Memorandum submitted by E.ON UK
ENERGY PRICES
E.ON UK is keeping its energy prices to residential
customers under review in the light of developments in wholesale
and other costs, and its competitive position in the market. Taking
these factors into account we will reduce prices as soon as we
are able.
A brief explaining in more detail the factors
that affect our energy costs and our prices to residential consumers
is attached. Essentially we purchase energy over a variety of
timescales up to some years ahead to meet the needs of customers
in this group. The energy we are supplying now has been bought
over this timescale. Prices therefore go up and come down more
slowly than for industrial consumers. However this smoothes out
the effect of volatile prices in the wholesale market. Prices
to large industrial consumers follow wholesale prices more closely
and have already fallen for those users.
The longer term outlook for prices will be determined
by fossil fuel prices (which are largely a function of supply
and demand on international markets and the £:$ and £:€
exchange rates), the impact of environmental and other costs,
including those associated with meeting the EU's renewable energy
targets for 2020, and the large investment requirements facing
the industry in both the power and gas markets, as discussed below.
E.ON has already announced a number of price
reductions for particular groups of customers this year:
— we launched "E.ON WarmAssist"
on 1 December 2008. This offers our most vulnerable fuel
poor customers, who are aged 60 or above and in receipt of
Pension Credit, a 15% discount on our standard electricity and
gas prices. In addition customers receive free energy efficiency
measures including cavity wall and loft insulation saving, and
a personalized energy efficiency audit;
— we announced on 4 December 2008 that
residential electricity customers in the East Midlands, East of
England and North West (our "core" regions) who are
not on mains gas supply would see a reduction in their annual
bills of £14. This followed discussion with Ofgem after the
regulator's recent market probe found that, while the energy market
works well and is competitive, some electricity customers without
mains gas could not get the benefits that dual fuel customers
receive.
Energy companies have agreed to increase the
annual level of spending on their social tariffs to £150 million
in 2011, of which E.ON's share will be around £20 million.
A recent Ofgem report "Monitoring Suppliers' Social Programmes"
indicated that E.ON spent more per customer account on its social
programme than any of the other main energy suppliers in 2007-08.
Suppliers' major effort, however, is in energy efficiency spending
which government announced in September would increase for the
period 2008-11 from £2.8 billion to £3.7 billion.
This will be achieved through a 20% increase in CERT (£3.36 billion)
and a new Community Energy Saving Programme (£350 million)
to achieve further investment in energy efficiency measures targeted
at deprived areas.
INVESTMENT IN
GENERATING CAPACITY
By 2020 we expect investment in about 25GW,
equivalent to one third of total UK generating capacity, to be
needed to replace closing coal, oil and nuclear power stations
and meet some demand growth, with 12GW of new capacity required
between now and 2015 to replace plant closing as a result of the
Large Combustion Plants Directive. In addition the EU's renewable
energy targets for the UK are likely to require the construction
of about 30GW of new renewable capacity. Much of this will be
onshore and offshore wind farms which, although displacing a significant
volume of fossil fuel generation and thus reducing CO2 emissions,
will only make a limited contribution to the UK's capacity requirements
as about 90% of this capacity will need to be "backed-up"
by more conventional generation. This is because wind generation
of electricity can only be relied on to a limited extent to meet
peak demand at winter peaks because of its intermittent and relatively
unpredictable nature.
We are currently building a 1275MW CHP plant
at Grain in Kent and a 180MW offshore wind project at Robin Rigg
in the Solway Firth. We also have consent for the 1000MW London
Array project in which we are a partner, and for a 1200MW CCGT
at Drakelow in Derbyshire. We have also applied for consent for
the 300MW Humber Gateway offshore windfarm and for a 1600MW cleaner
coal-fired power station at Kingsnorth in Kent, which we have
entered into the Government's carbon capture and storage (CCS)
demonstration competition.
We have also formed a Joint Venture with RWE
to develop, construct and operate at least 6GW of nuclear power
stations at NDA sites.
Substantial investment is needed in additional
transmission capacity to connect the new renewable and nuclear
plant. In addition, more investment is needed in gas storage,
where the UK lags behind other European Member States.
The required investment is an opportunity to
reduce carbon emissions from the power sector but we need to make
the transition to a low carbon power sector while ensuring we
maintain diverse and secure energy supplies, and avoiding over-reliance
on imported gas.
The Planning Act will support the construction
of further capacity and should provide a much more predictable
and timely process for reaching a decision than exists at present.
Nevertheless, delivery of this investment should not be taken
for granted. A number of uncertainties are affecting future investment
plans and investment requirements. These include:
— the absence of a Government decision
on our consent application for a supercritical coal-fired plant
at Kingsnorth, which we applied for in December 2006. We are also
still awaiting a Government decision on its definition of CCS
ready as it affects fossil-fired plants;
— the effect of the predicted large volume
of wind generation on the wholesale power market. This will reduce
the amount which other types of new capacity will generate during
the year which means they will need to recover their costs from
higher prices over shorter operating periods. This raises the
question of whether the current market framework will deliver
these prices and incentivise this capacity, and whether additional
incentives are needed;
— the impact of the Industrial Emissions
Directive, currently under discussion in the EU. As presently
proposed by the European Commission, the Directive would mean
that more UK coal-fired plants would face the choice between substantial
new investment in upgrades to enable them to meet the new standards,
or closure by the end of 2015. It would also mean that pre-2002
CCGTs would face the same decision;
— the precise incentives the Government
will put in place to support renewable electricity to achieve
its targets for 2020;
— the nature of an international climate
change agreement concluded in Copenhagen and its effect on the
EU ETS and the carbon price after phase 2 ends in 2012; and
— potential changes in energy policy, should
there be a change in Government at the next election.
We recognise that some of these uncertainties
are inevitable and investors need to make judgements about how
they will turn out. However, although in most respects the broad
direction of travel is clear, the energy policy framework to implement
it is unusually unclear at present. We are looking for some of
these uncertainties to be addressed over the next six months as
the Government responds to the Climate Change Committee report
and sets out its intended "strategic direction" of the
energy market in the summer of this year.
February 2009
NOTE—PRICE
CHANGES EXPLAINED
Earlier this year Ofgem said:
"Company decisions on whether to increase
prices are based on their own reading of the market. In Britain's
competitive market, if they increase bills they have to weigh
up how much of that increase will lead to a loss of customers."
In fact, suppliers need to read the market at
all times, whether costs are rising or falling (they are never
static). There is no simple answer of when to change prices.
This fact sheet seeks to explain how we purchase
energy and the impact of the recent falls in wholesale prices
on the potential for lower retail prices.
How does E.ON purchase energy for domestic electricity
and gas customers?
As electricity cannot be stored and gas only
in limited quantities, wholesale energy costs are highly volatile,
varying in the short term to factors such as weather and plant
availability and in the medium term to expectations of movements
in oil and other prices and of the margin of supply over demand.
Energy suppliers manage this volatility on customers'
behalf. To do this we buy energy ahead of need and over a period
of time. These forward purchases can be for some years ahead.
The market price for these forward contracts
varies over time. The graph below shows how the year ahead[1]
energy costs for an average customer[2]
have changed from January 2004 to the present:
By buying forward over different periods, we
smooth this volatility for our residential customers. The reasons
for this are practical, to reduce estimations in billing, and
to reduce uncertainty for customers. Customers can also choose
to further reduce volatility, at a small premium, through a fixed
or capped price product.
The periods over which suppliers buy energy
forwards will vary, but Ofgem's assumption of an average of 18
months gives the picture. Our energy costs now are therefore the
average of the prices we have paid for our forward contracts over
the last eighteen months for the current period, as shown by the
red line in the graph below. The red line also projects how our
energy costs into 2009 would evolve, assuming no change in the
forward prices, as shown by the black line (which of course won't
happen, but there is no better forecast than the current market
price).
Despite the recent fall in forward wholesale
prices our energy costs are still rising. This is because our
energy costs still include some purchases in the period of low
forward prices in Summer 2007 and we are having to replace these
with higher priced contracts.
When will domestic customers' prices fall?
No-one can answer this with any degree of certainty.
It will depend on how market conditions develop.
Each supplier has to keep the market under constant
review, with key considerations being competitors' actions and
the movement in forward wholesale prices relative to current energy
costs. In Spring 2007, retail prices fell, when average costs
started falling after a sustained drop in forward prices.
Suppliers can have quite different energy costs,
depending on how they purchase. The graph below shows the impact
of a supplier buying energy forwards by an average of 12 months
(the blue line), compared to an 18 month average (the red line):
The very sharp rise in energy costs during Summer
2008 means that just a six month difference in the average period
of forward purchase can make a significant difference. In August
2008 the blue line would have been around £100 higher than
the red line (8% of a typical dual-fuel bill), but falls away
from its peak two to three months earlier than the red line. Of
course, suppliers cannot price to their own level or timescale;
they must weigh up the risk in a competitive market of losing
customers from an early increase or late reduction in prices.
Note there is no rule that there is a six month
lag between wholesale and retail prices. This is an observation
of what has happened in the past (with the lag no greater when
prices are falling than when they are rising), but as Ofgem observed,
suppliers need to read the market. We have not previously seen
prices rise sharply and then reduce in such a relatively short
period, so that although average costs have increased substantially
they did not approach the peak.
It should also be noted, that although customer
prices are primarily influenced by energy costs, other elements
are also included that currently place upward pressure on tariffs.
These include the costs of system operation, environmental obligations
and bad debt.
Do retail electricity and gas prices follow oil
prices?
Yes, but only to an extent, as many other factors
are involved. There is a relationship with oil prices because
many wholesale gas contracts are indexed to oil prices—from
the North Sea to ensure balanced production between oil and gas,
and from Russia and Norway as this is the preference of these
countries. However, other factors are also very relevant—notably
the gas supply: demand balance in the UK, gas production and pipeline
availability, the price of Liquefied Natural Gas on world markets
and exchange rates. The relationship between oil and wholesale
electricity prices is still more limited; as only about 40% of
UK electricity production is from gas or oil plant and there are
other many factors, such as environmental constraints and plant
availability which affect wholesale electricity prices.
The chart below bears this out and shows that
over the last year forward wholesale energy costs rose proportionately
higher than spot oil prices and have not fallen as far.
February 2009
1 Looking at a whole year removes the effect of seasonal
price changes. Short term, "spot" prices vary much more,
but do not directly affect retail prices. Back
2
Electricity 3,300 kWh; gas 20,500 kWh. The energy cost
shown is for a flat demand shape, as traded on the forward markets;
the cost for a customer's actual demand profile is higher, but
follows the same shape. Back
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