Appendix 1: Government response
Introduction
The Government welcomes the Trade and Industry Committee's
report as a useful independent investigation of the gas and electricity
markets.[2] In addition
to making several helpful practical suggestions for actions in
the short term, it makes many positive statements that should
serve to dispel a number of myths about how the markets work.
As the report recognises, the UK is in a substantially
different position now from even two years ago with regard to
its gas supplies. The supply/demand balance was tight for last
winter, and is expected to be tight next winter. This requires
a fundamental shift in behaviour of buyers and sellers if we are
to minimise price spikes in the future. It also bears repeating
that gas prices are currently to a large extent determined by
the price of oil, which has experienced some historic highs over
the past few months.
The Government takes the issue of high energy prices
extremely seriously and is very mindful of the hardship they are
causing for consumers, especially the energy-intensive industrial
sectors and the domestic fuel poor. There is a big challenge
ahead in ensuring the timely commissioning of new import and storage
facilities and in persuading our European partners to introduce
fully liberalised markets. We face a tough couple of winters,
but we have developed a range of measures to tackle the issues
and we are working with industry, consumer groups, Ofgem and across
Government to deliver these as a matter of the highest priority.
We are reassured that the Committee supported Ofgem's
view that there is no evidence that producers have withheld supply
from the market in order to drive prices up. We also welcome
the conclusion that the advantages of receiving information from
all major parties (including Norway) even on a voluntary basis,
outweigh any benefit from imposing any element of compulsion.
We are also pleased that the Committee has applauded the firm
stance that the Government has taken on the centrality of energy
liberalisation and the Lisbon Agenda.
Impact of price increases on business customers
1. The recent gas and electricity price rises
have created major problems for the competitiveness of UK manufacturing
industry. As the EIUG suggested, industry would be able to live
with these problems if it felt that the competitive disadvantage
would shortly disappear—after all, UK industrial consumers
have experienced a relatively long period of below average fuel
prices to offset the recent peak, and such fluctuations are an
integral part of a liberalised market. However, industry fears
that the autumn 2004 price spike will not prove to be an isolated
incident, partly because one cause of it was the lack of liberalisation
in European Markets which will not be rectified quickly, and partly
because it feels the spike has not been fully explained by market
fundamentals and is probably a symptom of serious market failure.
We believe such a failure could be attributed to supply side rigidities.
We return to this issue later. (Paragraph 24)
The Government takes the concerns over high energy
prices and whether the market is working properly very seriously.
The price spikes in the spot and forward gas markets have been
looked at by the Competition Authorities, who found no evidence
of market abuse. The DTI has commissioned its own work because
of the importance of this issue. The report on the Forward Gas
Market by independent consultant Global Insight concluded that
the price spike in September/October 2004 was a price excursion
rather than a serious market failure. Their analysis concluded
that the UK forward market is a functionally liquid efficient
hedging and trading market, free from market distortions and major
abuse, with efficient price formation outside of short spike periods.
We are working with others, especially the energy intensive users
and Ofgem, to see what can be done in the short term, but the
biggest long-term challenge is how to cope with imports from the
unliberalised EU into the fully liberalised UK market.
2. We accept that the overall statistics mask
significant price imbalances between individual UK companies and
sectors and their competitors in Continental Europe. However,
we note that Continental supply contracts also usually contain
provisions for a time lag of between three and nine months before
customers are affected by any price increases in the commodities
to which the contract is indexed. We suspect that I&C customers
on the Continent will soon experience higher prices for gas too—E.ON
confirmed that this was already beginning to happen in Germany.
This would reduce the competitive disadvantage experienced by
a number of UK companies. (Paragraph 15)
We agree with the Committee's view that it is difficult
to find up to date robust equivalents when looking to compare
energy prices in the UK with those seen on the Continent. We
have been in the forefront in pressing for further liberalisation
of Continental markets, which will lead to more liquid trading
markets which, in turn, will increase price transparency and comparability
between Member States.
3. Industrial customers continue to run the serious
risk of paying much higher prices for their energy if they opt
for the stability of annual contracts over the risk associated
with shorter-term contracts. They must make this decision for
themselves. However, we urge trade associations and the DTI to
work quickly to provide (especially smaller) business customers
with the information they need about options. We also think that
companies should seriously consider disconnecting their energy
contracts from the October renewal date: although annual contracts
should smooth out the seasonal price peaks and troughs whatever
the starting date, the effect of so many contracts being renewed
at the same time would tend to make it a sellers' market. (Paragraph
25)
4. In this context, we were pleased to hear from
the Minister that the DTI intended to hold a seminar early in
spring to enable I&C customers to discuss different purchasing
strategies and to share ideas on how they might reduce the problem
of the autumn price spike by smoothing out the bunching of contract
renewals. (Paragraph 26)
5. Universities and Public Sector bodies have
experienced particularly sharp price rises. We expect the DTI
to include them in the proposed discussions with industry on how
to cope with the price rise. (Paragraph 27)
The Government acknowledges that this is a challenging
time for many major users of energy, and we are in close and continuous
dialogue with the affected sectors. Further study has shown that,
while some participants do still rely on the old system of annual
contracts starting on 1 October or 1 April, there has been a significant
move towards more flexible contracts over the past year, in terms
of length of contract and in the dates when they are negotiated
and signed.
We would expect the EIUG and MEUC to provide guidance
to their members on different purchasing strategies, and for the
sector specific trade associations such as the CIA and EEF to
provide examples of best practice. However, there is also a role
for energywatch, with its remit for protecting the interests of
all consumers, not just domestic, to provide advice to some of
the smaller companies and public sector organisations. We are
considering organising a seminar over the summer with energywatch
and Ofgem to share ideas on flexible purchasing policies with
these smaller energy users.
The DTI hosted the seminar on Forward Gas prices
on 16 May. The seminar was attended by 40 senior and well-informed
representatives from a broad cross-section of bodies actively
involved in the forward gas market, such as producers, traders,
shippers, suppliers, consultants and a variety of end users from
industry, commerce and the public sector. The new Energy Minister
attended, gave a short address emphasising that he considered
the gas prices issue one of his major priorities, and listened
to the concerns of the intensive energy users and the public sector.
There was a good level of constructive debate and we drilled down
into the factors influencing the forward market. The Government
and Ofgem will be continuing the dialogue with end users with
a view to seeing what changes could be put in place before next
winter, and what other longer term steps could be taken to improve
the functioning of the forward gas market.
In addition to the representative bodies for the
end user sectors, such as the Major Energy Users Council, the
Local Authority General Utilities Resource (LAGUR), The Energy
Consortium (representing over 130 universities and colleges) and
the Institute of Purchasing and Supply, also invited to the Forward
Gas Prices Seminar on 16 May were: the Department of Health, the
Welsh NHS Trust and the University of Leicester. LAGUR also gave
a presentation on the Public Sector perspective, which proved
very stimulating.
The Office for Government Commerce (OGC) established
a Procurement Work Stream for energy in late 2004 in response
to the Gershon report. It has been talking to a number of large
Government Departments such as MoD and DoH, about how they do
their energy procurement, and is aiming to make recommendations
for doing things differently, e.g. strategic sourcing solutions
such as aggregation of small contracts. They are seeking to establish
an Energy Users Forum, involving all the main Government purchasing
departments, and to share best practice with other public sector
bodies such as LAGUR and The Energy Consortium. DTI will work
with OGC in developing purchasing guidelines and taking advantage
of their existing communication channels.
Impact of price increases on domestic customers
6. energywatch and the Fuel Poverty Advisory Group
advocated a number of actions that could be taken to mitigate
the effect of the price rises on poorer customers. We endorse
all these suggestions, which repeat our recommendations over a
number of years in our Reports on various aspects of fuel poverty.
It is clear that the long term solution to the problem of fuel
poverty must not rely on low energy prices. We note Ofgem's assurances
that some of the necessary responses are already happening—for
example, the development by companies of innovative tariffs, and
continued pressure by the regulator for companies to follow best
practice guidelines on dealing with customers in debt. (Paragraph
32)
7. However, more efforts are required. We particularly
emphasise the need for greater co-ordination within Government
to deploy key providers of public services (especially in the
fields of health, social services and social security) in the
task of identifying those in fuel poverty and informing them where
they can obtain advice and help. (Paragraph 32)
The Government shares the Committee's view that it
is important to increase efforts to target, reach and assist the
fuel poor, particularly those in vulnerable households. A good
deal of progress has already been made. Work will continue with
a range of organisations, within central Government and beyond,
to ensure there is a co-ordinated, and increased, effort to help
the fuel poor.
As the Committee recognises, low energy prices have
significantly contributed to the substantial decline in fuel poverty
since 1996. However, the Government has always taken the view
that fuel poverty cannot be eradicated by low energy prices alone:
that will require further energy and non-energy measures and
approaches.
The Government considers it important that households
have access to tariffs that minimise energy cost, and it encouraged
the development, and welcomes the introduction, of 'social' and
other innovative tariffs. Households should also be encouraged
to use the most appropriate payment method (usually direct debit).
The Government has also taken steps to improve the
energy efficiency of homes, particularly through changes to the
Energy Efficiency Commitment, Warm Front and Building Regulations.
Warm Front also offers Benefit Entitlement Checks (which have
increased household income by an average of £1,000 per annum
for successful claimants), which promote access to measures under
the Scheme as well as increasing household income. The industry
has also supported a range of individual fuel poverty programmes,
including the Warm Zones model, the pilot of which was funded
by the Government.
However, whilst key measures to address fuel poverty
are in place, the Government agrees that more needs to be done
to continue to target, reach and assist fuel poor households.
This entails improving and extending the way in which the lead
Government Departments work with, and co-ordinate the activities
of, a range of parties, including central and local Government,
the health service and the voluntary sector. There are three
main strands to this activity.
Within central Government, DTI and Defra have discussed
with DWP and DoH how to improve cross-Departmental involvement
in tackling fuel poverty. These discussions are geared towards
improving the reach, delivery and impact of fuel poverty messages
and measures, for example, by improving referrals between those
in contact with the most vulnerable and those delivering energy
efficiency schemes. Identifying and reaching fuel poor households
will be aided by, inter alia, DoH's Single Assessment Process
for those with multiple needs and DWP's LinkAge scheme. The recently
formed Health, Housing and Fuel Poverty Forum will encourage further
activity in the health sector. The Government is also considering
whether delivery of the Strategy could be improved by the identification
of fuel poverty 'champions' in local authorities.
However, individuals in need are often hard to reach
and help. The Government recognises that many of the organisations
with which individuals deal, and which they trust, are not within
central or local Government. The Government is, therefore, working
with the voluntary and care sector to establish what it might
do to improve advice to disadvantaged customers and promote take-up
of measures critical to removing households from fuel poverty.
These activities in turn link with a major initiative
being developed by the industry, following discussion with Government.
This involves the introduction of a Helpline for disadvantaged
customers. It is intended that the Helpline project will identify
the most vulnerable customers, assess how they can be helped and,
following one initial call, deliver measures that will provide
affordable energy. The Helpline, which will be accessible by
individuals or intermediaries, is due to be in place by October
2005.
The Government shares the Committee's appreciation
of the contribution that the Fuel Poverty Advisory Group and energywatch
have made to the debate about fuel poverty and the development
of the measures required to eradicate it. The Government will
continue to work with these and other key parties to deliver the
Strategy.
Social responsibility of production companies
8. Since we started this inquiry, a number of
oil companies operating in the UKCS have announced record profits.
These are multinational companies producing both oil and gas,
and it would be wrong simply to assume that much of this profit
is attributable directly to the dramatic increase in UKCS gas
prices. We also acknowledge that the production industry is subject
to a higher rate of Corporation Tax than other sectors. Some of
our witnesses advanced arguments for a windfall profits tax, but
we have received too little specific evidence on its potential
impact on future investment in the UKCS to report on this issue.
However, if the current very high levels of world oil and gas
prices continue and if a specific proportion of the profit can
be identified as coming from the UKCS, then we believe that the
Chancellor of the Exchequer should carefully consider the options.
We would prefer those companies that have benefited from the price
rises voluntarily to contribute to the alleviation of fuel poverty
as part of their Corporate Social Responsibility programmes: it
would enhance their reputation and would provide help more swiftly
to those who, though unable to afford it, are contributing to
their unearned profits. We do not expect the production companies
to set up fuel poverty programmes themselves—as they pointed
out, government agencies and the energy supply companies are much
better placed to identify those in need of help and deliver that
help. But we do not believe it would be difficult to devise a
mechanism through which they could donate money to such schemes.
(Paragraph 36)
We agree that any contribution from production companies
to deliver their own corporate social responsibility goals should
be made on a voluntary basis. We note that many offshore producers
are already either members of, or participate in programmes run
by, Business in the Community. This is an independent business-led
charity with over 20 years experience whose purpose is to challenge
business to improve continually its impact on society. Others
have their own programmes reflecting their social responsibilities
and charitable trusts. The Government believes businesses benefit
from a positive corporate social responsibility profile but that
it is very much up to individual businesses to devise their own
strategy for delivering this.
Decline of the UKCS
9. Because of the difficulties in extracting the—substantial—remaining
reserves of gas from the UKCS, it is not at all clear that the
decrease in production will take place in a managed and predictable
way. This simply highlights two points which we address later
in this Report: the need urgently to put in place infrastructure
to ensure that adequate supplies can be imported into and stored
in the UK to meet any shortfalls from the UKCS; and the need for
sufficient information to be supplied to the market about why
production rates are lower than expected, in order that the market
players can then take a more rational view of pricing. (Paragraph
42)
We agree with the Committee's views that the decrease
in production of the UKCS needs to be met with adequate storage
and import infrastructure projects. The Energy White Paper expectation
that market participants, in anticipation of future needs and
in response to price signals, will deliver these projects can
be seen with the number of planned projects already underway,
none of which have required any subsidy from the taxpayer. The
financial burden of risk rightly falls to the private sector businesses
who have most to gain from making these investments. We will
continue to ensure that the correct market framework is in place,
and this includes the markets being governed by an independent
regulator, so that market participants are appropriately incentivised
to make these investments while at the same time representing
the best value to GB customers.
Projects underway include three new LNG import terminals
at Milford Haven and Isle of Grain, two new pipeline connections
to import gas from Europe and an expansion of the import capacity
of the existing interconnector. By 2008, import capacity from
new pipelines and LNG facilities will be equivalent to annual
production from the UKCS, each at 80% of total annual forecast
demand. In addition, by 2009/10 new storage capacity is anticipated
to be in the region of 2 billion cubic meters (bcm). This is additional
to the existing short, medium and long-range storage capacity
of 3.7 bcm; and there are more new storage project proposals coming
forward that are not yet in the public domain. Progress on these
projects will be carefully monitored and we will not be satisfied
until they are complete.
We agree with the Committee that the decline of the
UKCS is one that must be monitored closely. This year's programme
of work in support of the Joint Energy Security of Supply committee
includes further and more detailed analysis of offshore performance
including field commissioning; within seasonal reservoir decline;
plant availability and unplanned shut downs.
It must be stressed that the UK's record on attracting
investment into the UKCS, including the exploitation of marginal
fields, is widely recognised as being excellent. The Government,
working jointly with industry under the high-level PILOT forum,
is fully committed to the objective of maximising economic recovery
of UKCS oil and gas. In the last 4 years measures unique to the
UK have been introduced to, inter alia, open up acreage
that is not being developed, reduce barriers for potential new
licensees, promote access to infrastructure, and improve access
to seismic and well data. All these have helped to generate fresh
interest and investment by an increasingly diverse range of companies.
97 licences were awarded in the most recent licensing round—a
level not seen since the 1970s—with over half being 'promote'
licences that seek to encourage smaller, more nimble firms. Moreover,
production levels are now in line to meet the PILOT target of
three million barrels of oil equivalent per day by 2010—well
above anticipated levels given the relative maturity of the North
Sea basin. Recent industry commitment to Codes of Practice and
novel criteria for 'good stewardship' to extend the life of older
producing fields are further steps in ensuring that Government
and industry are wholly in partnership in ensuring that any changes
in future North Sea production will take place in a predictable
and managed way.
Gas storage
10. As we discuss below, there are currently plans
to build significant storage capacity in the UK. However, this
does not help with the immediate problem of a tight supply over
the next year to 18 months. Both Ofgem and the DTI suggested that
the price spikes had provided strong market signals that extra
storage capacity was necessary. So they have, but even before
the price spikes it was absolutely certain that storage would
be needed as the UKCS declined: we pointed out the consensus on
this issue in our January 2002 Report into the Security of Energy
Supply. We are therefore disappointed by the lack of progress
in the last three years. We recognise that this is not entirely
due to lack of foresight: because of difficulties in obtaining
planning permission, construction has begun only recently of the
storage facility in Cheshire, which we were told in the winter
of 2001-02 would shortly be built. As one of the witnesses from
Ofgem indicated, the tight supply situation this winter would
have been significantly eased if even one of the proposed facilities
had already been built, and both domestic and I&C consumers
might have been spared a proportion of the recent price increases.
Planning guidelines should be reviewed to ensure that the strategic
importance of gas storage and other infrastructure projects is
fully recognised. (Paragraph 48)
Planning decisions for gas storage will need to address
and balance a range of issues including local concerns and the
national need for energy infrastructure. The planning process
may take time and it is only right that new gas storage projects
are considered thoroughly. At the same time the DTI recognises
the importance of making sure that national energy policy considerations
are fully taken into account in planning decisions regarding gas
storage and will be drawing on its experience with renewable energy
projects to ensure the message is understood. The DTI also recognizes
that for the planning process to operate as efficiently as possible,
new investors will need to engage with stakeholders early in the
process and plan ahead to factor the time taken by the planning
process into their project timetables, especially where an appeal
may be necessary.
Overall supply situation
11. Over this and perhaps the next two winters,
the UK will be in the uncomfortable position of having a relatively
small surplus of gas over normal winter demand. As National Grid
Transco has indicated, because supply cannot be increased measures
may have to be taken to decrease demand—which means that
customers with interruptible supply contracts may find their gas
supply temporarily suspended. Although the existence of the price
spikes seen over the last six months is explicable by the actual
state of supply in relation to demand, it seems to us that the
degree of volatility is not fully explained by this. (Paragraph
49)
In general we would expect gas demand to reduce of
its own accord in response to higher prices reflecting tightness
in the supply-demand balance. We have seen this in particular
in the electricity generating sector; and empirical evidence from
last winter, as well as research undertaken for DTI, indicates
that there is also potential for demand reduction by other large
users of gas, e.g. in energy intensive industrial sectors. Where
further reductions are necessary to maintain balance on the national
gas network it is normally for gas suppliers, who are responsible
under the terms of the Network Code for balancing their own inputs
and their customers' off-takes on a daily basis, to deliver this
by arrangement with their customers in the first instance. We
would expect last winter's experience to encourage more large
consumers to investigate with their suppliers ways in which flexibility
to reduce gas demand at times of supply-demand tightness can be
turned to commercial advantage.
As noted above in the response to paragraph 1, in
view of concerns over difficulties in explaining the price excursion
in the forward market experienced in October 2004, the Government
commissioned research into the workings of the gas forward market.
This concluded that the UK gas forward market is a functional
hedging and trading market, but that it is immature, structurally
limited and, by global standards, insufficiently liquid; such
factors, along with the general high energy price climate that
was being created around persisting high crude oil prices, the
general decline in UKCS production levels and reactions to public
comments by certain organisations, provide a general explanation.
The report made a number of recommendations to Government and
to end users and these are now under active consideration.
Behaviour of the gas market
12. Although we are not suggesting that the shipper
subsidiaries of production companies are able to buy gas at a
lower cost than external competitors can—we accept that
the transfer price of gas sold to the shipper arm by the production
company is scrutinised closely by the tax authorities—such
vertical integration between producers and shippers may give shippers
better access to pertinent information than other market participants.
(Paragraph 51)
13. We received no evidence that producers have
withheld supply from the market to drive prices up. None of our
witnesses has suggested collusion or any other illegal behaviour
in the offshore production market; nor do we consider that the
sharing of information between companies owning or making use
of the same facilities is improper or unnecessary. However, the
structure of the UKCS production market does mean that participants
in it have access to significantly more knowledge than those to
whom they are selling their gas. We note also that there have
been allegations in the past that the oil majors have shown a
disinclination to share infrastructure with newer market entrants—a
situation that, the industry hopes, it has addressed by a new
Code of Practice "to ensure equitable and timely access to
infrastructure", which was launched in September 2004. These
factors, together with the fact that the big gas production companies
also act as shippers, result in a market where actual competition
appears less than might be expected from the number of players
and market share. This leads to a further question, which is whether
the market therefore needs to be regulated or made subject to
closer monitoring. (Paragraph 58)
We note that the Committee found no evidence to support
suspicions of collusion or other illegal behaviour by upstream
producers. There is an extensive competition framework in place,
with the gas market subject to both general and sector-specific
competition law. Government policy is that it is the role of the
UK's independent competition authorities or regulators (where
they have the powers) to investigate competition matters. Ofgem
has concurrent power under the Gas Act 1986 to investigate agreements
or conduct relating to the shipping, conveyance or supply of gas
and ancillary activities. It already has an on-going remit to
monitor the market and has powers of investigation, if needed.
Against that background, we are confident that any market abuses
can be identified and dealt with. We are also confident that
the updated industry Infrastructure Code of Practice is working
to facilitate the continuing development of the UK Continental
Shelf.
14. There is a serious shortage of companies willing
to sell gas in the wholesale market when prices are high. Unfortunately,
because of the tight supply situation, prices are likely to remain
high over the next two years. This does not bode well for I&C
customers. We hope that Ofgem's prediction about the imminent
arrival of more active traders proves correct. Perhaps—if
they are financial institutions themselves—they will not
be subjected to as tight a credit straitjacket as current market
traders, and greater liquidity will return. However, we can only
conclude that at present the market is not functioning efficiently.
Price spikes are more and more frequent, and they seem to be higher
each time. Much of the volatility can be attributed to real difficulties
in balancing supply and demand, but the scale of the peaks will
remain high until more traders are encouraged to sell short.
(Paragraph 65)
In the main body of the report of their findings,
the Committee makes reference to a witness who stated that the
forward price excursion in the Autumn of 2004 represented a market
failure. The Committee also refer to a lack of shippers active
in the forward gas wholesale market.
As we said in answer to Recommendation 1, in response
to claims that the forward market was 'broken', earlier this year
the DTI commissioned independent energy consultants Global Insight
to undertake a detailed analysis of the workings of the UK forward
market in the UK, which included an assessment of the events of
Autumn last year. Their analysis suggested that the price spike
was a "perfect storm" of a number of coincidental factors,
some of which were unlikely to be repeated, and with that experience
in mind, the market players would be better prepared to avoid
a similar price spike occurring in the future. They also noted
that banks and commodity traders have been joining the market
over the last two years with no sign that this steady trend is
about to change. We acknowledge that there is room for improvement
in terms of developing the liquidity and critical mass of the
forward gas market and key future objectives will be improving
the confidence in the market and encouraging more players to trade
within it.
Transparency of the gas market
15. We understand and accept NGT's explanation
of why it is currently impossible to provide real time information
on gas flows. This may not be very significant: information delayed
by an hour represents a huge increase in the transparency of this
market, and is, we believe, quite sufficient for the needs of
customers. However, we suspect that to restore market confidence
there may be a need for still more information about production
outages, not least because of the mistrust that has arisen over
maintenance patterns in 2003. It is too soon to make a firm judgement
on this, but we recommend that the DTI and Ofgem keep a watch
on this area to see whether further information is needed. (Paragraph
72)
16. We note that the Norwegian gas production
companies have agreed to participate in the arrangements for providing
voluntary information. We welcome this. We consider that the advantages
of receiving information from all major parties, albeit on a voluntary
basis, outweigh any benefit from imposing any element of compulsion
which might lead the Norwegian companies to withdraw from the
scheme altogether. (Paragraph 73)
We agree with both of these recommendations from
the Committee. The issue of information is one of a number of
important factors to consider when assessing how a market operates.
This is why the DTI drove forward an agreement with UKOOA, to
which the Norwegians have also agreed to participate relating
to Norwegian gas exported to the UK, to voluntarily release information
to help the market work better. As the Committee notes, this
agreement is less than a year old. It is already delivering important
information. Publication of the final element (aggregated near
real-time flows) is scheduled for July 2005. We share the Committee's
view that some time is needed before the value of this information
can be properly assessed.
The Government welcomes the Committee's support for
a voluntary framework and its recognition of the wider advantages.
In addition, we consider that well focused voluntary arrangements
are likely to attract more co-operation from producers, leading
to them being more successful, effective and responsive to market
needs. However, if there remain concerns relating to the release
of information, we will not hesitate to address them, ensuring
that all stakeholders' views are accounted for by balancing the
evidence on prospective benefits against the commercial concerns
of the information providers.
Oil indexation in gas contracts
17. Because of the variety of ways of determining
future price increases under long-term gas contracts, it is impossible
to come to a firm conclusion about the degree to which UK gas
prices have been affected by the increase in prices of crude oil
and some oil products. The effects will vary markedly from company
to company. There seems to be a strong trend to replace oil indexation
in contracts as they come up for renewal. There was a consensus
that this trend was likely to be beneficial in the medium to long-term.
However, there is no guarantee that gas prices would fall if oil
indexation ended. Shell cited the example of the USA where—it
said—there was no indexation to oil but gas prices had increased
significantly, being at higher levels during the winter of 2004-05
than in both the UK and Continental Europe. (Paragraph 79)
18. Oil and gas prices will to some extent tend
to move together even if the explicit indexation to oil is broken
because oil and gas are still, to a degree, competitive products.
However, what the actual correlation between the two will be remains
unclear. (Paragraph 80)
We agree that it is unclear whether gas prices will
fall significantly as a consequence of the ending of oil indexation.
However, further liberalisation and competitive pressures on the
Continent, coupled with new import capacity and gas supplies,
are likely to lead to increased gas-to-gas competition (where
the cost of the marginal source of gas sets the price) which can
be expected to put downward pressure on prices in the medium to
longer term.
Competition within Europe
19. We welcome the European Commission's announcement
of inquiries into competition within the European gas and electricity
markets. We note the timetable announced to us, and look forward
to the completion of both inquiries by the end of 2006. We are
also pleased that the UK Government has taken such a firm stand
on the centrality of energy liberalisation to the whole Lisbon
Agenda. However, we recognise that both the Commission and the
UK Government will need to exercise considerable persuasive powers
to convince other Member States of the need to take prompt action.
(Paragraph 90)
The Government has taken the lead in pushing for
fully competitive EU gas and electricity markets, which we see
as a key plank of the Lisbon economic reform agenda. This led
to the agreement of a landmark liberalisation package in 2003
which requires full market opening and full legal separation of
network businesses by July 2007. The importance of this achievement
should not be underestimated. We recognise, however, that there
is still a long way to go before EU energy markets function as
they should. This is why an important theme of our Presidency
in the second half of this year will be the need for full implementation
of existing EU energy market legislation and effective enforcement
action by the Commission, where necessary, to achieve this. In
this context, we will be looking to the Commission to carry out
a thorough assessment of the practical impact in each Member State
of the existing legislation, in the report that it is required
to publish before the end of this year.
We welcome the sectoral inquiry formally announced
by the Commission on 13 June, and we will be working with Ofgem
and UK market players to ensure that the inquiry identifies the
real barriers to the proper functioning of EU gas and electricity
markets, and leads to appropriate remedial action. By highlighting
the areas where EU energy markets are not working at present and
proposing action to improve their functioning, these two reports
should have a significant impact on the pace of liberalisation
in Europe. To ensure that this happens, we will continue to play
a leading role in keeping up the pressure for reform.
20. Without further real (not just cosmetic) liberalisation
of the European gas market, the wholesale market in the UK will
malfunction: it will continue to be difficult for buyers to access
adequate supply and, because of this and other distortions caused
by the mismatch between the liberalised market in the UK and the
more rigid contractual arrangements on the Continent, there will
be a tendency for prices to diverge significantly. Even on the
most optimistic forecast, it is unlikely that the Continental
market will be functioning as a fully liberalised one before about
the end of this decade. Moreover, as BP reminded us, "Liberalisation
does not, per se, lead to lower prices. Rather it gives consumers
the freedom to choose suppliers, encourage the development of
new products and services and lets the market react more quickly
to changes in supply/demand fundamentals." European liberalisation
is not a complete answer to the problems in the UK gas wholesale
market. In fact, the Director for Conventional Energies, Directorate
General for Transport and Energy, observed that the object was
not cheap energy but rather a more efficient mechanism for establishing
energy prices. (Paragraph 91)
We agree that it will take time for EU energy markets
to function as they should but we have come a long way and all
Member States now agree that there can be no going back on liberalisation.
We will continue to work together with the Commission and national
regulatory authorities over the next few years to bring about
the changes needed for market players to have easier access to
gas supplies and transport facilities on non-discriminatory terms,
leading to greater market liquidity. This in turn should ensure
that price movements reflect market fundamentals, i.e. rise and
fall depending on the supply/demand balance.
Regulation of the gas market
21. The DTI and Ofgem consider that the current
regulatory regime is robust; they base this view on their assessment
that the gas market is competitive. We believe that some of the
peculiar aspects of gas production and trading militate against
full competitiveness at present. The result is a loss of confidence
in the market, and suspicions by gas users that those benefiting
from price spikes have somehow engineered them. None of our witnesses
suggested any failure of the market in respect of areas wholly
subject to the sectoral regulator, Ofgem: concerns focussed on
the supply of gas to the wholesale markets, not the 'downstream'
operations. We acknowledge that any extension of Ofgem's remit
would require primary legislation, which would mean delay, when
the problems of supply/demand balance in the gas market are likely
to be at their worst over the next two years or so. Furthermore,
attempting such legislation would undermine investor confidence
at this crucial time. (Paragraph 97)
We believe that the current regulatory regime is
sufficiently strong. There is a comprehensive framework of sectoral,
general competition and financial regulation. The Government,
through Ofgem and the Competition Authorities keeps the market
under close scrutiny, and we will not hesistate to act if there
is any evidence of market abuse or failure. We will continue
to pursue our PSA target to "Ensure that the UK remains in
the top three most competitive energy markets in the EU and G7."
22. We therefore recommend that the DTI itself
should take a more active role—not necessarily by increasing
its intervention in the offshore industry but by monitoring the
situation more closely to ensure that there are no activities
which would warrant referral to the Competition Commission. We
accept that such an increase in activity may require greater staff
resources within the DTI; we would expect extra resources to be
made available, if required. (Paragraph 98)
We disagree with the Committee that more resources
need to be made available to discover if there are any activities
which ought to be referred to the Competition Commission.
The Competition Act 1998 and Enterprise Act 2002
have established a robust framework for the investigation of competition
concerns by independent competition authorities (including the
sectoral regulators) who we believe are well resourced. We can
give the Committee our assurance that should we become aware of
any anti-competitive arrangements or behaviour in relation to
the offshore sector these would be brought to the competition
authorities' attention without delay.
Vertical integration in the gas and electricity
industries
23. It is clear that company mergers are creating
gas and electricity markets dominated by a few, vertically integrated
companies. We know that Ofgem monitors this situation closely
to ensure that no anti-competitive behaviour emerges. However,
we detect increasing unease among consumer groups, I&C customers
and some companies within the industry about the possible effects
of such integration. (Paragraph 102)
As indicated in our response to recommendation 12,
we do not consider that vertical-integration leads to any significant
loss of competition. There are enough companies in the gas and
electricity markets to ensure a good level of competition. Indeed,
some argue that vertical integration leads to greater efficiency
and should therefore enhance the competitiveness of market players.
Electricity market
24. Although some individuals who wrote to us
felt that the electricity price rises for consumers were unjustified,
the vast majority of our witnesses accepted that they were a direct
result of the increase in the cost of the main generating fuels,
coal and—especially—gas. We, too, believe that electricity
producers have not been profiteering. The variations in price
rises from company to company can be explained in part by the
differences in their portfolios of generating plant and the degree
to which they have been able to offset the gas price rises by
changing to cheaper fuels; and in part by the different commercial
approaches they have adopted (whether they have chosen to increase
prices across the board or to shelter some customers from the
full effects of the price rises, for example). (Paragraph 108)
The Government welcomes the Committee's conclusion
that they believe the electricity producers have not been profiteering.
To the extent that we expect gas prices to decline after 2007,
there will be a downward impact on electricity prices as well.
Coal prices have been pushed up largely as a result of the increase
in freight rates rather than a change in the economic fundamentals
in coal mining. World coal markets are competitive, with a diversity
of sources of supply, so we would expect prices to decline as
the freight capacity situation unwinds.
25. However, the effect of the price increases
on customers has been significant, and further increases are inevitable,
given that the cost of environmental legislation has yet to be
passed through to customers. We note that the cost of the Large
Combustion Plant Directive and the EU Emissions Trading Scheme
will add to the existing cost of the Renewables Obligation and
the Climate Change Levy. Although fluctuations in fuel costs will
occur, over the medium to long-term electricity is unlikely to
be as cheap in real terms as it has been over the last six years.
I&C customers have considerable incentives to reduce their
energy use. As a result, we think that it is now time for the
Government to re-examine the operation of the Climate Change Levy,
and in particular to consider the scope for reducing it to help
UK industry during its present difficulties. (Paragraph 109)
The Government announced in Budget 2005, partly in
response to recent movements in energy prices and the advent of
the EU ETS, a freeze in the rates of the Climate Change Levy (CCL)
for 2005-06. Decisions on future rates are a matter for the Chancellor
as part of the Budget process.
The Government published, at the time of the Budget,
a report by Cambridge Econometrics suggesting that the CCL is
expected to deliver over 3.5 million tonnes of carbon savings
by 2010, well above estimates made at the time of the levy's introduction.
With the introduction of the EU Emission Trading
Scheme from January 2005, overlapping policy measures will cover
some business sector emissions. This mix of climate change measures
is under consideration as part of the Climate Change Programme
Review. Some business stakeholders have argued for greater simplicity
and streamlining of instruments and this will be an important
consideration in deliberations for the Review.
New infrastructure projects
26. We have no doubt that the UK will shortly
have significant extra import capacity, but we cannot predict
when construction of this capacity will be completed. We note
that, between UKOOA's submission of its original Memorandum to
us in late November 2004 and the production of its Supplementary
Memorandum in mid February 2005, the target dates for completion
of three facilities had been put back, and there had been a reduction
in the expected capacity of two facilities (including Phase 1
of the Isle of Grain LNG facility, which is likely to be the first
to come into operation). This is in the nature of large infrastructure
projects. However, this does prolong the uncertainty to which
the wholesale gas market is prey. Government departments should
ensure they are well placed to facilitate these developments where
they have a regulatory or planning function. (Paragraph 112)
Gas infrastructure projects have a strong incentive
to commission on time, because that maximises the commercial benefits
to the project. One of the DTI's important roles is to facilitate
new gas infrastructure projects by working with them to identify,
and where possible address, non-commercial barriers. Recent examples
include:
— new
inter-Governmental treaties with Norway and the Netherlands, which
will facilitate the new Langeled gas import pipe-line into Easington
and the proposed BBL gas interconnector between the Netherlands
and Great Britain;
— putting
in place the legal framework to enable Ofgem to exempt certain
projects from the requirement for Regulated Third Party Access;
— providing
exemptions from the requirement for a gas transporter licence
in respect of further classes of project, including LNG import
terminals;
— and,
for the longer term, reviewing whether Great Britain's gas quality
requirements constitute an avoidable barrier to new projects.
The Government response to the TIC's comments on
the planning function is covered in response to Recommendation
10 above.
Future of gas prices
27. We cannot take the Panglossian view of the
gas wholesale market that the DTI and Ofgem appear to hold. There
are failures in the market which arise from significant problems
with physical supply, the lack of information about supply available
to participants, the difficulties caused by operating a liberalised
market (the UK) alongside a relatively unliberalised market (Continental
Europe), and the dearth of traders willing to sell gas into the
forward market. These problems are serious enough for us to conclude
that the autumn 2004 price spike, and the recent spike in late
February, will be repeated over the next two years. We urge Ofgem
and the DTI to keep a close watch to ensure that the market is
responding to all the proposed developments likely to make it
function efficiently (extra infrastructure and storage capacity,
the provision of more information, and so on). If there continue
to be well-founded concerns over the operation of the market after
these changes have taken effect, then we conclude that the market
must be considered to be failing. (Paragraph 116)
The Government recognises that energy is fundamental
to the economic and social welfare of the country. Within a liberalised
market our role is to set the regulatory framework which allows
a competitive market to flourish. Where there is market failure
the Government will not be complacent but take action to redress
it. There is strong evidence that business is flourishing and
increasing opportunities are developing in global energy markets.
The DTI recognises it has a significant task in pushing for further
liberalisation in Europe and it does not underestimate this challenge.
28. Although all the problems with the market
could, and probably will, be solved eventually, customers—and
especially I&C customers—will face serious disadvantages
in the meantime. The DTI is placing heavy reliance on customers
changing their buying practices: avoiding the October bunching,
and purchasing gas on short-term markets when forward prices seem
excessive. We think that this is going to be difficult for companies,
especially the SMEs whose interests the DTI has pledged itself
to take particularly into account. (Paragraph 117)
Government acknowledges the impact high energy prices
are having on industrial and domestic consumers and is working
with those sectors to ease the pain. Discussions with industry
members, both major users of energy and the smaller buyers, will
continue, with a view to helping them understand the dynamics
of the gas market and to adapt their purchasing strategies to
the changed situation. In order to address fuel poverty, we will
be working with agencies and the voluntary sector to better target
assistance to vulnerable households, and help them to help themselves.
2 In this and the following Appendix, paragraphs in
bold are quotations from the Committee's Report. Back
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