Select Committee on Business and Enterprise Written Evidence


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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