Select Committee on Business and Enterprise Written Evidence


Supplementary memorandum submitted by Drax Power Ltd

INTRODUCTION

  1.  Through its operating subsidiary Drax Power Limited, Drax Group plc ("Drax") owns and operates Drax Power Station, the largest, cleanest and most efficient coal-fired power station in the UK. We are a generation-only company, with no business interests in the end user supply market. With a capacity of some 4,000MW, Drax Power Station is nearly twice the size of the next largest power station in the UK and we sell all our output through the electricity wholesale market of Great Britain, and at current output levels meet some 7% of the UK's electricity needs.

  2.  As a power generation business operating in commodity markets, we are exposed to the prices of power, coal and carbon. There are many factors that drive the prices of these commodities, including the weather. Forward power and gas prices are highly correlated, with gas strongly influenced by and indexed to oil which has seen dramatic price increases over the last 18 months. Coal prices too have hit record highs, driven by tight markets for both coal and freight, especially in the Pacific Basin caused by strong demand from China and India, combined with some production and logistical issues in Australia and Indonesia. It is important to note that the effects we are seeing, in terms of increasing UK power prices, are being driven by long term global growth and demand factors. Drax sits at the end of this long and interrelated commodity market chain.

  3.  Further to giving oral evidence to the Committee on 3 June, Drax should like to submit the following clarification on its answers to the questions raised during the session concerning market structure effects.

VERTICAL INTEGRATION

  4.  Drax believes the current market rules and arrangements for trading power place the right incentives on market participants to deliver an efficient wholesale market. However, price transparency is critical. In the absence of price transparency market price and price signals are dulled.

  5.  Whilst we are not against vertical integration per se, our concern is that the hedging behaviour of the vertically integrated companies limits participation in the wholesale market as significant volumes of power are transacted between the generation and supply businesses of each of the vertically integrated companies. The effect is that these trades are not visible to the wholesale market, which essentially forecloses competition in the contested part of the wholesale market. It is our contention that this brings inefficiency to the wholesale market.

  6.  It is imperative that there is clear separation between the generation and supply businesses and price transparency for all power trades to ensure that the true value of generation is revealed.

VERTICAL INTEGRATION AND LIQUIDITY

  7.  As an independent, generation-only company selling its entire output into the traded power market we are an important market participant. Through our activity in the wholesale market, we provide a clean indicator of price which assists in the discovery of the value of generation. If the vertically integrated players were also to trade all their generation output through the wholesale market and satisfy their supply requirements in the same way we would have a much deeper, more efficient and more liquid market.

  8.  Again, it is our view that vertical integration per se is not the problem, and therefore forced divestment as a remedy is not necessarily required. A potential solution would be to require all vertically integrated companies to take all their physical requirements to the open market and/or offer the same terms to counterparties that they offer themselves internally.

VERTICAL INTEGRATION INVESTMENT EFFECTS

  9.  It is the market spreads, that is, the difference between the price of power and the cost of fuel (or cost of generation) that signal new entry. The current spreads are too low to signal new entry and with no long term hedges available in the market, for example, through long term power purchase agreements, there is little incentive to invest in major, capital intensive new build projects.

  10.  Given that there are power plants currently being built there must be some other driver at play. Analysis of the approved projects reveals that it is the vertically integrated companies that dominate the new build sector. It is interesting to note that companies would be expected to come to the market seeking long term contracts before taking the risk of building. We have not seen this activity which again suggests other factors are at play.

  11.  New entrants or independents are unable to put in place long term hedges due to market illiquidity. The vertically integrated companies, however, have the additional long term hedge through the inertia of their domestic customer base.

MARKET CONSOLIDATION

  12.  It is Drax's view that the sale of British Energy to one or more of the vertically integrated players would have a significant detrimental impact on wholesale market liquidity if no conditions were attached.

  13.  British Energy produces around 17% of UK electricity, a large proportion of which underpins volumes for the wholesale market. Removing volumes from the wholesale market would lead to a critical decline in market liquidity and in the extreme would place at risk the ability of the independent players to sell output. In short, the reported wholesale market would diminish and price signals would be even less reliable.

CONCLUSION

  14.  In conclusion:

    a.  the current market rules and trading arrangements provide the appropriate incentives to deliver an efficient electricity wholesale market;

    b.  whilst not against vertical integration per se, there is concern that the hedging behaviour of the vertically integrated companies limits participation in the wholesale market, forecloses competition and brings inefficiency to the electricity wholesale market;

    c.  clear separation between the generation and supply businesses of the vertically integrated players and price transparency is critical to ensuring that the true value of generation is revealed;

    d.  forcing all the power trades of the vertically integrated players through the wholesale market would deliver a much deeper, more efficient and more liquid market;

    e.  the hedging behaviour of the vertically integrated players masks price signals and deters new entry into the independent sector of the generation market; and

    f.  further consolidation in the market resulting in the removal of power trades from the wholesale market would lead to a critical decline in market liquidity and in the extreme would place at risk the ability of the independent players to sell output.

23 June 2008





 
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