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 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:
— Colliery/colliery group-specific.
— 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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