include that. Internally we have very much,
I think, captured that. Externally I think it is best seen in
some of the decisions that we have made in the last year. On the
distribution electricity price review that I mentioned just now,
we spent a good deal of time looking at distributied generation.
We also introduced for the first time undergrounding allowances
for the companies so we are looking to take that into account.
On the high voltage area, and again you discussed this with National
Grid when you were talking about this Beauly-Denny line, the Inverness-Glasgow
line, this has been part of the fast-forwarding that we have allowed
on capital expenditure. We have allowed £560 million-worth
of network capex to be fast-forwarded; by that I mean that companies
do not have to wait until the next five year price review. They
have come to us, made a case. There are four major projects, Beauly-Denny
is one of them, to which we have given the green light. That means
they get full funding. There is then an amber light, which is
another set of five projects which gets R&D funding and will
be allowed for pass-through. Then there are the remaining projects
which have been presented to us, which have not yet met a basic
cost benefit analysis test but if they do, we will look at them
and see whether we make them amber or green projects. I think
across both our decision-making and also our internal approach,
we very much want to show that we take and are seen to be taking
our sustainability duty seriously.
Q529 Colin Challen: Do you think that
your five year price review process actually stands in the way
of developing your long-term strategy for sustainable energy?
Indeed, you recognise in your memorandum that many market participants
feel that the Government signals are all short-term. The five
year thing is also short-term, is it not?
Mr Buchanan: It is a really interesting
question, because after the last price review we went out to the
companies to do a post-event review and I thought one of the issues
that was going to come back was that we are too short-term on
the five year review. I think perhaps that the companies did not,
because on some of the key criteria, like capex, where quite clearly
we are looking at the long-term view because we are having to
adjudge if we are awarding a 48% increase in capex, that this
is the right moment in the cycle and therefore we look both backwards
and forwards, but also we looked at a long-term cost of capital
signal, because the worry for the companies is that the moment
when they need to spend a vast amount of capital is the moment
when the cost of capital has dipped and therefore they are not
going to get rewarded against assets that have a 50 year life.
I sensed that perhaps the feed-back from the companies was more
relaxed about the five year profile because of that, because they
felt that we did take that into account. I think it is a very
good point that you make and we are about to put out our consultation
for the gas distribution price review which runs in 2007 and we
have invited, again, any comments from people who think that five
years is too short, although I should, just as a rider to the
gas companies, say that in 2002 the gas companies and Ofgem at
the time agreed a 30 year gas planning horizon, so in gas it has
been built in over that kind of horizon.
Q530 Colin Challen: We have had a number
of witnesses who have argued that the price review is fundamentally
flawed, in the way in which it focuses on asset values. Do we
need to have a more responsive regulatory structure that promotes
longer term investment, particularly looking at a distributed
technology aspect, such as micro-CHP?
Mr Buchanan: What we have tried
to do in the one review where we have been tested, as it were,
was to put in place some real incentives for companies to come
forward with plans so on distributed generation we have allowed
80% cost passed through and an 11% rate of return. That stands
against the 6.9 return that they would get from the regulated
business. So we are really trying to say, "Look, have a go.
Get involved, because we are going to, as it were, tilt the return
for this business to give it that kind of promotion at the beginning."
We are trying to do that. It may be not enough and, again, I would
very much welcome your views, either carried in your formal report
or privately after this meeting.
Q531 Colin Challen: What stage are we
now at with regard to the price review process? Is it now fixed
in stone for the next five years?
Mr Buchanan: For electricity distribution,
it is, unless there is a major change, frankly, in terms of a
political decision and then we would have to re-open. As far as
the high voltage transmission is concerned, that is our bread-and-butter
work for next year, and then the gas distribution companies is
our bread-and-butter work for 2007 and the plan currently is that
they will run for five years.
Q532 Emily Thornberry: The energy market
over the last few years could really be characterised as somewhat
boom and bust. We have had 1998 to 2003, and now we have got,
it seems, a reversal of those trends. This is not sustainable,
is it? This has grave impacts on not just what you are trying
to sort out for your policy but also has great impact on the market
and how we are ever going to ensure that we have proper investment?
Mr Buchanan: I think the only
time so far that the market has been seriously tested as to whether
it would react as you would expect a market to react is when the
reserved margin fell from 30% in 2001 to 16% in 2003 and you saw
a price fall from just short of £30 per megawatt/hour down
to £14 per megawatt/hour. You are right; there was that very
sharp decline as effectively excess margin was driven off the
system, which was always one of the reasons for moving to the
new style market at the turn of the decade. The interesting feature
though is that, as that price went down, plant came back on and
therefore the price started to go back up, which signalled that
price could come back on. Therefore we have ended up with a reserve
margin around 20% to 21%. The market has been tested, you are
right, and we saw a very precipitous fall as the new market was
introduced. I think, quite frankly, the prices that have been
driven now, that are causing such great concern to the fuel-poor,
we have just seen price increases put through by all the companies
around 10% to 15%, that is another 400,000 plus on the fuel-poor
level. The price increases that have just been put through are
being driven by the raw material price. Coal prices last year
went from £35 per tonne to £70. Your gas price has gone
through the roof on the back of the oil price. It is small comfort,
but Holland, which is a gas marginal country like ours were up
64% gas price on the year; they are up 60%. It is not being driven
by foul play either by parties within the market place or by contracts,
and to give consumers some comfort there, Steve's team have carried
out two major reviews in the last 18 months to ensure that in
fact there was not either a contract causing the prices to go
up or a degree of collusion and bad play by the players in the
industry. So to the degree that I can give consumers comfort,
that is where we have got to try and give them comfort but quite
clearly, with these global price movements in coal, oil and gas,
it is deeply uncomfortable. If you look to other countries in
Europe—Scandinavia has driven off hydro, so it is obviously
a different profiling for them, Germany has driven off nuclear,
lignite coal and hard coal—so again they do not have this
pressure that we have on electricity prices which is driven by
gas. It is very uncomfortable. You are quite right to point it
out.
Q533 Emily Thornberry: At the beginning
of your submission you state what your objectives are and you
state that your objective is to protect the interests of present
and future gas and electricity consumers wherever appropriate,
by promoting effective competition. We do not seem to be getting
particularly effective competition at the moment, given the way
in which prices are going up and down and, furthermore, and in
any event more importantly, we are facing the big challenge to
our generation, which is climate change. Should not your objective,
as you are supposed to be looking after the interests of consumers,
be looking after us in terms of our long-term future and ensuring
that decisions are being made with the future of the planet in
mind as your primary objective?
Mr Buchanan: If I may perhaps
just deal with prices and then ask Steve to deal with the question
you are asking which is, "How far do you go on sustainability
in terms of a just society?" and things like that. I do not
like using these examples, because it sounds as if I am not worried
about the impact in the UK, but at the weekend I looked around
the world to see what was going on in price movements. In the
regulated environment in Colorado and in Georgia, Colorado had
just put up their prices by 30%, Georgia put up their prices by
17%. You are seeing major price increases going through both regulated
and non-regulated environments. It is very uncomfortable. Texas,
I was reading some research at the weekend, is an unregulated
market, but they are seeing a 100% increase in gas prices this
year. It is very uncomfortable.
Q534 Mr Ellwood: That is actually because
of very recent events that have taken place there. It is not the
same context that we are talking about. That has been happening
long-term.
Mr Buchanan: In fact, gas prices
have been going up markedly in the US and to the point that, last
year, wind farms were being run as more economic than gas stations
in certain states. There have been major increases in the US and
of course the US also burns a lot of coal and therefore they have
also been impacted by that very high increase in raw material
prices on coal. It is uncomfortable talking about these examples,
because it may sound that we do not care.
Q535 Mr Ellwood: That will have a massive
effect on the entire energy market in America. That is why I am
saying the comparisons you are giving are entirely out of context.
Mr Buchanan: The price increases
for Colorado and Georgia went through before.
Q536 Mr Ellwood: And for Texas?
Mr Buchanan: For the Texas price,
you are quite right, that was an impact on the back of Hurricane
Katrina.
Q537 Chairman: We are out of time. I
am sorry. It has been interesting and helpful. We are grateful.
We may have a couple more questions for you. I was going to ask
you, for example, whether you thought it was necessary to have
an energy review, only a couple of years after we had an Energy
White Paper.
Mr Buchanan: Would you like us
to answer that in writing?
Q538 Chairman: You can answer it now
in two sentences.
Mr Buchanan: My two sentences
would be: one, I think we have got an energy review on-going anyway
with DG Comp's of liberalised markets. Two, I would agree with
you that we have recently had a review. I think the pros and cons
of a new review are the pro, there is a degree of uncertainty
being created at the moment and I think markets and capital markets
are unsure because of that. The con is, we would argue that the
markets are working pretty well and therefore what was hoped for
in the White Paper is largely being delivered and that the commitment
to markets in the White Paper which is very important, we see
as part of our role as taking that through.
Chairman: All right. Thank you very much
indeed. We will be in touch.
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