Examination of Witnesses (Questions 360-379)
MR ROBERT
ARMOUR, DR
STEVEN RILEY
AND MR
IAN FOY
3 JUNE 2008
Q360 Chairman: What is the difference
between cash out and single cash out?
Mr Foy: There are all kinds of
models but the single cash out is where both the spill price and
the long price—ie if you are short or if you are long—the
value of that power will be exactly the same.
Mr Armour: There is a healthy
debate in the industry between whether the model that penalises
you for being over or under or a single cash out that gives you
a balance both ways would be better. Equally, does it create a
barrier to other people coming in in the same way as some of the
other issues like the lack of a derivative market which gives
depth to that, which we heard from Mr Tane? It is an issue in
terms of pulling in more players and counterparties.
Q361 Mr Clapham: One of the things
that we note from the submissions that have been made is that
it does require a high degree of security with the sellers. There
is that aspect of it. Is that a down side to it? Is that distorting
the market?
Dr Riley: On cash out generally,
I think the market needs a mechanism whereby there can be some
balancing for suppliers or generators who are not able to quite
deliver on their contract obligations. The details of the cash
out pricing are fairly detailed and are being investigated within
the industry structure already. I think it is a second order effect
in terms of any of the issues of vertical integration or how this
market is functioning long term. It really is a very detailed
point.
Mr Armour: The issue of security
that you raise is an issue, partly because post-2001 with the
difficulties with Enron, TXU, et cetera., the merchant generator
model has been seen as riskier by the credit rating agencies.
That means that companies like ourselves which do not have an
investment grade credit rating have to post collateral in terms
of certain market trades. Given the volatile market, you have
to be ready, the price moves substantially in a very short period
of time, you may have to post substantial amounts of money to
match the imbalance. You strike a deal at a certain price and
as the market moves there will either be a risk that the person
you have sold to will not be able to pay it or that the generator
will not be able to provide it. Therefore, the collateral is there
to secure it and that can be quite a barrier to market-entry as
you go forward because of the amounts of money that you might
have to post.
Q362 Mr Clapham: Given that, as British
Energy, you are in that kind of market, do you feel that it is
disadvantaging the independent generator?
Mr Armour: I think it limits the
amount of trading. If you do not have an ability to deal using
parent company guarantees rather than posting money, it will limit
the volume of trading that you are prepared to do. Therefore,
the level of trading going to the market is going to be limited
by that exposure. Equally, if you end up saying it will be useful
to put more and more proportions of trades through the market,
you have to take into account that that creates an issue for players
coming in. They are going to have to post substantial amounts
of collateral money or take that risk, which may in turn be a
barrier to them coming into the market.
Dr Riley: If we had a more liquid
and transparent market and we had the ability to trade further
forward than we currently do, the amount of credit support that
independent generators have to post would probably become a constraint
to how much you would want to contract.
Q363 Mr Binley: Is this not just
an argument for a monopoly market? Is that what you are arguing
for, the status quo? Are you not arguing for the status quo with
a monopoly market amongst the big six and you do not really want
to widen it out?
Mr Armour: I do not think that
is what we are saying.
Q364 Mr Binley: It is what I am getting.
Mr Armour: It would be much better
if the market were somewhat deeper, if there were a variety of,
let us say, derivative products which extended it beyond simply
a limited group of maybe 30 counterparties that are prepared to
play the market.
Q365 Mr Clapham: Taking the structure
of the market and the way in which it has changed, I am looking
here at your submission, Mr Armour. You are saying at paragraph
16 that vertical integration is largely a response to the market
structure and the risks faced by the market participants. We are
seeing that the current structure of the pricing system is a driver
towards vertical integration. Is that the view of you all?
Mr Foy: No. The current market
structure is designed to promote forward contracting and keep
the generation and supply businesses separate such that the market
can operate efficiently. That is what we would always argue for.
We find it difficult to see how vertical integration can be a
response to the market structure because that would suggest that
there is some kind of cross-subsidy within the vertically integrated
bodies, which helps you overcome some of the problems of the market.
We would say the structure itself is fine.
Q366 Mr Clapham: Drax is quite satisfied
with the market as it currently is?
Mr Foy: We are satisfied with
the rules of the market. We are not necessarily satisfied with
the potential for vertically integrated companies and how they
would operate in that market and sell and buy their power. Are
they totally transparent? That is our concern.
Mr Armour: Vertical integration
is a symptom and a market response. I do not think it means cross-subsidy.
If you organise yourself in a way that the credit agencies are
happy to rate because you happen to have both a supply business
and a generation business and that allows you to therefore compete
effectively in the market, that is not really cross-subsidy. That
is a logical market response to the market structure and it goes
back to the previous witnesses who said it is not per se
vertical integration that is the issue. It is the fact that you
have the market structure the way you do.
Q367 Mr Clapham: Currently we know
that Ofgem is undertaking a review of the balancing market cash
out regime. Given that, do you feel that an inquiry by Ofgem is
going to be sufficient to address the problems that you have highlighted
in the market, particularly you, Mr Armour?
Mr Armour: I would rather wait
and see what Ofgem come out with in September. There has been
a whole variety of reviews of this market. Last year, the European
Commission. We see a variety saying this is a pretty competitive
market. There are a variety of things which the industry as well
as the regulator have identified that could lead to improvements
in it. I would rather not pre-empt the outcome of Ofgem's inquiry.
Q368 Mr Clapham: Could I ask the
three of you what you feel are the main issues that Ofgem should
be concentrating on and seeking to address in the market?
Mr Foy: In the market as a whole?
Q369 Mr Clapham: Yes.
Mr Foy: I think it is transparency.
I think it is convincing themselves that the vertically integrated
companies have true separation between the generation, supply
and trading businesses such that what may be efficient for a vertically
integrated company is not necessarily efficient for the market.
As the gentlemen before us quoted, what they want is a market
where they can understand the prices so they can potentially hedge
forward. That is the area where Ofgem need to convince themselves
that the market is operating correctly.
Dr Riley: I would echo that. I
do not see any reason why Ofgem could not with the resources that
they have do a thorough investigation and come to a sensible conclusion
on the market. Clearly, anything that aids the market's transparency
and liquidity will be beneficial to players like ourselves but
as we say in our submissions we do not particularly think, for
the portfolio of generation stations that we have in the UK or
for our business model, that this market is a bad market or is
particularly broken. We still view the UK as a well functioning
market, relatively attractive compared to other European markets
where you heard in the previous session there is not much liberalisation
at all. I think there was a question there about the status quo.
We do not see that a huge amount needs to change for us to be
an effective, independent power producer in this market.
Q370 Mr Clapham: You are happy with
the way in which the current rules set the prices?
Dr Riley: For the business and
the portfolio we have, we can trade and manage the risks in our
business, in the market as it currently stands.
Mr Armour: I would echo all those
points with one further proviso. Is this a market structure that
is going to facilitate new investment? That comes back to a degree
of regulatory certainty, reasonable but not excessive returns
but sufficient of a signal that allows an industry that is going
into an investment phase the ability to rise to that challenge.
Q371 Chairman: You are happy with
a market that for the last year has been deliberately, systematically
delivering higher prices to consumers than anywhere else in Europe?
Mr Armour: I am not in the retail
market.
Q372 Chairman: It is very good for
your investors but not so good for the consumers.
Dr Riley: You heard from the major
energy users earlier. Clearly, the concerns that they raised are
real concerns and legitimate ones that people should worry over.
I think it is also fair to say that the bulk of the reason why
the UK is facing the issues that it is facing is down to lack
of liberalisation in other European markets rather than any fundamental
problems with the structure or the rules in this market.
Chairman: Let us look at the liquidity
of the UK market which does concern me.
Q373 Mr Bailey: It is acknowledged
that the problem with liquidity is because the vertically integrated
companies largely bypass the wholesale market. What role have
the independent generators in improving that market? Do you feel
that you have any role? As independent generators, what potential
do you think you have to improve that situation?
Dr Riley: All the power we trade
goes through the market. It is offered to the whole range of counterparties.
There is no more of our power that we could trade through the
market.
Q374 Mr Bailey: You are saying that
all the power that you supply is traded through the wholesale
market?
Dr Riley: Yes.
Q375 Mr Bailey: Does this relatively
low level of liquidity affect your trading strategy?
Dr Riley: It limits the length
of time that you could trade for. We might see that we would like
to trade for the calendar year 2010 at the moment or we might
be constrained on that because there are other counterparties
out there who either feel that they want to trade for that particular
calendar year or that they would like to buy at the price we would
like to sell at.
Q376 Mr Bailey: Are you satisfied
with the level of liquidity in the wholesale market at the moment?
Mr Foy: I would say no. It should
be further. The longer that you can trade in the market the more
liquidity there is and the less chance there is of getting prices
flattened out. We try to hedge ourselves. Our business model is
we hedge progressively over a number of years but it takes two
to tango and at the end of the day there is only one buyer, the
big six. They do not appear to come out into the market beyond
a couple of years. We would prefer more hedging and the more liquidity
obviously. It gives better price signals. It takes away some of
the volatility for the customers and allows the customers to put
in hedges.
Q377 Chairman: I would like to hear
each of you answer that question separately.
Dr Riley: We would like to see
more liquidity and more transparency going forward. I would just
caveat that by saying that even if that were the case there may
be other constraints—for example, the amount of credit support
we would have to post—that would limit our ability to trade
that far out anyway. It is not just an issue of liquidity and
transparency in the market. We are definitely in the position
of saying that the market should not allow any transactions to
go on unconditionally that would make liquidity and transparency
any worse than they are. We are also in the position at the moment,
maybe because we have a different portfolio to the other players
here that can better manage in the short term, that we are okay
with the market arrangements as they currently are. There is sufficient
liquidity there for our portfolio because it is more short term
responsive plant.
Mr Armour: We would be supportive
of greater liquidity and transparency but mindful constraints
on collateral. Effectively, if all trades went through the market,
you would have to post very substantial amounts of credit and
collateral for that and that would in turn be a barrier. There
has to be a balance.
Q378 Chairman: I know you have slightly
different perspectives. You have different portfolios for generation
and different future owners as well in Mr Armour's case potentially.
Looking at you, Dr Riley, you are a shareholder in Opus and Opus
clearly do not think the market is anything like sufficiently
open. They say in a submission to us that a broader ownership
of generation assets would be a benefit to competition. They suggest
a break up of the big six. They think that cannot happen because
of the investment requirements of the markets. They advocate a
public auction of a percentage of all generators' outputs—say,
5% to 10%. How would you feel about having a public auction of
5% to 10% of all your output?
Mr Foy: It depends what form that
auction would take. Vertical integration itself is not the problem.
Vertical integration can exist. It is the cross-subsidy. It is
making sure the businesses are separated. The vertically integrated
companies must buy all their retail power from the market and
they must sell all their generation output into the market separately.
If there is no cross-subsidy, it will have no impact upon them.
Either that or whatever internal deals they may deal with in their
businesses from the generators to the supply to the trade, they
offer those to the market.
Q379 Mr Bailey: Assuming that the
big six remain as they are and do not divest their generating
assets, we have talked about the possibility of having a certain
percentage of output auctioned. Are there any other policies that
might be pursued that would improve liquidity in the market?
Mr Foy: Auctions could be difficult
to run. What most people suggest is an auction for generation
capacity. You still have the supply side on the other side. You
still have the big six. You only have one buyer. That may cause
some difficulties. Somehow you have to get them to open the generation
book and sell their generation as a generation portfolio on the
market and buy as a retail business in the market and take away
these internal trades or links.
Dr Riley: A forced auction of
some of their output would bring that to market. That would aid
transparency and liquidity. Whether there is something that could
be done just in terms of more open disclosure, in terms of the
differences between their retail and the generation businesses,
that might also be an aid to understanding the real price signals
in the market.
Mr Armour: Some of the big six
do put some levels of their trade through the market. You might
quiz them on that. Where you are looking at into a percentage
going through the market may well be one possible solution but
it is tempered by the other point that Opus made, which is that
there are some quite chunky investments required from this market
as well. The idea that you went back and broke up vertical integration
and created a number of small players who then have to face up
to large investment does not seem a recipe for—
Mr Bailey: I was discounting that and
just looking at alternatives over and above that situation.
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