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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