Examination of Witnesses (Questions 100-119)
MR DAVID
PORTER, MR
JOHN MCELROY
AND MR
ANDY LIMBRICK
28 NOVEMBER 2006
Q100 Chairman: The DTI revised its
projections for demand for electricity in 2010 upwards and also
its projections of the emissions that that would cause. Are your
members doing anything to restrain demand for electricity?
Mr Porter: As generators I suppose
the answer, strictly, is not a lot, but a number of our companies
of course are vertically integrated businesses that have retail
interests as well and they are required to do things to restrain
demand. I do not know whether John might like to comment on things
like the Energy Efficiency Commitment and other measures.
Mr McElroy: I would have to say
that the supply business is extensively involved in the issue
of energy efficiency. Clearly within the domestic sector the major
instrument is the Energy Efficiency Commitment, which I think
has been a very successful policy instrument. We have seen increasing
interest in terms of the energy-intensive sector in managing their
energy demand over the next few years. I think that is an area
where the market in energy services will develop over the next
few years, and to a certain extent that will be reinforced by
the Energy Performance Commitment which is currently being consulted
on, if that comes into force in due course. We are working with
customers right across the piece on energy efficiency. I think
in the domestic sector there are major challenges in raising customer
awareness and securing customer engagement.
Mr Porter: I ought to add, Chairman,
that although consumption rose by 26% between 1990 and 2005, it
did show signs of tailing off after 2000, so something is happening
in the market now.
Q101 Chairman: Do you think, looking
ahead, that the operation of the EU ETS can itself have any effect
on demand?
Mr Porter: I think it can and
in some respects it is meant to, in that the cost of emitting
carbon (which became a reality in 2005) is going to become increasingly
important, and it will find its way through into electricity prices,
and to some extent that will affect demand. However, customers'
demand for electricity is inelastic and they are prepared to tolerate
quite large rises in energy prices before those rises affect their
behaviour. Having said that, I think a number of things have woken
people up to the cost of energy. The debate about climate change
is one of them and also of course the quite large rises in fuel
prices in the last couple of years have had that effect as well.
And at home, where we did not care about leaving something on
standby or leaving lights on very much, we now take it more seriously,
and there must millions of people with the same reaction.
Q102 Colin Challen: We have heard
a great deal about concerns over windfall profits for the power
companies after the introduction of the ETS. In fact, the DTI
commissioned a study which estimated these profits to be in the
order of £800 million a year. You are making this money because
you have raised your prices to take into account the market value
of the allowances under the ETS that you are using up, even though
you received the original allocation for nothing. What is the
justification for that?
Mr Porter: I think there have
been a great many misunderstandings about those allegations and
that report that went to the DTI. The starting point is that until
January 2005 an electricity company making electricity could emit
carbon free of charge. As from January 2005, in one way or another,
the emission of carbon was going to impose costs on that company.
Those costs arise either through having to switch fuels, to run
different plant at different times to meet demand, and they also
arise when companies are unable to stay within their emissions
allowance and they have to go into the market-place and buy allowances,
and I will ask my colleague John McElroy in a moment to comment
on what that actually means and how much money has to be spent
to buy allowances. So there is another side to this story and
when we looked at the report—
Q103 Colin Challen: Can I just ask
how many companies have got to the point where they now have to
buy allowances?
Mr Porter: Could I come to that
in just a moment. I was going to say that the report to the DTI
was riddled with assumptions, and I think it was very much a worst
case headline that came out in terms of the extra revenue that
went to the electricity industry. One way or another, however,
this is meant to increase costs, and that is bound to flow through
into prices. Companies have been accused of making gains. Actually
the system is meant to give gains to some companies that can work
within their allowances, but John would you like to say a bit
more about going into the market and paying for allowances?
Mr McElroy: The situation in 2005
was that the electricity sector had to buy somewhere around 36
million tonnes of CO2 allowances in the market, given
the shortfall in allocation versus emissions. If you assume an
average allowance price through 2005 of about €20 per tonne,
that effectively cost the industry around £500 million. I
think the other thing to say, as David has mentioned, is the £800
million figure which was in the DTI report was very much based
on the assumption that there was full pass through. It was very
much a worst case. The simple fact of the matter is that the way
the electricity market works, generators tend to contract their
output up to two years ahead, and if you look at the expectation
on CO2 allowance prices that the market had in 2004,
it was typically in the range €5 to €10 per tonne, compared
with the outturn in the market, which was in the range of €15
to €30 per tonne in the first year. So I think there are
a range of factors which would suggest that the market was not
fully able to pass that £800 million through. I think the
other point to note is that of course allowance prices have fallen
substantially over the last year and we are now at an allowance
price of around €8 per tonne so clearly the potential for
gain is considerably reduced from the figure that was quoted in
the report by IPA Consulting.
Q104 Colin Challen: I will read the
transcript because I am not sure I am getting everything with
this bell going on. Am I to understand that we should organise
a whip round for these power companies because you are actually
out of pocket and the DTI's figures were completely wrong and
you are not having a windfall at all?
Mr McElroy: I think it is important
to recognise that there may be an element of gain but the Emissions
Trading Scheme is supposed to benefit certain parties; that is
the whole point of the design. There is a big distributional impact
in terms of how any gains might be spread across the sector which
would depend on the allocation to particular players. It will
also depend on their fuel mix. If you recognise that gas plant—combined
cycle gas turbines—were setting the marginal price in the
electricity market through almost all of 2005, then the potential
was only to pass the level of carbon through to the market emitted
by combined cycle gas turbine plant. Emissions from coal plant
were very much higher, so coal plant was significantly disadvantaged
in that market in terms of any ability to pass through carbon
costs, so it is a very complex picture and it has got to be considered
in terms of individual players and not just the market as a whole.
Q105 Colin Challen: It is complex
but can we get one or two simple conclusions out of this part
of the discussion. For example, has any profit been generated
and has that profit, as some power companies have claimed, been
used to provide cleaner plant and therefore lower carbon emissions?
Mr Porter: There is one simple
condition that we must not lose sight of and that is that the
UK's electricity companies work in an intensely competitive market-place.
The largest ones of them have retail businesses and those retail
businesses depend for their very existence on having very large
numbers of customers. The UK customers of electricity are more
sophisticated today and they know that they can switch between
suppliers. Around 50% of them have a record of having done that.
Companies can lose customers if they pass on price increases and
get it wrong, and they hate doing that. They depend in their retail
businesses on having very high levels of customer base, and upsetting
the customers through price increases is not something that they
want to do. As for investing in new plant, that is coming but
it could not come at the beginning of the EU ETS. The industry
wants to invest in new plant. It knows it has got to have cleaner,
greener plant and it knows that it is facing a bill, as I said
before, of roughly £20 billion for doing that. But in the
early stages of the EU ETS there was really no possibility that
anybody could build new plant to respond to the allowances. In
fact, today they are looking for the Government and the EU to
give them a clear indication well beyond 2012 of what the allowances
are likely to be so that they can make those investment decisions
and deliver cleaner, greener electricity for the EU.
Q106 Colin Challen: If the price
of allowances goes down, does the price of electricity also go
down?
Mr Porter: That does not necessarily
follow because there are several things that a generating company
has to keep an eye on virtually every hour of the day. It has
to have an eye on demand and what it is contracted to do. It has
to have an eye on fuel prices, which in the last few years have
been extremely volatile, and it also has to watch the carbon price.
There is quite a complex, dynamic relationship between these things
and if somehow fuel prices went down but the carbon price went
up, you may not necessarily see a response in the price to customers.
John or Andy, would you like to add anything?
Mr McElroy: Ultimately, in the
balancing market, in the short-term market you would expect to
see the price of allowances factored into the market. If the market
was not doing that, then emissions trading would have completely
failed to deliver. The fact is that not all electricity is sold
through the balancing market, a lot of it is sold in the contract
market, and there are dynamics in terms of how the market responds
to price signals in particular segments. It is a complex issue
but, generally speaking, ultimately you would expect to see changes
in various price influences reflected in the price of electricity,
however it is not necessarily an immediate response.
Q107 Dr Turner: Can I just butt in
on this before we leave the money, because I am not personally
satisfied with Mr Porter's answers. He has danced very nimbly
around the issue and done everything except answer the original
question, because it almost beggars belief that by this stage
the industry does not know, pretty accurately, how much extra
profit, assuming it made an extra profit, it made overall during
the first year, during which I think it is probably safe to assume—and
you can correct me if I am wrong—that the industry's emissions
did not fall by one tonne. Am I correct? Can you give me that
figure because I just do not believe that you do not have it.
Mr Porter: Can we deal with the
emissions question first.
Mr McElroy: Emissions, as we know,
were relatively flat between 2004 and 2005. In fact, they have
been relatively flat since 2003 so, yes, there was no change in
emissions as such in 2005, but then, equally, one has to recognise
that if you look at gas prices during that period the level of
the carbon allowance price was not sufficient to drive coal to
gas switching, so essentially on that basis there was no signal
in terms of driving a short-term response. Generators have been
investing significantly in efficiency improvements and those will
flow through to the market over the next few years. We do not
have a long-term price signal to drive investment at scale.
Mr Porter: And as for what profits
are made by the industry, of course there is not a single figure
for profit for the electricity generating industry. Different
companies have different results.
Q108 Dr Turner: I am sure somebody
adds it up.
Mr McElroy: Can I just say that
it is important to recognise the structure of the industry. Price
flows through to the customer via a chain and it is very hard
to say, if there are any gains, how they are actually distributed
across that chain. The ability to pass costs through in the domestic
sector has been driven much more by rising fuel prices than it
has by the carbon price and therefore estimating what the element
of carbon in that might be is extremely difficult. It is not a
straightforward question to answer.
Q109 Joan Walley: I just want to
press you a little bit further on this. You did not talk about
a windfall tax but your face suggests there has been an element
of gain. I would like to ask you where that element of gain has
come from because it seems to me that it has come from carbon
allowances which you had which you did not actually pay for, so
is it not slightly bizarre that you have got this element of gain
on the back of the carbon allowances which were there for free?
Mr Porter: It starts with restricting
the emissions of carbon. Until January 2005 that did not happen.
Once that kicks in, companies have to respond and it costs them
money to respond to that. That cost finds its way through to the
electricity price.
Q110 Joan Walley: But you receive
the bulk of those allowances for free.
Mr Porter: Yes, we cannot help
that.
Mr McElroy: That was the intent
of the design of the scheme. The intent of the design of the scheme
was to recognise that there was no price of carbon in 2004; there
was a price of carbon in 2005, and the free allocation was to
compensate for the fact that for the people who had invested in
the industry up to that point without any carbon price, their
assets had been written down in value. We did not design the scheme;
that is the European Directive.
Q111 Joan Walley: So are you saying
that the scheme was to compensate those who had invested who now
had less value in their assets?
Mr McElroy: That was part of the
reasoning behind the basis for free allocation.
Q112 Joan Walley: And am I right
in thinking that the value to the industry was in the region of
£850 million?
Mr McElroy: That is the maximum
that the industry could have gained by, had it been able to pass
the full opportunity cost through to the market but, as I think
we have explained, there were a lot of reasons as to why that
may not have happened.
Q113 Chairman: On that point, even
if you disagree with the DTI figure, the Carbon Trust have estimated
a figure of £677 million. Do you disagree with that figure
as well?
Mr McElroy: They are in the same
ball-park. I would not disagree with the DTI's figure of £800
million as the maximum possible that could be passed through to
the market, and I think that is actually what the IPA Consulting
report said—it said it was the maximum; it did not actually
say it was the number.
Q114 Joan Walley: What is your figure?
Mr Porter: We do not come up with
a figure.
Joan Walley: You do not have one.
Chairman: This might be a good point
to go on to auctions.
Q115 Colin Challen: Will you ever
come up with a figure or is it something that you want to avoid
at all costs?
Mr Porter: It is not something
that is going to help us in delivering cleaner, greener electricity
through the EU ETS.
Q116 Colin Challen: It will help
policy-makers decide how to structure things. We are going to
come on to the auctioning aspect, but do you not agree that this
is just a hole in your analysis which needs to be filled? How
do we design these schemes if you cannot even produce these basic
figures? It is massively complex but surely if the DTI can come
up with figures and you do not agree with them, it is because
you have got your figures somewhere? If you have not got your
figures, we will assume that the DTI figures are correct.
Mr Porter: We have already said,
Chairman, that we are not disagreeing with the figures that went
to the DTI in the IPA report. What we are questioning is whether
that was a worst case. A lot of guesswork went into that. The
point for the future is that the scheme had to be started in a
way where it would actually work and get off the ground. It needs
to be improved and there are measures coming now which will improve
it. We are going to see something come in tomorrow. Probably we
are going to hear an announcement from the European Commission
to the effect that in Phase 2 they want to see a number of countries
tighten up on the cap that they are applying, on the allowances
that they are giving, and over time the scheme is going to become
more refined and more effective; in fact, it has to.
Q117 Colin Challen: What impact will
auctioning have on your members?
Mr Porter: I think the most important
thing to us is what is the cap on allowances and how much do we
have to buy in the way of allowances, but for a more detailed
comment on auctioning, I will hand over to John.
Mr McElroy: The position in the
UK Phase 2 NAP is that the Government has decided to auction 7%
of allowances. All of that will be taken from the allocation to
the electricity sector so it equates to around 15% of the allocation
to the electricity sector. That is around 17 million tonnes of
CO2 allowances per year. Obviously the impact of that
will be that the electricity sector will either have to reduce
emissions by fuel switching or bringing forward investment. Again
that can only happen towards the tail end of the phase, or go
out and buy allowances in the market. So it will increase the
cost of compliance to the electricity sector in Phase 2. Our view
at the moment is that incumbent generators have been allocated
around 100 million tonnes of CO2 allowances in Phase
2 against a need of around 165 million tonnes, so the electricity
sector will be significantly short of allowances in Phase 2 of
the scheme.
Q118 Colin Challen: What effect will
that have on electricity prices?
Mr McElroy: Again that depends
on the price of carbon in the market, which is set at European
level, so it will depend on the decisions that the Commission
makes and ultimately how it deals with the other national allocation
plans which it has still got to consider and how short, ultimately,
the market is of CO2 allowances. At the moment it is
impossible to speculate what the price of CO2 will
be in Phase 2. The market at the moment is trading in 2008 at
around 18 euros per tonne of CO2. The issue is whether
the Commission's actions will drive that price up or whether it
will fall. We are all sitting with interest to see what happens.
We want a scheme that works and we want to see the Commission
actually exercise some muscle in ramping down caps in Europe to
make certain that we put the scheme on a sound footing to move
through to hopefully something which is much more efficient and
transparent in Phase 3.
Mr Porter: There is another aspect
of auctioning that we are interested in and that is where the
money goes, and at the moment it appears that it goes straight
to the Treasury, but what they are intending to do with it is
still unclear. It may be used for public purposes generally but
we would be sensitive to the use of that money within our industry.
There are good and bad ways in which it could be used.
Q119 Colin Challen: The Government
has talked about an Environmental Transformation Fund as a possibility.
Are you saying that you really want to see this money, if you
like, hypothecated for an environmental good? What sort of thing
would you like to see it spent on?
Mr Porter: It is not clear how
much is going into the Environmental Transformation Fund. John,
would you like to comment on the good and bad.
Mr McElroy: In terms of the good
and bad, our key concern is that auctioning is often seen as the
panacea for emissions trading and it is the way in which it deals
with all harmonisation issues and level playing fields, et cetera,
et cetera. However, it is interesting to note that the Commission's
review is totally silent on the use of auctioning revenues. Any
consultation that has been carried out by the UK Government has
also been totally silent on the use of auctioning revenues, but
potentially if those auctioning revenues are used in a way which
helps bring low-carbon technologies to the market-place, that
would certainly seem to be a good way to move forward. Our real
concern in wanting a robust carbon market is that it is not used
to distort the market or be seen to support particular industries
in the market. There is the potential for auctioning to result
in just as distorted a market as free allocation is perceived
to lead to.
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