Examination of Witnesses (Questions 840-859)
MR ANDREW
DUFF, MR
VINCENT DE
RIVAZ AND
DR PAUL
GOLBY
24 JUNE 2008
Q840 Mr Hoyle: So we have got it
right: the market has failed the United Kingdom, and the bottom
line is they did not react quickly enough, and now what we are
trying to say is, "It's down to planning issues". We
should have been planning this ten years ago when we could see
what was going to happen?
Dr Golby: I do not think the market
has failed. The market is not perfect. The pricing signals were
not there at an early enough point in time, but the market is
now responding.
Q841 Chairman: What this Committee
and its predecessor said in 2001 was that the Government should
look at strategic gas storage, because it identified this problem
coming down the track to meet us. That was a recommendation of
this Committee that was not acted on. In fact in the 2003 Energy
White Paper again gas storage was not pushed right up the agenda
by the Government either, so there has been a collective failure,
has there not? It was blindingly obvious to this Committee's predecessor
that there was a problem emerging and no-one managed to address
it.
Dr Golby: We are addressing it.
We have been investing; we have been building a new gas facility
for the past two and a half years and we have another one in the
pipeline.
Q842 Mr Hoyle: Is the reality not
that you can make more profits by the way you deal with it, rather
than storing gas? There are bigger profits to be made by not creating
storage?
Dr Golby: No, I do not believe
that is the case. My company does not have a lot of storage in
the UK at the moment, but companies which do have storage I think
they are quite transparent in their profit and loss accounts and
which profit they make from storage. It is a profitable business
to be in.
Mr de Rivaz: I think globally
the more you are mitigating your risks as a company, the more
your customers are benefiting from such a risk policy. Gas storage
is part of mitigating our risks. We are certainly better off with
gas storage than we would be without; that is why we are all investing
in gas storage.
Mr Hoyle: I do not think we quite see
that, but I suppose we all have different opinions.
Q843 Chairman: Mr de Rivaz, may I
just ask you, this is quite a difficult inquiry for the Committee
because we are hearing such contradictory and different things
from different people. Some people told us the wholesale gas market
is fundamentally broken; there is no effective forward trading.
The forward prices are determined by a very small volume of trading
gas, if any. Others say that actually it is all hunky-dory, it
is working perfectly; it is marvellously competitive and we have
not got a thing to worry about. Others, like you, fall somewhere
in between, because I think it was your evidence to us which said,
"While the wholesale market in the UK is competitive, there
is still room for improvement ..." What improvements would
you like to see in the wholesale gas market?
Mr de Rivaz: I think it is a fair
comment to say that this market is not perfect and can be improved.
I think we have to be realistic, modest and recognise the strengths
and the weaknesses that we are all facing in Europe in general
and in the UK market in particular. Certainly more visibility
on the physical flows, for instance, would support a better market.
We have been promoting modification to the unified network code
to make more information available, and are doing everything to
make information more available, more reliable, more transparent
and this is going to improve this market. I think in the gas wholesale
market we are in a slightly better position than in the electricity
wholesale market, where we are still, despite the fact liquidity
has increased over the last few years, hoping some improvement
will be made. We are also working on having some better spot market
indicators commonly shared for that market to work even better.
Chairman: The wholesale gas market is
of huge fundamental importance to everything we are talking about
today, but we also want some of the wholesale electricity market.
I will move on now to Adrian Bailey.
Q844 Mr Bailey: Ofgem estimated that
in 2006-07 the value of the over-the-counter electricity market
was just £31 million, which is a tiny fraction of the total
generated. My question is: firstly, what proportion of your purchases
are made from the open market; and, secondly, why is this market
appearing to become more illiberal in the UK but more liberal
in countries such as Germany and the Netherlands?
Mr de Rivaz: I can only answer
as far as the electricity market is concerned. Basically we all
have the same objective, to be better vertically integrated—maybe
we can discuss that further. In our situation with our own generation
we are producing ourselves about half of what we are selling on
the market; but globally it covers our residential retail market.
Having said that, everything we are producing is sold on the wholesale
market. The generators are contributing, even if they are vertically
integrated, to the liquidity of the market. My view is that we
should be even more vertically integrated. To have more intregration
is a good thing in this market, simply because I believe that
in doing that we are mitigating our risks, and in mitigating our
risks we are protecting our customers.
Q845 Mr Bailey: I am sorry, are you
saying that the electricity that you generate is all sold on the
open market?
Mr de Rivaz: Yes.
Mr Duff: The electricity markets
are not as liquid as the gas markets. I would just like to re-emphasise
the transparency and liquidity are absolutely aspects of this
market that our company would like to see and encourage. One of
the problems is that during the failure of a number of major companies
in electricity generation and supply in 2002-03, some liquidity
was lost to the power markets markets in the UK, and perhaps there
was also a collective loss of confidence there which did not help.
I am referring to the restructuring of British Energy, to the
failure of TXU, to the failure of Enron and so on; all of whom
were very helpful in stimulating liquidity particularly in the
power markets in the UK on which we all depend. This company is
very, very supportive of trying to continue to build liquidity
back and it is doing so and has been improving for the last two
or three years; but perhaps one of the barriers to improving liquidity,
in the power markets particularly, is the ability for companies
to exit positions close to real time without being left with untradable
physical positions. For that reason, Npower is leading an industry
group looking at trying to create an exchange traded mechanism
that would allow a more diverse range of participants in the market
to enter the market safe in the knowledge that positions could
be cashed out effectively, close to real time, which would bring
in banks, trading houses and other independent players as well.
As it happens, the generating market is extremely fragmented and
the result is that a very large proportion of the energy generated
in the UK is traded openly in the wholesale markets. In terms
of our position, we have to purchase from the open market at least
as much again as the energy that we generate, and we run our generation
businesses and our retail businesses quite independently, and
they both trade independently with the market too, therefore further
stimulating liquidity. So, yes, I feel less comfortable about
power than about the gas market, but all the signs are that liquidity
is moving into that market in the way that we would like it to
do, and it is certainly far better than any other similar market
that I know.
Q846 Chairman: Adrian, can I interrupt
one second? Mr de Rivaz, you said, I think, just now that all
the electricity generated is sold on the open market. Is that
the case?
Mr de Rivaz: Yes. We are not selling
directly from our plants to our customers; we are going through
the wholesale market.
Q847 Chairman: Your written evidence
says: "By using a proportion of electricity that we generate
in order to meet part of our own demand, we are reducing our customers'
exposure ... " There seems to be a contradiction there.
Mr de Rivaz: It is not a contradiction,
it is a fact that globally in having half of our needs covered
by our own generation we are mitigating our financial risks, and
that is a benefit to our customers. Every day we are trading on
the wholesale market what we are producing.
Q848 Mr Bailey: In 2006-07 the total
wholesale market, which is £31 million— how much electricity
did you generate in 2006 and 2007, in financial terms?
Mr de Rivaz: Can you say that
again?
Q849 Mr Bailey: How much electricity
did you generate in 2006-07, because you have said it was all
traded on the wholesale market? We are told by Ofgem that the
total value of the wholesale market is £31 million.
Mr de Rivaz: We have sold on the
wholesale market all the electricity we have produced, which is
to the tune of 25 terawatt hours, I think.
Q850 Mr Bailey: I am sorry?
Mr de Rivaz: Twenty-five terawatts,
which we are producing every day.
Q851 Chairman: This is very confusing.
Adrian, I do not want to take over your questioning, but your
written evidence says, again: "Generators, including those
who are part of vertically integrated companies, must compete
to minimise the cost of the electricity they generate—essential
to ensure their supply business is able to sell competitively
priced electricity". You are saying there is no point in
being vertically integrated; you run the businesses entirely separately
and your generation capacity flogs it to the wholesale market
and the supply business buys it back from the wholesale markets.
I do not understand that.
Mr de Rivaz: I am sorry, Chairman.
I am saying that vertical integration does not mean that we sell
only to ourselves; we sell into the market and we buy from the
market. That is what is happening every day. Having said that,
as a company, when we look at the risks which exist in the retail
market, or the generation market, we are better off in having
a business which is in both elements of the buying chain, because
in doing that we are limiting our risks, our exposures, and in
limiting our risks we are limiting our costs, and that is beneficial
for our customers. It is why in every country vertical integration
is a better solution than non-vertical integration. It has been
the case in the UK since the beginning of the opening of the markets
with more and more vertically integrated companies, and it is
the case in other countries. You have, in Germany, vertically
integrated companies and a high level of liquidity in the market.
There is no contradiction between vertical integration and liquidity
on the market. That is the point.
Q852 Mr Bailey: Surely, the issue
is how many of those vertically integrated companies have what
are effectively "off market" contracts between the generators
and the suppliers?
Dr Golby: Can I, maybe, tell you
what we do in the UK? That would help. Firstly, we are also participating
in the design project that Mr Duff referred to in terms of trying
to devise instruments and systems to increase the liquidity of
the UK market. I think it is fair to say that the UK market is
not perfect, it trades at about three-times physical; European
markets trade at between six and seven-times physical, so they
are more liquid, and because they have those instruments in place
in NordPool and EEX, for example, that means they get more financial
players and people who do not have physical positions trading
in the market place. So the market is not perfect and we need
to make some changes to increase the liquidity. However liquidity
is increasing, I think it was independently confirmed by the Financial
Services Authority just recently that it increased by 52% in 2006-07,
so it is moving in the right direction, but it is not perfect.
In the case of my own company, in the year to March 2008 we generated
41 million megawatt hours and we bought in the market 92—so
we are trading in the market twice what we are producing.
Q853 Mr Bailey: Can I turn it round—and
you have touched on this. What needs to be done in the British
market to make it more liquid? Possibly it is being done in the
German and Dutch markets, but what is the lesson you have learnt
for the British market?
Mr De Rivaz: As I think all three
of us have said, we are working to find a sensible spot market
index providing a reference price that could be used as a base
for the financial forward contract for the UK market, and it is
something which will improve further existing liquidity. So it
is all about having tools which exist in other countries which
provide a higher level of liquidity. It is not a question of vertical
integration, it is a mechanism by which the market is more efficient—the
wholesale market is more efficient.
Dr Golby: Could I say I think
it is a very good and detailed question. I am not an expert in
this area but perhaps I could come back with a note to actually
set out precisely what we need to look at here, if that would
be helpful, Chairman.
Q854 Chairman: That is quite urgent.
Dr Golby: We can respond very
quickly.
Q855 Mr Bailey: I think, Chairman,
that would be helpful and is necessary. To a simple layman such
as me, it seems to me that if you want a perfectly liquid market
all that you have to do is insist that generators put all their
production on the open market for the suppliers to purchase from.
What is your opinion on that?
Mr Duff: From my experience—and
I cannot say for other companies—we are seeing that happening.
We have to buy, every year, 30 terawatt hours—that is, at
least, between 5 and 10% of the UK market—from the markets
in order to cover our sales. So I do not think there is, in the
short term (by that I mean one to two years forward) a major problem
in liquidity, although it can be enhanced, and we want to see
it enhanced. Beyond that, there is probably no more to be said
than to look at the specific reasons why the market may be difficult
for certain players. One of the issues is the ability to exit
financial positions close to closure without being left with an
untradable physical position.
Q856 Mr Bailey: I have to say there
is a significant body of disagreement with that. Can I move on
in terms of new entrants to building large-scale generating capacity?
It would appear that something like 13 gigawatts of the 17 gigawatts
of approved projects are being built by existing vertically integrated
companies. What do you think needs to be done to encourage new
entrants into that?
Mr Duff: The biggest challenge
for new build is just the basic economics, at the moment. You
are talking about very large plant, with very long paybacks and
returns looking forward in the market that are not very attractive.
In fact, for the first time in four or five years we are starting
to see, on a going forward basis, returns that just about cover
the cost of capital for new entry for new build. So this is an
issue for all potential or would-be investors in this market.
Actually, the UK power generation market is pretty fragmented
and there are very healthy signs of significant amounts of new
investment not just in fossil plant but in renewables as well,
from independent non-integrated organisations.
Q857 Chairman: Where is the subsidy?
It seems to be there where new build comes from the independent
sector but where there is not, there is not.
Mr Duff: No, the evidence, I do
not think, supports that. We see Severn Power and ConocoPhillips
building KG plants on the east coast; we see Gas France entering
the market as a new entrant as well, and many other new entrants
looking at building plant as well as existing generators in the
UK.
Dr Golby: Could I add to that,
Chairman? I think there is a legacy issue here. It was only back
in 2003 when this market was bust; the Government had to rescue
British Energy, TXU went bust (and my company bought it) and other
power stations ended up with the banks. So there is a legacy of
people losing their shirts in this marketplace. I am afraid the
recent credit crunch has not helped there; it is increasingly
difficult for companies to raise finance for these investments.
Yes, vertical integration helps—it helps manage the risk—but
the fact of life in this big ticket industry is that it is the
bigger companies that are more robust and able to invest during
these very difficult financial times. I have got no suggestion
as to how we help other parties also invest—that is up to
them—but I am sure that you would want the large companies
to invest because we are facing an energy crunch if we do not.
Q858 Mr Bailey: The cynic would say
that it is only the current vertically integrated companies and
their ability to rig the market and to guarantee the market that
gives them the financial capacity to produce the new generating
capacity. What would your response be to that?
Mr De Rivaz: First of all, I think
the structure of the market itself does not prevent new entrants
from building large-scale generating capacity, and today more
than 40% of the electricity generated in this country is generated
from outside the alleged `Big 6'. I think it is very important
that large companies like ours are in a position to invest the
billions that this country desperately needs to have the lights
on, tackle climate change and, at the end of the day, have more
affordable prices for all. I think the priority is to be in a
country which is encouraging investors to invest in the long term,
and if it is a new entrant, fine; if it is one of the existing
large generators, fine as well. What is important is that new
investment flows in this country.
Mr Duff: I think diversity is
the key word when we talk about energy supply and, particularly,
generation. I mean diversity not just in fuel type but ownership
as well, and a healthy, competitive environment. The scale of
the investment required in this industry over the next ten years
is absolutely staggering, as a result of the age of much of our
infrastructure and the need to build climate-friendly capacity
in place of much of the old dirty capacity we have got. It is
absolutely staggering. We simply cannot afford to discourage any
investor in the generation infrastructure in this country. I cannot
imagine that any group of participants or individual participant
could possibly have any concern about the extent of the openness
of the market to investment. The concerns are about access to
finance and the scale of the investment that is needed. It needs
everything that we have got—in the short term, in gas-fired
generation, because it is really only the quick solution in the
short-term, but in the longer term, in renewables, in nuclear
plant, in carbon capture and storage technologies—to get
this country to still be in a secure energy marketplace and still
competitive in 10 years' time, as it is today.
Q859 Mr Bailey: So you do not think
that "dulling market signals" (a quote from Drax) is
disincentivising new entrants into the industry?
Mr Duff: No, absolutely not. I
do believe that we are in a very difficult transitional phase
where the forward returns visible currently barely cover the cost
of new investment but at a time when we know that over the next
five to ten years a significant amount of capacity is going to
retire and is going to be withdrawn from the market, and therefore
one has to take quite courageous decisions in order to initiate
new build projects, not least because the returns are marginal
in the current view but, also, because the paybacks are so long.
I really do not understand the basis of the question; I think
that this country needs all the investment it can muster in new
infrastructure, particularly in climate-friendly generation, and
it needs to be encouraging it from whatever source.
Mr Bailey: The basis of the question
is that the `Big 6' vertically integrated companies are acting
in such a way as they rig the market, which effectively prevents
any other would-be entrant into the generating—
Chairman: I think that has been comprehensively
denied by the witnesses.
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