Select Committee on Business and Enterprise Written Evidence


Memorandum submitted by Energy Information Centre Ltd

  As the UK's leading independent consultancy to industrial, commercial and public sector energy users, EIC was established in 1975 and was purchased by Broadfern in 2007. Both companies have considerable experience in the energy sector, representing approximately 1,300 clients with a combined annual energy procurement spend of £1,250 million in 2007.

  As such, we welcome the opportunity to comment on the issues raised insofar as the above investigation is concerned.

OVERVIEW

  Many of our clients have been in repeated contact with us over the last few days and weeks to express their concern following the extent of gas and power price increases. In addition as the immediate term impact of the prevailing situation on the energy market, the recently published Energy Bill has set out the medium to long-term roadmap for the UK's energy mix, which will have major implications for the future of the UK economy and its businesses.

  Recent weeks and months have seen energy price increases back in the spotlight of the mainstream media, as suppliers have sought to increase gas and power tariffs for their domestic users. While such customers will keenly feel the impact of these increases, they are well below those experienced by their industrial and commercial counterparts.

  As well as being subject to greater movement in terms of absolute price direction, business customers have also faced considerable underlying market volatility and—while some customers have the ability, by choice or by circumstance, to deal with this variation in prices—others are not in a position to do so.

  While a proportion of this volatility is due to market fundamentals and the need to guarantee that the supply-demand balance is met, some is due to uncertainty and technical trading in the market, while the long-standing inefficiencies of the energy sector as a whole continue to add further potential for price variation.

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

  The process of consolidation that has been seen in the UK energy sector over the last decade has effectively reversed the process of privatisation and deregulation, at least as far as energy supply is concerned. The introduction and development of vertical separation and ownership unbundling has proven successful in terms of network operation, although even here consolidation has emerged with the integration of the post-privatisation National Grid and Transco into the current transmission network operator.

  However, there is an argument that such a consolidation of gas and electricity network operators has brought with it economies of scale and advantages in terms of planning and system management that more than outweigh any negative consequences. In the case of energy supply, such natural monopoly benefits do not exist, and the question is whether the evolution of the sector has been to the benefit of customers.

  From a situation of vertical separation in the wake of privatisation with a wide range of companies undertaking roles as generators, suppliers, local network operators, etc, the mergers and takeovers seen in the past decade have resulted in a small number of companies that have differing levels of vertical integration.

  This has led to the dominance of the so-called "Big Six" within the domestic supply market (British Gas, E.ON, EDF Energy, npower, Scottish and Southern Energy and ScottishPower), with industrial and commercial customers and public sector organisations more able to draw on suppliers beyond this group (eg Gazprom, Corona, Bizz Energy).

  From a theoretical standpoint, this represents a shift away from an imperfectly competitive energy supply market in the latter part of the 1990s to one that more closely represents an oligopoly with a competitive fringe. This fringe in turn comprises companies of differing sizes that are seeking to establish themselves within that oligopoly.

  Therefore, there is the question of competition within the oligopoly and that within the fringe. While competition within the fringe would appear to be well established, the extent of competition within the oligopoly is less apparent. Furthermore, competition within the oligopoly appears to be based more on non-price factors, while that of the fringe is more focused on price (see Question 3).

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

  As stated in the response to Question 1, the process of vertical integration in the energy sector has meant that there are fewer participants, and this has in turn had major adverse consequences for the depth of liquidity in the wholesale market. This has resulted in a situation whereby the majority of trading seen for both gas and electricity is in the prompt and near curve contracts, with little activity seen in the more distant periods. As such, this raises the question of how reflective trading prices are of actual market interest and the underlying value of the commodities involved.

  The presence of companies across the value chain—either as upstream gas producers and shippers/suppliers, or as electricity generators and suppliers—means that there is inevitably a large degree of internal trading within a company and across the different operational entities, albeit governed by accounting separation. However, this means that a large proportion of the gas and electricity that is produced for consumption within the UK market is not traded openly on the wholesale market, and hence remains opaque to the majority of participants.

  As such, the wholesale market is only a small subset of the total traded energy market, but the prices that are set in that market govern the prices paid by virtually all consumers within the UK. Against this backdrop, there is the need to ensure greater wholesale market liquidity in a bid to ensure that prices are both transparent and representative of the underlying supply-demand balance for the commodities traded.

  Instances of deliberate market manipulation are thankfully rare in the UK energy sector, but there will always be the suspicion that a highly concentrated and vertically integrated energy sector has the potential for such behaviour.

  The issue of effective competition within the wholesale and retail energy markets is also governed by the relationships between the two. While EIC's view to this is covered in the response to Question 4, it should also be pointed out that there are still high levels of informational asymmetries across the respective markets. This has been improved considerably in recent years—notably in the case of gas through the implementation of Uniform Network Code Modification 006—although there is still a considerable advantage held by gas producers and generators.

  This level of asymmetry is also reflected in terms of market behaviour and the extent of any demand side response. While this has also been encouraged in recent years through new and innovative product offerings by suppliers, this has been relatively slow and has in some cases only emerged after repeated pressure from customers and their representatives. It is unclear whether, in the case of gas, the planned reform to the interruptible supply regime from 2011 will improve this situation, although initial indications from customers are ambiguous.

3.  The implications of growing consolidation in the energy market

  Based upon the assessment that economies of scale are such that a minimum of five million accounts is needed to effectively compete within the domestic supply market, the argument is whether there has been competition to assume dominance having already achieved what is seen as a "satisfactory" customer base.

  In recent years, there has been greater focus on retention of existing accounts by suppliers rather than an aggressive pursuit of expansion, with efforts to increase service and non-price factors the objectives. Competition on price has been focused more on ensuring appropriate financial performance rather than aggressive price cuts in a bid to bolster market share, although this is due in part to the repeated escalation in wholesale market prices.

  In essence, the competitive strategy adopted by suppliers—certainly in terms of their domestic supply businesses—has been more defensive than offensive. The situation in the non-domestic supply business has been more varied, notably with regard to product innovation and contractual pricing, with competition more evident due to the greater number of potential suppliers.

  It is the experience of EIC that the approach of suppliers to contracting with end users varies across suppliers and on a case-by-case basis depending upon the customer in question. Inevitably, there are clients that are attractive to suppliers in terms of their volume or load profile, or potentially through some other non-market specific factor such as the prestige of being associated with that client. However, as with the domestic market, there has been an increasing focus on non-price factors with a more defensive strategy of retention frequently being the primary objective of suppliers, rather than growth.

  One of the primary criteria used by suppliers in the wake of the collapse of Enron and Worldcom and its associated fallout has been credit compliance. In this climate, suppliers have refused to quote for sites with which they have previously had a long-standing and successful relationship on the grounds that they do not meet their revised credit criteria. As such, recently implemented risk management practices have also affected a willingness to compete for the business of certain end users.

  To conclude, the general decrease in the number of suppliers has inevitably meant that there is less competition in the energy supply market, and while a more concentrated structure is certainly more conducive to collusion, such an outcome is not a forgone conclusion. The nature of the energy sector in recent years has also meant that the larger suppliers (ie those in the oligopoly group rather than the fringe) have adopted a more defensive business strategy, reflecting rising wholesale costs and the need to defend margins.

  As detailed in the response to Question 3, similar challenges exist in the wholesale market, where a structure has emerged that does not promote either competition or transparency. However, it does promote investment certainty and long-term commitments to infrastructure and supply projects, resulting in a delicate balancing act in order to preserve energy supply security.

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

  The response by most consultees to this particular issue will inevitably focus on the domestic market, and whether companies fully pass on the increases and decreases seen in the wholesale market to their consumer base. In summary, domestic customers will experience the underlying wholesale market movement, but this will be on a lagged basis of between three and six months and will not reflect the full extent of the change in wholesale prices.

  By contrast, non-domestic customers are subjected to greater wholesale price volatility and do not always have the benefit of the mass media or elected officials to champion their cause. In the case of the recently announced domestic tariff increases at the start of 2008, this followed months of continued difficulties for industrial customers and the UK economy in general.

  Clearly non-domestic customers have greater options open to them in terms of managing their energy price risk compared to their domestic counterparts, but the risk itself is exponentially greater for non-domestic customers and necessitates a high level of time, skill and resources.

  As such, while suppliers will continue to stress the need to make a profit on their domestic supply businesses, households should continue to think themselves fortunate that—despite the increases that will be seen in their gas and electricity bills in 2008—they have not been forced to ensure the rollercoaster ride of their industrial and commercial counterparts.

5.  The interaction between the UK and European energy markets

  This is assessed on a commodity-specific basis as follows.

Gas

  The main problem faced by the UK gas market is its deregulated standing next to its peers of Continental Europe, which remain largely uncompetitive despite the requirements of European Union legislation requiring market opening by the start of July 2007. This mismatch of market structures means that deliveries of gas through the UK's import infrastructure—deliveries on which the country has become increasingly reliant since 2004—do not always respond to prices.

  This is primarily as a result of the contractual and regulatory structures that exist—for example, those related to the access to pipeline infrastructure needed to transport gas. This is just one of the issues that have been highlighted in recent years by the European Commission, and while we are glad to see that it is an area that the government is keen to champion—both directly and indirectly—the extent of progress in this area has been disappointing at best.

  While the Commission is hopeful of addressing this problem by 2009, a longer-term problem facing the UK gas market in its relationship with those of Continental Europe is the practice of oil indexation of gas supply contracts. This is a practice that the UK successfully moved away from in the early years of gas market deregulation, transitioning to a system whereby gas prices were determined by gas market fundamentals. However, the use of such pricing clauses on the Continent remains a long-standing arrangement that incumbents in the sector have little interest in changing, frequently with the implicit or explicit backing of the relevant government.

  As such, the increasing reliance of imports from the Continent has meant that the UK has effectively reverted back to this method of charging for wholesale gas, meaning that gas prices are effectively not based upon market fundamentals, but are instead dependent upon the ebb and flow of the global commodity markets. With oil prices at close to record nominal high levels, the issue of oil indexed pricing needs to be addressed as a matter of urgency to ensure that gas prices do indeed reflect fundamentals.

Electricity

  The greater push towards low carbon energy sources and renewable generation is a key facet of the broader objective of reducing greenhouse gas emissions in order to mitigate the effects of climate change. As such, this should be a key objective of responsible government and policy making, but the challenge for the UK and the European Union is to ensure that businesses are not punished for the actions of their leaders in this regard given the potential absence of a similar commitment from other nations.

  One of the main challenges to the expansion of renewable generation is the delays associated with their development. In the case of onshore wind, these include connection agreements, the negotiation of planning agreements and compliance with planning conditions. Against this backdrop, it is the responsibility of government to ensure that the planning regime works to the benefit of companies and does not subject them to undue and unnecessary delay—problems that have prompted some developers to abandon their plans for the projects.

  However, it should be remembered that renewables are not in a position to fully service the country's energy needs, although the potential for such a development is a possibility for the future. In this light, governments should remain reasonable and prudent in ensuring their nation's energy needs are met, and should make decisions on their generating mix accordingly and in a manner that ensures security and diversity of supply.

  Ultimately, there is a cost to ensuring that energy needs are met—both in the immediate term and in the long-term—and also a price to be paid if the energy mix does not have an adequate degree of flexibility and contingencies associated with it.

Emissions trading

  Overall, the cheapest unit of energy that one can have is that saved through greater efficiency. As such, this is a key area that needs to be pushed at all levels of the economy—notably the domestic sector. Businesses have too long shouldered the burden—and cost—of reducing greenhouse gas emissions while the contribution from domestic customers has failed to match expectations. This is an inequity that must be addressed as a matter of urgency.

  The European Commission's "20 20 by 2020" emission reduction and renewable energy plan represents a major challenge for the member states of the European Union, notably given the obligations on biofuels and road transport. For their merit, the expansion of biofuels needs to be undertaken in a socially responsible manner, and it will be a core obligation of the European Commission to ensure that such fuels are indeed sustainable and do not ultimately cause greater long-term problems.

  While political responsibility and a desire for strong leadership on emission reduction is important, targets on emissions and renewables must be undertaken in a manner that is achievable and do not compromise the needs of businesses and consumers.

  The plan to have the lion's share of emissions come from the EU Emissions Trading Scheme (EU ETS) is a welcome move, provided that the reforms to the scheme are undertaken in a clear and coherent manner. The prospect of a single EU-wide cap on emissions from 2013-20 provides long-term stability for business (as do the provisional details of the scheme beyond 2020), but the planned use of allowances as a means by which to redistribute income among nations must not result in implicit state aid to certain nations, nor should it unduly penalise certain member states at the expense of others.

  On the issue of penalties, the proposals requiring non-EU trading partners to purchase allowances in order to sell their products within the EU—assuming that a long-term global emission reduction policy is not agreed—must be implemented in a transparent manner and in full accordance with international trade law. European business needs to compete on a fair global playing field and not be dragged into a trade war and arguments on protectionism—regardless of the best intentions of the EU.

6.  The effectiveness of regulatory oversight of the energy market

  The early years of the post-privatisation era for both gas and electricity were characterised by an increasingly hostile and adversarial relationship between energy companies and their respective regulators. In the case of the gas sector, this saw British Gas face scrutiny from both the Office of Fair Trading (OFT) and the Monopolies and Mergers Commission (MMC), while the electricity sector saw National Power and Powergen criticised by sectoral regulator Offer over their conduct and be repeatedly threatened with a referral to the MMC.

  In recent years, the relationship between the regulatory authorities and energy companies has become more conciliatory in tone, although this has not stopped investigations being undertaken by groups including Ofgem, the Financial Services Authority (FSA) and the (then) Trade and Industry Select Committee (TISC) into the operation of the energy sector.

  The main question that should be considered is whether regulatory action and its consequences is a credible threat for energy companies, as opposed to how effective regulation has been. Regulators should serve as guardians of the market and customers, rather than reactive entities that are called into action, and they should also have appropriate tools and resources at their command.

  For example, the challenge that existed in the early years of post-privatisation within the UK electricity sector was that the market structure itself was conducive to behaviour that was not always in the interest of consumers. This resulted in a situation whereby Offer made repeated threats of an MMC referral to the two primary competing generators (National Power and Powergen) but did not carry this threat out. As such, and as has been subsequently demonstrated by academic research into this period, the credibility of this threat declined over time as it was made and not actioned.

  Therefore, the first criteria of any regulator is that it must be ready to act decisively against any potential anti-competitive behaviour, and that the companies under its remit must be faced with the potential for substantial and wide-ranging penalties as a consequence of this behaviour.

  The second criteria is that it must be wholly independent of the companies that it monitors in order to avoid regulatory capture, ie when the regulator—intentionally or otherwise—becomes the advocate of the relevant companies. This is far from evident in the UK, although there have been questions over the independence of regulators in some of the markets of Continental Europe, where companies—directly or through state involvement—are essentially protected by the regulator in order to preserve the status quo.

  This is an area that must be addressed as part of the process of market deregulation within the EU (see Question 6).

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

  EIC does not have a comment to make on this matter insofar as the domestic sector is concerned, although it should be pointed out that non-domestic customers have increasingly faced their own equivalent of fuel poverty in response to rising energy costs and the inability to fully pass these on to their customers.

  As such, the percentage of total costs contributed by energy spend must be considered as a priority for all consumers—not just domestic. This is particularly the case for those industrial customers that face international competition for their goods and services, with some of their peers—even those within the EU—still subject to regulated energy rates below the corresponding market rate.

CONCLUSION

  In conclusion therefore, the main challenges facing business customers relate as much to the broader energy sector as to specific industries and their end users.

  Firstly, the need for a coherent energy policy, which it is hoped that the Energy Bill will provide. However, with much of the Bill being of the "hurry up and wait" stance of further consultations, these must be concluded in a swift and efficient manner such that the uncertainty that has dogged the energy sector for some time is addressed. Overall, the Energy Bill is a welcome step, but its policy measures need to be adhered to—after all, the 2007 White Paper on energy was the third such document from the UK government in less than 10 years.

  Secondly, and on a related point, the need for a coherent energy policy must sit alongside the requirement that it is also consistent. There has been a tendency in recent years for energy policy to become reactive rather than proactive, to the extent that some policies have descended into knee-jerk reactions to prevailing market conditions or attempts to grab headlines. The recent example of windfall taxes on oil companies and power generators illustrate this—private companies are in the business of making profits and it should not be the business of government to determine what is an "acceptable" level of profit. The role of government should be to create a framework within which these businesses can re-invest their profits in infrastructure, not seek a short-term gain and one that may adversely affect the long-term health of the sector.

  Thirdly, in terms of ensuring an appropriate framework within which energy supply companies can operate, there is an urgent need for a balance to be struck between the UK's deregulated structure and the comparatively uncompetitive structure of most of Continental Europe. The two main consequences of this for the UK are the absence of a fully traded gas market on the Continent—due to the traditional retention of oil-linked gas supply contracts—and a lack of complete third party access to network infrastructure. Both of these serve as a barrier to entry and a route by which to maintain the status quo, and while the European Commission's commitment to address both is welcomed, this rhetoric needs to be backed up by policy.

  Finally, business customers have been seen in recent years as a source of greenhouse gas emission reductions while simultaneously shouldering a heavier burden in terms of higher energy bills. Against this backdrop, domestic customers have faced comparatively less pressure in terms of environmental policy obligations while also having more vocal support from politicians and the media when energy prices increase. As such, it could be argued that domestic customers have had a "free ride" at the expense of their business counterparts, and although industry is not averse to meeting its obligations in terms of emission reduction or paying justified energy price increases, there is a need for a more equitable distribution of the burdens resulting from national and international policy commitments.

  Given EIC's long-standing presence in the UK energy sector, we trust that you will consider these comments appropriately, and we would welcome the opportunity to discuss them further with you at your convenience at a future date.

March 2008





 
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