Examination of Witnesses (Questions 300-319)
MR HUGH
CONWAY, MR
JEREMY NICHOLSON
AND MR
CHRIS TANE
3 JUNE 2008
Q300 Mr Bailey: Before I focus on
some more detailed questions, I personally, and I think probably
other members of the Committee, would like to get a grasp of the
whole issue of the wholesale gas market and its liquidity. This
is an issue which, forgive me, is jargon-ridden and you will use
phrases every day that we may not be fully understanding of—I
am looking at "forward supply models", "long-term
contracts", "index-linked contracts", the "oil/gas
price link"—and I think it would be helpful before
we went into the more detailed questions if you could define exactly
what you mean, and the best way of doing so might be if I were
to be a gas consumer and wanted to get a contract to supply gas
to me, what would be the theoretical options in purchasing that
gas, what would be the practical options and, if you like, what
would determine what I had to do on this?
Mr Nicholson: Typically industrial
consumers will sign up to 12-month contracts. There is no limit
on that, sometimes you have longer contracts, sometimes you have
shorter, through a supplier in principle the same way we do as
domestic users, and the price quoted by the supplier will almost
certainly be calculated on the basis of forward market price in
the wholesale market in the UK plus some additional costs for
distribution.
Q301 Mr Bailey: What is a forward
market price, to get to the basics?
Mr Nicholson: That is the price
in the wholesale market for a continuous supply of gas over the
next 12 months or the month ahead, averaged out, or it could be
done seasonally. One of the alternatives to that is to have a
contract which is where the price of gas varies throughout the
contract period. It is not quite a spot market price, it is the
prompt market, the day ahead price that tends to determine the
costs. In other words, it is not a fixed price contract, it depends
what happens on a day-to-day basis. Those are the two principal
options. It is rather different, by the way, in Continental markets
where virtually all sales are indexed on a lagged basis not to
a wholesale market price but to the price of oil products, and
that is where the oil price linkage comes in.
Q302 Mr Bailey: Right so all other
things being equal the normal preference would be to link to a
forward market price?
Mr Nicholson: Typically yes.
Q303 Mr Bailey: So why do gas sellers
not sell on the forward market, which seems to be a problem?
Mr Nicholson: The problem might
actually be more acute in power than it is in gas, but it is a
question that we have asked ourselves and not come to a conclusive
answer. It is certainly true that we have a more liquid, in other
words more trading going on forward market in gas than many other
European countries, but whether it is adequate is another matter.
I am sure Chris will add to this but presumably it is not in the
commercial interests of those who are producing and supplying
to sell their gas in this way. They perhaps would be better placed
to say why but what we can see is there is no alternative for
consumers out there and that relatively small volumes of trading
in a thinly traded market in the future are effectively determining
the price for all our members' contracts.
Mr Conway: All the suppliers link
their gas prices to the forward market but as far as we can see
they only buy their gas through bilateral over-the-counter deals
which of course are not transparent. In that bit we do not know
what is going on.
Mr Tane: Clearly volatility and
unpredictability is a major factor, meaning whether to me as a
customer or I am sure to the suppliers, it is very, very difficult
indeed to predict what the cost or price of gas, in this case,
is going to be 12 months from now in this market. On the Continent
you can look at the way oil prices are moving and you can come
up with a fairly good prediction where gas will be but in this
market it is very, very difficult to predict that for a number
of reasons. Because of that I think the suppliers err on the side
of caution and they do not make commitments long term because
they do not know what the cost to them is going to be 12 months
from now, so they prefer to stay mostly on spot trading because
they can always sell at whatever today's price is and I have got
to pay it. They have no incentive to do long-term deals with anybody.
Q304 Mr Bailey: I need to get it
clear in my mind. There is relatively little gas available for
the forward price market and that is because suppliers are obviously
supplying gas in terms of other sorts of contracts. Exactly where
are these contracts focused and what sort of percentage of the
total supply is involved in these contracts?
Mr Nicholson: I am not sure we
could give you figures on that. I am sure the gas producers and
suppliers could, but if you look at the volumes that are being
traded in forward market compared with the total volume of gas
that is sold in aggregate, there is a very big difference between
the two and plainly most of the rest is sold between suppliers
or, in the case of vertically integrated producers, contracted
internally on a different basis, and I do not think we could easily
comment on the nature of those deals.
Q305 Mr Bailey: Is that because of
the scale of vertical integration in the market?
Mr Nicholson: It is a factor,
perhaps a stronger factor in electricity than it is in gas. In
gas there is more in the way of independent suppliers and separation
with producers so I do not think vertical integration can be the
whole explanation there.
Mr Bailey: Could you elaborate a little
further on the oil/gas price link
Q306 Chairman: Why is it still there?
Why can the European Commission not just say get rid of it?
Mr Nicholson: That is a very good
question. In fact when we have dealt through the European organisation
with the Commission we have been asking that same question. There
is no reason why there should not be oil-indexed sales if producers
and consumers want to do those sorts of deals; it is the fact
that there is no choice in the Continental markets that should
raise suspicions. I know that is a view shared by energywatch
here, quite rightly. When all suppliers—and I am trying
to avoid using the word "conspire"—coincidentally
agree to price their product on a consistent basis right across
the market, there is no choice at all. In the UK it is all on
the basis of the wholesale price in our market here with the margin.
In the Continental markets it is all on the basis of indexation
to oil products and it offers no choice. Incidentally, sometimes
they are the same players in the UK and Continental market but
strangely on the Continent they will only offer one type of model
and in the UK they will only offer the other. If you go to that
supplier and say, as Chris and others have tried to do, "I
would like one of your Continental-style deals in the UK,"
they will not provide it, nor will they provide a UK-based deal
on the Continent. That should raise the suspicions of any competition
regulation in my view and it should be a matter for the European
Commission to get to the bottom of it.
Mr Bailey: Presumably the Continental
model is cheaper than the model in the UK?
Q307 Chairman: We are going to move
on to the European gas market.
Mr Nicholson: That will vary from
time to time.
Chairman: I am going to bring in a couple
of colleagues with supplementaries on this aspect of the liquidity
of the wholesale gas market here in the UK and then come back
to the European market in more detail.
Q308 Mr Weir: Throughout our evidence
sessions we have been talking particularly about domestic customers
and it has been suggested to us that the linkage between oil and
gas is pushing up prices in the UK. What I am getting from you
is a slightly different story where you seem to be wishing you
could get the contracts that are linked to oil. It seems to be
totally the other side of the coin. Why is that? Do you believe
it is beneficial? Is it beneficial because it gives certainty
about price or is there another reason why you believe it is beneficial?
Mr Nicholson: That is a good question.
Please do not interpret from our remarks that we like oil indexation
and no choice or that we do not like the competitive market; quite
the contrary. There is an interesting question however, and you
will possibly have seen from the graph in the our evidence that
over the last three years, if you compare the year ahead wholesale
price here with the Continental oil-indexed price elsewhere in
Europe, there has been no advantage to the UK from our competitive
market compared with largely state-owned monopolies in the rest
of Europe. What does that say about the state of competition in
our market? The point is whether competition is delivering what
it theoretically could in the UK. You would imagine that averaged
over time it should be an advantage in the UK but at the moment
we seem to have historically recently no net advantage and some
considerable periods of disadvantage.
Q309 Mr Weir: Is that because in
the UK the same thing is happening—people are looking at
forward oil prices and, if you like, projecting their own price
against where they think the oil price is going to be?
Mr Nicholson: First I should say
that we all understand that it was inevitable that gas prices
were going to go up in the UK given the pressure on energy prices
internationally. We make no complaint about that. It is difficult
for all classes of consumers but it is a fact of life so to some
extent we were always going to have to absorb these sorts of increases
in price because that is what is happening internationally. However,
what we have seen is UK prices spiking above the Continental level
in a way which we would argue is avoidable both in its frequency
and its intensity, and I would go back to the central point, why
are we paying either the same or a premium relative to monopolistic
markets where there is virtually no choice at all?
Q310 Mr Binley: I think this is a
very vital point. We have boasted about a competitive market and
the truth of the matter is it does not exist. Where does the competitive
edge lie and how big is that competitive edge; what percentage
of the total area is that competitive edge?
Mr Nicholson: I am sure my colleagues
will contribute to this but my initial comment is that we have
historically benefited from it. In a period when the UK was in
surplus with gas we had an extremely competitive gas market. Unfortunately,
partly due to circumstances beyond our direct control, that advantage
has been lost and arguably we are in a more risky situation now.
In electricity the reasons are slightly different because we have
seen market concentration and greater vertical integration.
Q311 Chairman: Mr Binley will be
asking that question later.
Mr Nicholson: To a lesser extent
that has happened in gas too. There are a number of reasons why
our competitive market is not delivering competitive prices and
that of course is what matters to consumers.
Q312 Mr Binley: Sorry, there must
be a competitive edge somewhere or people would not be competing
to sell you their product. Where does it lie?
Mr Nicholson: It lies in the last
0.5 %.
Q313 Mr Binley: That narrow a margin?
Mr Nicholson: Yes.
Mr Tane: To be clear, as I said
before, my business is the largest single point consumer of electricity
and the third largest industrial consumer of gas in the UK. Nobody
has competed to get my business. I have never ever, with one notable
exception, had an approach from any gas or electricity supplier
trying to get my business.
Mr Binley: That is crazy.
Q314 Chairman: That is interesting
and a very telling observation you just made. Can I ask one question
just to clarify stuff that has been said. Your forward price contracts
are based on prices in a malfunctioning market a market with almost
no liquidity where strange things can happen for whatever reason—speculation,
hoarding, all kinds of bad things can happen in that market—and
that badly functioning market determines your underlying price?
Mr Nicholson: Absolutely and has
a knock-on effect on power prices too.
Mr Tane: And determines whether
my business can compete with French, German and Belgian producers.
Chairman: Thank you very much, I think
we have pinned that down. Mike, do you want to come to your main
questions.
Q315 Mr Weir: I am still a bit confused
by this whole linkage between oil and gas prices. Mr Tane, you
said that the European supplier would not give you the same contractual
terms. Did they give any reason why they would not give you these
contractual terms?
Mr Tane: The nearest we got to
a reason was, "The UK operates on a different pricing model
and that is the only one we are prepared to offer you."
Q316 Mr Weir: So in effect there
is no European-wide model despite what the EU may be saying about
competition?
Mr Tane: In my simple summary
there is a Continental model, potentially a Scandinavian model
and a UK model in terms of pricing structures.
Q317 Mr Weir: And you cannot get
the same type of contracts from the UK suppliers as available
in the European mainland?
Mr Tane: Correct and to come back
to your question earlier as to why would I want to get a Continental-style
contract, the first thing is I would like to have a choice. At
the moment I have one choice and that is it. I would like to have
more than one choice. The second thing is, as I said before, I
am competing with French, German and Belgian produces (and I do
not care what my price of gas is; what I care about is that it
is same price or better than the others) and at the moment I am
facing the situation where my price is either the same or worse
than theirs and is much more unpredictable and volatile than theirs,
so I am losing out quite considerably.
Q318 Mr Weir: We have heard a lot
in our evidence about this famous Interconnector between the European
mainland and the UK. We are told that Sam Laidlaw of British Gas
has noted that the UK is in danger of becoming a gas lender of
last resort to Europe in the sense that they will take gas from
us when they need it but will not give it back when we need it.
Is that your experience of what is happening there?
Mr Nicholson: Yes and it leaves
us very vulnerable as a highly gas-dependent nation. Maybe that
did not matter so much when we had a lot more indigenous production
but that is in decline. We are becoming more gas-intensive if
you look at the demand from the power sector just at the time
when we are becoming exposed to some very difficult price influences
from outside. You have mentioned what we see as an inequitable
asymmetry. In short they have got access to our markets; we have
not got equitable access to theirs; we cannot access their storage
facilities; we cannot get access to the pipelines; we cannot get
access to contracts on the same terms. We have "done the
right thing" by liberalising our market but trying to operate
an import-dependent liberalised market in a less liberalised whole
is leaving us in a very vulnerable position.
Q319 Mr Weir: Is the real problem
then the failure of the European mainland, particularly Germany
and France, to liberalise their markets and, if so, what do you
feel the European Commission should be doing about it to end this
situation and have a true free market across the European Union?
Mr Nicholson: It is unquestionably
the case that the biggest fault lies with other European countries
that have not liberalised their markets. In our view, the Commission
has proposed some very sensible arrangements to help bring that
about, not dissimilar to the sort of reforms we instituted here
in the UK. The problem is not so much with the Commission but
with a number of other European Member States who, despite what
they have said publicly, have no intention of fully liberalising
their gas markets, and here I think some criticism is due of BERR
and DTI previously in undue optimism about this. We applaud the
efforts they have made to campaign for liberalisation. Indeed,
we have been supporting them in doing it in Europe but, as with
so many European issues, I think there has been a level of naivety
about what our competitors—and they still are competitors
within this allegedly single European market—are actually
going to do. We need to face up to it because our security of
supply depends on this.
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