Further supplementary memorandum submitted
by the Office of Gas and Electricity Markets (Ofgem)
1. On 17 June 2008 Ofgem's Chief Executive,
Alistair Buchanan, and Managing Director of Markets, Andrew Wright,
gave oral evidence to the Business and Enterprise Select Committee.
There are several issues on which we thought it would be helpful
to provide the Committee with further information.
INVESTIGATING THE
WHOLESALE ENERGY
MARKETS
2. We can assure the Committee that our
decision to launch a probe into the energy supply markets neither
precludes us from investigating the wholesale markets nor stops
our ongoing monitoring.
3. The background to our announcement of
February 2008, which focused principally on the downstream supply
market, was of rising customer concern about bills. When we met
the Chancellor in the previous month, only one major supplier
had raised its prices. A month later five of the six had done
so, and the spread between the offers available to customers had
narrowed significantly. In addition, the differentials between
the tariffs for different payment methods had been rising. Our
view was that the level of customer concern about this behaviour
in the retail market justified investigation.
4. At the same time, our eye remains very
firmly on the position in the wholesale markets. Current work
in that area includes:
— an investigation into Scottish
Power and Scottish and Southern Energy, focusing specifically
on allegations of uncompetitive behaviour in the upstream generation
market;
— examining the relationship between
wholesale and retail energy prices as part of our current supply
markets probe;
— the impact of vertical integration
on energy supply markets is also being covered in the probe; and
— we have also recently published
National Grid's latest winter outlook report, analysing the outlook
for security of supply in gas and electricity this winter.
5. This work will continue and, should we
receive any evidence of anti-competitive behaviour in the wholesale
markets, we will not hesitate to investigate that information
very thoroughly.
LIQUIDITY IN
THE WHOLESALE
GAS MARKET
6. The Committee requested our views on
the figure cited by energywatch in their evidence that "80%
or so of all of the gas coming in is covered by these mysterious
[off-market] contracts and we do not know whether there are restrictive
clauses."[333]
Energywatch have now advised us that this figure is not correct.
Furthermore, their revised assessment of 70% is based on a report
by Global Insight from 2005 which is now out of date.
GB WHOLESALE GAS
MARKET LIQUIDITY
7. As we explained in our oral submission,
liquidity in the GB gas wholesale market is significantly higher
than in other European markets. This makes the GB market the most
liquid in Europe by some distance. (See Chart 1 for more information.)
Information from a range of sources suggests that the level of
gas made available to the market is significantly higher than
the 20% suggested by energywatch in their oral evidence, since
revised by them to 30%.
— Gas market liquidity has increased
steadily since 1996, with 11,000TWh of gas traded in 2007-08 up
from 7,329TWh in 2006-07. (The volume in April 2008 alone was
1,253TWh). The current gas churn ratio (the total level of gas
trading divided by actual throughput) is almost 11, meaning that
on average each unit of gas is traded 11 times before delivery.
This figure includes all reported trades to National Grid and
includes products for delivery in under a few months (known as
the prompt) and those for delivery further in advance (the forward
market).[334]
In comparison, the Nordic power market has a churn of 10 whilst
oil churn is around 18.
— Figures from National Grid indicate
that 60 to 70% of total gas physically delivered is in fact visible
to the market, ie it is traded via the National Balancing Point
(NBP). This is up from just 20% in 2000. National Grid's figures
are based on all trades registered on NG's systems for daily balancing,
BP, Shell and ExxonMobil have confirmed (as part of their evidence
to the Committee) that around 60% of their gas is not tied up
under long term contracts but is sold into the market.
8. Ofgem investigated the wholesale gas
market in 2004. As part of that probe we examined whether any
of the long term contractual arrangements for the supply of gas
from the North Sea were restrictive or capable of withholding
gas from the market. We only found concerns that justified further
investigation with one set of contracts relating to the Sean field.
We concluded, after a thorough investigation that these contracts
were not problematic. All of our analysis and the reasons for
our conclusions were published in a series of detailed reports.
Given the decline in North Sea production and the size of new
fields that have been commissioned since that report we doubt
if any new contracts signed since 2004 would be likely to have
restrictive features or be capable of having a significant impact
on the GB gas market. The most significant long term contracts
signed since then have been related to imported gas through the
major new import infrastructure, such as the Langeled pipeline
from Norway and the Bacton-Balgzand (BBL) pipeline from the Netherlands.
The existence of these long term contracts relating to Norwegian
supplies and supplies through BBL are in the public domain and
were announced by the relevant companies as part of their financial
reporting when signed.
9. The majority of these new infrastructure
projects have applied for and been granted an exemption from the
requirements to offer third party access. As part of the process
for determining whether an exemption should be granted, Ofgem
takes into consideration the allocation of capacity, including
where this is done on a long term basis, to determine whether
it will have a detrimental impact on competition. In addition,
the exemption application and all supporting analysis is provided
to the European Commission which is able to review and has final
sign-off on many exemption applications.
10. The European Commission also carried
out its own detailed sector inquiry into both the gas and electricity
markets across Europe and requested detailed information on all
of the long term contracts in place. The Commission's report highlighted
a number of concerns with the effects of these contracts in a
number of continental European gas markets but did not directly
raise any specific concerns about their effects in the GB market.
11. As a result, we have no evidence or
grounds to be concerned about the effects of existing restrictive
long term contracts to the GB market.
12. In addition, long term contracts can
and do have an important role to play in helping to maintain security
of supply. Long term contracts may be necessary to support substantial
investment in new infrastructure necessary to bring imported gas
to the GB market and to promote security of supply. In assessing
the impact of long term contracts, it is important to assess the
terms of the contracts and to determine whether downstream companies
are able to compete effectively to sign them. If the contracts
do not prevent re-sale of the gas to other suppliers and are not
indexed to commodities such as oil, then there is no reason to
assume that they will have any detrimental effects on the market.
In fact, they are likely to have a positive impact on both competition
and security of supply. Most of the existing North Sea long term
contracts, and the new import contracts, index the delivered price
of gas to the spot price of gas. This helps make sure that the
price under the contract rises and falls in line with changes
in demand and supply.
13. For these reasons, we have focused on
whether spot gas markets are competitive and liquid. We also undertake
routine market surveillance to make sure that any change in price
in the spot market can be explained by changes in demand and supply.
We see this as a more useful measure of whether the market is
competitive than the share of long term contracts. However, we
would have concerns if long term arrangements had an impact on
liquidity in wholesale markets and we will not hesitate to investigate
any evidence of anti-competitive behaviour.
14. Trading in gas is focused on the prompt,
rather than the forward market. A similar issue is found in the
forward market for oil, a commodity for which the market is commonly
thought of as liquid. Bank of England research suggests that liquidity
in oil further out on the forward curve is very low compared with
the prompt.[335]
We have seen some increase in forward trading in gas. This increase
in trading has occurred on exchanges as well as over the counter
(OTC)[336]
as can be seen in Charts 3 and 4.
15. Contracts need two parties and since
our appearance before the Committee both Major Energy Users Council
(MEUC) and Ineos Chlor have confirmed to us that they will be
submitting additional information to you. This broadly confirms
our oral submission on the spot/short term purchasing habits of
the large users. They will outline their reasons for this strategy,
but it has been confirmed to us by a number of larger purchasers
that Stock Market considerations are a key factor behind this.
Chart 1: GB and European gas traded volumes
Chart 2: Total monthly traded volume as
a percentage of gas throughput (churn)
Chart 3: Exchange based trading by product
Chart 4: OTC trading on Spectron (smoothed
to eliminate seasonality)
GB WHOLESALE ELECTRICITY
MARKET LIQUIDITY
16. The wholesale market for electricity
is considerably less liquid than that for gas. The estimated value
of electricity traded over the counter in 2006-07 was £31
billion.[337]
This represents an increase of £1billion, roughly 3%, on
the previous year. Total traded electricity—including both
OTC and exchange—is around two to three times the total
physical delivery. This is low compared with other commodity markets
such as gas, where total traded volume is roughly 11 times the
total physically delivery. In addition, trading in electricity
is very heavily weighted towards products on the prompt rather
than the forward market.
17. In the oral evidence session on 24 June,
Members expressed interest in comments by some witnesses who said
they still trade heavily in the market despite being vertically
integrated. It is worth noting that a vertically integrated company
may still trade extensively on the open market, partly to hedge
its position but also to speculate on the price of power, and
so its total volume traded may be close to its total physical
generation.
18. One factor that may inhibit liquidity
in the wholesale electricity market is the current operation of
the "cash out" arrangements. These denote the commercial
incentive on generators and suppliers to balance their contractual
and physical positions at any given time, thus helping National
Grid to balance supply and demand and maintain security of supply.
Parties who are not in balance incur charges that are designed
to reflect the costs incurred by National Grid in dealing with
any imbalance. The charges are known as cash out prices. We have
conducted a review of the cash out arrangements and our impact
assessment suggested that the current cash out prices often do
not reflect supply and demand conditions and prices can be too
high when the system is not under stress. This creates additional
risk for the parties involved and may reduce the role that financial
institutions such as banks and companies without generation or
supply businesses could play in trading electricity and improving
liquidity. There are currently two proposed changes to the rules
that are being developed through the industry's governance process.
These proposals will shortly come to Ofgem for a decision.
GAS STORAGE
CAPACITY
19. As we outlined in our oral submission
most European countries have significantly more storage than the
UK and this needs to be seen in the context of their indigenous
production. The British market is in a period of transition as,
until recently, we were self-sufficient in gas. Large swing fields
in the North Sea were capable of significantly ramping up production
either between seasons or—in the case of fields such as
Morecambe and Sean—within day.[338]
This meant there was less need for storage to cope with supply
shocks and the seasonal pattern of demand. Britain also had a
large fleet of gas fired power stations that were capable of running
on back up fuel and the ability to switch between gas and coal
generation. This provides a significant source of "virtual"
storage as was seen in the winter of 2004-05. Gas production from
the North Sea has been declining in recent years and therefore
the commercial rationale for storage has become much stronger.
This has been reflected in the significant increase in the price
of capacity at existing storage facilities.
20. Current investment in storage—which
is not limited to the existing main energy suppliers—suggests
that the incentives to invest in storage are strong. Customers
want a reliable and continuous supply, and suppliers have strong
market incentives to meet their contractual supply obligations.
Therefore, they are willing to pay for storage to meet the uncertainty
of very high demand periods. In addition, the fact that there
is demand for storage means that companies can make sufficient
returns to justify investing in new facilities. We can see this
happening in practice. Major investments in new storage facilities
are planned by energy companies, including Scottish and Southern
Energy and E.ON, and by companies who are not existing energy
suppliers. For example, Statoil and Ineos Chlor are both investing
in storage. A list of proposed and under construction gas storage
facilities can be found in Annex 1, Table 1. If all the above
projects are completed, our gas storage capacity will double by
2010.
21. However, the planning regime remains
a major barrier. For example, Canatxx want to build a large facility
in Fleetwood, Lancashire, that would store 1,660 million cubic
meters (mcm) of gas—but it has been blocked by the local
planning authority. At a minimum this will delay the commissioning
of a significant new storage facility by at least two years from
2010-12. Furthermore, it sends a damaging signal to all companies
wanting to invest in storage in the UK. Developers have to incur
substantial costs in getting to the stage of making an application;
the length of time it can then take to get a final decision makes
the case for investment in storage much less compelling.
22. One witness has suggested that an additional
blockage could be the regime for gaining access to the gas transmission
system. This is not the case. The arrangements for access to the
gas system are relatively simple and any new user, including storage
sites, can secure access to the system by using the annual long
term or shorter term capacity auctions. Once they have agreed
contracts to secure capacity rights, they are entitled to compensation
if National Grid does not deliver the capacity. A number of storage
sites, including Aldbrough, have used this mechanism, secured
rights and connected to the system. Canatxx also used this mechanism
to secure access to the system for their planned facility from
2010 and secured long term rights for the next 20 years.
23. An additional facility at Hornsea bought
capacity in the September 2006 auctions that commence in January
2010 when it will be ready to enter commercial operation.
24. It is important to emphasise that there
are strong commercial incentives to invest in storage and companies
are ready and willing to invest. The major barrier remains the
planning regime.
ISLE OF
GRAIN LNG IMPORT
TERMINAL
25. National Grid opened a Liquefied Natural
Gas (LNG) import terminal at the Isle of Grain in July 2005. BP
entered into a contract to secure half of the slots and Sonatrach
the other half. In addition, the terminal has "use it or
lose it" arrangements. These arrangements were part of a
package of demands by Ofgem in return for the facility being exempted
from directly regulated third party access. The "use it or
lose it" arrangements allow other companies to gain access
to the facility if it is not being used by the primary capacity
holder (BP/Sonatrach). The current arrangements for the Isle of
Grain facility are that if a slot is not going to be used it must
be offered to the secondary market 10 days in advance, with an
auction held seven days in advance.
26. Since February 2006, there have been
127 slots available for the importation of LNG. BP/Sonatrach have
used 63 of those slots themselves. In accordance with the rules
they have offered 64 for sale on the open market. None of the
slots that have been offered to the secondary market has ever
been bought. This assessment is consistent with National Grid's
figures which cover the period since the opening of the terminal
in July 2005. NG state that, since July 2005, there have been
158 possible slots for cargoes to import LNG. Of those 158 slots,
74 have been used. In our oral submission we caused some confusion
by only focusing on the 63, rather than the 64. We wish to clarify
this and refer to the caveat we provided the committee in answer
to question 545 in the Hansard transcript.
27. The above figures raise two obvious
questions. Are the current arrangements for third-party access
appropriate? Are there other reasons why more LNG is not being
delivered?
28. In November 2007, Ofgem published an
open letter requesting comments on the way that the "use
it or lose it" arrangements at the Isle of Grain work. Of
the responses received, none suggested that the current arrangements
had ever prevented a cargo being brought into the terminal. Many
of the respondents were companies who have purchased capacity
at one of the future LNG terminals.
29. Concern has been expressed about the
lack of LNG arriving at Grain during winter 2007-08, despite high
spot gas prices, with only 11 of 32 slots being used. There are
two important points to make. The first relates to the LNG market.
The fact that more LNG did not come to Britain in that period
can be explained by the higher prices on offer in other LNG importing
countries. For example, demand and prices in Asia were much higher
than spot prices in Britain at the NBP, reflecting nuclear outages
in Japan and high demand from China and India. Most Asian countries
have no alternative source of natural gas and will therefore pay
whatever is needed to secure it. Closer to home, shortages in
Spain and Turkey meant that any available cargoes in the Atlantic
Basin went to these markets in preference to the UK.
30. Second, there was an alternative to
the Isle of Grain if suppliers wanted to import LNG to the UK.
Excelerate now have a facility to import LNG through the Teesside
terminal using special ships that can re-gasify LNG without the
need for an onshore terminal. They are also able to transfer LNG
from conventional tankers to their ships. No deliveries were made
through this facility either, thus suggesting that it was not
the lack of effective "use it or lose it" arrangements
at the Isle of Grain that prevented more LNG arriving.
31. A large increase in UK LNG importation
capacity is due for winter 2008-09. The Dragon and South Hook
terminals at Milford Haven are expected to have a base-load delivery
of 16mcm/day and 29 mcm/day respectively. In addition, the facility
at the Isle of Grain is due to expand by 25mcm/day (phase two).
The new capacity at the Isle of Grain will see a number of new
capacity holders[339]
with primary rights to use the terminal. All these facilities
are due to be in operation by Q4 2008. This will see much greater
competition and availability of LNG import capacity in GB. As
with last winter, however, there are uncertainties over the amount
of LNG that will be attracted to the UK market if demand in Asia
remains strong and prices in other markets remain above UK prices.
32. We would be pleased to answer any further
questions, and to provide any additional information that the
Committee may require.
June 2008
Annex 1
Table 1
OPERATIONAL STORAGE FACILITIES
| Facility | Space (GWh)
| Deliv. (GWh) | Start date
| Capacity Holder |
| Rough | 36,800 (max)
| 455 | 1985 | Centrica (subject to Third Party Access)
|
| Hornsea | 3,496 | 195
| 1979 | SSE (subject to Third Party Access)
|
| Avonmouth | 877 |
156 | 1978 | NG
|
| Dynevor Arms | 303
| 49 | 1983 | NG
|
| Glenmavis | 509 |
101 | 1975 | NG
|
| Partington | 1,126 |
219 | 1972 | NG
|
| Hole House Phase 1 | 325
| 58 | 2007 | EDF
|
| Hatfield Moor | 1,260 |
22 | 2002 | Scottish Power
|
| Humbly Grove | 3,100 |
82 | 2005 | Petronas
|
| |
| | |
Table 2
POSSIBLE, PROPOSED AND UNDER CONSTRUCTION STORAGE FACILITIES
| Facility | Space (GWh)
| Deliv (GWh) | Proposed start date
| Applicant |
| Aldbrough (completed) | 4,550
| 421 | 2008 | SSE/StatoilHydro
|
| Hole House Phase 2 (under construction) |
325 | 58 | 2009
| EDF |
| Humbly Grove Expansion (under construction)
| 630 | — | 2008
| Petronas |
| Holford (under construction) | 1,758
| 175 | 2009-10 | EON
|
| Holford H165 | 50 | 75
| ? | EON |
| Aldbrough phase II | 4,550 |
0-210 | 2013 | SSE/StatoilHydro
|
| Whitehill Farm | 4,548 |
433 | 2012 | EON
|
| Stublach (under construction) | 5,800
| 525 | 2013 | GDF/Ineos
|
| Caythorpe | 3,000 | 120
| Planning inquiry | Warwick Energy
|
| Portland | 10,830 | 216
| 2011-12 | Portland Gas |
| Saltfleetby | 7,650 | 85
| Planning stage | Wingas/Gazprom
|
| Gateway | 12,775 | 305
| Planning stage | Stag Energy
|
| Esmond/Gordon | 44,403 |
567 | Planning stage | Petronas
|
| Albury I | 1,850 | 46
| 2011 | Petronas |
| Welton I | 2,520 | 63
| 2011 | Petronas |
| Welton II | 1,258 | 32
| Planning stage | Petronas |
| Gainsborough | 1,730 | 63
| 2011 | Petronas |
| Bains | 6,000 | Unknown
| 2011-12 | Centrica |
| Bletchingley | 9,450 | 126
| 2012? | Petronas |
| Albury II | 7,553 | 945
| 2012? | Petronas |
| British Salt | 10,800 | Unknown
| After 2010 | British Salt |
| Larne Lough | Unknown | Unknown
| Planning stage | Portland Gas
|
| Fleetwood18,400 | 650 | 2010-delayed, planning refused
| Canatxx | |
Source: Ofgem.
25 June 2008
| | | |
|
333
Response to Q 277. Back
334
The trades included in the churn figure are all trades for the
month of gas flow and not the month of the trade. Back
335
http://www.bankofengland.co.uk/publications/quarterlybulletin/qb060105.pdf Back
336
OTC trading describes trading of financial instruments such as
commodities directly between two parties and can be conducted
via a number of routes including over the phone and via net. In
contrast exchange based trading takes place at one physical location.
Exchanges are organised to provide "trading" facilities
for brokers and traders for example clearing services. Back
337
Not £31 million as stated in Table 11 of our written submission. Back
338
This is likely to become more limited in the future. Back
339
Centrica (3.4 billion cubic meters (bcm)), Gaz de France (3.3
bcm) and Sonatrach (1.9 bcm). Back
| 
