Memorandum submitted by Drax Power Limited
SUMMARY
1. Observations of the operation of the
electricity wholesale market suggest that the hedging behaviour
of the vertically integrated companies operating in the electricity
market may be dulling or masking market price signals leading
to market inefficiency. Such inefficiency has the potential to
have an impact on investment decisions, which holds implications
for security of supply. Analysis of the proposed generation capacity
new build would appear to support the suggestion of market inefficiency.
2. Power prices are driven by a number of
factors, however, the more recent price increases witnessed in
the electricity wholesale market are a reflection of the increases
in the input costs of power generation. It is worth noting that
generators do not achieve the spot prices in the market; generation
businesses are hedged over a period of time and therefore achieve
a variety of prices.
3. In a market characterised by vertically
integrated companies there may be a tendency for businesses not
to compete aggressively, but instead to maintain relatively stable
market shares. Analysis of the relative market shares of the six
largest vertically integrated companies appears to uphold this
theory on behaviour.
INTRODUCTION
4. Drax Power Limited ("Drax")
is the operating subsidiary of Drax Group plc and the owner and
operator of Drax Power Station, the largest, cleanest and most
efficient coal-fired power station in the UK. With a capacity
of some 4,000MW, Drax Power Station is nearly twice the size of
the next largest power station in the UK. Drax sells its electricity
through the electricity wholesale market of Great Britain, and
at current output levels meets some 7% of the UK's electricity
needs.
5. Drax is pleased to have the opportunity
to participate in the Committee's inquiry into energy prices.
As a generation-only business operating solely in the wholesale
market, Drax should like to provide some context to the inquiry
by offering observations on the general functioning or efficiency
of the electricity wholesale market, the price increases witnessed
in that market and the implications for competition in the electricity
supply market.
EFFICIENCY OF
THE ELECTRICITY
WHOLESALE MARKET
6. In determining whether the wholesale
market operates efficiently and testing that electricity prices
are a true reflection of the costs of both fuel and capacity,
it is necessary to understand the functioning of the market and
this necessarily demands some consideration of the industry structure.
7. The electricity market is characterised
by six large vertically integrated players, who between them account
for some 58% of the total generation capacity on the system or
69% of the price-setting plant (gas, coal and oil) (with a controlling
interest, through full ownership, part ownership or tolling contracts
in 74% of the price setting plant) and together these companies
supply some 85% of the total demand. In the early years of the
privatised electricity sector, vertical integration was recognised
by both the regulator and the Government as a potential source
of concern and at odds to the rationale for the restructuring
the electricity market. Indeed, policy decisions were taken during
this time which prevented the then two major generating companies
from owning supply businesses.
8. The "anti-vertical integration"
policy was relaxed following the forced divestment of coal-fired
plant owned by the same two generating companies. However, the
existence of Standard Licence Condition 12b, which essentially
prohibits cross subsidy between licensed activities, for example
the activities of generation and supply, is evidence that the
concern surrounding vertical integration remains today.
9. Observations from the electricity wholesale
market are that the vertically integrated companies tend to hedge
their supply positions by allocating their own generation to the
smaller commercial and domestic customer market. Given this natural
hedge, the vertically integrated companies do not have to go to
the market to contract for power other than in spot and short-term
markets. Therefore, volumes of power traded in the market in the
medium and long-term are reduced, so reducing liquidity in the
wholesale market.
10. Locking out both generation and supply
volume from the contested market carries the risk that the true
value of generation is never revealed leading to inefficient operation
of the market as a whole. By allocating their own generation to
their supply businesses, the vertically integrated companies may
not be putting these power transactions in the most efficient
place and the costs of this inefficiency are, in effect, passed
on to the end customer.
THE IMPACT
OF MARKET
INEFFICIENCY ON
INVESTMENT DECISIONS
11. Investment decisions rely on the medium
and long-term markets for price signals. A further potential consequence
of an inefficient market, therefore, is the impact on investment
decisions in the generation market, which ultimately holds consequences
for security of supply.
12. Analysis[46]
of the proposed new generation capacity in Great Britain reveals
that 13GW of the 17GW of approved projects are being built by
the vertically integrated companies. More interestingly is that
"incentivised generation capacity", such as renewable
and CHP generation, is being built by a mixture of the vertically
integrated companies and a number of smaller companies. Whereas,
the building of "non-incentivised generation capacity",
that is the large conventional new builds, is noticeably dominated
by the vertically integrated companies or joint ventures involving
the vertically integrated companies.
13. It is the "non-incentivised generation
capacity" which one would expect to be driven by market price
signals, therefore, there is a suggestion that vertical integration
is dulling market signals. If this were not the case wider market
entry/new build would surely be observed.
14. If greater volumes of power were to
be traded in the market, liquidity in the market would improve
and so the market would tend towards finding the true value of
generation. A market with high and regular liquidity should be
encouraged, only then will the price signals become efficient
and only then will the market see prices truly reflect the fundamentals
of supply and demand.
ELECTRICITY WHOLESALE
MARKET PRICES
15. Power prices are driven by a number
of factors: the underlying commodity prices, for example, gas
and coal prices; the margin on the system, that is, the relative
level of generation to demand; market sentiment, that is, the
market's reaction to information (which is more pronounced in
less liquid or thin markets); and the physical positions taken
by the individual market players.
16. Recent power price movements, however,
are clearly linked to gas price movements and so the increases
experienced in gas prices have fed directly through to power prices.
The price of coal has also risen dramatically over the last year—some
90% from the start of 2007 to the end of the year. It should also
be noted that the price of carbon allowances for delivery in Phase
II of the EU Emissions Trading Scheme has risen by 45% on last
year. These, amongst other factors, were responsible for the reported
lower earnings of Drax Group plc in 2007 compared to the previous
year.
17. From the highs of early Summer 2006,
power prices in the wholesale market fell until Spring 2007, since
when they have been steadily increasing. It should be noted, however,
that although power prices have been increasing not all power
over the period would have been traded at these higher levels.
Generators do not achieve the spot prices in the market; generation
businesses are hedged over a period of time and therefore achieve
a variety of prices.
IMPLICATIONS FOR
COMPETITION IN
THE ELECTRICITY
SUPPLY MARKET
18. With electricity prices being a function
of fuel and capacity margin, any business owning generation capacity
would only do so if the market covered its long-term fixed costs,
as determined by the margin over and above its fuel costs that
it can achieve in the wholesale market.
19. With vertical integration there is a
danger that the margin may appear in another part of the supply
chain suggesting generation capacity has reduced value; equally
true is that the margin attributable from supplying retail customers
could appear in another part of the supply chain making it appear
that the supply business is not profitable.
20. The obvious danger for any business
in a market which displays such characteristics is that it becomes
out of step with the rest of the market, losing or gaining market
share quickly without the ability to hedge itself which in turn
leads to less predictable revenues and costs.
21. As a consequence, in order to avoid
financial unpredictability, there may be a tendency for businesses
not to compete aggressively, but instead maintain relatively stable
market shares. Although it is claimed by some that the electricity
supply market of Great Britain is competitive, it is surprising
that no single supplier has broken out of the pack and taken a
larger market share than the others. To illustrate this point,
the chart below shows the market shares held by the six largest
vertically integrated suppliers.
CONCLUSION
22. In conclusion:
(a) It is suggested that the hedging behaviour
of the vertically integrated companies effectively locks out both
generation and supply volume from the contested market carrying
with it the risk that the true value of generation is never revealed.
This in turn leads to inefficient operation of the market as a
whole, the costs of which are passed on to the end customer.
(b) A potential consequence of an inefficient
market is the impact on investment decisions in the generation
market, which ultimately holds consequences for security of supply.
(c) Analysis of the proposed new generation
capacity reveals that "non-incentivised generation capacity"
build, that is the large conventional new builds, is noticeably
dominated by the vertically integrated companies or joint ventures
involving the vertically integrated companies. If the market was
operating efficiently and prices reflected the fundamentals of
supply and demand, one would expect to see wider market entry/new
build.
(d) Price increases witnessed in the electricity
wholesale market are a reflection of the increases in the input
costs of power generation. Although it should be noted that generation
businesses are hedged over a period of time and therefore achieve
a variety of prices.
(e) Analysis of the relative market shares
of the six largest vertically integrated companies appears to
suggest that there may be a tendency for businesses not to compete
aggressively, but instead to maintain relatively stable market
shares.
March 2008
46 Power Station Tracker, Power UK, pp 5-39, 29 January
2008 Back
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