Select Committee on Trade and Industry Written Evidence


Letter from EDF Energy

  EDF Energy is one of the UK's largest energy companies. We are a vertically integrated company with a balanced portfolio of business throughout the energy chain—from generation through to supply. Most pertinent to this inquiry:

    —  EDF Energy is a major supplier of gas and electricity, with over five million electricity and gas customer accounts throughout the UK.

    —  We own and operate the electricity distribution networks serving London, the East and South East of England, which means that around one quarter of the UK population relies on our distribution networks for their electricity. This makes EDF Energy the largest electricity distribution network operator in the UK.

    —  We are the fifth largest electricity generator in the UK. We own and operate an 800MW CCGT (combined cycle gas turbine) power station at Sutton Bridge and 4 GW of coal-fired generation assets that are currently being fitted with Flue Gas Desulphurisation equipment as well as CHP and renewable generation assets.

    —  We are a major owner and provider of private electricity infrastructures in the UK including those for the major London airports, the London Underground, the Channel Tunnel Rail Link, the Docklands Light Railway and Canary Wharf.

    —  We are part of EDF Group, a leading European utility and a world leader in nuclear generation with over 40 million customers across the world.

  EDF Energy is committed to finding the right balance between providing sustainable financial returns and investment.

EXECUTIVE SUMMARY

    —  The margin on both fuels has shrunk considerably over the past year and for gas has been negative at some points in 2005 and 2006.

    —  The gas forward curve suggests that the price of wholesale gas will ease after this winter.

    —  Electricity prices are highly correlated to gas prices and should show a similar pattern.

    —  But there are still elements of risk—reflecting significant current uncertainties—in the forward view for prices in both fuels.

    —  The rise in long-term prices that has occurred in the past few years is partly due to the market beginning to signal the need for the major energy infrastructure investments that are required over the next 20 years.

    —  Our strategic approach to buying forward has, to some extent, reduced the impact of very high wholesale market prices on domestic and small business customers.

    —  For EDF Energy, the full effect of electricity wholesale price rises has not been seen in increased generation profitability, because generation profits are, in effect, used to mitigate price rises in the domestic and small business market.

HISTORIC WHOLESALE AND RETAIL ENERGY PRICE EVOLUTION

  Figures 1 and 2 below plot annual wholesale costs (£/MWh) against the average UK annual bill (£/MWh) from January 2001 to September 2006, averaged across all suppliers, PES areas and payment types for gas and electricity.[1] Consumer bill data is fully inclusive of all costs.[2]

Figure 1

Figure 2

(Source: Heren and Argus reports)

  The data clearly show that there has been a major difference in percentage movements in wholesale costs when compared to consumer prices with a 171% cost increase in wholesale gas prices matched with only a 106% increase in average gas bills. Similarly, wholesale prices in electricity have increased by 139% with only a 59% increase in electricity bills.[3]

  As a result, the margin on both fuels has shrunk considerably over the last year and for gas has been negative at some points in 2005 and 2006. This has resulted from a time lag in wholesale price changes being reflected in bills, in part arising from competitive market pressures. Whilst margins are returning to levels more akin to those of 2003, there is still a margin shortfall that suppliers have experienced, arising from not fully passing through to customers the full impact of the increase in wholesale prices (see section on Prospects for Retail Prices for more detail), which suppliers may see the need to recover.

PROSPECTS FOR WHOLESALE PRICES

  Figure 3 below shows that the forward curve (ie today's price for future delivery) is currently trading below 2005-06 prices. However, the sharpness of the recent decline does not continue into future prices and a more gradual decline is evident. This leaves prices significantly above closing 2004 levels, largely because of gas prices in Europe indexed with oil that in turn are supporting higher wholesale prices in the UK.

  The gas forward curve suggests that the price of wholesale gas will ease after this winter as new import capacity in the gas market combined with additional sources of gas (eg Ormen Lange) increase supply margins in the UK gas market. There is still a risk premium in the gas that is available to cover demand for winter 2006-07, which reflects uncertainties about the utilisation of new capacity this winter (there are no additional significant sources of new supply until Ormen Lange comes on stream in October 2007). This premium has decreased recently as the commissioning of new infrastructure to schedule has been confirmed and with the return of the Rough storage facility to service.

  Electricity prices are highly correlated to gas prices and show a similar pattern, although uncertainty surrounding the price of CO2 in the EU Emission Trading Scheme (EU ETS), in particular in phase 2 which commences in 2008, provides a further element of risk in these

Figure 3

  The UK energy sector requires major investment over the next 20 years to replace closing oil, coal and nuclear generation capacity and to secure new gas supplies to replace declining production from the UK continental shelf. A key factor in securing this investment are forward prices in a competitive wholesale market that will provide an acceptable rate of return to investors. The rise in long-term prices that has occurred over the past few years is partly due to the market beginning to signal the need for this investment. An equilibrium needs to be reached in which both competitive prices for end consumers and acceptable rates of return to investors are maintained.

PROSPECTS FOR PRICES TO END CONSUMERS

  In order to secure supply and reduce exposure to the volatility of wholesale prices, EDF Energy puts in place forward contracts to fix prices over a medium term period for a large proportion of their expected domestic and small business demand. The proportion of domestic and small business demand covered by this hedge progressively reduces further out in time. The residual un-hedged volume reduces progressively as real time is approached, with incremental purchases made at regular intervals at prevailing market prices. This form of hedging strategy with small regular incremental purchases smoothes the impact of wholesale price changes as the cost of the energy sold to domestic and small business customers at any point in time is made up of the weighted average of purchases that have occurred over a long period of time (which could be as much as several years in duration).

  This form of strategy, in part, enables price increases to domestic and small business customers to be limited during periods of increasing wholesale prices as the average energy cost includes wholesale purchases made several years ago when the forward curve was lower. This lag effect is clearly visible in Figures 1 and 2.  The converse, however, means that the costs of energy procured for domestic and small business customers going forward will include a component of energy purchased in earlier periods when the forward curve was higher than it currently is. Therefore domestic and small business customers will continue to see the impact of the high wholesale costs in the forward curve experienced in 2005 and 2006 feeding into domestic bills in 2007 and perhaps 2008.  This form of forward purchase strategy by suppliers provides market signals for new investment and insulates domestic and small business customers from short-term market volatility.

  In contrast to domestic and small business customers, the buying behaviour of the large industrial and commercial (I&C) customers requires suppliers to adopt a different hedging strategy. Typically, most large I&C customers are only prepared to enter into short term contracts. Suppliers risk very large volume swings in their I&C portfolios depending upon their competitiveness in periodic contract rounds. It is therefore not appropriate for suppliers to employ the same hedging strategy for I&C customers as they do for their domestic and small business customers. Instead, suppliers usually lock in wholesale market purchases required to service these contracts when the contract is agreed at prevailing market prices. As these I&C customers renew their contracts, the pricing will reflect the actual wholesale prices prevailing at the time.

THE ROLE OF VERTICAL INTEGRATION

  It is also worth commenting on the role of vertical integration. Some critics have suggested that all vertically integrated companies are benefiting significantly from wholesale price rises by putting up residential (and industrial) prices whilst making more profits in their wholesale business, thus improving the overall profitability of their business. This is not the case for EDF Energy. EDF Energy has no upstream gas assets and takes full account of the profits made by its generation business when setting tariffs. Generation profits are in effect used to mitigate price rises to our domestic and small business customers, with the highly competitive nature of the market limiting the level to which we can raise tariffs. It is also worth noting that recent rises in the input fuels of coal and gas have increased the costs of generation. The introduction of the EU Emissions Trading Scheme in January 2005 has also introduced the opportunity cost of CO2 as a further factor in wholesale electricity prices.

  So, whilst the wholesale price of electricity has risen, so have the costs: therefore the full effect of electricity wholesale price rises is not seen in increasing generation profitability.

4 October 2006



1   Annual year ahead wholesale prices; typical bill for the next 12 months. Back

2   Includes wholesale costs, transmission/transportation costs, use of system costs, Renewables Obligation, cost to serve, margin and VAT. Back

3   Percentage price changes measured from 03/01/2001 to 15/09/2006. Back


 
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