House of Commons - Trade and Industry

Select Committee on Trade and Industry Written Evidence

APPENDIX 5

Memorandum by the Chemical Industries Association

The following paper represents the Chemical Industries Association's (CIA's) formal submission to the House of Commons' Trade and Industry Committee's Inquiry, in accordance with the terms of reference set out in the Committee's press notice of 27 September 2005. The paper briefly reviews the chemical industry's main characteristics as an energy consumer, outlines the fundamental features of UK gas supply and demand, assesses the likelihood of shortages and consequent high prices in the coming winter, emphasises the risks for serious lasting damage to industrial competitiveness, and suggests how disruption to output may be minimised.

KEY CREDENTIALS

1. The CIA is the leading representative and employers' body for the UK chemical industry, with 150 members at over 200 manufacturing sites. Some sites produce bulk chemicals by energy intensive processes; others make smaller volumes of speciality chemicals. Almost all depend upon energy inputs at some stage of their operations.

2. The chemical industry contributed a surplus of £4.5 billion[4] to the UK's balance of payments in 2004. Total turnover is almost £50 billion. 4 It accounts for 1.5% of UK GDP1; 11% of manufacturing's gross value added; 4 employs some 200,000 highly skilled people directly4 and supports several hundred thousand jobs throughout the economy nationwide. The industry is global both in terms of markets and ownership, with over 65% of CIA's membership being foreign "headquartered". Any significant imbalance between the UK business climate and other markets can therefore lead to the loss of UK trade and investment.

3. The industry is one of the most energy intensive sectors of the economy, and accounts for 19%[5] of total industrial energy consumption. Gas is also used as a feedstock for making many chemical products, including fertilizers. The industry's annual combined energy and feedstock bill amounts to an estimated £2.5 billion. [6]The industry has an excellent record of improving energy efficiency and was the only industry sector to commit to a voluntary energy efficiency agreement with Government. As part of its ongoing commitment to energy efficiency, the CIA is now part of a negotiated Climate Change Agreement with UK Government to deliver an aggregate improvement in efficiency of 34% between 1990 and 2010. A significant proportion of these improvements have already come from additional Combined Heat and Power (CHP) plants and the chemical industry now generates around 30% of its own electricity requirements, most of which is from CHP. [7]

4. The CIA warmly welcomes this Trade and Industry Select Committee inquiry into the security of the UK's gas supply. We hope the Inquiry may help to deliver greater business planning certainty and competitiveness for our members as significant energy users and major contributors to the UK economy as a whole.

SUMMARY OF CIA RESPONSE

5. CIA believes that gas supply in the coming winter will be tighter than expected earlier this year. The period of cold weather in late February and early March demonstrated clearly that capacity to import does not guarantee that gas will flow to the UK, even when UK prices are at unprecedentedly high levels. Output from the North Sea is expected to decline further this winter, leaving the UK even more dependent on imports. Storage capacity remains wholly inadequate. After the cold spell in February and March forward prices for gas delivery in winter 2005-06 rose even higher: the market clearly adjusted expectations towards increased tightness.

6. The UK chemical industry already suffers from high and volatile energy costs that place it at a serious disadvantage to European competitors. Closures and job losses have already occurred. Cold weather this winter is likely to see industrial plants cut off in order to protect household supplies. For chemical plants the consequences are particularly serious, since lengthy closing and restarting procedures are often needed. Production is lost for much longer than the actual emergency period. Product quality can be impaired and process plant damaged. Energy efficiency is adversely affected, leading to possible failure to meet agreed climate change targets, resulting in financial penalties. Credibility is lost with both customers and (mostly overseas) owners: UK plants are less likely to receive essential investment to maintain, upgrade or expand them. Performance suffers and site closure is more likely.

7. Short-term measures by Government and Ofgem to minimise the risk and severity of industrial dislocation should include:

— Maximise supply from all sources. Storage should be full at the start of winter, and if drawn down early in the season should be replenished as soon as market conditions allow. If import channels are not fully utilised, promote access to spare capacity by third parties at regulated, cost related tariffs.

— The least disruptive way to reduce gas consumption is by persuading generators to switch fuel. To encourage this, alternative generating capacity should be at the ready, with adequate stocks of backup fuel in place, and the logistical means of replenishing them. Any disincentives such as higher cost of carbon allowances or infringement of other controlled emissions levels should be removed by a temporary waiver of such regulatory constraints.

— If industrial shutdowns cannot be avoided, then give maximum notice and ensure appropriate compensation.

PRELIMINARY OBSERVATIONS ON ESSENTIALS OF UK GAS MARKET

8. Demand for gas in the UK in 2004 was a little over 100 billion cubic metres, or an average of roughly 290 million cubic metres (mcm) per day. There is however a large seasonal variation in demand, both in the daily average and the peak on a single day, as shown by the chart[8]:

Supply flexibility comes from primary sources, that is to say beach deliveries and imports, in conjunction with available buffering storage. Peak short term supply is determined by the maximum physical flow rates from primary sources plus storage. Supply over an extended period is also limited by total storage capacity, since it is finite. It should also be noted that import capacity does not guarantee actual flow, as the experience of late February/early March this year demonstrated — see paragraph 16 below.)

9. In the UK's current position, the maximum gas supply may be inadequate to meet peak winter demand, so that demand must necessarily adjust. Some gas users might consider switching to electricity as an alternative, but since 40% of UK electricity generation is now gas fired, this would be of only limited help. Greater relief would be obtained if industrial gas users and electricity generators could switch to other primary fuels such as coal or oil distillates. This requires the necessary plant flexibility, fuel stocks, replenishment arrangements, and emission agreements to be in place. If all other measures are inadequate, the ultimate "demand side response" means enforced shut down of industrial operations.

10. The UK is linked to Continental Europe by the Bacton-Zeebrugge Interconnector pipeline. This provides physical access to gas in the Continental European market from Russia, North Africa and other sources. UK supply and prices are therefore affected by market conditions on the Continent. Two-way flow of gas is possible: at any given time, the balance of exports and imports required by shippers determines actual physical flow.

11. The indirect effect on the gas market of the electricity link to France should also be noted—export or import of power respectively increases or reduces generators' demand for gas in the UK.

12. The newly commissioned Isle of Grain LNG import terminal provides another import route. Investors in the terminal presumably intend it shall be used, but LNG cargos destined for the UK could nevertheless be diverted elsewhere, most obviously to the US, if a more attractive price is available.

PROSPECTS FOR THE COMING WINTER

13. National Grid's assumptions in the Winter Outlook Report foresee the following gas supply capabilities for winter 2005-06:

— Beach deliveries (from North Sea): a maximum potential of 327 mcm (million cubic metres) per day, with likely sustained production levels of 92.5% of this, or 303 mcm per day available over an extended period;

— The Interconnector, after the expected timely completion by December this year of its augmented import flow capacity, can supply up to 48 mcm/day (previously 25 mcm);

— The Isle of Grain LNG import terminal has a maximum throughput of 17 mcm/day, although the principal users (BP/Sonatrach) have purchased capacity of only 13 mcm/day;

— Maximum flow rates from storage are 42mcm/day from Rough (75 days' capacity), 29 mcm/day from medium term storage (for 26 days) and 49 mcm/day from LNG storage (but only 3.3 days' capacity at this rate.)

14. Overall maximum supply over an extended period, excluding storage, is therefore 354 mcm/day (taking Interconnector imports at 80% of maximum capacity, [9]and Grain imports at the contracted 13 mcm/day), which equates roughly to the average midwinter demand in the last two years. Meeting a cold weather peak no worse than those in these last two very mild winters would still involve drawing at maximum rate from long and medium term storage. Any prospect of extended cold weather would inhibit release of the limited stocks of LNG from short term storage at anything like peak rate. All the examples of peak day, week and month in the Winter Outlook Report (Fig 5, p19) show the necessity of curbing demand in order to protect supplies to households. If storage falls below the safety monitor level (set high at the beginning of the winter season, and falling as spring approaches), an emergency is triggered, and the Network Emergency Co-ordinator acts as system operator and can curb withdrawals or indeed require storage to be replenished. This would obviously further reduce gas available for immediate consumption.

15. Apart from variations in weather related demand, uncertainties exist over the reliability of North Sea output and the extent to which both the Interconnector and Isle of Grain terminal actually deliver their projected contributions. We note that National Grid have now adopted a more conservative view of maximum North Sea output than previously assumed (327 mcm/day compared to 336 mcm/day in the May provisional Winter Outlook Report): there should therefore be a smaller chance of an unwelcome undershoot. This new baseline, together with a downward revision to the demand forecast (now flat: increased domestic consumption is offset by lower price sensitive industrial and CCGT demand) implies a similar supply balance to that assumed earlier in the year. However, with increased imports not fully compensating for projected lower domestic output, the market is expected to be tighter than last winter.

16. Experience of late February and early March this year, when a cold spell in the UK coincided, not unexpectedly, with below average temperatures on the Continent, suggests that the Interconnector is unlikely to import gas at its maximum rate. According to Ofgem's analysis of this period, inward gas flow was an average of 8 mcm/day, or 30%, below its maximum. [10]Shippers may find it even harder to source an increased volume of gas from the Continent, which has its own logistical supply and flow limitations. The possibility of the Interconnector actually exporting gas cannot be ruled out. After the recent hurricane damage in the US, there is likely to be greater competition for international LNG supplies, so that the Grain terminal may not reach capacity when most needed. LNG may also be diverted away from the terminal at Zeebrugge, thus reducing gas availability on the near Continent and putting further pressure on the UK market.

17. Shippers must be expected to act in their own best commercial interests to maximise profits by exploiting opportunities both in the UK, on the Continent and indeed further afield: in a free market they have no explicit obligation to ensure that the UK is adequately supplied with gas.

18. It is therefore extremely likely that the coming winter will force some form of the euphemistically named "Demand Side Response", either because instantaneous demand is so high that supply cannot cope, or because there is sustained high demand over a longer period so that storage is depleted and the need to conserve what is left further reduces the maximum available flow.

19. Ideally, generators would switch to alternative fuels, but their flexibility may be limited. Electricity demand itself is likely to be higher than normal during cold weather. Demand from the Continent could lead to electricity exports to, rather than imports from, France: as well as higher demand in cold weather, extended dry periods can reduce hydroelectricity supply in France, Italy and Spain. Given the role of gas in UK electricity generation, this implies extra strain on UK gas availability. Further, stocks of alternative fuels have to be available, and capable of replenishment if needed for an extended period. Greater use of coal is penalised by the cost of CO2 allowances under the EU Emissions Trading Scheme (ETS), and use of various forms of fuel oil, while incurring a lower EU ETS penalty, may fall foul of regulations relating to emissions of other pollutants.

20. If the generating sector is not able to reduce its gas usage significantly, or in the absence of adequate financial incentives chooses not to do so, it is almost inevitable that the burden to make these fuel switches and/or to reduce demand for gas and gas-generated power will fall on energy intensive manufacturing plants, including key chemical sites.

21. While a few chemical plants can be stopped for a limited period and restarted later, suffering "only" disruption to deliveries and commercial reputation in the global market place, many operate continuous processes that are difficult and expensive both to shut down and restart. Even batch processes operate in cycles which run over several days and where it is simply not feasible to halt the process in the middle of a cycle. Apart from the need for advance warning in order to plan such a temporary interruption in production—without proper notice, it may be impossible to undertake such a procedure safely—the time needed for both shutdown and start up of the largest plants is measured in days rather than hours. Instantaneous response cannot be expected. The cost of lost output and spoiled batches of very high value product will be high. Further, many chemical plants are interlinked, with the output of one plant being piped direct to a neighbouring one, without any significant intermediate storage, so that a stoppage at one immediately affects the rest. Many CHP plants at industrial sites are in a similar position, in that they supply steam to several process units. The output of some energy intensive chemical plants may be essential to the operation of other vital activities, for example chlorine for water purification, and carbon dioxide for cooling in nuclear power stations.

22. The experience of the last winter suggests that high prices may persuade plants which can safely do so to pre-empt calls for emergency demand reduction by closing or reducing production levels before any enforced response to safeguard physical supplies is called for. While such action might appear "voluntary" it demonstrates clearly the damage being done to the competitiveness of UK companies and to the reputation of the UK as a reliable place to do business. High prices are in any case a symptom of market tightness and of worries over actual shortage.

23. Although fuel switching may be a theoretical option at some chemical manufacturing facilities, sites which are covered by tight environmental regulation of their emissions (for example, under the Integrated Pollution and Prevention Control (IPPC) regulations) may find themselves out of compliance with their emission limits if they switch fuel for any substantial period and thereby run the risk of prosecution by the regulator.

24. The Climate Change Levy agreement and rebate system requires individual companies to meet energy efficiency improvement targets, which will have been set on the basis of running their most energy efficient fuel mix—most likely gas—and on the basis of running the plant at planned levels of "occupacity". Any enforced changes in fuel mix or requirements to run the plants at lower level of production, and therefore less efficiently, are likely to risk failure to meet energy efficiency performance targets. In the event that this happens, the company will be liable to pay the full climate change levy, without any rebate, on all of their energy consumption for the next two year agreement period.

25. Many UK chemical plants are owned and operated by multinational companies, of which a significant proportion are owned and headquartered outside of the UK. The UK plants have sister facilities located elsewhere in the world and overall company sourcing plans are determined through central planning functions and planned on a long term basis. Any short-term unplanned interruptions in production at UK facilities as a result of enforced demand side management measures or of plant closure because of prohibitive gas prices, will lead to long term loss of confidence in the UK as a reliable sourcing location for such a multinational company.

POSSIBLE AMELIORATING ACTIONS IN THE EVENT OF A COLD WINTER

26. We believe the following measures could help in the first instance to prevent, and subsequently ameliorate the effects of, a gas shortage. We recognise that in a free market, with independent commercial operators, the Government's ability to intervene is limited, so that some suggestions may be difficult to enforce; however, we have tried to review all the principal aspects of the supply balance:

— Ensure that North Sea installations are kept in best possible operational order and that maintenance work is completed in good time.

— Ensure that all available storage is full at the start of winter, and that if drawn down early in the winter it is replenished as quickly as weather and market conditions allow. Any potential planning barriers for future projects should be removed expeditiously to ensure new storage sites can be completed as quickly as possible and ideally be available for next winter 2006-07.

— Maximise flexibility in demand side response by removing disincentives to use alternative fuels (by simplifying dealings with regulatory authorities, for example by temporary waivers of emissions limits and other regulatory constraints); ensuring that as much alternative generating capacity as possible is at the ready; that adequate stocks of backup fuels are in place and replenishment supply lines are available; and that trials of fuel switching and voltage reduction have occurred.

— Give maximum notice of any required demand side response. This would allow our member companies to explore a full range of operational options.

— National Grid Gas should consider contracting directly with end users for the ability to turn down consumption in order to be able to balance supply and demand.

— National Grid Gas to ensure their web site is stable and robust as consumers use this site to keep themselves informed about the market.

— Review the current drafting of the Network Emergency Co-ordinator's Safety Case and its interaction with the Network Code. We are concerned that the NEC's ability to curtail flows from a storage site in the event of an imminent or actual breach of the safety monitors may create perverse incentives on market participants, for example to withdraw from storage earlier in the winter than otherwise.

— Promote customers' equal access to data. We call for the approval and implementation of energywatch's modification to publish real-time data detailing flows of gas into the market.

October 2005