APPENDIX 9
Memorandum by E.ON UK
1. E.ON UK is the UK's second largest retailer
of electricity and gas, selling to residential and small business
customers as Powergen and to larger industrial and commercial
customers as E.ON Energy. We are also a leading power generator
and operate Central Networks, the electricity distribution business
covering the Midlands. We buy gas for power generation and for
supply to customers, and trade on the UK wholesale gas market.
2. E.ON Ruhrgas is responsible for E.ON's
Pan-European gas business. It procures gas from Russia, Norway,
the Netherlands, Germany, Denmark and the UK, and delivers it
to gas retailers, industrial consumers and power stations in Germany
and in other European countries. It has interests in offshore
UK gas fields, a stake in the Bacton-Zeebrugge gas interconnector,
and is a partner in the new BBL interconnector.
3. This evidence updates the evidence we
submitted to the Committee at the beginning of 2005, covers market
developments since January 2005, the impact of continental gas
market conditions, and steps that we and the E.ON group are taking
to help customers and ensure secure gas supplies for the future.
GAS MARKET
DEVELOPMENTS SINCE
JANUARY 2005
Security of Gas Supply
4. Expected UKCS supply for winter 2005
is lower than expected, with the UK demand/supply balance now
much tighter than forecast a year ago as a result of declining
UKCS production, notwithstanding the commissioning of the LNG
import facility at Grain and the upgrading of the import capability
of the existing gas interconnector with the continent. NGT's Winter
Operations Report has concluded that under normal weather and
supply conditions, there are sufficient gas supplies to meet demand
with only a limited amount of demand side response required. In
severe weather conditions there are sufficient gas supplies to
meet domestic demand but this will require a significant demand
side response (from CCGT power stations and industrial and commercial
gas customers). The gas interconnector cannot be relied upon to
import gas as a cold weather spell is likely to have an impact
also on northern Europe.
Prices
5. Gas prices continue to be driven by a
combination of declining UKCS gas supply and UK exposure to market
conditions in continental Europe, with the tightness in supply
essentially accounting for prices rising above those available
on the continent. In addition to the tight demand/supply balance,
the following factors are particularly relevant:
— forward gas prices have reflected
the risk of high demand this winter arising from a potential return
to normal winter temperatures or colder;
— although forward prices have, in
our opinion, at times exceeded the top end of extreme weather
scenarios (assuming reasonable infrastructure availability), a
period of cold weather could lead to very high spot prices as,
if conditions get tight, gas pricing will not be based on cost,
but on scarcity value;
— forward gas prices also reflect some
concern about the availability of continental gas supplies, given
that cold weather in the UK will also cause high demand in North
Western Europe. We estimate that there is an 80% chance of cold
weather in the UK also being experienced in North Western Europe;
— gas prices on the continent have
themselves risen further in response to rising oil prices;
— the effects of hurricanes in the
Caribbean have led both to temporary rises in oil prices and to
concerns that LNG that otherwise might be supplied to the UK,
would be diverted to the US market.
LONGER TERM
PRICE TRENDS
6. It remains our view that, with the completion
of additional gas import infrastructure by 2007, the supply/demand
balance will improve and UK gas prices will converge with continental
gas prices which are likely to continue to be influenced by oil
prices for some time to come. It is unlikely that prices will
fall to the level experienced when the UK had surplus domestic
gas production.
THE EFFECT
OF CONTINENTAL
GAS PRICES
ON UK CONSUMERS
7. Some commentators have suggested that
UK gas consumers have been disadvantaged by the relationship between
gas and oil prices on continental gas markets and that this in
turn arises from limited progress with the introduction of competition
in the gas markets of some Member States. A report by Global Insight
estimated the cost to the UK consumer at £10 billion.
8. We support the introduction of more competition
in EU energy markets but believe it is misleading to hold out
the expectation that the UK consumer could benefit from price
reductions of this order of magnitude. Examination of the validity
of Global Insight's assumptions which underpin the £10 billion
figure make clear why this is the case:
— Global Insight adopts long run marginal
costs as its benchmark for assessing the level of gas prices that
would apply in a fully competitive market but then recognises
these will not in fact determine day to day prices and short run
marginal costs are far more relevant;
— it assumes that gas would be in substantial
surplus. This assumption does not hold for the continental gas
market where existing gas purchase contracts are used to nearly
full capacity to meet contractual commitments to customers. The
report also assumes that the producers of gas selling into the
EU market have no market power. This cannot be assumed given that
five gas producers account for about 60% of total supplies.
9. In the absence of oil indexed contracts
gas prices would be driven by gas fundamentals (including demand
for LNG from the US and for piped gas in South East Asia) and
more influenced by the decisions of upstream players. There is
no reason to suppose that prices would be based on LRMC. In fact
prices could be set at what the market would bear.
10. Continental Europe imports most of its
gas (for example, Germany imports 80% of its gas) and the market
has been driven by the need to support the investment in long
distance pipelines and gas fields necessary to ensure security
of gas supply. This fundamentally requires an approach where investors
in new gas fields and long distance pipelines can recover their
costs through long term contracts with gas buyers.
11. Oil-indexed gas contracts have been
attractive, either because they have historically offered competitive
pricing given market conditions, or because they avoid the price
variability that could result from indexation to short-term gas
prices which could be affected by supply/demand imbalances or
any emergence of co-ordinated behaviour by the limited number
of upstream gas producers. Oil indexed long term contracts have
enabled large amounts of infrastructure to be built while maintaining
the competitiveness of gas with other oil-based fuels. Without
them, gas supplies to the EU could be less secure than they are.
12. We expect more indexation of contracts
to shorter term wholesale gas prices to emerge, but oil-indexation
to remain a significant component of long term contracts with
major producers and a continuing, if diminishing, influence on
final prices for some time.
13. A key conclusion from this is that the
UK Government should not only be seeking to encourage more EU
energy market liberalisation but should be doing what it can to
reduce the price of oil given that the link between UK gas and
oil prices is likely to persist. We welcome the Chancellor's proposals
for international action to increase production and investment
of 13 September.
RETAIL GAS
PRICES
14. Suppliers have been obliged to pass
on rising wholesale gas costs to consumers, although very large
industrial consumers will see more immediately the effects of
rising wholesale prices as suppliers individually hedge these
contracts with their own purchases in the wholesale market. Suppliers
will back their domestic sales with a portfolio of gas purchase
contracts purchased over time and the effect on domestic consumers
of rising prices is delayed.
WHAT CAN
BE DONE
TO HELP
CUSTOMERS?
Domestic customers
15. Rising fuel prices can create major
problems for consumers, particularly those for whom energy already
accounts for a significant proportion of expenditure. We have
taken a number of steps to reduce the impact on both domestic
and industrial customers.
16. To reduce the impact of the increase
in prices announced in July, we offered an £18 million package
of measures to protect our most vulnerable customers, including:
— a rebate for all customers on our
Age Concern tariff for the over 60s to offset the price rise until
next year;
— an increase in the Cold Weather Payment
for Age Concern gas customers of 40%;
— removing the surcharge for prepayment
electricity customers;
— free cavity wall insulation for all
customers aged 60 or over and for those on means tested benefits,
Tax Credit or Pension Credit;
— free loft insulation for all customers
who are on means tested benefits, Tax Credit or Pension Credit.
17. Our Staywarm tariff continues to provide
customers over 60 with energy at a fixed annual price and we now
offer an energy audit to high energy consumers on this tariff
to enable them to continue to benefit from these terms.
Industrial customers
18. Rising prices over the last year have
led to large gas consumers increasingly procuring gas on flexible
contract prices related to short term as opposed to forward wholesale
gas prices. About 40% of our total industrial and commercial sales
volume is on this basis, with about 40% of that on a day-ahead
price mechanism which enables customers to use the day-ahead gas
price as a signal to load manage if they have the ability and
desire to do so.
19. Many customers approaching contract
renewal from a particular date are simply deferring the purchasing
decision and waiting as long as possible to see where the price
goes before fixing the price. In our view, delaying a decision
is not necessarily prudent and some customers have found themselves
disadvantaged as a result.
20. We have also seen some fuel switching
driven by high gas prices. One of our customers has switched 10
million therms usage from natural gas to gas oil over the period
January to March 2006.
ENSURING THE
UK HAS ACCESS
TO SECURE
AND AFFORDABLE
GAS PRICES
IN THE
FUTURE
21. In January, we outlined a number of
steps to be taken by Government, regulators and companies to ensure
that UK markets are operating efficiently and that the UK adopts
policies which will help ensure that it has access to energy at
prices that remain competitive. The following developments since
then are worth highlighting.
22. To help maintain secure energy supplies
this winter, we have:
— returned 1300MW of mothballed plant
at Grain to service, which will enable us to switch from gas fired
to oil generation, reducing demand for gas. However, output from
Grain is limited by environmental constraints, which would need
to be relaxed if the station is to contribute effectively to avoiding
any supply emergency. We are in discussion with the Environment
Agency about this;
— purchased distillate for Corby CCGT
power station to enable switching from gas to distillate, subject
to technical and environmental constraints;
— ensured fuel stocks at coal and oil
stations are at maximum levels in preparation for the winter,
that our gas storage is full; we have also purchased LNG;
— conducted emergency planning to ensure
we are as prepared as can be under such conditions.
23. To support secure gas supplies to the
UK in the longer term, E.ON continues to invest in infrastructure
which will enhance UK access to gas:
— E.ON UK will be investing £100
million in a major gas storage development in Cheshire and continues
to explore further opportunities for investing in flexible storage;
— E.ON AG has signed an agreement with
OAO Gazprom, and BASF AG for the construction of the North European
Gas Pipeline (NEGP) through the Baltic Sea which will provide
an additional supply route for Russian gas into North Western
Europe including the UK;
— E.ON Ruhrgas has diversified its
own sources of gas through the purchase of Caledonia Oil and Gas
Limited with interests in a total of 15 gas fields in the UK Southern
North Sea. Caledonia's gas reserves total about 14 billion m3
and are to be produced mainly over the next 10 years.
24. Political and regulatory developments
are also relevant:
— the UK Government has worked to develop
a more effective EU and UK dialogue with Russia on energy issues
culminating in the recent meetings in London in October;
— liberalisation of the EU gas market
in Germany has made progress with implementation in July of the
EU electricity and gas directives in national law, establishing
the Federal Networks Agency as an independent energy regulator;
— further progress has been made on
making available to the market additional aggregated information
about the physical flow of gas from the UKCS as a means of improving
market confidence. Ofgem are expected to approve an energywatch
proposal to publish near real time delivery flow data at each
of the larger multi-user entry terminals in the late Spring of
2006;
— changes to the Network Code have
been implemented to encourage market participants to take action
which would help avoid supply shortages and short term price spikes.
The harsher emergency cash-out regime under the Network Code is
designed to elicit an early demand side response. However this
may also increase the premium of forward over spot prices, increasing
the incentive on retailers to buy forward, and the incentive on
upstream players to hold gas until the day ahead. (Significant
concerns remain about the potential financial exposure of shippers,
who through no fault of their own find themselves "short"
of gas either because of a "rapid" emergency brought
about by major field/transmission system failure and/or Transco
preventing storage withdrawals in an emergency. We have proposed
an urgent modification to deal with final exposure caused by Transco
curtailing shippers' ability to withdraw gas from storage in an
emergency).
October 2005
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