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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