Conclusions and recommendations
Introduction
1. The
evidence we have heard during this inquiry can lead to only one
conclusion—that whatever short-term fluctuations occur,
and whatever regulatory action is taken in the UK to improve the
functioning of the energy markets, as the Minister of State for
Energy, Malcolm Wicks, recently stated: "the era of cheap
energy is surely over". (Paragraph 1)
2. Wholesale gas prices
have increased throughout 2008. As a result, we expect gas and
electricity bills for domestic consumers to rise significantly
in the near future, over and above the increases already announced
this year, with serious consequences for millions of households,
and especially the fuel poor. Industrial consumers now face prices
above European levels. If these price differentials are sustained,
they will affect the competitiveness of the UK economy, and put
many thousands of jobs in manufacturing at risk. (Paragraph 6)
Ofgem's inquiry
3. We
welcome Ofgem's inquiry into the energy markets. Our written and
oral evidence has highlighted serious problems in the functioning
of a number of aspects of the markets for gas and electricity.
We are particularly concerned by the perception that Ofgem has
already predicted the outcome of its inquiry, by stating at the
outset that it has seen "no clear evidence that the market
is failing". We hope this perception is proven wrong, and
intend to scrutinise the regulator's findings thoroughly. (Paragraph
7)
4. Once Ofgem announced
its probe, we decided to conduct our inquiry quickly to feed into
and inform its work. Accordingly, at this stage we have not concluded
whether the problems with the energy markets we have identified
can best be tackled through direct action by Ofgem, or through
further investigation by the Competition Commission itself. Considering
this in depth would have extended the length of our inquiry and
so prevented its conclusion before that of the regulator. We received
a significant amount of contradictory evidence, particularly in
relation to the functioning of the wholesale markets for both
gas and electricity, which was a cause of deep concern to the
Committee, and emphasises the magnitude and importance of Ofgem's
task. We will examine their analysis when it is available and
we will look with particular care at their recommendations for
further action. (Paragraph 8)
5. We appreciate that
Ofgem will have some difficult decisions to make. In doing so,
it must take account of the Government's overarching priorities
for energy policy as set out in its 2007 Energy White Paper, which
are to cut carbon emissions and maintain security of supply. The
market structure must deliver these, while also providing competitive
prices for consumers. In addition, Ofgem will need to weigh two
factors carefully—the effect regulatory uncertainty may
have on firms' investment decisions at a time of general consensus
that such decisions are needed urgently if electricity supplies
are to remain reliable and adequate beyond the middle of the next
decade; and the desirability of a thorough investigation into
the market that might improve its long-term competitiveness.
(Paragraph 9)
The UK gas market
6. We
are troubled by the apparent discrepancy between the figures cited
by our various witnesses on the extent to which gas is delivered
to the UK via off-market contracts, as opposed to the visible
market. The absence of consensus on such a basic characteristic
of the market makes it difficult to reach secure public policy
conclusions about desirable interventions. (Paragraph 15)
7. While the UK has
one of the most liquid spot markets for gas in the world, industrial
consumers and Energywatch have significant concerns about the
lack of liquidity in the forward gas market—an issue our
predecessor Committee raised in 2005. Given the apparent impact
on the prices major users pay in comparison to their competitors
on the Continent, we recommend that Ofgem investigates urgently
why gas producers seem unwilling to trade in the forward market.
This investigation should include the wider market effects of
both the lack of price transparency for forward contracts and
the risk premiums attached to them. If Ofgem is unable to reach
firm conclusions or suggest appropriate remedies, it should consider
a referral of this aspect of the wholesale gas market to the Competition
Commission. (Paragraph 17)
Increasing gas dependency
8. The
implication of the UK's growing gas import dependency is that
it must increasingly compete in European and global markets. This
means the UK gas price is influenced by changes in supply and
demand in other countries. Also, where market distortions exist
in other countries, such as the oil-gas price link in Europe,
which we discuss later, this too will affect the UK gas price.
The existence of import capacity does not necessarily guarantee
the flow of gas to the UK. Rather, this is determined by market
attractiveness and willingness to pay. (Paragraph 19)
Wholesale gas market concentration
9. Whilst
the overall level of gas market concentration is relatively low,
current figures provide only a snapshot of a rapidly evolving
market. Market concentration in the supply sources on which the
UK will become more dependent in the next few years are much higher
than that for the UK Continental Shelf. Ofgem must monitor this
situation closely, particularly if the marginal source of supply
to meet UK demand increasingly comes from these highly concentrated
markets. (Paragraph 22)
10. Ofgem states that
in examining the competitiveness of the gas supply market it is
worth noting that "at certain price levels a demand side
response occurs" and that this can "act as an additional
brake on potential market power". The regulator should remember
that this brake has a very real social and economic cost. We cannot
form public policy in a world of energy shortages and sharply
rising prices on the complacent assumption of a "demand side
response". The gas price spikes of winter 2005/06 were cited
as a key factor by the industrial energy user groups in the loss
of around 100,000 manufacturing jobs in the months that followed.
(Paragraph 23)
LNG import capacity
11. The
Isle of Grain LNG import terminal has seen little use this year.
It is possible the regulatory framework for the use of the facility
is part of the reason why LNG cargoes are not coming to the UK.
Ofgem should investigate the situation with a view to making any
necessary changes. Moreover, if international price competition
can so easily drive cargoes elsewhere there must be doubt about
the extent to which new capacity, such as Milford Haven, will
provide the anticipated benefits in terms of security of supply
for winter 2008/09. Ofgem and the Department should explore the
possibility of such diversion of supplies to inform other aspects
of energy policy, specifically in relation to gas storage. (Paragraph
26)
Gas storage
12. The
Government has not responded quickly enough to the UK's increasing,
and entirely predictable, gas import dependency by encouraging
investment in storage. This is an issue our predecessor Committee
raised in its 2002 and 2005 Reports on security of supply and
fuel prices. Significant additional storage, beyond that currently
planned, is needed to reduce volatility in the wholesale gas price,
which is otherwise likely to increase as the UK becomes increasingly
dependent on gas imports. It is now an issue of national importance
and should be a high priority in domestic energy policy. (Paragraph
29)
European-UK gas price link
13. In
recent years, the European gas price has set the floor for the
UK price during the summer, when the UK has been a net exporter
and its gas has generally gone into boosting European winter storage
levels. In winter, prices have risen markedly above European levels
in order to draw gas to the UK. We are concerned that European
gas suppliers are not responding to price signals more quickly
during the winter months by selling into the UK. We strongly support
the efforts of the European Commission both in its attempts to
increase the transparency of, and to liberalise certain contractual
and legal aspects of the European gas markets. Its task is particularly
challenging, given countries have increasing concerns over energy
security. The Government must also continue to exert strong pressure
in this regard, as a political solution to this issue would do
more to improve UK market conditions than any other domestic or
international initiative. We consider these objectives should
be a high priority for the Government in negotiations on EU policy
generally, not simply within energy policy. (Paragraph 35)
Oil-gas price link
14. The
contractual link between oil and gas prices on the Continent distorts
the wholesale gas market and therefore the environment in which
investment and consumption decisions are made throughout the EU.
In the absence of liberalisation in the short to medium term,
it seems unlikely that market liquidity will increase sufficiently
on European trading hubs to provide an alternative means of indexing
long-term gas contracts. The oil price will therefore continue
to have a significant influence on UK gas prices. It is likely
that European gas prices will continue to rise in lagged response
to the current increases in oil prices, and thus will feed through
to the UK market. (Paragraph 38)
15. Trading on London
markets plays an important role in setting the global price of
oil. We fully acknowledge the important role futures markets play
in helping purchasers of commodities to hedge against future price
movements and so assist in planning their businesses. We also
note the Treasury Committee's current interest in this subject.
We consider, however, that the Financial Services Authority would
be well advised to investigate the extent to which speculators
within its jurisdiction are currently driving up global oil prices,
and to take action if appropriate. (Paragraph 39)
Gas contracting
16. Clearly
something is wrong with the GB wholesale gas market if INEOS ChlorVinyls,
one of the UK's biggest industrial energy consumers, would rather
ship gas from abroad under a European contract, than engage directly
with the domestic market. Not only should Ofgem investigate why
companies are behaving in this way, in conjunction with the European
Commission it should also investigate the legality of gas suppliers
offering widely different contract terms in different jurisdictions
within the European Union. We cannot believe such behaviour is
compatible with the Single Market. (Paragraph 41)
The wholesale gas market and Ofgem
17. One
of our major concerns is that Ofgem's investigation is not giving
more explicit attention to the wholesale gas market. In 2004/05
Ofgem conducted an inquiry into the upstream sector in response
to gas price spikes that winter, but the recent price spikes have
been sharper still. The focus of Ofgem's investigation this time
is on the supply to households and small businesses. As part of
this it will examine the relationship between retail and wholesale
energy prices. However, it also needs to look again at whether
the wholesale markets themselves are functioning satisfactorily.
(Paragraph 42)
Wholesale electricity: rising environmental costs
18. It
is clear that the 'Big 6' firms and the independent generators
have, to varying degrees, benefited financially from the free
allocation of permits in Phase 2 of the EU Emissions Trading Scheme.
However, the magnitude of this windfall is not clear. Furthermore,
at least some of the value may be passed on to consumers through
lower prices, via cross-subsidy from their generating arms, while
some may support much needed investment in new capacity. We are
disappointed by the superficiality of Ofgem's current analysis.
We recommend that the Government now conducts and publishes a
rigorous analysis, estimating the value of any windfall profits
which companies have gained, and the use to which they have been
put, or are planned to be put. It is only on this basis that the
Government can then decide if there is a case for reallocating
some of this windfall—an issue we return to in Chapter 5.
(Paragraph 47)
Wholesale electricity market concentration
19. At
present, Britain has a diverse electricity generation portfolio,
owned by a number of different companies. However, we are concerned
that this may be undermined by market consolidation, such as a
takeover of British Energy or Scottish Power. Ofgem and the Competition
Commission should ensure that, were this to happen, measures are
put in place to protect current information flows to the market,
and to ensure no single generator has excessive market power.
We acknowledge the urgent need to secure investment in new generating
capacity, but that investment must not come at the price of a
less competitive or transparent market in the long term.(Paragraph 49)
New generating capacity
20. The
need for investment in new generating capacity—and associated
transmission infrastructure—in the coming years is huge.
This investment will only be delivered by profitable companies
which see a commercial opportunity, whether they are existing
players or new entrants. While the market seems to be providing
price signals for the vertically integrated firms to invest in
new large-scale conventional capacity, there is a question mark
over whether new companies face disproportionate barriers to entry.
(Paragraph 52)
Vertical integration
21. While
the 'Big 6' claim to be losing money in domestic supply, there
is evidence that they are earning increased profits from their
wholesale operations. We acknowledge that some of these profits
may be earmarked for investment in new capacity rather than for
distribution to shareholders, but we recommend that Ofgem conducts
further work to understand where profits are being made within
the energy supply chain. As part of this, we also recommend that
Ofgem investigates whether it can require more detailed financial
disclosure from the vertically integrated companies on the performance
of their wholesale and retail operations, where they do not already
provide this. Such information should not deter new investment,
but would inform potential new entrants to the sector—both
generators and suppliers. (Paragraph 56)
Wholesale electricity market liquidity
22. The
wholesale electricity market suffers from a severe lack of liquidity,
which contributes to price volatility and poor price transparency.
This, in turn, dulls market signals for potential investors in
new capacity, outside of the 'Big 6'. It also reduces the ability
of new energy retailers to compete in the market. As Ofgem has
already identified the issue as a serious problem, and in the
absence of tangible progress on the Market Design Project, its
market probe should propose a solution. As a starting point, and
in addition to any increase in transparency that can be achieved
as a result of our earlier recommendation, the regulator should
conduct a detailed analysis of the risks and benefits of requiring
the 'Big 6' firms to trade a proportion of their electricity openly
in the forward market. We acknowledge that the regulator must
take account of the need to balance the effects that greater regulatory
risk might have on the investment decisions of incumbent companies.
In principle, however, creating a better functioning wholesale
market should facilitate new entry both in supply and generation.
(Paragraph 63)
Changes in supplier costs
23. Higher
wholesale electricity and gas prices have been the largest contributor
to increasing household energy bills, though the impact of environmental
and network costs should not be underestimated. While the 'Big
6' claim to be losing money in their domestic supply businesses,
as noted earlier, there is evidence that they are making much
greater margins on electricity generation. We note that while
the 'Big 6' have cited rising wholesale prices as the reason
for collectively increasing prices in 2008, it required a 'naming
and shaming' by Ofgem for two companies to reduce their retail
prices in early 2007, when wholesale prices were falling. Whatever
the result of their current investigation, Ofgem must make it
clear it will use such an approach in the future if circumstances
demand similar action. (Paragraph 71)
Retail market concentration
24. Despite
the fact that both gas and electricity supply are now dominated
by just six firms, the level of concentration in both markets
has fallen as the firms have competed with one another. Nevertheless,
the gas and electricity markets are likely to remain highly concentrated
so long as there are only six major players. The regulators should
oppose any further consolidation within the 'Big 6' which
would diminish retail competition, at least until one or more
of the smaller suppliers has established a significant presence
in the domestic market. (Paragraph 74)
Direct selling
25. Whilst
direct sales currently provide the most effective means of persuading
hard-to-reach consumers to switch supplier, they must be conducted
with the utmost propriety. We welcome Ofgem's investigation into
Npower's selling practices, and we will be looking at the regulator's
conclusions and recommendations with particular care. Any further
significant breach of best practice by any supplier would inevitably
lead to calls for this sales technique to be abandoned. The industry
must consider itself on notice. (Paragraph 80)
Switching
26. By
international standards and in comparison with other sectors,
there is a high level of switching in the energy supply sector.
However, around half of customers are still with their original
supplier for at least one fuel, and 20% have not switched either
fuel source, despite the fact that incumbent suppliers consistently
fail to provide the best available offer in their home areas.
Moreover, most people who do switch fail to change to the cheapest
supplier, and a significant number actually move onto a more expensive
tariff. Ofgem is considering these issues as part of its probe.
We believe its recommendations should include new ways to engage
consumers that have not switched away from their incumbent supplier,
and it should consider ways in which customers who do switch can
make more informed choices. Ofgem should also investigate how
all customers could benefit from competition, whether they switch
or not, for example by preventing energy companies from over-charging
their legacy customers. (Paragraph 82)
Payment types
27. There
has been a widening gap between companies' direct debit tariffs,
and those for standard credit and prepayment meters (PPM). Nine
years after liberalisation, this suggests a serious failing in
the competitiveness of the market. Recent debate has focused on
the prices for PPM. However, we are equally concerned about the
poor deal standard credit customers are receiving, particularly
given that this is the payment method for the vast majority of
the fuel poor and the evidence suggests they are on average being
over-charged even more than those on PPM. (Paragraph 87)
28. This issue is
a major part of Ofgem's probe. In a fully competitive market the
tariff differences for each payment type would not exceed their
economic cost; there would be no cross-subsidy between, for example,
standard credit and online direct debit customers. The regulator's
probe must form a robust view of the additional costs associated
with standard credit and PPM customers. If, in a year's time,
the 'Big 6' have still not narrowed the gap between the different
payment types, Ofgem should consider re-introducing some form
of price control, limiting the differentials that can be charged.
(Paragraph 88)
Smart metering
29. We
believe smart meters would play an important role in facilitating
competition in the retail sector by giving consumers better information
about their electricity usage and cost, thus encouraging greater
and more informed switching. The Chief Executive of E.ON UK told
us: "we should get on with this, because, quite frankly,
we are using Stone Age technology here; we know we can do better;
we just need to agree the process by which we roll it out".
We agree, and hope the Government's decision, due by the end of
the year, includes a clear and urgent timetable for implementation.
(Paragraph 90)
The SME Market
30. The
evidence put to us by small companies in the market for SME electricity
supply is compelling and suggests some of the 'Big 6' companies
may be abusing their market position to choke off new entrants.
We are also concerned by the role of third party intermediaries.
We welcome the fact that Ofgem is considering small business customers
as part of its probe. We believe that until now Ofgem has in the
past paid too little attention to this important part of the market.
If it finds evidence of serious anti-competitive behaviour by
specific companies, and is unable to address this situation with
suitable undertakings, it should refer the matter to the Competition
Commission. (Paragraph 95)
Product innovation and 'green' tariffs
31. Overall,
there has been a growing level of product innovation in recent
years for those customers who are able and willing to engage in
the market. However, we have serious concerns that customers on
many 'green' tariffs are being misled about the extent to which
their tariff offers an additional environmental benefit, over
and above their energy supplier's existing legal requirement under
the Renewables Obligation. We welcome Ofgem's belated guidelines
for suppliers offering green tariffs, and hope that they will
reduce the potential for customer confusion. Once in place, Ofgem
must monitor compliance with the guidelines closely. (Paragraph
99)
Off-network gas consumers
32. Many
consumers whose homes are not connected to the gas network have
the frustration of knowing gas pipelines are close by, but cannot
be accessed. They are condemned to using more expensive means
of heating their homes. Ofgem should consider whether the current
incentives are strong enough to encourage network operators to
connect more households to the gas network. It should also consider
the appropriateness of the charges involved, especially where
communities could club together to pay for such connections. The
Government could also consider targeting part of any increase
in budgets to address fuel poverty towards schemes to provide
direct financial assistance to secure connections to the network,
or to assist the development of local combined heat and power
or renewable heat schemes for such communities. (Paragraph 102)
33. We are concerned
that there is not sufficient regulatory oversight of the market
for domestic fuel for households which are not connected to the
gas network. The Government should consider whether both the statutory
duties of Ofgem and the successor to Energywatch, the National
Consumer Council, should explicitly cover the market for fuels
used by off-network households. (Paragraph 103)
Final remarks on markets
34. Our
overall conclusion on the functioning of both the gas and electricity
wholesale markets is that there are significant questions that
need to be addressed in the interests of both retail and business
consumers. We have also identified important issues that need
to be addressed in the retail market itself. We have at this stage,
however, recommended consideration of the merits of referring
only two aspects of the markets to the Competition Commission
(the forward gas market and the supply of electricity to the SME
sector), and then only if Ofgem is unable to take sufficiently
robust steps itself. We note that no witness has suggested that
there is any evidence of active collusion in the wholesale or
retail markets. It is clear, though, that in a retail market dominated
by six big players, it is easy for those players to make informed
judgements about the behaviour of their competitors. This can
distort competition, without any active collusion occurring. The
regulator therefore needs to remain very watchful. (Paragraph
104)
35. We believe that
there are very real problems that need to be addressed. This can
best be done through improving market design, taking specific
regulatory steps, and by continuing to work for liberalisation
of European markets. Such an approach is more likely to bring
real and lasting benefits to consumers. It is also less likely
to inhibit the investment the UK needs so urgently if we are to
"keep the lights on" as we lose a large proportion of
our generating capacity around the middle of the next decade.
It will, however, need Ofgem to demonstrate a rather greater sense
of urgency than has been made apparent so far. In this context
we look forward to reading the conclusions of its market probe
in September. (Paragraph 105)
Recent developments in fuel poverty
36. Other
things being equal, with every 10% increase in energy prices 400,000
people go into fuel poverty. The rise in prices since 2004 means
the Government is certain to miss its target of eradicating fuel
poverty for vulnerable households by 2010. We welcome Ofgem's
Fuel Poverty Action Programme as a sign that the Government is
aware of mounting concern in this area. In particular we welcome
plans to enable data-sharing that will help energy suppliers identify
pensioners most in need, although such information will need to
be handled with the utmost propriety. We hope the Government will
implement similar plans for other vulnerable groups. However,
in the context of sharply rising prices and reductions in funds
for the Warm Front programme, discussed below, the additional
money pledged by the energy companies, while welcome, will make
very little difference to the overall number of fuel poor households.
We believe the Government must now consider a fundamental re-think
of its approach to tackling fuel poverty. (Paragraph 109)
Social tariffs
37. In
rethinking its approach to fuel poverty the Government must decide
whether companies should have a larger, perhaps statutory role
to play in delivering its social policy objectives—that
is, to what extent energy companies should be expected to divert
their profits away from investment and distribution to shareholders,
and to what extent relatively more affluent energy consumers,
many of whom are themselves far from rich, should, through the
price they pay for their electricity, cross-subsidise those who
are less well-off. This cross-subsidy is currently modest, but
it would inevitably grow if social tariffs were to be expanded.
(Paragraph 113)
38. Energy suppliers'
existing social assistance initiatives (which go well beyond specific
tariffs) do not reach the vast majority of the fuel-poor. They
also vary widely, confusing consumers and providing inconsistent
coverage. Irrespective of its broader conclusions on the role
of such tariffs, we believe the Government should define the criteria
for both the prices charged by suppliers under the banner of social
tariffs, and for identifying those customers that qualify for
them. We recognise that companies could only implement such an
approach if they have access to information provided by central
and local government. We do not accept the view that a mandatory
and comprehensible definition of what constitutes a social tariff
would create a 'race to the bottom' for all suppliers—rather,
it would provide a minimum level above which they can compete,
not only on tariffs, but also on other schemes to assist the fuel-poor.
(Paragraph 114)
Raising incomes
39. The
Winter Fuel Payment is targeted at pensioners rather than the
fuel-poor. The political reality is that either removing it from
any existing recipients, or taxing it, to release funds for the
genuinely fuel-poor, would be courageous decisions. However, we
believe that any additional funds to help households cope with
rising energy prices should be better targeted on the fuel-poor—not
only pensioners, but also disabled people and other vulnerable
consumers. (Paragraph 117)
Improving housing
40. After
several years of increases, it is very disappointing that in the
current three-year spending period the Government has reduced
the budget for Warm Front at a time when the need for it is greatest.
This is especially so, given that HM Treasury has received additional
income from the auctioning of permits under Phase 2 of the EU
Emissions Trading Scheme, while electricity generators are benefiting
from windfall gains from the free allocation of the majority of
permits under the same scheme. We hope that this reduction in
funding will be corrected very quickly. (Paragraph 121)
41. We recognise the
claims made by the generators about the way in which they have
used the 'windfall gains' under Phase 2 of the EU ETS, and we
understand the danger that regulatory uncertainty could delay
investment plans. However, given the apparent size of the gain
(something we have already asked Ofgem to examine more carefully),
and the extreme need of many households, we believe there is a
compelling rationale for at least a modest, one-off top-slicing
of these gains to help fund action to reduce the energy bills
of vulnerable families in the long term. However, we also note
the windfall gains accruing to HM Treasury, and believe it too
must make its contribution in these exceptional circumstances.
(Paragraph 122)
42. Energy prices
are likely to remain high, by historic standards, and the Government
is unlikely to be able to raise incomes sufficiently rapidly to
meet its fuel poverty target, especially given the current economic
downturn. This means that in the future, government and industry
efforts need to focus on improving the housing stock of the fuel-poor,
as the most cost-effective means of reducing both their energy
bills and their carbon emissions. We believe the Government must
consider whether the Carbon Emissions Reduction Target and Warm
Front should be more precisely focused on helping the fuel-poor,
and whether synergies between the two initiatives can be more
actively exploited. If the Government remains committed to eradicating
fuel poverty it must have in place policy instruments specifically
designed to achieve this aim that do not rely on ongoing subsidy
of fuel bills. A great many households face a difficult winter;
it is imperative that the Government reviews its approach to fuel
poverty and does so urgently. (Paragraph 123)
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