Letter from Scottish Power
Thank you for your letter of 19 September inviting
comment on the relationship between wholesale and retail energy
prices over the last year, and the prospects for prices looking
forward.
Whilst I understand your desire to look particularly
at the period since December 2005 when you last reported on this
subject, it is nevertheless necessary to consider a longer period
to get a representative picture of the relationship between wholesale
and retail prices given that retail prices tend to lag movements
in wholesale prices by many months.
Prices for what we call annual "flat gas"
(ie where a constant volume is taken every day over the year)
increased from approximately 19.8p per therm in January 2003 to
52.2p as I write this letter. That is an increase of 164%. Over
the same period, the Scottish Power domestic gas price has increased
by 94%. Our competitors face the same wholesale price increase
and all, to greater or lesser extent, have increased their domestic
prices by a lower percentage than the wholesale price increase.
ScottishPower is able to do this because we
hedge our position by buying in the forward market up to two years
ahead, so that all our gas is not costing the latest wholesale
price. This allows us to average out the volatility present in
wholesale markets and to hold retail tariffs stable for longer
periods. Under this approach retail prices do not immediately
follow wholesale prices up; neither will they immediately follow
them down. At the time of writing, the retail price does not cover
the latest forward wholesale price—even after the
recent softening in wholesale price which has received much comment
in the media.
The period since January 2003 has been one of
sustained increases to wholesale prices. By January 2004 the forward
price had risen to 23.8p per therm, by January 2005 to 31.5p and
by December 2005 had reached 61.8p. This buying policy allowed
us to delay retail prices increases. However over time the retail
price needs to fully reflect the wholesale cost or our business
becomes unsustainable. The lack of a full pass through of the
wholesale price to retail customers in recent years has directly
impacted the profitability of our business—in simple terms
we have delivered a return on our retail business well below our
cost of capital.
Since December 2005 the annual forward wholesale
price moved up to reach 67.1p per therm by the end March 2006
before more recently falling to its current level of 52.2p. This
reduction in gas price in part reflects a fall in world oil prices,
as well as more optimistic market sentiment on future gas supplies
from the Continent and Scandinavia. The latter reflects improving
news on new infrastructure developments bringing gas into UK,
relieving some of the market anxiety over shortages this winter.
Of course whilst physical infrastructure is a positive development,
it remains to be seen whether gas actually arrives in the UK when
most needed. Last winter demonstrated the fact that European energy
markets are not as open as that in the UK—gas did not flow
through the interconnector when the price signals clearly indicate
that it should have. We have been active, together with other
UK-owned energy companies, in taking our support for a single
competitive energy market with increased transparency to the EU.
The position on retail pricing is that at today's
wholesale price we are making losses in our retail energy business.
Our current retail tariff is based on our weighted average cost
of gas that, as I explained above, reflects longer term buying
so we are not sustaining losses at present and retain some benefit
from gas purchased at lower prices. However, if no further reduction
in wholesale price eventuates, we will have no alternative but
to increase retail prices further. In fact, wholesale prices will
have to drop further, and stay lower for a sustained period, simply
to hold our present retail tariff.
It is also appropriate to mention the impact
of two further factors. The first is the cost of the Government's
Energy Efficiency Commitment, which is costing our customers approximately
£50 million per annum and, based on statements from DEFRA,
could increase to in excess of £100 million per annum from
2008. The second is the increasing cost of bad debts which reflects,
inter alia, the changing attitudes to credit and the resultant
loss of stigma associated with bankruptcy or IVA, the increasing
number of customers who leave premises without a forwarding address
and the heavy restrictions preventing the industry from readily
disconnecting customers who have the resources to pay but fail
to do so.I understand that various bodies have called for tariff
cuts now. Such calls fail to recognise the job that suppliers
have done in shielding customers from the worst effects of the
unprecedented rises in wholesale price. Whilst this may be a politically
unpalatable message to convey when retail prices have increased
by large amounts over the past 18 months, it is nevertheless true
and can be readily demonstrated.
The situation for business customers is somewhat
different in that prices have increased more in line with wholesale
costs with much less of a lag. The result is that their prices
are already closer to the wholesale price. Most industrial customers
have annual contracts and should start to see the impact of falling
wholesale prices—provided the fall is sustained—when
their contracts come up for renewal. There will be some customers
who have entered into longer-term contracts and they may see increased
costs compared to prices struck, say, two years ago.
The above picture uses only "flat gas"
prices and it is important to recognise that domestic customers
clearly do not use gas in that way. They have a very seasonal
usage pattern but also with significant shifts in usage between
one day and another, largely determined by weather. As well as
generally higher wholesale prices, we have witnessed an increase
in price volatility and this volatility has a high cost impact
on servicing domestic customer demand. For example, in March 2006
we had a cold snap where our domestic demand increased by 50%
compared to seasonal normal and at the same time we had gas prices
as high as £2.50 per therm—Retail tariffs have to cover
this very real volatility cost increase as well as the increase
in "flat gas".
Looking ahead, our view is that wholesale prices
should, with further action by the Government and the EU, fall
further and align more closely with those prevailing in continental
Europe. We do, however, believe that volatility will remain high
because of the decline in UK Continental Shelf production, which
is the source of much of the UK's ability to absorb daily and
seasonal changes in gas demand. Additional gas storage capacity
will be required to fulfil this buffering role in future, but
this is unlikely to be available for some years, primarily due
to planning constraints. In addition, there remains the risk of
significant volatility in global commodity markets as a result
of the threat of continued geopolitical instability, particularly
in the Middle East, and this has the potential to place upward
pressure on UK gas prices.
The electricity wholesale price is closely linked
to gas given the extent of generation from Closed Cycle Gas Turbine
plants. We therefore. believe, that as the wholesale gas price
falls, the power price may also reduce. However, there is a clear
need for substantial new investment in UK generation capacity,
and current electricity prices coupled with the lack of a long-term
framework for carbon pricing do not provide a sufficient return
to bring forward this new investment. That means that industry
earnings from generation will need to increase to fund investment.
If that substantial investment does not take place between now
and approximately 2011, the historic balance where available supply
has exceeded peak demand by some 20% will no longer be sustained.
We believe that the result of this will be an increased level
of volatility in power prices at times of peak demand.
In conclusion, absent further geopolitical instability
we see a backdrop of easing wholesale prices, although in relative
terms these will remain at high levels compared with the 1990s.
In addition we see price pressure flowing from increased commodity
price volatility, a reduced margin of supply over demand and environmental
obligations introduced by the Government. We further believe that
reductions in demand from changes in consumer behaviour can play
a real part in relieving some of these pressures, but that any
step change in this area requires a rapid Government-mandated
national roll-out of smart metering.
4 October 2006
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