Memorandum submitted by Chemical Industries
Association
SUMMARY
The Chemical Industries Association is pleased
to have the opportunity to make a submission to the Committee
and highlight our continuing concern over the high and volatile
prices prevailing in UK wholesale energy markets.
We represent around 150 of the mostly larger
producers in the chemicals sector, which in 2006 had a total turnover
of around £57 billion and a trade surplus of £7 billion.
Further details are in the Appendix at the end of this submission.
Below we provide a background section explaining
the main features of UK energy markets, and then go on to consider
specific issues of concern to our members.
In summary, we conclude that fundamental market
characteristics provide scope for anti-competitive behaviour in
UK energy markets. These include the fragmented nature of supply,
lack of storage capacity and lack of transparency in some key
import sources, all of which add to market nervousness and volatility,
which in turn encourages speculation. Suppliers have little motivation
to secure extra physical supplies of gas on a long term basis,
since they may lose contracts with customers; conversely customers
feel they are offered little choice of contract. There is an uneasy
stalemate and most contracts are tied to the spot price. Vertically
integrated suppliers have a vested interest in maintaining high
prices. Longer term contracts could benefit both sides.
The proximity to a Continental market run on
very different principles is costing the UK dear. While the Continent
has a large element of long term contracts and some price predictability
thanks to a system of retrospective adjustment to an index based
on a basket of oil product prices, the UK works on a short term
basis and industrial customers are forced to rely mainly on spot
buying. The same vertically integrated suppliers largely control
flows of gas between the UK and Continental markets. While the
UK is open to Continental buyers, the Continent is largely closed
to the UK.
Our members are finding instances of less competitive
behaviour: there is a tendency for fewer competing tenders at
contract renewal, and these vary little. They sense the market
may be being manipulated at certain times—instances appear
in paragraph 15 below. They cannot directly access cheaper Continental
gas to ship back themselves.
BACKGROUND
1. We first outline in paragraphs 2-10 below
why the question of energy prices and security is so important
to the chemical industry, why gas in particular is a focus of
concern, and why we believe features of the present market arrangements
lead to less than satisfactory competition and can leave customers
less than well served.
2. The UK chemical industry operates in
fiercely competitive global markets. The industry is also global
in ownership, with over 65% of CIA's membership being foreign
"headquartered". Investment decisions are therefore
mostly made overseas. Any significant imbalance between the UK
business climate and other markets can lead to the loss of UK
trade and investment.
3. Key "building block" products
are made using raw materials purchased at global prices and are
sold as commodities likewise at global prices. Companies compete
on the efficiency of the conversion processes, which are frequently
energy intensive. Gas also serves as a raw material for fertiliser
manufacture. Intermediate products are widely used by downstream
speciality chemical companies, who thus indirectly feel the effects
of high energy prices, even if their own operations are less energy
intensive. Finished products of the industry are used as industrial
components, for example in automotive manufacture, as process
enablers, for example in textiles and paper manufacture, and as
consumer products such as detergents, paints and pharmaceuticals.
Access to internationally competitively priced energy and gas
as a feedstock is therefore vital to the viability of the UK chemical
industry. Consequently the members of this association take an
exceptionally keen interest in energy markets and employ skilled
manpower and devote considerable senior management time to energy
purchasing.
4. Crude oil and refined products are easily
transported. There is a true global market and essentially common
prices apply (disregarding local taxation differences.) The same
is not true of gas, whose delivery depends on expensive pipeline
infrastructure or liquefaction facilities at source (LNG—liquefied
natural gas) and specialised ships to transport LNG to purpose
built receiving terminals. Globally, significant price differences
occur, and access to the transport infrastructure is vital if
competition is to be given full rein. In the UK a large proportion,
around 40%, of electricity generation is also dependent on gas,
underlining the importance of a competitive gas market.
5. As North Sea reserves are slowly being
exhausted, the UK market is becoming increasingly dependent on
imported gas. The main import routes are pipelines from Norway
(Langeled and Vesterled), the Netherlands (BBL), and Belgium (Interconnector).
LNG can be imported at Isle of Grain; additional facilities at
Milford Haven are nearing completion. Existence of import capacity
does not, however, guarantee a flow of gas. While Langeled, Vesterled
and BBL have flowed consistently, almost no LNG has come through
Isle of Grain in 2008, and net inflows along the Interconnector
have been negligible—from 1 October to mid-March they averaged
only 1.1 million cubic metres (mcm) per day, compared to UK demand
of about 325 mcm. It has been a long standing concern that gas
has not flowed to the UK from the Continent via the Interconnector
when market prices suggested it should. Conversely, the Interconnector
has sometimes exported gas from the UK even while gas was being
taken from storage to meet UK demand.
6. UK gas demand has a strong seasonal component,
as demonstrated by the following chart[33]:
There is a large variation in summer and winter
demand, almost entirely due to changing heating requirements for
domestic and commercial premises. Industrial process use, in contrast,
is quite stable. Unfortunately the UK is not well supplied with
storage capacity—the main "long term" storage
facility, Rough, can provide only 45 mcm per day (less than 15%
of average winter daily demand) for 70 days. Drawing on "medium
term" storage can double this daily flow, but for fewer than
20 days, since Rough represents around 80% of storage by volume.
Consequently the UK needs a large seasonal increase in imports
just when the rest of Europe has maximum demand. Our storage capacity
is manifestly inadequate given our present and expected increasing
future dependence on imports.
7. Suppliers are not required to hold any
physical gas in store; all assume they can "go to the market"
if needed. If contracts with users are linked to the "spot"
price, the shipper runs no risk. Supply and demand will ultimately
balance as demand is choked off by higher prices—and with
disastrous consequences for industrial customers, who help to
provide the euphemistically named "demand side response".
Forward contracts are either unavailable or have such a large
risk premium that chemical industry users cannot afford to buy/use
gas at that price, and of necessity rely largely on spot-linked
contracts. When prices spike they are forced to reduce or even
cease production.
8. Many suppliers are part of a larger vertically
integrated energy company. Despite "Chinese walls" the
shippers do not always have an obvious interest in trying to win
market share if this involves increasing supplies to the market
and thereby reducing the price of the commodity their parent produces.
9. All in all the combination of uncertain
supplies from the Continent and of LNG, and the UK's limited storage
capacity, create a sense of nervousness in the wholesale gas market
which is reflected in high forward price premiums and frequent
spikes in spot prices whenever the UK is hit by a spell of severe
weather, or if there is reported or rumoured interruption to supplies,
for example damage to pipelines. Against such a background it
becomes easier to create perceptions of shortage which lead to
higher prices to the benefit of integrated suppliers.
10. Because of the high proportion of gas
fired generating capacity, any increase in the wholesale gas price
feeds directly through to electricity prices.
SPECIFIC ISSUES
OF CONCERN
TO OUR
MEMBERS
11. Market transparency
Despite improvements in recent years, transparency
in markets remains less than ideal. This applies in particular
to conditions in Norway, and the reasons for flow variations along
the Langeled and Vesterled pipelines are not clear. Much of the
Continental European system remains opaque; volumes of gas in
storage are not readily obtainable, certainly not on a timely
basis. Flow capacity constraints within Europe are not always
known. This serves to increase uncertainty and volatility in the
UK market.
12. Impact of interface with Europe
The principal link with the UK market, the Interconnector,
does not always behave in a manner consistent with price differentials
in the markets. There is an uneasy meshing of the UK's liberalised
market with the much less free market on the Continent. Gas prices
there are often linked to an index based on a basket of oil products,
and adjusted every six months in arrears. Many suppliers on the
Continent operate in the UK market too, but their relative priorities
are unclear. In practice they determine flows of gas—in
both directions—through the Interconnector. Their motivations
for not taking advantage of the opportunity to sell gas at a higher
price in the UK are likewise unclear, since the precise forms
of contract with Continental customers are not known. There may
be penalties for failure to supply; stocks in storage appear to
be guarded until later in the winter. However, they are free to
take gas from the UK market, and frequently do, even in our winter,
as our own stored gas is being drawn down.
Views recently expressed by Centrica's chief
executive, Sam Laidlaw, reflect these concerns. Speaking at a
conference in Amsterdam on 5 March, he commented that the
UK was in danger of becoming a "gas lender of last resort".
He observed that some governments in Europe were reluctant to
open up their energy markets, which had led to insufficient gas
flows to Britain. Without further liberalization of European markets,
"Europe will continue to use the UK as a main source of gas
at short notice, but may not be willing to provide gas to the
UK when the UK needs it".[34]
Major gas consumers are further frustrated by
being unable to use spare import capacity through the Interconnector
if they attempt to buy gas on the Continent to use in the UK.
Many have manufacturing operations in Europe and know they can
buy gas more cheaply there, but find that the charge to bring
such gas back to the UK precisely offsets any gain from the price
differential, despite the marginal cost of transporting gas through
the Interconnector being very low (around 1p/therm.).
13. Contracts available
Lack of choice in contracts is a major issue.
Members report that when they put up their supply contracts for
renewal, the number of replies has tended to fall in recent years.
For major industrial users the wholesale price of gas represents
around 95% of the delivered cost, and suppliers differentiate
themselves only on the remaining 5%. Even here variations are
small.
14. Low utilisation of import capacity
It is frustrating for consumers to see import
facilities not being used even when UK prices are high. OFGEM
is aware of concerns over the lack of use of the Isle of Grain
facility, which as observed above, has essentially been unused
so far in 2008. Third parties find access extremely difficult
to arrange, and OFGEM appear so far to have been thwarted in their
efforts to secure better access.
15. Members' examples of unsatisfactory market
features
In response to a CIA questionnaire undertaken
to assist the formulation of this submission, responses included:
— "Lack of storage, and high level
of speculation around supply problems, be they real or perceived,
or possibilities that may or may not occur, result in the price
being far too sensitive in the UK. This inevitably results in
inflated higher market prices and unstable conditions. Traders/Market
reactions to these `problems' seem quite disproportionate to the
reality and there is a real sense of `playing the system' at the
expense of the end consumer".
— "No competition between suppliers
(even when several offers are received), since differentiating
factors between suppliers operate on less than 5% of the total
contract cost, thus resulting in no motivation for changing supplier.
No long term offers means no visibility either for industry or
for the supplier and thus impossibility for long term investments".
— "It's broken—too volatile,
too much speculator involvement, too influenced by non-UK energy
companies who exploit our market freedom, whilst defending their
home market rigidity".
— "There are too many players
who can manipulate market prices without having to suffer the
consequences of buying daily energy. Why does the Bacton pipeline
[from Belgium] frequently flow counter intuitively (why
when Rough fell over did Germany & France accelerate filling
already adequate storage and prevent gas flowing to the UK)? Why
do within-day Norwegian flows to Easington change suddenly at
sensitive trading slots? How many bull runs on the gas market
are triggered by speculators? How few gas trades are made by industrial
buyers? How frequently does electricity generation switching fuels
to/from gas accelerate market swings? How often does the UK's
lead in energy/carbon markets reform disadvantage UK manufacturing
eg electricity generators were able to pass through all their
EU ETS exposure (leading to a step increase in costs by 7%?[35])"
16. Ranking of issues
When asked to rank the order of importance of
various factors influencing UK market competitiveness, this was
the result:
1= Lack of UK storage
Lack of access to Continental markets
3= Lack of pre-contracted LNG
Inadequate transparency of Norwegian gas flows
Access arrangements at LNG terminal
These are the issues we would ask the Government
to address.
17. Damage to UK industry caused by present
state of UK energy market
CIA asked members what steps they were taking
to mitigate the impact of high energy prices. All are endeavouring
to be more efficient in their energy usage, but other more worrying
measures were mentioned too. Responses included:
— "Greater focus and effort on
gas/electricity purchasing activity (we have no choice and this
is an additional cost to our business), continuous energy efficiency,
production shift overseas".
— "Not only have we shifted manufacture
from UK and mainland EU to Asia, we are losing significant parts
of our US & Australian markets to Asian manufacturers with
higher carbon footprints".
— "Our company has clearly been
shifting production and investment overseas, becoming every day
a smaller and smaller industrial and energy player in the UK".
We could add here that climate change measures
which disproportionately affect UK (and possibly other EU) manufacturers,
for example being forced to buy allowances at auction, rather
than receiving a free initial allocation under the Emissions Trading
System, can only accelerate the exodus. Moreover, auctioning has
no impact on the incentive to reduce emissions: however allowances
are acquired, their value at the margin remains the same when
the cap is fixed.
CONCLUSIONS
18. Any anti-competitive behaviour taking
place in UK energy markets is being facilitated by fundamental
market characteristics. These include the fragmented nature of
supply, lack of storage capacity and lack of transparency in some
key import sources, all of which add to market nervousness and
volatility. This in turn encourages speculation. Suppliers have
little motivation to secure extra physical supplies of gas on
a long term basis, since they may lose contracts with customers;
conversely customers feel they are offered little choice of contract.
There is an uneasy stalemate and most contracts are tied to the
spot price. Longer term contracts could benefit both sides. Vertically
integrated suppliers have a vested interest in maintaining high
prices.
The proximity to a market run on very different
principles on the Continent is costing the UK dear. While the
Continental market has a large element of long term contracts
and predictable price levels (at least over six months, given
the retrospective adjustments), the UK works on a short term basis
and industrial customers are forced to rely mainly on spot buying.
The same vertically integrated suppliers largely control flows
of gas between the UK and Continental markets. While the UK is
open to Continental buyers, the Continent is largely closed to
the UK.
APPENDIX
CIA CREDENTIALS
The CIA is the leading representative and employers'
body for the UK chemical industry, with 150 members at over 200
manufacturing sites. Some sites produce bulk chemicals by energy
intensive processes; others make smaller volumes of speciality
chemicals. Almost all depend upon energy inputs at some stage
of their operations.
Turnover of the UK chemicals sector in 2006
was £57 billion (including merchanted goods). It accounted
for 1.5% of UK GDP and almost 12% of manufacturing's gross value
added. [Source: Office for National Statistics (ONS), Annual
Business Inquiry.] It employs some 185,000 highly skilled
people directly and supports several hundred thousand jobs throughout
the broader economy. The chemical industry typically contributes
an annual surplus of £5 billion to the UK's balance of payments
[Source: ONS]. The industry is global both in terms of
markets and ownership, with over 65% of CIA's membership being
foreign "headquartered". Any significant imbalance between
the UK business climate and other markets can therefore lead to
the loss of UK trade and investment.
The industry is one of the most energy intensive
sectors of the economy, and accounts for 22%[36]
of total industrial energy consumption. Gas is also used as a
feedstock for making many chemical products, including fertilizers.
The industry's annual combined energy and feedstock bill amounts
to an estimated £2.5 billion.[37]
The industry has an excellent record of improving energy efficiency.
As part of its ongoing commitment to energy efficiency, the CIA
is part of a negotiated Climate Change Agreement with UK Government
to deliver an aggregate improvement in efficiency of 34% between
1990 and 2010. A significant proportion of these improvements
have already come from additional Combined Heat and Power (CHP)
plants and the chemical industry now generates over 30% of its
own electricity requirements, most of which is from CHP.[38]
27 March 2008
33 Data from National Grid Monthly Reports. Back
34
As reported by Bloomberg news agency, 5 March 2008. Back
35
One member's direct experience. The impact in percentage terms
will vary according to the carbon price, the extent to which this
is passed on (and evidence so far suggests usually in its entirety)
and the "base" level wholesale electricity price. At
a recent presentation to a BERR/DEFRA meeting, another member
estimated that EUETS Phase 3 could add as much as €20-€25/MWh
to UK electricity prices. Back
36
Source: BERR "Energy Consumption in the United Kingdom",
as updated July 2007, Chart 4.2. Back
37
Extrapolated from 2004 input-output data from the Office of National
Statistics. Back
38
Source: BERR, Digest of UK Energy Statistics, Chart 5.2 (electricity
usage) and Table 6.8 (CHP output). Back
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