Select Committee on Trade and Industry Written Evidence


APPENDIX 54

Memorandum by UK COAL

1.  INTRODUCTION TO UK COAL

  1.1  UK COAL is the largest coal mining company in Britain. Over 85% of UK COAL's sales are to the electricity sector, supplying approximately 20% of all coal burnt at power stations in England and Wales. UK COAL makes an important contribution to the UK's energy needs, providing approximately 7% of total domestic energy demand for electricity generation and producing an output of 10mt of coal in 2005.

  1.2  UK COAL very much welcomes the extension of this inquiry's remit to examine the implications of the increasing dependence on coal imports. We believe that this is a crucial issue in the Government's decision-making about future energy supply, and we are pleased to be able to submit evidence to this inquiry.

2.  EXECUTIVE SUMMARY

    —  Britain's reliance on imported coal is growing, and is projected to grow further. Most of this coal is imported from Russia and South Africa.

    —    Domestic deep-mined coal can provide a secure energy supply to electricity generators at competitive prices—this offers a valuable hedge against international market volatility and security of supply issues.

    —    Deep-mined coal requires more investment than is possible from the current market, which has undervalued domestic coal supply. Changes in market behaviour will open the door to private financing of the deep-mined industry.

    —    Government help is needed to facilitate new contract arrangements and create a level playing field between producers and generators. A Government-sponsored mechanism which is acceptable within current EU and UK law can help facilitate this process without the need for state aid. We recommend a Government Coal Contracts Panel as a suitable mechanism.

3.  COAL IS A VITAL PART OF A SECURE, RELIABLE AND DIVERSE ENERGY MIX

  3.1  The UK's energy policy must recognise the value of indigenous deep-mined coal and its contribution to a secure, reliable and diverse energy mix. Coal is forecast to be required at 2005 quantities in the UK over the next 10 years to satisfy electricity demand.

  3.2  Based on the latest DTI projections, coal will provide around 17% of total energy needs and around 34% of electricity generation over the next ten years. In the same period, coal consumption for power generation in the UK is forecast to remain at around 50-60 million tonnes per annum. Coal-fired power stations will run at consistently high load factors.

  3.3  The value of coal was shown most starkly last winter, at a time of great instability in international gas supply, when around 50% of entire electricity generation for the period was provided by coal-generated capacity. This may continue to be the case for the foreseeable future if as expected gas prices remain high.

4.  FUTURE INTERNATIONAL ENERGY MARKETS ARE POTENTIALLY VERY VOLATILE

  4.1  The current international coal market is putting increasing pressure on prices. The vast majority of our coal now comes from Russia and South Africa—with growing world demand there is no reason to believe this situation will change. The following illustration (Fig 1) shows the world coal export market in 2004 (the latest figures which are available).


  4.2  The situation has become even more pronounced since 2004. In the past two years, world coal demand has increased by 100 million tonnes. Almost all of the Australian coal supply has switched to China, whose rapid economic development is consuming vast new quantities of power. Similarly, the majority of South African coal exports have switched towards India and China. Colombian coal exports have been almost exclusively taken by the USA. Increasing Indonesian production is mainly satisfying growing Chinese demand. As a result, Russian exports to the UK have increased significantly, but the rapidly expanding Chinese market is likely to divert some of this Russian coal away from Europe.

5.  DOMESTIC COAL CAN PROVIDE A BUFFER AGAINST UNCERTAIN WORLD COAL AND GAS PRICES

  5.1  Government must recognise that public policy priorities for security of energy supply and affordable electricity must take priority over the short-term commercial interests of individual generators. The Government must ensure that the UK's energy policy supports new market frameworks which are conducive to a long-term domestic coal mining industry and not short-term purchasing decisions by generators.

  5.2  In the global context, domestic deep-mined coal can provide some real benefits to the UK's energy mix. At a time when energy imports for power generation are forecast to rise year on year to around 75% of requirements by 2015 (DTI figures), indigenous coal provides both price certainty over increasing international market volatility and a secure supply from local sources. As existing coal fired plant is fitted with Flue Gas Desulphurisation and new clean coal capacity is built to replace the retiring coal fired fleet, higher sulphur UK mined coal will become increasingly desirable.

  5.3  Assuming that energy supplies from Russia remain relatively stable in the medium to long-term, a future for UK electricity generation without domestic deep-mined coal looks difficult. Imported coal volumes would increase, putting pressure on prices, increasing costs above forecast levels with a knock-on to power costs. Furthermore, the UK's import infrastructure and rail capacity would require substantial investment in order to enable larger volumes of imported coal to be transported effectively.

  5.4  The current forecast published by Number 10 on 16 May 2006 (Figure 2), shows that sustained levels of coal burn will be required over at least the next ten years, when new energy sources may come on stream. However, were domestic production to fall significantly, it has to be questioned whether the UK would be able to secure coal to meet demand at prices below the cost of deep-mined coal over the next 10 to 15 years.


  5.5  UK COAL is currently facing investment decisions to access new coal reserves which need certainty over proceeds to allow the investment to be made. With appropriate contracts, UK deep-mined coal will be in a position to provide 8% of the UK's energy supply going forward. This contribution could prove crucial at a time when 75% of our energy is being imported, particularly given the potentially unstable nature of imported gas and coal.

6.  A REVIEW OF CONTRACT STRUCTURE AND THE COAL MARKET IS NEEDED IMMEDIATELY TO SAFEGUARD FUTURE DOMESTIC SUPPLY

  6.1  Approximately 300mt of deep-mine coal reserves could be accessed from the seven remaining collieries at affordable and stable prices below those projected for coal imports. This is subject to immediate and ongoing capital investment, which if not forthcoming, effectively precludes future access. The first of these immediate issues will face the company at Harworth colliery.

  6.2  Deep-mined coal reserves represent a reliable and secure source of indigenous energy with existing planning permission and which can be extracted over the next 15-30 years, obviating the need for increased levels of imports at increasingly higher prices. It is the level of import prices together with an appropriate estimate of the associated future transport costs, and the ability to contract at these levels for future reserves, which is the key area of concern for domestic producers.

  6.3  A failure to invest in existing deep-mine infrastructure will result in the continuing decline in production to potentially just 4mt per year from 2008 from existing accessible reserves of 57mt. A review of coal contracts and the operation of the coal market is now urgently needed if the domestic industry is to access the financing required to invest in deep mining beyond this level of existing limited reserves.

7.  EXISTING CONTRACT ARRANGEMENTS ARE BASED ON THE FLAWED ASSUMPTIONS OF A FAILED MARKET, WHICH DOES NOT RECOGNISE THE VALUE OF DOMESTIC COAL

  7.1  One of the major problems with existing contract arrangements is illustrated in the graph below. This shows the difference between prices paid for coal imports (the ARA price index) and domestic coal since 1995.


  7.2  Up to 2000, the market priced and correctly valued deep-mined coal as the last incremental tonne of generation capacity. This was correct in a market where coal imports could not satisfy demand due to port and rail capacity constraints. The creation—and subsequent demise—of the DTI Price Parity Panel in 2000 ended this as it benchmarked domestic coal prices to imports for the purposes of Coal Operating Aid.

  7.3  At this time, the market was based on assumptions which have subsequently turned out to be inaccurate—UK coal burn has not fallen as expected; coal import levels are far higher than predicted; and government aid has not provided the level of financial security to the industry that was intended. Furthermore, assumptions on the transportation costs of imported coal were far lower than the reality has borne out, with the result that the true (delivered) cost of imported coal has been much higher than predicted. Domestic prices have also been limited by the industry-wide presumption that indigenous supply should be priced against the delivered price for imports at optimal ports only, whereas current reliance on imports has meant that non-optimal (and therefore more expensive) ports have been used to transport imported coal.

  7.4  As a result, domestic producers were forced into long-term fixed-priced contracts with generators who commanded prices that reflected neither market value nor the true value of domestically-mined coal.

  The effect of this failure of the market has been that since 2000, generators' purchasing strategies have consistently failed to recognise the benefits of domestically-mined coal, such as reliability of supply, proximity to suppliers, and the hedge value it can provide against international market volatility. A failure to break this behaviour model has resulted in generators' continuing to determine prices for domestically-mined coal at levels below international market rates, as Drax has made clear in recent public statements:

    "Drax's current procurement strategy is to purchase domestic coal at below the international market price and international coal at or just below the international market price to back power sales".

    Drax prospectus, p 46

    "Drax experiences less volatility in the UK coal market than in the power market as Drax typically enters into long-term supply contracts with UK suppliers, including UK COAL, and can leverage its buying power".

    Drax annual report 2005 p 14

  7.5  The current market structure for domestic coal therefore places disproportionate power in the hands of generators to determine contract terms and prices, leaving coal producers unable to agree prices which correctly value domestic deep-mined coal. This additional uncertainty and discount represents a further significant barrier to investment, and undermines the potential for secure domestic coal supply to underpin a more secure and diverse national energy policy.

8.  SOLVING THE PROBLEM REQUIRES CONTRACTS THAT REFLECT FAIR AND COMPETITIVE MARKET CONDITIONS, THE VALUE OF DOMESTIC SUPPLY, AND A LEVEL PLAYING FIELD FOR NEGOTIATIONS

  8.1  An immediate solution is required to allow new contracts to be negotiated which recognise the value of domestic deep-mined coal, create a more equitable price negotiating framework between producers and generators, and allows producers to raise the capital investment required to access new coal reserves. Key requirements are:

    —    Appropriate term.

    —    Colliery/colliery group-specific.

    —    Appropriate pricing.

    —    That existing contracts are reshaped so as not to impinge on new investments.

  8.2  With the change in energy markets in recent years and increases in expected coal burn and the price for energy, the deep-mining industry does not need aid, it needs to ensure a fair price for its coal now and in the future.

9.  HOW GOVERNMENT CAN HELP

  9.1  The Government should consider a Statement of Need for the domestic coal industry as part of the outcome of the energy review process. In the same way that the Secretary of State for Trade and Industry recently published a Statement of Need for new gas storage capacity, so too should the Government similarly recognise the role of domestic coal in the energy mix, particularly over the next 10 years.

  9.2  It is vitally important that a relationship between generators and producers is created which recognises the need for a secure domestic coal supply as part of the UK's energy policy. This must recognise that substantial investment will be needed in the deep-mined coal industry, and that this will not be available from the capital markets unless appropriate contracts are in place.

10.  PROPOSED SOLUTION MECHANISMS

10.1  Coal Contracts Panel

  A Coal Contracts Panel should be established to help facilitate new contract agreements between coal producers and electricity generators that reflect a competitive market, do not discriminate against any one party, and provide adequate flexibility for commercial negotiations between parties. DTI should consider the remit and terms of reference for the Panel, including:

    —    establishing a rationale and forum for determining long-term coal price forecasts, which should recognise the benefits of domestic coal supply including reliability benefits, hedge value against ARA, UK seasonal requirements, transport infrastructure constraints, predictability of supply from surface-mined sources, and long-term supply assumptions from import markets.

    —    calculating a long-term price benchmark for indigenous deep-mined coal which recognises the value of domestic supplies as a basis for flexible commercial negotiations between producers and generators.

    —    creating an industry code of practice or memorandum of understanding between industry and the Government which provides a framework for contract agreements based on price expectations for both transport and international coal prices, and a mutually agreed understanding of what constitutes a fair and economically-viable market for both parties.

    —    consideration of the viability of current contracts between producers and generators and to make recommendations on revised and sustainable contracts which ensure economic viability for producers and do not disadvantage generators.

    —    ensuring a level playing field between generators and producers so that no one party is able to use a dominant market position to determine prices and contract structures that are uneconomical.

    —    acknowledging that the function of the Panel is not to recommend or introduce any form of aid or subsidy to the UK coal industry.

  10.2  The Coal Contracts Panel represents one suggestion for a potential framework which would function to establish new market structures and ensure the long-term viability for the UK coal industry. The DTI may wish to consider alternative delivery agencies as part of the energy review in order to ascertain the most effective means of satisfying policy objectives within current or new legislative frameworks and also the apparatus of government.

  10.3  For example, the Government may wish to explore the possibility of extending the remit of OFGEM to cover fuel input, and legislate to allow OFGEM to regulate the relationship between coal producers and generators to ensure UK energy policy meets policy goals, and ensures appropriate contract arrangements for domestic deep-mined coal producers are in place.

  10.4  Any mechanism or policy framework which is established to help deliver these objectives must of course concord with the provision of both domestic and EU law. It must be recognised that such a mechanism, its functions and outcomes, must not contravene EC free market regulations, state aid law or EC competition rules. Any form of intervention must also ensure that no discrimination applies unduly to any generator or producer operating in a similar situation.

  10.5  Recently commissioned legal counsel has confirmed that it may be possible to introduce such a mechanism subject to the prescriptions of existing law. It will be important for DTI to work with producers and generators to construct a workable and legal solution which satisfies both the demands of existing law and UK energy policy goals. In particular, we believe that the principles outlined in this paper are wholly consistent with the principles of the EC Electricity Directive and in fact correct a currently existing market distortion which, if it were to continue, would hinder the achievement of the Directive's aims; namely to achieve a competitive, secure and environmentally-sustainable market in electricity.

  10.6  Moreover, we believe that the solution mechanisms that we have outlined would not fall within competition prohibitions set out in Article 81 of the EC Treaty, but even were this issue to be raised, we would feel that the solution would clearly fall within the exemption categories set out in Article 81(3).





 
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