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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