APPENDIX 14
Memorandum by INEOS Chlor Ltd, INEOS Fluor
Ltd and INEOS Vinyls Limited
Contents
Section
| Title |
| Section 1 | Executive summary
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| Section 2 | Review of price movements since "Fuel Prices" report
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| Section 3 | Gas supply situation for the coming winter
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| Section 4 | Gas supply—an assessment of risk by INEOS Chlor
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| Section 5 | The consequences of supply shortages on the UK
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| Section 6 | Required actions
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| Addendum 1 | Key Price Information
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| Addendum 2 | Correspondence with DTI Energy Team March 2005
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| Addendum 3 | Report on Supply/Demand sent to DTI in March 2005
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| Addendum 4 | Winter Scenarios
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| Addendum 5 | Market Structure
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| Addendum 6 | Background to INEOS
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1. EXECUTIVE SUMMARY
1.1 INEOS Chlor Limited, INEOS Fluor Limited and INEOS
Vinyls Limited are major chemical companies operating throughout
Europe. We are able to provide evidence on behalf of all three
companies based on extensive and comprehensive knowledge of the
gas and electricity markets in which the companies operate.
1.2 Our evidence is based on first hand experience of
the operation of UK and Continental European markets as well as
our own extensive modeling of possible supply and demand scenarios
developed over the last 12 months. This demonstrates that without
corrective action it is foreseeable that the UK will experience
Security of Supply failures combined with continuing uncompetitive
energy prices into the medium term. In March of this year we sent
a report to DTI highlighting our concerns about security of supply
for the coming winter.
1.3 The UK needs secure supplies of affordable energy.
In our view it is unacceptable to balance supply and demand by
either closure of massive sections of the UK's industrial base
or by putting vulnerable households at risk.
1.4 Since the Committee's Fuel Prices Report (HC 279-I)
was published there have been two further price "shocks"
in the UK gas market. In February/March "spot" prices
rose by around 400% and in July forward prices rose to levels
very significantly higher than those seen during the October 2004
"spike". Prices for the next three winter periods are
already around the price seen at the peak of the October 2004
spike.
1.5 It is the stated and published view of OFGEM/National
Grid (NG) that the supply situation for the coming winter will
be worse than predicted in February this year or more correctly
since the previous Winter Outlook publication. An assessment of
NG's one in 10 winter case (which we believe is optimistic) by
consultant cornwallenergyassociates concludes that, for a 40-day
period, there will be a need for 100% switch off of NTS industrial
loads, LDZ large loads and 20% of LDZ interruptible loads.
1.6 We agree with the demand numbers and the capacity
of the various supply systems used in the current Winter Outlook
Report (WOR). However a fundamental issue is how much gas will
flow through the interconnector in the event of a colder than
average winter across the UK and Continental Europe. We believe
the assumption in the WOR that the interconnector will be almost
full to capacity is unsafe. The only time this has been tested
in cold conditions (last February/March) the flows through the
interconnector fell to almost zero.
1.7 In the event of very credible temperature scenarios,
the interaction of the UK and European Gas Markets can result
in very severe gas shortages in the UK leading to the wholesale
closure, for significant periods of time, of vast sections of
UK industry.
1.8 The impact of such a scenario will be hugely damaging
to UK manufacturing in both the long and short term. It is quite
conceivable that many businesses will simply not restart production
operations.
1.9 New infrastructure projects are unlikely to help
in the near term. They are simply import infrastructure and do
not give the guarantee of secure sources of supply.
1.10 We consider it untenable that as the EU's largest
and world's 4th largest gas producer we have nearly the world's
highest prices and the severe risk of energy rationing in anything
other than an average winter. It is not being overly dramatic
to warn that in the event of below average temperatures the UK
will be thrown into crisis.
1.11 As a member of the EIUG, we have met regularly,
over the last 12 months or so, with DTI and OFGEM as part of the
Gas Working Group. We made a number of suggestions of action that
could have helped improve the situation for this winter. In our
view these suggestions have been largely ignored.
1.12 It is now too late to take proper corrective action
for this winter. The window of opportunity has been missed but
some immediate actions could be taken to ensure that the UK is
prepared for a Gas Deficit Emergency. These actions are covered
in more detail in section 6.
1.13 For the future, the UK needs to press for liberalisation
of Continental markets but in the meantime take urgent action
to ensure secure and affordable sources of supply for the UK.
1.14 The DTI acknowledge the success of UK manufacturing
as being crucial to the UK's prosperity. Manufacturing is one
sixth of the UK economy, accounts for two-thirds of exports, generates
3.5 million jobs directly and millions more through supply chain
and related services. This world leading manufacturing base is
already being eroded by high energy prices. An energy crisis will
inflict terminal damage on many sectors, destroying huge amounts
of value for the UK economy in the long term.
2. REVIEW OF
PRICE MOVEMENTS
SINCE "FUEL
PRICES" REPORT
2.1 At the time of the Committees inquiry into Fuel Prices,
forward gas prices had gone through a peak in October 2004. This
was observed by Government to have been a "spike" and
indeed Global Insight, in a report commissioned by DTI, noted
"contributory factors to the spike were many and various".
Some observers have referred to this price excursion as "a
perfect storm".
2.2 Since the Committee published its Fuel Prices report
two further price "shocks" have been observed in the
gas market:
— The February/March price shock. During the period
23 February to 11 March 2005 "prompt" prices increased
by around 400% from around 30 pence/therm (ppt) peaking at around
150 ppt on one day. During this period, imports of gas through
the interconnector fell to nearly zero. The UK became an exporter
of energy by supplying electricity to France through the England
to France interconnector;
— During July 2005 forward prices went through another
"spike" reaching levels much higher than those seen
in October 2004. While prices for the near winter have fallen
from these highs they remain at levels seen around the October
2004 spike and prices for future winters are already trading at
record levels (Addendum 1).
2.3 In the Fuel Prices Report, the Committee observed,
"without further liberalisation of the European Gas Market
the wholesale market in the UK will malfunction". We have
now seen further stark evidence of this and are alarmed that the
serious impact this is having on the competitiveness of energy
prices in the UK, which we believe will now continue beyond even
the next couple of winters.
2.4 Gas producers have invested in infrastructure, which
has enabled them to benefit for many years from selling the UK's
gas reserves at on average near the European "oil-linked
price"—a price that bears no relation to the cost of
producing the commodity. This additional demand has surely increased
the rate of decline of UK production and in so doing, has contributed
to many of the problems that the UK market now faces. We believe
the energy industry has a responsibility to the UK market and
they should be required to provide some of the solutions.
3. GAS SUPPLY
SITUATION FOR
THE COMING
WINTER
3.1 The Committee is seeking views on "whether the
supply situation in the coming winter is likely to be about the
same, better or worse than predicted in February this year".
3.2 In March of this year, following the spike in prompt
gas prices, we predicted the potential for severe security of
supply issues and made our concerns known to the DTI and OFGEM.
The e-mails in Addendum 2 and the report in Addendum 3 were sent
to the DTI Energy Team during March. The report was also sent
to OFGEM and NG (then Transco) during March. Our view remains
as it was then; the UK is very vulnerable to supply shortages
in cold winter conditions.
3.3 On 5 October 2005 OFGEM/NG published NG's "Winter
Outlook Report 2005". This report was presented with the
cover headlines that "under average weather conditions .
. . a modest amount of demand response required" and "in
1 in 50 winter conditions . . . sufficient gas to maintain supplies
to domestic".
3.4 In our view the latest version of the WOR is correct
in its assessment of the capacity of the various supply systems
and the demand that is likely in various winter scenarios. There
is in fact a large amount of agreement in the capacities of the
various "building blocks" that make up any supply/demand
model.
3.5 The WOR seems to assume that various market actions
are independent of each other. In our view several facets of the
market are likely to depend on temperature as shown in the table
below.
| Supply/Demand | Winter Temperature
|
| Warm | Cold
|
Demand
UK demand | Low
| High |
| Continental Demand | Low |
High |
Supply
UK Beach Supplies |
High and reliable | High (possible reliability issues)
|
| Storage "Churn" | High
| Low |
| ICUK Imports | High if required
| Low (no gas available) |
| LNG imports | High if required
| Probably low |
| Demand Response | High if required
| Low (risk of freezing) |
| | |
In summary a cold winter is likely to have two effects, demand
will go up and available supplies are likely to go down. This
"double whammy" causes supplies to be low when the need
for them is greatest and is the key reason why the UK market is
so vulnerable to cold winter conditions. A more detailed explanation
is given in section 4 and Addendum 4.
3.6 Within the detail of the WOR, NG has considered a
single base case supply scenario and the likely consequences of
different weather conditions. In particular, NG considers the
scenario of a 1 in 10 cold winter, which we would consider to
be statistically quite likely. (We would note the Met Office have
already issued an "amber alert", based on their long
range forecasting models, to the energy industry, essential and
emergency services). In NG's report it is hard to understand the
real implications of such a scenario. One independent consultant,
cornwallenergyassociates, has interpreted the analysis and has
described much more clearly the reality of this. They note that
for a 40-day period, there will be a need for 100% switch off
of NTS connected industrial loads, LDZ large loads and 20% of
LDZ interruptible loads. This is in addition to Demand Response
by the power generators.
3.7 The extent and impact of this is actually quite difficult
to comprehend but in our view such impacts are likely to make
recent petrol shortages look trivial.
3.8 Importantly we are concerned that NG do not adequately
recognise the experience of February/March 2005 and have base
case analysis assumptions which are, at best, extremely optimistic.
In particular we do not consider that sufficient attention has
been given to:
— The behaviour of Continental European Markets
in the event of cold weather and the implications of this on the
likelihood of imports being made at the time that we have the
greatest need;
— The ability of the demand side, both power generation
and industrial sectors, to provide demand response; and
— The likelihood of LNG imports being available,
again at the time when we actually need it.
3.9 We conclude that the official view from OFGEM and
NG is that the supply situation is significantly worse than they
expected in February. Our view is that the situation is likely
to be even worse than this official view. Security of supply is
clearly threatened and our concerns, expressed last March remain
valid.
3.10 It is essential that we recognise the gravity of
the situation facing the UK and take appropriate action to try
and restore a balance to the market.
4. GAS SUPPLY—AN
ASSESSMENT OF
RISK BY
INEOS CHLOR
4.1 We accept the view of OFGEM and NG that the coming
winter will be tighter than they previously expected. However,
we consider that the WOR fails to adequately recognise the threat
to supply security currently faced by the UK, not only this winter,
but also in the medium term, while liberalisation in Continental
European Markets is developed. Our view is based on experience
of the market including the one period when the UK market was
actually put under stress and demonstrably failed to provide secure
supplies (during the February/March 2005 spike). We have undertaken
our own analysis of likely supply and demand scenarios combined
with temperature scenarios across the UK and Continental Europe
(see Addendum 3).
4.2 In the discussion below, it is important to recognise
the difference between market structures in the UK and the rest
of Europe. A summary is set out in Addendum 5.
4.3 Below we have set out our key observations on the
analysis put forward by NG. For clarity we have considered scenarios
and issues under the following headings:
Weather
4.4 We are in agreement with the demand profiles that
NG use for different UK temperature scenarios. The demand consists
of industrial, power generation and domestic heating. It is worth
noting that the power generation demand (40% of UK power) has
virtually all been built since the last cold winter in 1985-86.
4.5 We are not sure what NG assumes for Continental demand.
During the February/March spike, temperatures in the UK fell,
although not to exceptionally low levels in absolute terms. In
this period, temperatures were also cold across Continental Europe.
We have discussed with the Met Office, the correlation of low
UK temperatures coincident with low European temperatures. They
advise there is an 80% correlation and we conclude that in a period
when UK demand increases, demand is likely to be increasing across
the whole of Europe.
Supply
4.6 With the UKCS continuing to decline (now confirmed
in Winter Outlook) the UK will, this year, be more reliant on
imports over the winter months. Imports are a combination of Norwegian
imports to St Fergus, continental imports to Bacton and LNG through
the Isle of Grain. Based on our understanding of weather correlation,
we will be reliant on imports at precisely the period when "suppliers"
of imports will be most reluctant to sell gas to the UK market
as they may be required, for example, to retain gas to maintain
legally required strategic stocks.
4.7 In the case of the Interconnector, NG has assumed
as a base case that the Interconnector will flow at 100% of its
current capacity and 75% of the new capacity (due to be on line
from 1st November 2005). During the February/March spike, flows
through the interconnector actually fell and approached zero as
temperatures in the UK and Continental Europe fell. Our view is
that from available evidence to date we should assume, that in
time of peak demand, imports through the interconnector will be
significantly lower than NG's base case scenario. Paradoxically,
if conditions are actually relatively mild, there will be little
requirement for high rates of imports as demand will simply not
be sufficient to require large imports of gas.
4.8 We also note that for a time during the February/March
spike, the UK was actually a net exporter of energy by way of
electricity exports to France through the England to France interconnector.
This export was effectively equivalent to around 10MCM of gas
(because this electricity would have resulted in additional generation
by gas fired power stations).
4.9 Since last winter, the Liquefied Natural Gas (LNG)
Peaking Plant at Isle of Grain has been converted to receive imports
of LNG by ship. NG have assumed this facility will flow gas at
around 75% of its import capacity. Again we have very real concerns
regarding the validity of such an assumption. There are two reasons
for this:
— During the February/March prompt price spike,
a major contributory factor to high prices was the reported diversion
of an LNG cargo from the import terminal at Zeebrugge (to Spain).
It is likely that in time of stress cargoes will be diverted away
from Grain to other markets.
— Further, forward prices in North America are already
at higher levels than the UK for the peak winter months. It is
very easy to foresee that LNG will be in tight supply this winter
and players will take the opportunity to divert cargoes. Again
due to the more liberalised market in the UK compared to Europe,
it is likely that the first cargoes to be "diverted"
will be those intended for Isle of Grain.
4.10 We would stress that the issues described above
do not merely impact on the coming winter or the one after that.
They will prevail as a result of the systemic failure of the UK
market created by inequitabe levels of liberalisation between
the UK and European markets.
Demand Response
4.11 We consider that the need for Demand Response must
be seen as a fundamental failure of the market to deliver security
of supply at affordable and competitive prices. Indeed, it is
quite possible that even at unaffordable prices, security of supply
may not be guaranteed.
4.12 We also have serious reservations that the level
of demand response assumed by NG will actually be delivered, in
particular by the power generation sector but also by the manufacturing
sector.
4.13 In the case of power generators there are a number
of factors which will inhibit demand response:
4.13.1 In previous periods of high prices, power prices
also rose and "spark spread" remained positive. As a
result there was little financial incentive on generators to reduce
demand beyond normal "two shifting" (which generators
will undertake as a matter of course to take advantage of power
price profiles). We consider that, at least in part, evidence
put forward by NG to demonstrate the level of potential demand
response is based on what has actually been seen as a result of
such commercial "two-shifting" behaviour.
4.13.2 Power stations with "dual fuel capability"
will be reluctant to switch fuels routinely due to the risk of
plant "tripping" during changeover which would give
massive exposure to punitive "cash-out" pricing. This
is clearly seen as a risk by generators who are seeking a derogation
to "cash-out" pricing for fuel switching operations.
The price of gas oil is currently above 90 pence per therm so
there is no financial incentive to fuel switch unless the price
of gas is substantially above this level.
4.13.3 In addition power stations will be reluctant
to shutdown stations during cold weather due to the risk of lines
freezing causing damage and difficulties restarting operations.
4.13.4 Distillate stocks at UK power stations are
relatively limited—around five days typically. When stocks
are depleted, it will not be possible to sustain running on distillate
or to quickly replenish stocks as the logistics infrastructure
is unlikely to be in place. In any event, if there is cold weather,
transport may well already be severely impacted and rail alternatives
no longer exist.
4.14 In the case of the manufacturing sector there are
a number of factors preventing consumers from shedding demand:
4.14.1 Many consumers are not able to quickly respond
to high prices as processes take considerable time to shut-down.
4.14.2 The implications of shutting down a process
particularly in the middle of a cold spell can be disastrous.
In the case of INEOS Chlor, a closure of our manufacturing facilities
could result in a shutdown for many weeks as miles of pipelines
may freeze.
4.14.3 Many manufacturers who have alternative fuels
such as distillate are specifically prevented from burning these
due to environmental restrictions, which only allow their use
in the event of a NG interruption. However, due to a recent change
to the Unified Network Code, NG may no longer call interruption
for supply demand balancing purposes. As a result such alternative
fuels are unlikely to be used ahead of a Gas Deficit Emergency
being called.
4.14.4 There are no "demand response products"
available in the gas market which parallel the existing and effective
arrangements in the electricity market which compensate consumers
to provide response services.
5. THE CONSEQUENCES
OF SUPPLY
SHORTAGES ON
THE UK
5.1 INEOS Chlor gave evidence to the previous TISC inquiry
suggesting that current market arrangements will result in high
forward market prices which are severely uncompetitive to all
consumers (not only super large users) and which are unaffordable.
5.2 These uncompetitive prices are already having a devastating
impact on UK manufacturing with many companies already having
closed, transferred production abroad and stopped further investment.
Through our contacts with customers and others throughout the
industrial community we are very aware that this is not simply
a possibility—it is happening now.
5.3 The DTI, on its web-site, notes that manufacturing
is one sixth of the economy, generates 3.5 million direct jobs
and millions more through the supply chain and related services.
Indeed "the success of manufacturing is crucial to our countries
prosperity, now and in the future". We consider that prosperity
is already being eroded and the prospect for the future is bleak.
5.4 We have done a simple economic analysis of the impact
of the "competitiveness gap" between UK and European
energy prices. We concluded this is costing the UK economy £24
billion per annum.
5.5 The UK now faces the potential for a devastating
energy crunch in scenarios we consider to be more than merely
credible—they are quite likely and currently being "forecast"
by the Met Office. Ewen McCallum, chief meteorologist at the Met
Office, was recently quoted as saying "If our predictions
are right, then the coming winter is likely to be dominated by
easterly winds from the Continent, bringing very cold dry air."
5.6 In the event that we have cold weather in the UK
and Europe, we expect we will see massive price increases in the
prompt market (sustained prices of greater than £1/therm).
This is very likely to put many manufacturers out of business
for good.
5.7 Following this, we expect the UK to be short of gas
leading to a Gas Deficit Emergency. This will have consequences
such as "3 day weeks", wide scale power cuts, loss of
essential services such as water and sewerage and further business
closure.
5.8 In summary, we are faced with the nightmare scenario
that, in the event of very credible winter weather conditions,
the UK will essentially be "closed for business." Much
of this business will not recover and is unlikely to operate again.
6. REQUIRED ACTIONS
6.1 We believe that the long-term solution, to the current
energy crisis, is the opening up of gas markets in Continental
Europe and the development of significant UK storage capacity.
However, this is not yet happening and will not happen in the
short or medium term. Urgent action, to address the iniquitous
position UK consumers face is required now, to halt the devastating
impacts we are already witnessing. These actions need to be bold
and there should be no "sacred cows".
6.2 As part of the Energy Intensive Users Group, INEOS
Chlor have worked with DTI and OFGEM as part of the Gas Working
Group. We are disappointed at the lack of progress on the development
and implementation of actions as a result of the many discussions
we have had and the ideas we have proposed.
6.3 The UK has reached the point where little can be
done ahead of this winter but some measures which could be taken
are:
6.3.1 Gas power stations be required to test and demonstrate
their fuel switching capability;
6.3.2 Immediate dispensation on emissions restrictions
be given to facilities with alternative fuel sources;
6.3.3 NG be instructed to bring forward proposals
for Demand Response which adequately compensate consumers who
can offer demand response services;
6.3.4 Testing be carried out by NG across the system
to validate that voltage reduction can still be employed—a
"brown-out";
6.3.5 Consideration be given to withdrawal of the
recent network code modification which prevents NG from calling
interruption for "supply/demand" purposes;
6.3.6 Gas producers be required to ensure that LNG
cargoes are delivered to Isle of Grain when required -this could
easily be done by NG buying options for LNG cargoes through the
winter.
6.3.7 Gas producers be required to ensure the interconnector
is fully utilised when required—this could be done by NG
buying options from energy companies with pipeline capacity.
6.4 In addition to these short-term proposals, it is
essential that actions are taken to improve the market for the
next few winters. Some of these may be seen as interventionist
and possibly having unintended consequences. However it is difficult
to see consequences that are worse than the ones being faced by
the UK if nothing is done ahead of market liberalisation on the
continent. The actions we would like to be considered are:
6.4.1 A fully functioning supply and demand side response
market be developed by OFGEM and NG to enable the market to effectively
balance supply and demand. This could be based on the system that
already works well in the UK power market.
6.4.2 Arrangements could be put in place to provide
regulated third party access to the interconnector on a cost reflective
basis;
6.4.3 Arrangements be put in place to regulate the
cost of Rough Storage, which enjoys a monopoly position as the
provider of Long Range Storage in the UK;
6.4.4 Action is taken to avoid further delays on the
building of new storage facilities by cutting through the current
planning regulations.
6.4.5 DTI and OFGEM be encouraged to implement the
energywatch proposed modification on information release, which
would provide more equitable access to information to all market
participants. We find it unacceptable that gas producers are prepared
to share off-shore information between themselves (as competitors)
but not with consumers.
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