House of Commons - Business and Enterprise

Select Committee on Business and Enterprise Written Evidence

Memorandum submitted by EDF Energy

ANTI-COMPETITIVE BEHAVIOUR IN THE UK'S ENERGY MARKET

SUMMARY OF EDF ENERGY'S POSITION ON COMPETITION IN THE UK ENERGY MARKET

1. Many studies have found the UK energy market to be competitive and an independent study on behalf of BERR has found the UK energy market to be more competitive than those in the rest of Europe. As a result, customers benefit from prices that are lower than the European average. They also have the opportunity to easily switch supplier or products, demonstrated by the fact that more than 13 million electricity and 11million gas customers (half of the total) have taken advantage of this opportunity since market opening in 1998, and a range of new products from existing and new suppliers in the market such as green tariffs.

2. The vertical integration of the market, where companies operate generation and sell direct to customers, has brought many benefits to customers. Energy suppliers have become vertically integrated to manage the risk associated with price volatility in the wholesale markets and customers therefore benefit by paying prices that are much less volatile at the retail level. High levels of competition between these suppliers ensure that margins remain slim and prices competitive.

3. The interests of the companies are closely aligned with those of customers. Both want low carbon, diversified, affordable and secure energy sources. Contraction in the credit market has highlighted the value of having companies with strong balance sheets to make the substantial investment required to renew the UK's energy infrastructure and secure low carbon and affordable energy supplies over forthcoming years.

We build on these positions in response to each of the questions posed by the Committee.

1. Whether the current market structure encourages effective competition in the retail markets for gas and electricity

The current market structure is encouraging a very high level of competition for customers between the large energy suppliers and also between the larger suppliers and smaller suppliers, particularly in the area of new product offerings to the market.

The National Audit Office ("NAO") report of 26 March 2008, entitled Protecting consumers? Removing retail price controls ("the NAO Report"), found that conditions for competition have developed in the gas and electricity supply markets and that Ofgem has taken action to help consumers take advantage of competition, for example, by ensuring that they can switch easily between suppliers.[53] The overwhelming majority of consumers now have the power to exert competitive pressure on suppliers.[54] The evidence for the level of competition can be seen in the high level of customers switching supplier (demonstrated in section 1.1 below) and the numbers of customers switching to new products (demonstrated in section 1.2 below).

Suppliers who have been able to keep their prices low have gained significant market share in recent years (demonstrated in section 1.3 below). All suppliers are also seeking to compete on more than just price alone, making significant efforts to improve levels of customer service, which has resulted in a fall in complaint levels (as demonstrated in section 1.4 below).

This high level of competition has meant that energy suppliers have not been able to pass on the full cost of wholesale price increases and other costs to customers. Margins in the market are very slim and this is reflected in UK prices being lower than the European average (demonstrated in section 1.5 below).

1.1 Customer Switching

There is a high level of awareness among customers that they are can switch supplier. The level of churn, the proportion of existing customers who change suppliers, in a year, has been growing in recent years and has reached a very high level by comparison with other industries.

While the proportion of gas customers switching supplier has increased from around 16% to 18% in the last three years, the proportion of electricity customers switching has increased even further, from around 16% to over 20% in the same period. BERR reported that 1.34 million electricity accounts changed supplier in Q3 2007.

Customers say that they find it very easy to switch their supplier. This is supported in the NAO report, which refers[55] to research by the National Consumer Council in 2005 reported in Switched on to Switching, as demonstrating that 95% of energy consumers who switched supplier found it easy to do so.

Research by Mori illustrated in the chart below demonstrates that switching energy supplier is thought to be easier than switching some other service providers and only a small number of customers found the process difficult.

Source: MORI

Energywatch has facilitated the process of switching energy supplier by accrediting companies that offer price comparison services. Currently 12 companies are accredited by energywatch to provide these services under their "confidence code" scheme.

Ofgem has also recently begun a campaign with the Citizens' Advice Bureau to raise awareness amongst its advice workers of the ability to save costs by switching energy supplier and of how to obtain the best deal.[56]

1.2 Innovative Products

The NAO Report recognises[57] that the main area of innovation in the retail energy markets has been the introduction of a range of new tariffs. EDF Energy has participated actively in the introduction of innovative tariffs, introducing its own range of fixed price, green, and online tariffs.

Customers are now being given new options when choosing tariffs from a wide range of new products being offered in the market.

New tariffs include internet based tariffs and price guarantee products, such as fixed or capped price tariffs. Both of these new types of product have become popular with customers, as illustrated in the charts below.

NUMBER OF PRODUCT ACCOUNTS SIGNED UP TO PRICE GUARANTEE TARIFFS IN MARCH OF EACH YEAR

Source: Ofgem

NUMBER OF CUSTOMER ACCOUNTS SIGNED UP TO ONLINE TARIFFS IN MARCH OF EACH YEAR

Source: Ofgem

Green products have been growing in popularity in recent years, and as at April 2007, around 215,000 customers were registered on these tariffs. While at present this only represents a small proportion of the electricity supply market, we are seeing steady growth in demand and expect it to increase significantly in the future.

Source: Organic Life

Smaller suppliers have shown themselves to be very competitive in the market for green products, having captured a significant share of this new market.

EDF Energy was also the first energy company to offer a new tariff to our customers that rewards them for using less energy. Our Read Reduce Reward tariff launched in May 2005 currently has 276,000 customers who are rewarded in loyalty points through the Nectar scheme for reading their own meter on a quarterly basis. Energy usage can be tracked online and if energy use reduces from one year to the next bonus points are earned.

1.3 Changes in Market Share

The chart below shows how active competition in the domestic supply market has led to significant changes in several companies' market shares. Centrica in particular has lost energy market share, as customers have switched to other suppliers to take advantage of lower prices and higher standards of customer service.

PERCENTAGE OF DOMESTIC ENERGY (ELECTRICITY AND GAS) ACCOUNTS BY SUPPLIER 2001-07

Source: EDF Energy and Cornwall Associates

1.4 Customer Service

Price and innovation are not the only differentiating feature of energy services, however, and all companies are seeking to improve their quality of service.

The chart below produced by energywatch shows that suppliers have been improving quality of service, reflected in the reduction in complaints received, although, as is publicly known, British Gas has suffered particular problems relating to a new IT system in the last two years.

MONTHLY COMPLAINTS BY SUPPLIER (DECEMBER 2005 TO NOVEMBER 2007)

Source: Energywatch

1.5 Prices and comparison with European Energy Prices

Despite the increases in costs experienced by the energy industry within the UK (see answer to Question 4), the high level of competition has ensured that domestic prices have remained competitive. Downward pressure on EDF Energy's prices caused by customer switching has had an impact on its prices to all customers, including those customers not actively engaged in the market. EDF Energy's approach to smoothing prices to protect customers from volatile wholesale prices has resulted in prices that are competitive, and it has in fact made lower profits in an attempt to provide this protection—see below, section 4.

The following charts created by Ofgem illustrate that UK energy prices remain low compared to many parts of Europe.

Source: Ofgem fact sheet based on Eurostat data second half of 2007. Shows domestic tariffs.

1.6 Conclusion to question 1

In conclusion, it is clear that the current market structure encourages effective competition in the retail markets. In addition to competitive prices customers are being offered improved quality of service and new products more suited to their own needs. The success of the market is reflected in the high numbers of customers that are actively engaged in it by changing their energy supplier, a process that customers find easy to undertake.

2. Whether there is effective competition in the wholesale markets for gas and electricity

A number of investigations, including those conducted by BERR and the European Commission, into the wholesale energy market within the UK have found it to be competitive, and significantly more competitive than many other wholesale energy markets in Europe.

The electricity and gas wholesale markets have a large number of participants and liquidity remains high in the gas market, and is improving in the electricity market (demonstrated in section 2.1 and 2.2 below).

Significant increases in the cost of gas and coal, and the introduction of a price for carbon (demonstrated in section 2.3 below) have driven increases in wholesale electricity prices since 2005.

While the six vertically integrated suppliers do each operate electricity generation portfolios, they also purchase electricity from the wholesale market. In addition, vertically integrated players compete to minimise production costs, so that they can offer competitive retail prices to customers (demonstrated in section 2.4 below).

2.1 Participants in the market

There are a large number of participants in the wholesale electricity market; we estimate that there are 42 currently active players, comprising a number of generators, smaller suppliers, upstream energy companies (such as the large oil companies), dedicated traders and financial institutions. Around half of the electricity generated in the UK is generated by the six vertically integrated suppliers and many of the other generators directly supply industrial and commercial customers and some smaller suppliers also generated their own electricity. In its factsheet on the UK energy market the European Commission states that "Ownership of generation is rather diverse, with the UK having the lowest generation sector concentration in the EU".

Source: Digest of UK Energy Statistics, BERR

In gas there is even greater participation of parties in the wholesale market. The European Commission UK energy factsheet states "The wholesale market is highly competitive consisting of many offshore producers and importers." EDF Energy, EON, SSE, Scottish Power, Centrica and RWE purchase the majority of their gas from the wholesale market in which there are 245 licensed shippers.

2.2 Market Liquidity

In its most general sense, liquidity is a measure of the number of times a given volume of a commodity or contract for a specified delivery date is traded between parties. It is sometimes argued that high levels of liquidity demonstrate that a market is competitive.

The UK gas wholesale market is often considered as a highly liquid market, with the same physical gas traded many times over. Liquidity has increased significantly since the market was liberalised in 1996.

In the electricity market, liquidity grew steadily in the first five years after liberalisation to 2001 but then decreased significantly after 2002 as a result of the market makers such as El Paso, Dynegy, and Aquila etc leaving the market and with the demise of Enron and TXU holdings. However, since 2007 we are now seeing a marked increase in liquidity in the market.

EDF Energy believes that the market would benefit from greater liquidity and we support the development of the Futures and Options Association "Market Design Project" which EDF Energy expects to promote power market liquidity. The first stages of this project will be the development of a central clearing service for the trading of prompt power (which is power traded close to the time of demand) and a robust spot market index. A spot market index should make it much more possible to develop a power futures market, and may lead to the development of a day-ahead auction.

This recent improvement in liquidity is highlighted in the findings of BERR's annual review, conducted by Oxera, of the competitiveness of the UK energy market compared with other European markets. The latest report, which gives preliminary results for 2006 states, that: "the UK remains the most competitive of the electricity markets evaluated. The competitiveness of the UK electricity market has in general remained unchanged (with a score of 8.3/10), other than an increase in wholesale market liquidity". On gas the report also states "A series of factors have been in play driving increases in the UK's gas market competitiveness from 8.2 to 8.5. In particular, the wholesale liquidity figure has increased from 100% to 240%.

2.3 High Wholesale Prices

Since 2004 wholesale gas prices have become highly volatile and have increased significantly relative to pre 2004 levels. This has been driven primarily by high and volatile international oil prices. Electricity wholesale prices have also increased significantly since 2004. This is primarily a result of the high volatile wholesale gas price, and more recently as a result of rising international coal prices. In addition, since 2005, the introduction of the European Union Emissions Trading Scheme (EU-ETS) has meant that the cost of carbon is now included within the electricity wholesale price.

The graphs below show the changes in wholesale coal and gas prices between 2003 and 2008. Gas prices increased significantly between 2003 and 2005, with prices falling at the end of 2006 but then rebounding strongly from September 2007 and remaining high. Coal prices remained relatively stable until the middle of 2007, but have since increased significantly.

Source: EDF Energy analysis. Each data point shows the average price of gas for delivery in the next two seasons. For example, the May 2005 data point shows the average price of gas for delivery in Winter 2005 and Summer 2006. This approach is used to reflect the fact that generators will buy fuel in advance.

Source: EDF Energy analysis. Each data point shows the average price of coal for delivery in the next two seasons. For example, the April 2005 data point shows the average price of coal for delivery in Winter 2005 and Summer 2006. This approach is used to reflect the fact that generators will buy fuel in advance.

Source: EDF Energy analysis

There has also been a significant and prolonged increase in the price of oil since 2005. Even though the UK does not maintain an oil related pricing system for wholesale gas traded at the National Balancing Point (NBP), gas prices here are not decoupled from oil. This is because the UK gas market is increasingly linked to those in Europe, where traded gas prices are generally still directly oil indexed in some way (due to the absence of liquid and competitive gas markets). This means that as we import more gas (as continental shelf reserves fall) gas prices in the UK will still tend to move in line with the price of oil.

2.4 Wholesale Market Exposure of the Six Vertically Integrated Companies

GAS MARKET

EDF Energy like four of the other major UK suppliers has very limited gas reserves of our own. To meet our customers' demand we buy gas in the wholesale market through a mixture of long, medium and shorter-term contracts struck with upstream companies. We are very much a "price taker", and must compete with other suppliers to secure supplies.

As an energy supplier to the domestic market we have to absorb considerable day to day volatility in wholesale gas prices so that it does not fall on our customers in the prices they pay.

ELECTRICITY MARKET

The six vertically integrated suppliers all have their own electricity generation, but are all also active in the wholesale market. Around half of GB electricity generated is by generators other than the six vertically integrated suppliers, and we believe all of the six have greater electricity demand than they are able to meet from their own generation.

The chart below highlights the level of demand compared with own generation and Power Purchase Agreements (PPAs) which are longer-term contracts to secure generation from other companies. The figures for EDF Energy are compared with an estimated average for the five other suppliers.

COMPANIES' OWN ELECTRICITY GENERATION AGAINST DEMAND

Source: EDF Energy analysis based on publicly available data for 2006

Purchasing from the Wholesale Electricity Market

All of the six vertically integrated companies are therefore exposed to wholesale market prices, and compete with other suppliers to purchase electricity. Each supplier will have a different strategy for purchasing electricity from the wholesale market, based on its view of future energy prices and the level of risk they are willing to accept. This is known as a "hedging strategy", which a supplier will keep confidential as it seeks to gain advantage in the market.

Own Generation

By using a proportion of electricity that we generate in order to meet part of our own demand, we are reducing our customers' exposure to the electricity wholesale market.

This market structure does not reflect a lack of competition between generators. Generators, including those who are part of vertically integrated companies must compete to minimise the cost of the electricity they generate—essential to ensure their supply business is able to sell competitively priced electricity.

As discussed in section 2.3, electricity generators are exposed to gas and coal wholesale price markets—we do not have significant reserves of gas or coal. Changes in fuel prices will affect the six vertically integrated energy companies in different ways, depending on the mix of generating plant that companies operate and their fuel hedging strategy. Companies are competing with each other on these factors.

The six large suppliers all have significant generation portfolios, but the type of plants they operate vary. EDF Energy for example, operates two large coal fired power stations and one smaller gas fired station, whereas Centrica's portfolio consists entirely of gas fired power stations. Therefore when coal prices are very high relative to gas prices, EDF Energy's overall cost of generation is likely to be higher than Centrica's.

In addition, as mentioned previously, costs will also be influenced by when the companies purchased in the wholesale markets the fuel they need to run the power station (hedging strategy). In a rising price market, a company that has locked in a fixed price contract for delivery of coal in the following year will benefit in comparison to a company that has not secured sufficient reserves and is now exposed to the latest coal prices.

The competitive market structure described above means that individual vertically integrated companies will incur very different average costs when securing electricity for their customers. This is known as their weighted average cost of power (WACP).

Each company's WACP will have a direct impact on its need and ability to increase or decrease prices, with some suppliers needing to change prices at a different time to other suppliers, albeit driven by the same underlying trends in coal and gas prices. As noted in section 1, the extent to which they can actually vary prices is limited by the competition in the market. This means that profitability can fall even when retail prices are rising.

The graph below shows the suppliers' different pricing strategies showing the broad trends in fuel costs but very different timings and size of price changes, depending on their own generation portfolio and hedging strategy.

Source: EDF Energy analysis based on publicly available data

Potential Improvements to the Wholesale Market

While the wholesale market in the UK is competitive, there is still room for improvement, and EDF Energy has been active in arguing for a number of measures that would make it easier for smaller suppliers and generators to be active in the market. We have introduced a change proposal[58] to the electricity Balancing and Settlement Code. The change aims to encourage parties to contract ahead of the delivery date to cover customer volumes, thus helping the system reduce any imbalance between supply and demand. The proposal has been widely supported by smaller suppliers and generators, and is awaiting a decision from Ofgem. In gas we have pushed for greater transparency in the gas market. We proposed a change that forced the gas network operator to publish after the day gas flows to large users of gas.[59] We as a company are therefore fully committed to improving the UK's wholesale energy markets.

2.5 Conclusion to question 2

The UK wholesale markets for electricity and gas are regarded as among the most competitive in Europe. There are many participants in these markets in addition to the large six suppliers, and all six suppliers need to purchase electricity and gas in addition to their own generation, to meet the customer demand. There are indications that the wholesale markets are becoming more liquid, but improvements can still be made to make it easier to trade in the market. EDF Energy has been leading efforts in the industry to make these improvements.

While the six vertically integrated suppliers do operate large electricity generation portfolios, they also purchase electricity from the wholesale market. In addition, vertically integrated players must compete to minimise production costs, so that they can offer competitive retail prices to customers.

3. The implications of growing consolidation in the energy market

Consolidation has been the natural result of companies responding to pressures in the market, and the emergence of a truly national market for electricity and gas (demonstrated below in section 3.1).

The exposure to volatile wholesale costs and the high level of competition in the retail market (demonstrated in sections 1 and 2) has driven companies to seek to grow in order to absorb these risks.

At the same time, the level of investment needed to replace the UK's energy infrastructure has grown rapidly (discussed below in section 3.2). Large companies that are able to manage the risks in the market are better placed to make these investments themselves, and can also support investment from others through Power Purchase Agreements (longer term contracts). Independent investors who have such agreements with large companies are better placed to secure financing for their investments. The UK is not alone in seeking to renew its energy infrastructure. The IEA forecasts that $20 trillion of investment will be needed worldwide by 2030. The European Commission estimates that nearly a trillion Euros of investment will be needed in Europe alone and this estimate was made before the new stretching targets for renewable energy were agreed. The UK will be competing with other countries for the financing of energy infrastructure and the resources to build that infrastructure. Large companies with a dedicated presence in the UK will strengthen the country's ability to secure the required investment and resources.

3.1 Creating a national market

The consolidation in the market has transformed what were once regional electricity supply companies and one national gas company into a number of electricity and gas supply companies that compete nationally for customers. As illustrated in answer to question 1, these companies compete fiercely with each other and have the structure and size to provide their customers with protection from the volatility experienced in the wholesale markets for gas and electricity, a protection considered by the NAO to be important.[60]

The creation of the national market is reflected in the growing market share of entrants and in the declining market share that energy suppliers have in what would historically have been their regional bases.

MARKET SHARE OF NEW ENTRANT SUPPLIERS (MARCH 2007)

Source: Ofgem

3.2 Investment in Energy Infrastructure

Much of the UK's energy infrastructure will need to be replaced over the next twenty years. Many power stations will be reaching the end of their lives and will need to be replaced. Changes to our sources of gas, as the UK continental shelf reserves decline, create new challenges to ensure import facilities and storage is sufficient for our needs. In transmission and distribution networks older equipment needs to be replaced and the nature of the networks is evolving to meet new patterns of demand and to connect different types of generating technologies.

The chart below shows the likely closure scenarios for existing coal, oil and nuclear power stations within the UK.

UK OIL, COAL AND NUCLEAR POWER STATION MINIMUM AND CENTRAL CLOSURE SCENARIOS

This challenge is also an opportunity. By replacing the older high carbon emitting infrastructure with new low carbon technologies the UK has the opportunity to reduce our carbon emissions quite rapidly. However, this opportunity will require very large amounts of investment and resources over timescales that are short in energy infrastructure terms. And this is needed in the UK at the same time as much of the rest of the world.

EDF Group has announced that its investment plans for 2008 to 2010 have increased to €35 billion. Within the UK EDF Energy plans to invest nearly £500 million in each of next two years—10% of annual turnover—on a new gas-fired power station CCGT, renewables, improving existing plant and customer service. As the largest electricity distribution network operator we are also investing more than £300 million a year on improving and expanding the network. We are furthermore planning to invest in four new nuclear power stations to be commissioned from 2017—a £10 billion programme. Other companies are also planning energy infrastructure investment.

This level of investment requires a large company with a strong balance sheet that is able to negotiate effectively with the providers of essential equipment and services, who are experiencing unprecedented global demand. Consolidation has created companies with the ability to deliver the energy infrastructure the UK needs for the future, without compromising expansion by other players.

4. The relationship between the wholesale and retail markets for electricity and gas

Vertically integrated companies look to achieve their profit margin across both the difference between supply costs and retail prices (the retail margin) and the difference between generation costs or upstream gas costs and wholesale gas or electricity prices (the generation margin). In order to deliver the required investment in new UK electricity generation capacity, and in gas infrastructure, vertically integrated companies need to make sufficient margin to justify this investment. However, looking at the profit margins made across both of these areas we can see that the level of profit has been low in recent years.

In section 2, we highlighted the level and volatility of costs in the wholesale markets. In addition to this increase in energy costs, energy companies have also incurred increases in other costs, such as network charges, metering costs, and the cost of Government environmental policies. However, the competitive nature of the market means that suppliers are unable to pass the full impact of these cost increases on to customers (demonstrated below in section 4.1), leading to very low and sometimes negative retail margins.

Therefore, energy companies are looking at margins in the generation business to decide whether of not to invest in new plant. EDF Energy has undertaken analysis based on publicly available information that demonstrates that while margins have risen they are still too low to justify the level of investment in new generation that is needed within the UK (demonstrated in section 4.2 below).

4.1 Increasing costs

Unlike certain industries, including the petrol retail industry, electricity and gas suppliers do not change prices on a weekly or even daily basis in order to reflect underlying energy input costs.

The graph below shows how, in the petrol retail industry, monthly average prices at the petrol pump closely follow crude oil prices and petrol spot prices.

Source: UK Petroleum Industry Association, based on data from WoodMac

By contrast, in the energy industry, suppliers absorb volatility and smooth prices to domestic customers as far as possible. The industry has been criticised for being quick to raise prices when wholesale costs rise but slow to reduce prices when costs fall. The analysis below shows this to be incorrect, and demonstrates that by smoothing retail energy prices, the companies have actually saved their customers significant amounts of money.

The graphs below compare EDF Energy's standard credit tariff (exclusive of VAT) for gas and electricity against the cost increases experienced within the market between Jan 2003 and Feb 2008.

While the fact that energy costs have increased is well known, it should also be noted that the other costs listed have also increased over the period. In fact, in February 2008 costs associated with using gas transmission and distribution networks and metering were 30% higher than they were in January 2003. The costs included in the total are:

— Energy costs.

— Industry Costs: Network costs, Metering costs.

— Regulatory Costs: The cost of complying with the Government environmental initiatives.

— Renewable Obligation (RO) and the Carbon Emissions Reduction Target (CERT).

The analysis in the charts below includes these costs but does not include our own operational costs. The charts also do not incorporate a likely hedging strategy whereby gas would have been bought more than four quarters in advance. In this way the charts actually present a more positive picture than was experienced by suppliers during, for example, late 2007 and early 2008 when some suppliers were publicly reporting substantial losses in their retail businesses.

Source: EDF Energy analysis. Electricity and gas costs for each month are calculated by taking the average price of gas for delivery in the next four quarters. This approach is taken because suppliers purchase gas and electricity in advance.

The graphs clearly demonstrate that suppliers' costs have increased significantly over the period. EDF Energy and, according to Ofgem analysis, other suppliers, have not passed through the full level of cost increases to customers and profit margins have been squeezed. In fact, our analysis shows that for a typical EDF Energy customer taking both electricity and gas over this period, we passed on in excess of £150 less than would have been justified by the underlying cost increases. This demonstrates the pressure of competition in the retail markets and that EDF Energy's approach to smoothing volatile prices has resulted in fair prices to its consumers.

This analysis is supported by the conclusions drawn by Ofgem in their Domestic Retail Market Report (June 2007) which looked just at the increase in wholesale costs and stated that with regard to the period Jan 2003 to June 2007)"... on average, suppliers passed through less than the full increase in the wholesale costs to domestic customers over the period. This saved the average [dual fuel] customer £116".

EDF Energy's Recent Price Increase

EDF Energy's recent tariff increase was partly a response to an increase in wholesale costs, but also due to a significant increase in "other costs", as discussed earlier.

Electricity prices for an average EDF Energy customer increased by £28 per annum and gas prices by £72 per annum. The graphs below show how this is broken down between the various cost elements. It should also be noted that the bill increase did not cover the full actual increase in energy costs which rose by more than 50% in 2007.

Source: EDF Energy analysis.

4.2 Margin Needed for New Investment

One of the margins on which energy companies can potentially earn a profit is from the sale in the wholesale markets of the power they generate.

The gap between wholesale prices and the costs of generation (fuel and carbon costs) is called the generation spread. There is trading in the wholesale markets at different time horizons:

— the prompt spread refers to same-day trading; and

— the forward spread refers to trading at longer time horizons, up to three years ahead.

Companies themselves will trade in wholesale markets, in order to keep their costs low and compete effectively on retail prices. Their exact strategy for trading is commercially confidential.

There are different names for the generation spreads for coal ("dark") and gas ("spark"). In either case, the spread can be measured as either the gap between wholesale prices and energy costs only (the "dirty" spread) or energy plus carbon costs (the "clean" spread). This distinction has been relevant since the introduction of the requirement on generators to buy some carbon allowances (the European Union Emissions Trading Scheme (EU ETS). The Phase 1 allocation of allowances covered only a proportion of historic capacity, amounting to 80% for gas and 70% for coal in the case of EDF Energy, so purchasing of additional carbon allowances has added to generation costs.

The charts below show both clean and dirty spreads for gas and coal respectively.

GAS (SPARK) SPREADS

Source: EDF Energy Analysis

COAL (DARK) SPREADS

Source: EDF Energy Analysis

The generation spread needs to be sufficiently high to provide a return on investment in higher environmental standards for existing capacity, and even higher for investment in new capacity, where there also needs to be a contribution for depreciation.

In the case of coal, we estimate the break even return even before covering depreciation and providing an incentive for new investment is more than £10MWh and, depending upon future depreciation and investment, the requirement is around £20/MWh. The chart shows that before 2005 many coal plants were effectively not worth keeping open for much longer. Clean spreads rose to a peak in 2006 but have since fallen sharply, to a level barely above the minimum required for further investment.

In the case of gas, a smaller margin is required as the capital investment and operating costs are lower in a gas power station than for coal. However, gas generators too have consistently earned a margin too low to justify investment (below £10MWh).

In practice the picture is slightly less stark because all generators would seek to use hedging strategies—trading in the wholesale markets on different timescales—to ensure they were not exposed to the full impact of increases in gas and coal costs. However, far from making an excess margin on generation, spreads have been too low for generators to earn a reasonable return on investment.

4.3 Conclusions to question 4

The analysis in this section has indicated that while wholesale costs have risen, the full cost of these rises have not been passed on to customers by the six large suppliers. Competition in the retail market has ensured that prices are kept low even in the face of increased costs.

It is not just fuel costs but also carbon costs which have risen. The EU ETS introduced the requirement to purchase carbon emission permits. The scheme gave a proportion of the allowances to emit carbon free to generators provided that the stations stayed open. These permits have a market value, but without free allowances it would otherwise have been difficult for a number of power stations to have sustained the level of investment required to meet statutory and environmental requirements and remained open. A reduction in generation capacity would have resulted in a less competitive generation market and the potential for higher prices. This shows that the vertically integrated energy companies have not been earning high margins as a result of the free carbon permits that have been given to them under the EU ETS, and margins are still below the level that would justify new investment in these technologies.

Generation spreads overall remain too low, despite recent increases, to justify the significant new investment in capacity required in the UK.

5. The interaction between the UK and European energy markets

The level of interaction between the UK and European gas markets has increased in recent years, predominantly as a result of the decline in gas supplies from the UK continental shelf. It is gas where the impact of European energy markets is greatest, but the gas market also has an impact on the electricity market, as gas is one of the fuels used to generate electricity.

In electricity there is a 2GW interconnector (about the size of a coal-fired power station) with France which gives a limited interconnection with the European energy market, although more interconnection is in the planning stage.

Historically the UK has been self sufficient in gas owing to the UK Continental Shelf, and until 2005 the UK was a net exporter of gas. As the UKCS has declined the UK has turned to alternative gas sources to meet its demand, with the UK now importing gas from sources such as Norway, Holland and Algeria.

The key infrastructure linking the UK with other gas markets are:

— Langeled/Vesterled: Connecting St Fergus in the UK to Norway, the Vesterled pipeline was connected into the Norwegian system in 2001.

— UK: Interconnector UK. Completed in 1998 linking Bacton in the UK to Zeebrugge in Belgium.

— BBL: Linking Bacton in the UK with Balgzand in the Netherlands, this pipeline was completed in December 2006.

— Isle Of Grain: A converted LNG storage facility, capable of importing 13mcm/day of gas into the UK. Capacity is held by BP and Sonatrach—Algerian. Currently a second phase of capacity is being constructed, with a third phase due to come on line in 2011.

— Excelerate Energy: Excelerate developed a facility for the supply of LNG gas direct from a ship, with connections at Teeside.

— Milford Haven: Currently there are two LNG terminals under construction at Milford Haven at Dragon and South Hook which are due to come on line in either 2008 or 2009.

The UK market will increasingly be more integrated with the European and world gas markets as the UK continental shelf reserves decline. This will continue to increase the extent to which the UK gas market interacts with markets elsewhere. Prices will continue to be influenced by what happens not just in Europe but also in the rest of world as LNG imports increase.

The UK market is therefore inextricably linked to the rest of Europe—and this interaction will increase in the future. This means that the creation of a single, competitive European market is crucial to how the UK market will develop. EDF Energy and the wider EDF Group supports the European Commission's efforts to create an integrated liberalised market. The "third package" of legislation proposed by the European Commission is an important step towards achieving more competitive energy markets elsewhere in Europe. There are a number of conditions that are needed:

— effective unbundling of transmission companies;

— clear, strong and predictable regulation at both the national and EU level to provide the right framework for investment, supplemented by effective coordination of regulators through the proposed Agency to deal with regional and cross-border issues;

— greater coordination between the transmission companies in the way they operate their networks and plan investments; and

— incentives for transmission companies to maximise the amount of capacity that is made available to the market.

An agreement on the third package in the coming months is crucial for the future development of the UK market.

The UK wholesale energy market is also affected by what happens in the global commodity markets for coal and oil. As explained in section 2.3, coal and oil prices influence what happens in the UK wholesale energy market, which means we are not isolated from price rises elsewhere.

6. The effectiveness of regulatory oversight of the energy market

The UK energy market has been closely monitored and regulated by the independent regulator, Ofgem. In addition to this constant oversight many other organisations regularly review the operation of the market, including BERR and the European Commission. The independence of the regulator is seen by the European Commission as a strength of the UK energy market. It said "the Office for Gas and Electricity Markets (Ofgem) has a high level of powers and independence from both the industry and the relevant Ministry" in `Prospects for the internal electricity and gas market' (published January 2007).

Ofgem

Ofgem reviews the operation of the domestic market annually in its Domestic Retail Market Report, which reviews all aspects of competition including cost and price increases and interactions between the wholesale and retail markets.

Ofgem also investigates complaints of anti-competitive behaviour under its Competition Act powers, and has conducted a number of investigations in recent years.

It is also worth noting that Ofgem has consistently reported a steady increase in the development of competition in the gas and electricity retail markets. In fact the retail market was thought competitive enough to remove price controls even when only 36-37% of customers had switched. Ofgem has consistently concluded that the market is competitive.[61] In their most recent survey in 2007 Ofgem concluded:

"Our analysis shows that all segments of the market remain highly competitive and not just for customers who pay by direct debit or online. The key findings are:

— Vigorous price competition between the big six suppliers for all customers—the spread between prices has shrunk and the most expensive suppliers have been forced to become more competitive to stem customers losses

— Suppliers are innovating to retain and win customers—there has been rapid growth in: fixed and capped price deals that shield customers from rising wholesale prices; cheaper online deals; and green tariffs. They now account for roughly 20% of the market.

— Customer service is improving: suppliers are investing huge sums to improve their systems and five suppliers have cut the number of unresolved complaints.

— Annual customer switching rates are at the highest in four years".

(Domestic Retail Market Report Ofgem 169/07 2007 p1)

BERR Reviews

BERR also reviews the level of competition annually and has a Public Service Agreement target to: "Ensure the UK ranks in the top three most competitive energy markets in the EU and G7 in each year". A report is produced annually by OXERA on behalf of BERR, the latest version of which confirms that the UK is the most competitive energy market in the EU and the G7.

We think this ongoing scrutiny of competition over the lifetime of the market has been strong, and regulatory oversight has been detailed and constant.

7. Progress in reducing fuel poverty and the appropriate policy instruments for doing so

EDF Energy has led the industry in responding to fuel poverty, as was recognised by Ofgem in its analysis of industry social responsibility initiatives represented in the chart below. But the energy industry alone cannot solve fuel poverty. Government has an essential role to play as fuel poverty is at heart a poverty issue that needs to be tackled from an income perspective as well as an energy cost perspective. It is also Government that has the information with which to identify who is fuel poor. Energy companies do not have the information with which to target vulnerable customers and must rely on imperfect estimations and self identification by customers.

SOCIAL RESPONSIBILITY SPENDING BY THE SIX LARGE ENERGY SUPPLIERS

Source: Ofgem

In February 2008 EDF Energy enhanced our activities in this area yet further with the launch of our Social Commitments. We committed to the following:

1. Provide a long term social tariff for our most vulnerable customers through to 2012 by extend our existing Energy Assist Tariff which gives a 15% discount to its 55,000 most vulnerable customers for a further year—until 31 March 2009. This social tariff has already been recognised by Energywatch as the most generous in the industry.

2. Customers on the company's social tariff also continue to receive free energy efficiency advice and practical measures to reduce their energy usage, as well as access to the EDF Energy Trust Fund and a free Benefits Entitlement Check.

3. By 2012, EDF Energy is also planning to help educate 2.5 million young people in the UK on the sustainable use of energy. As the first Sustainability Partner of London 2012, EDF Energy will support London 2012's education programme and will help schools understand and address their own use of energy, to reduce their climate change impact and reduce their running costs. The education programme will be supported by the EDF Energy Green Fund to deliver renewable technology projects for schools together with available public funds.

4. Manage the supply chain to help ensure that our suppliers meet agreed ethical standards and, in particular, comply with the UN Global Compact.

5. Lead the industry in protecting vulnerable customers from the adverse affects of power cuts.

6. Build on our ambition to achieve Zero Harm in our workforce by promoting health and safety awareness for children, community groups and our customers.

7. For our employees, attaining the gold standard for our approach to diversity and inclusion and increasing training opportunities to develop a range of new skills.

These commitments represent the one of the biggest packages of social initiatives launched by any major British company.

We are happy to work with the government in detailed consultations in coming months to understand what can be implemented on a longer-term basis to meet the government's target of eradicating fuel poverty. Everyone wishes to see fuel poverty eradicated, and to do this in a sustainable, robust and fair way we support a mandatory requirement on energy companies to provide a form of social tariff. This must be accompanied by firm commitments from Government to provide the information required to identify the fuel poor as well as tackling the wider social and income aspects of fuel poverty.

1 April 2008