Appendix 2: Ofgem Response
Introduction
The Committee is rightly concerned about the impact
of high British wholesale gas prices on business and domestic
customers, including the customers in fuel poverty. Ofgem shares
the Committee's concerns. Consistent with our principal objective
to protect the interests of consumers, wherever appropriate by
promoting effective competition, Ofgem carried out a comprehensive
review of the causes of the increases that identified the main
factors behind the increases. Ofgem is continuing to explore whether
certain contractual arrangements in relation to the Sean field
prevented some gas from reaching the market during periods of
high prices. Ofgem also highlighted some potential concerns about
the availability of European gas supplies through the interconnector.
Ofgem hopes that these concerns will be thoroughly investigated
as part of the European Commission's recently announced investigation
into the European gas market.
Given the importance of gas prices to consumers,
Ofgem continues to devote considerable resources to pursuing these
issues. Ofgem also continues to monitoring the wholesale energy
markets on a day-to-day basis, and is satisfied that it has the
necessary powers to investigate and take action should any anti-competitive
conduct be identified in the GB market. Declining UK gas supplies
will continue to have an impact on prices. However, there are
a number of confirmed major infrastructure developments that are
likely to mean that prices will ease going forward. That said,
Europe will remain an important and growing influence on UK prices
and hence the establishment of a fully competitive European gas
market remains a priority. With that in mind, we welcome the European
Commission's decision to review the gas as well as the electricity
market. The scope of this review will be published shortly.
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)
Ofgem shares the Committee's concern about the effects
of the recent high British wholesale gas prices on domestic and
business customers. We undertook a detailed review into gas prices
during winter 2003 and forward gas prices for winter 2004/5. We
found that price movements appeared to be in line with market
fundamentals although, as stated above, we are currently looking
into a number of offshore contracts relating to the Sean field.[3]
We also undertake routine market surveillance work. We agree with
the Committee that the physical nature of supply in gas will have
the potential to exacerbate any unexpected price spike, given
the relatively long lead times associated with the response from
many supply sources.
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)
The current high wholesale gas prices should be viewed
in their proper context: the current increases have come after
a long period of steadily decreasing prices since privatisation.
Indeed, for most of the post-privatisation period, British industrial
gas prices have been among the lowest in Europe. Industrial businesses
are long term concerns that are likely to take this fully into
account in deciding where to locate.
As we stated in our oral evidence to the Committee,
industrial customers are likely to consider a number of other
factors when deciding where to locate, in addition to the wholesale
price. For instance, they will consider network charges and the
state of competition in the market. In this context, we noted
that German network charges were very substantially more expensive
than the British network charges and that competition in Germany
remained markedly less developed than in Britain. In addition,
given the new sources of gas supply that are expected to reach
the market, the market expectation is that these projects will
have a downward effect on prices. Taking all of these factors
into account, Ofgem believes that the competitive British gas
and electricity market in which consumers have freedom to choose
and change their supplier and in which good service is available
consistently over a long period, is best placed to maintain the
competitiveness of UK industry in the long term.
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)
This is primarily a commercial matter for the companies
concerned, and Ofgem notes that gas suppliers continue to develop
new and more flexible contract options that allow customers to
manage the risks associated with high and volatile prices.
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)
We welcome the assistance being provided by DTI in
this area.
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 increases 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)
The Government faces a major challenge if it is to
succeed in eliminating fuel poverty in vulnerable households by
2010. While the broader poverty agenda is primarily an issue for
Government, Ofgem and the energy industry have a part to play.
Ofgem continues to consider what more can be done
to help mitigate the impact of rising prices on poorer customers.
We will shortly be publishing our Social Action Strategy and will
be consulting on ways in which energy companies, working with
other stakeholders including Government, can better focus help
where it is most needed. We have welcomed the companies' intention,
through the Energy Retail Association, to establish a national
fuel poverty helpline. This could help customers more readily
get information on tariffs and services which could help them
manage household bills.
We have recently published a review, commissioned
jointly with energywatch, into the progress made by the six main
energy suppliers with implementing good practice guidelines on
debt prevention and have recommended that industry sets targets
to help reduce debt and disconnection. We will shortly be publishing
a further review into progress with the adoption of Corporate
Social Responsibility programmes by the main suppliers. Ofgem
will be seeking to increase the spread of best practice identified
in these reviews.
The other major challenge for all involved in this
area is to increase awareness among vulnerable consumers of the
help that is available. Ofgem and energywatch are working together,
under the Energy Smart' campaign, to promote the message to customers
that there are three things they can do to bring bills down: switch
to a cheaper supplier, pay by a cheaper payment method, and install
energy efficiency measures.
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)
Ofgem agrees that there is a need for greater co-ordination
across Government, industry and all concerned with tackling fuel
poverty to get the most out of the many measures and schemes available
to help keep homes warm and comfortable. Ofgem will use its knowledge
and influence to help Government, companies and voluntary organisations
adopt a more joined-up approach to identifying which households
are most in need, and better target support to where it is most
needed. Separately, Ofgem has urged industry to improve the targeting
and quality of energy efficiency advice and the take up of benefit
health checks.
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)
This is primarily a matter for the Government and
for the companies concerned. As stated above, we will shortly
be publishing a review of the Corporate Social Responsibility
programmes adopted by the main downstream suppliers. This will
enable Ofgem to help spread best practice and to encourage a responsible
attitude by suppliers toward their more vulnerable customers.
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)
Ofgem recognises that the decline of the UKCS presents
challenges to the industry in providing new sources of gas supplies
to meet demand. Ofgem is continuing to work to ensure that market
conditions enable new sources of supply to come on line as quickly
as possible. For example, Ofgem has granted a number of exemptions
to requirements for third party access for new infrastructure
and storage projects where appropriate.
The wholesale gas market has responded well in meeting
future supply needs and has attracted substantial new investment
in LNG, pipelines and storage facilities. As Britain continues
to make the transition to become a net importer of gas over the
next three years, investments providing 105bcm pa (out of an annual
demand of around 400bcm pa) will be made in our gas infrastructure.
Some of these new supply projects are close to completion and
will begin to flow gas in the next couple of years. The market
expectation is that these projects will have a downward effect
on prices. This effect can already be seen in current forward
prices.
Ofgem agrees with the Committee that it is essential
for a well-functioning market that all participants have access
to sufficient gas production information (for details see our
response to recommendation 15).
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)
We agree with the Committee that planning regulations
are a key reason for the delaying of several storage projects
which could have eased the situation last winter. However, planning
regulations are a matter for Government.
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)
The Committee is correct to state that over the next
one or perhaps two winters the supply/demand balance will be relatively
tight in the event of very cold weather, and that there may be
occasions on which customers who choose to enter into interruptible
gas supply contacts may have their gas supplies interrupted. These
gas contracts are offered by suppliers at prices below firm contracts,
enabling customers to secure cheaper gas. A recent consultancy
report suggests that all large industrial users with interruptible
contracts have back-up energy supplies, which will enable them
to continue production in the event that their gas supplies are
interrupted under contract. It is also open to many customers
with firm gas supply contracts to sell back the gas that they
have previously bought for a profit. Interruptible contracts are
a common feature of all gas markets and Ofgem notes that during
the very cold weather in northwest Europe last March, French industrial
and commercial customers were interrupted on a number of days
to manage demand.
We welcome the Committee's conclusion that the recent
spikes in prices appear to be driven by underlying supply/demand
fundamentals. Ofgem is not complacent, however, and continues
to monitor the market. We would also note that volatility in the
spot market is not necessarily passed through to customers, as
hedging mechanisms are available to those participants who do
not wish to be exposed to these price movements, ranging from
fixed price contracts to more sophisticated financial products.
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)
Ofgem is currently consulting on issues surrounding
the disclosure of offshore information (see the response to recommendation
15). Ofgem notes that it has the necessary powers to investigate
if complaints are made about anti-competitive behaviour.
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)
The issue of whether the gas production market needs
to be regulated or made subject to closer monitoring is one for
Government.
Ofgem's view is that wholesale markets work best
when participants have access to transparent prices based on an
informed view of supply and demand fundamentals. This is particularly
important because it allows market participants to anticipate
and react appropriately to potentially tight supply situations
and to make efficient decisions regarding potential movements
in prices.
Ofgem is currently considering specific options and
proposals in the context of the DTI-Ied voluntary offshore information
scheme on this issue, which is discussed in more detail in relation
to recommendation 15 below.
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 l&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)
Ofgem recognises that declining liquidity is a key
issue. We stated in our Corporate Strategy that Ofgem would continue
to discuss with stakeholders what, if anything, Ofgem should do
to promote liquidity and new entry.
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)
Ofgem notes that the DTI-led voluntary agreement
between offshore producers, terminal operators and Transco has
improved and standardised certain offshore data provided to Transco,
for example on available gas supplies, planned and unplanned outages.
Market participants, including producers, have particularly welcomed
the improvements to Transco's annual 'Transporting Britain's Energy'
planning and operations process that have arisen because more
data is being submitted to Transco. Nevertheless, a number of
market participants continue to believe that more information
should be disclosed to the wider market.
In February 2005, Ofgem issued a consultation document
about the onshore regulatory framework governing information disclosure.
There are currently rights under industry code documents for relevant
market participants to raise proposals requiring Transco to disclose
certain information provided to it by offshore producers. Producers
and Transco have raised concerns that these disclosure requirements
pose risks to commercially sensitive data and confidentiality
clauses. Ofgem is carefully considering these issues and is due
to issue a decision on this shortly.
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)
Ofgem welcomes the fact that producers, including
those from Norway, have recognised the benefits of providing improved
data to Transco under the voluntary scheme and that there is general
support for the overall principle of transparent market conditions.
As stated above, Ofgem is currently considering further issues
in relation to governance arrangements and will issue a decision
shortly.
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)
The British experience suggests that the oil link
will weaken in Europe as liberalisation gathers pace and gas-on-gas
competition develops. Clearly, the challenge is to secure effective
liberalisation in other EU countries so that gas-on-gas competition
is able to develop.
Historically it made some sense to link the gas price
to oil because certain large industrial customers could operate
using either gas or heavy fuel oil, particularly given the lack
of a wholesale market at that time. Given that gas is becoming,
for environmental and other reasons, the fuel of choice, substitutability
is increasingly limited, and it follows to that extent that gas
should be priced with reference to gas. Additionally, we note
that the majority of the new gas supply contracts struck by the
owners of the new gas supply infrastructure projects are largely
indexed to UK gas prices.
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)
Ofgem has a key role to ensure both that liberalisation
of European energy markets is carried out fully and effectively,
and to ensure more broadly that EU policy develops in ways that
are consistent with Britain's existing market-based regulatory
arrangements. Respondents to our Corporate Strategy consultation
expressed strong support for Ofgem to commit resources to influencing
the European agenda where this would be important for British
consumers. Ofgem will engage fully with the European Commission,
national regulators and National Competition Authorities in addition
to continuing our close work with the DTI on European energy issues.
We will also use our membership of the Council of European Energy
Regulators and the European Regulators Group for Electricity and
Gas to make the case for full and rapid implementation of the
Directives and Regulations. Our top priority here will be to seek
a fully liberalised wholesale gas market in Europe, particularly
in terms of facilitating the unfettered transmission of gas across
the rest of Europe on a fair and non-discriminatory basis. We
are therefore pleased that the European Commission has decided
to undertake a review of the European gas, as well as electricity,
market.
One of Ofgem's primary goals in relation to Europe
is to enable Britain to have available secure supplies of piped
gas and LNG from within the EU and from outside but transported
through it at competitive prices. This means that we need, within
the framework of liberalised markets, regulated third party access
to gas pipes, proper investment incentives for the development
of gas pipes, LNG import facilities and gas storage, and liquid
traded gas markets across Europe, including access to gas storage.
Other significant issues for the UK are to resolve potential difficulties
posed by differences in gas quality, and to address any abuses
of market power. We hope that the Commission's review of European
gas markets will address some of these important issues.
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)
European gas markets will have an increasing impact
on energy markets and consumers in Britain. This is because European
energy markets are physically linked to Britain by the interconnectors
and because European energy prices have a major influence on British
energy prices. British wholesale gas prices are directly influenced
by European wholesale gas prices and, given that nearly 40 per
cent of British electricity generation is gas-fired, there is
also a significant impact on British wholesale electricity prices.
Clearly, to the extent that European gas markets are not properly
liberalised, they might be expected to have an adverse impact
on British energy markets.
That is why it is a major priority for Ofgem to ensure
that the liberalisation of European energy markets is carried
out fully and effectively, and to ensure—more broadly—that
EU policy develops in ways that are consistent with Britain's
existing market-based regulatory arrangements. Ofgem will work
with the Commission, national regulators and National Competition
Authorities to promote full and effective liberalisation of the
European energy markets and to shape the regulatory agenda going
forward.
New EU legislation on environmental and consumer
issues (for example on carbon or other emissions, energy efficiency
or billing) is also likely to have an impact on the prices paid
by British consumers. A challenge for Ofgem and the Government
will be to encourage Europe to follow the approach of securing
carbon reductions in the most efficient way, and to adopt the
better regulation agenda on consumer issues, rather than adopting
a more prescriptive regulatory approach.
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 welcome the Committee's recognition that none
of the witnesses to the inquiry suggested that there had been
any failure of the market in respect of areas wholly subject to
regulation by Ofgem. The issue of whether changes should be made
to the regulation of the offshore gas industry is for the DTI.
For our part, we remain content that we have the necessary powers,
through the Competition Act 1998, to tackle anti-competitive behaviour
by offshore parties in the UKCS where that has an effect on onshore
British energy markets. As stated earlier, we believe that a key
issue remains the relative lack of transparency in the market
and the relative paucity of information about gas production that
is made available to the market.
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)
This is a matter for the DTI.
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, l&C customers
and some companies within the industry about the possible effects
of such integration. (Paragraph 102)
Ofgem takes these concerns very seriously and continues
to monitor actively the competitiveness of the wholesale and retail
gas and electricity markets. We would not hesitate to take enforcement
action if there was evidence of anti-competitive behaviour. In
terms of the structure of the industry, it is open to us to advise
OFT to make a merger reference to the Competition Commission if
a merger would, in our view, lead to a substantial lessening of
competition. It is also open to Ofgem to make a market investigation
reference to the Competition Commission under the Enterprise Act
if Ofgem has reasonable grounds for suspecting that any feature,
or combination of features, of the market prevents, restricts
or distorts competition.
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)
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.
l&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)
Ofgem will continue to urge Government to develop
flexible market-based mechanisms which are effective in reducing
carbon and efficient in terms of their cost to the consumer. Ofgem
would also note that as new gas import infrastructure puts downward
pressure on gas prices, this will act to reduce electricity prices.
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)
Planning matters are for the Government. However,
as explained above, Ofgem has an important role in developing
a regulatory framework that attracts timely and efficient infrastructure
investment. The volume of investment so far made (and still to
come) is clear evidence that the market can respond effectively.
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. (Para 116)
Ofgem takes these issues extremely seriously and
is taking action on a number of fronts to ensure that British
energy markets remain competitive and efficient. In particular,
Ofgem:
— routinely
monitors the wholesale markets and investigates price movements
where necessary;
— is
taking steps to improve the arrangements for publishing gas production
data;
— is
adopting, where appropriate, a 'light touch' approach to the regulation
of proposed new infrastructure projects; and
— is
working with the European Commission, national regulators and
National Competition Authorities to promote full and effective
liberalisation of the European energy markets and to shape the
regulatory agenda going forward.
We will keep a close watch to ensure that the market
is responding appropriately to these developments. Ofgem continues
to believe that the current market-based framework provides appropriate
incentives for new investment in both the gas and electricity
industries, and ensures that market participants respond as effectively
as possible to changing circumstances, delivering secure energy
supplies at least cost.
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)
We welcome the DTI's initiative in this area.
3 Note: Since submitting its response, Ofgem
has concluded that there is no reason to take any further action
at present in respect of the flows of gas from the Sean Fields
on the Sean gas contracts: Ofgem press notice, 'Ofgem closes gas
probe', dated 24 June 2005. Back
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