APPENDIX 7
Memorandum by the Department of Trade
and Industry
INTRODUCTION
1. The DTI welcomes the Committee's continued
interest in this important issue and recognises the valuable contribution
of its 2002 Report on Security of Supply and the Report on Fuel
Prices from earlier this year. The Committee's emphasis is on
security of gas supply. In this Memorandum we have focussed on
security of gas supply for this winter which is of immediate interest,
and also looked at how we can ensure security of supply in the
longer-term.
The Government's Approach
2. The role of Government is to establish
a regulatory and commercial environment conducive to major new
ventures, and to work with individual projects to identify, and
help remove, avoidable non-commercial obstacles so that an efficient
energy market can best balance energy supply and demand.
3. We believe that this approach has borne
dividends, in the form of consumer benefits and a healthy and
forward-looking UK gas sector. Prices to consumers have been low
compared to our EU partners. However, we take the issue of rising
energy prices in the UK very seriously, and are leaving no stone
unturned in finding ways to mitigate the impact on customers,
particularly energy intensive industry and those in fuel poverty.
GAS SUPPLY
The UK Continental Shelf
4. As illustrated in the chart below, gas
production from the UK Continental Shelf (UKCS) peaked in 2000
and has since been declining. Forecasts of annual production are
given below and show a steadying in 2005-06 and then the continuation
of the decline to 2014. This chart also demonstrates how alternative
sources of gas will become increasingly important in addressing
this trend.
5. Maximum daily UKCS production for this
winter has been forecast by the offshore producers to be in the
region of 290 million cubic metres (Mcm) which represents more
than half of the total maximum supply capability from all sources,
including imports and storage.
6. After taking account of plant reliability,
within-season reservoir decline and potential commissioning delays,
gas availability from the UKCS is expected to be between 85% and
95%. DTI is working with the offshore producers to ensure that
disruptions are kept to a minimum.
7. This winter, UKCS production could meet
about three quarters of average winter demand, with the rest being
made up from imports and storage.
New Investment in Gas Infrastructure
8. In response to increasing demand for
gas, the UK gas industry has invested in a number of important
infrastructure projects, representing a private sector investment
of at least £10 billion over the next few years.
9. Three new import facilities will contribute
to the amount of gas available to the UK this winter. The new
liquefied natural gas (LNG) import terminal at the Isle of Grain
has already commissioned and received its first shipments of LNG.
A new gas storage project at Humbly Grove in Hampshire will begin
commercial operations by early November and a large increase in
the import capacity of the interconnector from Belgium is due
to commission in November, a month early. In addition, the effective
capacity of the large Rough gas storage facility has been increased.
10. There are several further major projects
which should be up and running over the next few winters. These
include further up-grading of the interconnector from Belgium.
The new "BBL" interconnector from the Netherlands is
on track to commission for winter 2006-07. The Treaty with Norway
signed earlier this year cleared the way for the major "Langeled"
import pipeline, also due to commission for winter 2006-07 and
further LNG import terminals are under development or being planned
at Milford Haven, with other conceptual LNG projects under consideration
for Canvey Island and in North Wales. There are also a number
of new gas storage facilities under active development or planning.
11. These projects are all contributing
to the security and diversity of the UK's gas supplies, including
giving the UK valuable access to the increasingly flexible LNG
market.
12. For the longer term, DTI has played
a key role in providing a regulatory environment conducive to
new gas infrastructure projects, for example through: inter-governmental
treaties with Norway (already signed) and the Netherlands (to
facilitate the Langeled and BBL import pipe-lines respectively);
exemptions from the requirements to hold a gas transporter's licence
and to offer regulated third party access (relevant to the interconnectors
and the new LNG import terminals); and by ensuring that local
planning authorities, considering gas storage projects, are aware
of the national energy policy background. DTI's confirmation that
there will be no early change to GB's gas quality regulations
(see below) has also helped to reduce regulatory risk.
GAS PRICES
13. Apart from short-term volatility and
seasonality, average wholesale spot prices have been rising over
the period from 2003, having fallen in 2002. These rises are partly
driven by the increasing tightness in the UK market, from the
fall in UKCS production, but are also determined by the rising
price of oil and other fossil fuel products. This latter factor
affects the UK gas price because gas prices on the Continent are
contractually linked to oil and oil product prices and the UK
gas market is physically linked to the Continent through the gas
Interconnector.
14. There is a similar story for the forward
wholesale price of gas. This has also been rising, again driven
by higher oil price but also the expectation of a continuing high
price, as seen by the forward curve for oil. However, forward
gas prices also are affected by uncertainty over the potentially
tight gas market in the coming two winters, as UKCS production
is projected to decline in 2006 and 2007 and dependence on import
sources and storage increases. Winter prices are very sensitive
to the weather and extreme weather can result in price changes.
Price spikes are also likely if the market becomes tighter and
nervousness takes hold.
15. Industrial and household gas prices
have also been rising from summer 2004. The factor driving these
price rises is the higher wholesale price. The UK prices for both
these groups of users are still below the EU median apart from
the very largest industrial users.
Impact on Electricity Generation
16. Gas has become an increasingly important
fuel source for electricity generation in the past fifteen years.
For instance, gas accounted for 40% of total UK electricity supplied
in 2004—the single largest component. By comparison coal
and nuclear provided 33% and 19% respectively. In a competitive
generation market the wholesale price is determined by the marginal
cost of generating electricity of the most expensive plant on
the system at any given time, so one would expect the cost of
natural gas to have a strong impact on wholesale electricity prices
given the importance of gas-fired generation.
17. Moreover, the growing integration of
the world gas market means its price is increasingly determined
by global supply and demand conditions over which the UK has a
relatively small influence. As mentioned above, the prevalence
of oil-indexed gas contracts on mainland Europe means that the
market price of gas is closely linked to that of oil. Consequently,
changes in the price of oil can cause similar changes in the price
of natural gas which then feed through to wholesale electricity
prices in the UK. Over the past year, for example, the price of
Brent crude has risen by around 19%, the day-ahead price of gas
by 18% and the forward annual baseload price of electricity by
21%.
Impact on Security of Supply
18. The impact of this particular relationship
on security of supply is no different in principle to having wholesale
electricity prices largely determined by alternative fuels. So
long as there are several independent sources of the fuel in question,
there is less risk of inadequate generation due to unexpected
supply disruption of the fuel. It is should be noted, furthermore,
that a potential shortage of one fuel can be offset by the greater
use of alternatives; and that the UK generation sector has demonstrated
itself capable of switching between different fuels in response
to price signals. For instance, coal's share of the generation
mix rose from 32% in 2002 to 35% in 2003 while gas's share fell
from 40% to 38% as the price of gas relative to coal increased
significantly.
WINTER OUTLOOK
2005-06
19. In May of this year, Ofgem published
a preliminary consultation by National Grid (NG) on its outlook
for winter 2005-06. This set out possible scenarios for winter
gas and electricity supplies and was published to allow the gas
and electricity markets to get information about likely supply
and demand scenarios so that it could prepare an appropriate commercial
response.
20. Taking on board those comments received
during the preliminary consultation, NG published its final Winter
Outlook Report for 2005-06 in October of this year.
Gas Supply
21. NG confirmed that the demand supply
situation for gas will be tight this winter. Principally this
is due to the decline in the UK continental shelf, although, as
detailed above, new imported sources of gas are expected through
an expansion of the gas interconnector capacity and the new LNG
terminal at the Isle of Grain. Increased aggregate peak storage
deliverability is also expected.
22. NG report that, in all credible cold
winter scenarios, it is expected that gas supplies to non-daily
metered customers (eg households and smaller businesses and organisations)
can be maintained.
23. In an average winter (such as last year),
it is expected that some large users of gas will be interrupted
through their commercial arrangements with their gas shippers
or large consumers could choose to sell their gas rather than
use it, in response to prices. This could include power stations.
24. If the winter is colder than average
or if supplies are below NG's base case scenario then more significant
demand response is required. Two weather scenarios are:
— A "1 in 50 cold" winter—this
is a severe winter where there is a prolonged period of cold weather
(ie temperatures averaging 2C over a month and +2C over a further
2 months).
— A "1 in 10 cold" winter—the
last cold winter in Britain occurred in 1985-86, where temperatures
averaged -2C for a week and around 0C for two months.
Electricity Supply
25. Events have shown that the market has
responded positively to NG's preliminary report, with some mothballed
plant returning to service, including Killingholme power station
and Unit 4 of Grain power station.
26. NG report that electricity generation
plant margins (the amount by which installed generating capacity
exceeds peak demand) are healthy at around 21% this winter. As
around 33% of British generating capacity is gas-fired, there
is of course an important interaction between the gas and electricity
markets. NG report that in all credible cold winter scenarios,
it is expected that electricity supplies to non-daily metered
customers (eg households and smaller businesses and organisations)
can be maintained.
Demand Side Response
27. Electricity generators routinely arbitrage
between different forms of fuel according to variations in price
and the Government would therefore expect an efficient response
from this sector to price signals indicating tightness in the
gas market.
28. Other large users of gas have been less
accustomed to active management of their energy buying, following
years of historically and internationally low prices. However,
Ofgem and DTI have been working closely with industry in such
as the Gas Prices Working Group and the Demand Side Working Group,
and a number of actions have emerged from those processes.
29. The Gas Prices Working Group confirmed
the value of much of the work already being taken forward by DTI,
such as the maximising of gas supplies from the UK Continental
Shelf, from storage, from imports and from the interconnector,
insofar as this can be addressed through regulatory means. For
example, all unused capacity on interconnectors and LNG facilities
will have to be made available to the market under a new "use
it or lose it" obligation. In addition, DTI is undertaking
a series of meetings with banks, commodity traders, hedge funds
and so on with a view to confidence building in forward gas markets.
30. Output from the work of Ofgem's Demand
Side Working Group includes the introduction of the "Gas
Balancing Alert" through which National Grid will notify
the market of impending shortfalls in gas supply. This will alert
market participants to the opportunity to offer additional gas
for sale, in a way analogous to the existing electricity Notification
of Inadequate System Margin (NISM). A new website offering at-a-glance
information close to real time on the overall supply-demand balance
in the market is to be launched shortly and additional technical
support is being made available to improve the reliability of
the National Grid website.
DTI response
31. Ministers are working to ensure that
all possible measures are taken to anticipate problems with energy
supply in the event that an extreme weather scenario should occur.
Weekly monitoring by DTI and Ofgem using information provided
by NG mean lengthy periods of severe weather and the consequent
impact on gas supplies will not come out of the blue.
32. Ministers are also in regular contact
with key energy industry players to make them fully aware of the
implications of a severe weather scenario and ensuring that they
are doing everything they can to be in a position to address any
potential problems.
33. Government also stands ready to respond
to an actual energy supply emergency however unlikely that is
this winter; we have well worked out and rehearsed plans to work
with industry in such an event.
Impact of Hurricane Katrina
34. There is still a lot of uncertainty
about the level of damage in the US, and the time taken to repair
infrastructure. There are of course reports, however, that the
US might be well behind the supplies needed this winter.
35. The US is likely to try to make up any
shortfall by increasing LNG imports from the Atlantic Basin—though
its ability to do so will be constrained by the availability of
import facilities, and the extent to which cargoes are contracted
elsewhere. This could potentially affect LNG supplies into Europe.
36. Both producer and consumer countries
could potentially benefit from maximising pipeline supplies of
gas into Europe this winter. It would also be beneficial to improve
transparency of gas in pipelines and storage capacity and to improve
flows of gas around Europe this winter—from the areas receiving
piped gas (eg Germany) to those potentially affected by Atlantic
Basin LNG trade (eg W and S Europe). My Department is in touch
with officials and market participants in major exporting and
importing countries to encourage consideration of the opportunities
here.
LONGER-TERM
OUTLOOK
37. We published our views on the longer-term
outlook for gas supply in the Secretary of State's first Report
to Parliament on Security of Gas and Electricity Supply in Great
Britain in July this year. Longer-term information is also published
by the Joint Energy Security of Supply working group (JESS).
38. In addition to the new gas import infrastructure
detailed above, it is worth touching on the likely sources of
imported gas. Russia holds around a third of the world's proven
gas reserves (2004 estimate). Over 80% of the world's proven gas
reserves, at end 2004, are located in the Middle East, Africa,
Europe and Russia; many of these are within potential pipeline
distance. Within Europe, the Netherlands and Norway have around
four trillion cubic metres of gas reserves (2004 estimate).
39. The UK is increasingly part of the integrated
EU gas network, which draws gas from as far afield as Russia and
North Africa and may soon do so from Central Asia and Iran. At
present most of the EU's imported gas is supplied by pipeline,
often over considerable distances, on long-term contracts. While
this creates potential exposure to political threats to cut off
the gas supply and to disruption of supply by political and economic
instability, in practice such incidents have been extremely rare.
Moreover the UK's chief supplier of piped gas for the foreseeable
future will be Norway and the UK has much experience of importing
Norwegian gas.
40. The sourcing of gas supplies from overseas
is a matter for market participants. Commercial operators have
every incentive to make their own assessment of the merits of
supplies from different countries and thereby to ensure diverse
sources of gas, supply routes and entry points so as to reduce
the risks arising from supply interruption from any one source.
Current UK gas market arrangements are already delivering a number
of competing gas import projects, potentially delivering gas from
such diverse sources as Norway, the Netherlands, Russia, Algeria,
Qatar and other LNG exporters.
EU Liberalisation
41. The 2003 EU energy liberalisation package
requires Member States to open their gas and electricity markets
to competition by July 2007.
42. DGTREN is currently reviewing the progress
made by Member States in meeting their obligations under these
measures and is to report to the European Council and Parliament
before the end of this year. We would expect the Commission to
take action to ensure Member States meet their obligations.
43. DGCOMP are also conducting a review
of competition in the energy sector, with interim results due
later this year and the final report in 2006. This could lead
to action being taken under competition law. The results of this
study and the DGTREN review will also be considered to see if
further legislation is required for the development of a properly
functioning internal energy market.
Gas Quality Exercise
44. On occasion it is expected that certain
future imports may not comply with the UK's gas quality specifications—the
1996 Gas Safety (Management) Regulations [GS(M)R]. The Government
committed in the Energy White Paper to monitoring developments
regarding gas quality (paragraph 6.21) and in June 2003 the then
Energy Minister launched the 3-Phase Gas Quality Exercise to examine
the interoperability issues arising. Work to identify the scale
of the issues involved, and the available policy options to address
these, is now almost complete. The Government expects to go to
public consultation on the policy options in due course.
45. Meanwhile, the Government has made it
clear that there is no question of an early change in the GS(M)R.
Available evidence indicates that the market is responding appropriately;
specifically that processing facilities to manage gas quality
differences are being developed where these are required. There
is no evidence that the UK's gas quality specifications have deterred
the development of import projects.
46. Completion of the 3-Phase Gas Quality
Exercise will also put the UK in a strong position to influence
developing proposals at European level for harmonised cross-border
gas quality specifications. This will offer the best opportunity
of ensuring that any proposals are conducive to the efficient
operation of a single EU gas market and are in the UK's best long-term
interests.
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