House of Commons - Energy and Climate Change

The Big Six Energy Companies - Energy and Climate Change Contents

Memorandum submitted by Centrica

SUMMARY

— We support Ofgem in calling for greater transparency in the energy sector and believe that being clear about pricing with customers will help build their trust. We pride ourselves on being the most transparent of the suppliers and British Gas and its parent Centrica, have provided full disclosure of profits and costs, both upstream and downstream, in its audited accounts since privatisation.

— However, we think Ofgem's calling for an investigation was somewhat premature as most suppliers' price increases have yet to come into effect and the wholesale market has risen by 5% since the Ofgem analysis was carried out.

— There have been 17 different inquiries into the UK market since 2001. In the latest inquiry in October 2008, Ofgem found that the British retail energy market was amongst the most competitive in the world.

— UK customers also benefit from some of the lowest energy prices in Europe. In the six months to June 2010, UK households enjoyed the 4th lowest electricity prices of the EU15. Domestic gas prices in the UK have been the lowest in the EU for ten years

— The last two years have seen British Gas domestic energy bills drop by an average of £188 per annum. However, wholesale gas prices are on average 35% higher for 2011 than 2010. Other costs such as network charges and environmental obligations have also increased. In its September market report, Ofgem calculated that these other costs had risen 6% on the average dual fuel bill between February and September this year.[3]

— Whilst Centrica has tried to absorb some of the increases, this is unsustainable and we have had to announce that we will increase gas and electricity tariffs by 7% from 10 December 2010. Our 300,000 most vulnerable customers on our Essentials social tariff will not face an increase until after the winter period. Even after this price change, average annual dual fuel bills for British Gas customers will be £108 lower than in January 2009.

— British Gas needs to make a fair rate of return in order to ensure we deliver our planned investment of £15 billion by 2020 in new energy infrastructure. This includes £3 billion-£4 billion in offshore wind, £5 billion in gas production, £1.5 billion on gas storage and £4 billion-£5 billion in new nuclear. Our investment programme is already underway. Over five years, we have invested 161% of our profits—that is for every £1 profit we've made, we've invested £1.60 in new energy infrastructure.

— We support the Government's Green Deal but believe more needs to be done to incentivise customers to take up the offer by including microgeneration and also financial incentives such as stamp duty reductions. The option of using the Green Investment Bank to help kick-start the Green Deal should be seriously considered.

— On the programme to bring smart meters to all UK homes and businesses, we would welcome the Select Committee support for the British Gas' "go- early" approach to ensure that the benefits of smart metering can be brought to UK consumers well before the 2020 Government deadline.

— Changes are needed to the current energy market arrangements through underpinning the carbon price and broader energy market reform. We believe it is vital that the Government's consultation on Energy Market Reform considers a small number of credible options that provide support over and above the wholesale market price and look forward to contributing to the Committee's future EMR inquiry.

CENTRICA SUBMISSION TO THE ENERGY AND CLIMATE CHANGE SELECT COMMITTEE

THE ENERGY CHALLENGE

The challenge facing the energy industry today is to deliver a low carbon future whilst meeting customers' evolving energy needs and maintaining security of supply.

Up to £200 billion of new investment is needed in UK energy infrastructure in order to achieve this while meeting our carbon and renewables targets.[5] The energy sector is ready and willing to make this investment, but to do so requires a clear and stable regulatory framework in which the polluter pays and there are strong incentives for investment in low carbon generation.

In parallel there needs to be a sharp reduction in carbon emissions from homes and businesses if the UK's targets are to be met. Energy companies have a central role to play in helping customers manage their energy use, supplying them with insulation, smart meters and microgeneration technology.

Centrica is committed to tackling the challenges and leading the transformation required. We source, generate, process, trade, store and supply energy. We will continue to lead in the investments required to decarbonise our power and maintain our security of supply with plans to invest £15 billion in new energy infrastructure by 2020.

OUTLOOK FOR FUTURE ENERGY PRICES

The last two years have seen British Gas domestic energy bills drop by an average of £188 per annum. However, wholesale gas prices are on average 35% higher for 2011 than 2010. Other costs such as network charges and environmental obligations have also increased. In its September market report, Ofgem calculated that these other costs had risen 6% on the average dual fuel bill between February and September this year.[6] Whilst Centrica has tried to absorb some of the increases, this is unsustainable and we have had to announce that we will increase gas and electricity tariffs by 7% from 10 December 2010. Our 300,000 most vulnerable customers on our Essentials social tariff will not face an increase until after the winter period. Even after this price change, average annual dual fuel bills for British Gas customers will be £108 lower than in January 2009.

The longer term outlook is one for higher energy prices. Ofgem has predicted that energy bills will increase between 14% and 25% by 2020 to fund the investment in new lower carbon forms of energy.[7]

Ultimately energy efficiency is the only sustainable way to cut customers' energy bills and we are seeing a significant increase in energy efficiency. British Gas customers, following our advice on energy efficiency are using 18% less gas now than they were in 2006, a trend that we expect to continue.

What is happening to wholesale prices?

Forward energy price curves are showing increases in gas and electricity prices. Wholesale forward gas prices for 2011 are on average 35% higher than in 2010 (53 p/therm for 2011 and 39 p/therm for 2010).

With gas fired generation accounting for 40% of UK electricity supplies and typically being the price setting marginal plant, electricity prices are being affected by the increases in wholesale gas prices. Forward power prices are on average 20% higher in 2011 than 2010 (£47/MWh for 2011 and £39/MWh for 2010) and indeed recently spot electricity prices have been as high as £58 MWh.

There are a number of reasons which can explain, in part, why prices are rising. These are:

— Decline of UKCS

The UK energy environment is rapidly changing. After decades of being self sufficient in gas, the UK is now a significant importer of gas. In 2020, the UK will import up to 70%-80% of its gas demand.[8]

This is not a problem in itself - many other industrialised countries have been importing gas for years and indeed the UK has been a net gas importer since 2005. The UK is however a particularly gas dependent economy with gas making up 40% of the primary energy requirements compared to other economies (that are more dependent upon Nuclear or Coal). However, it does mean that the UK is now part of a global gas market and the National Balancing Point (NBP)—a virtual trading location for the sale, purchase and exchange of UK natural gas - is thus influenced by market pressures originating well beyond our shores. With higher oil prices affecting European gas prices and some index linked UK contracts, the era of cheap energy is over.

— Uncertainty of supplies

LNG will provide most of the new import growth and has already provided the UK with 10% of supply in 2009.[9] However, most LNG is pre-sold on long term contracts linked to oil prices which are significantly higher than UK spot gas prices with a very limited "spot market" existing for LNG. Furthermore, the UK has no long term contracts for LNG supply. This means that supplies destined for the UK can be diverted to other higher priced markets at short notice as happened when there were nuclear outages in Japan and the hurricane in the Gulf of Mexico. Global economic recovery will also increase demand and therefore energy prices.

— Weather

Weather also has an impact on wholesale energy prices with prices rising during very cold periods as much of the UK's gas requirement is for domestic and commercial heating. Variability in demand due to weather can be above or below 20% which also makes it very difficult to fully hedge demand requirements.

COMPETITION AND PROFIT IN RETAIL MARKETS

The UK has one of the most competitive energy markets in Europe which has brought significant benefits to customers in terms of prices and innovation. In October 2008, Ofgem found that the British retail energy market was amongst the most competitive in the world. In the six months to June 2010, UK households enjoyed the 4th lowest electricity prices of the EU15. Domestic gas prices in the UK have been the lowest in the EU for ten years.[10]

In November 2010, Ofgem announced it was to investigate the retail supply market following recent price rises, as outlined in the section above. We support Ofgem in calling for greater transparency in the energy sector and believe that being clear about pricing with customers will help build their trust. We pride ourselves on being the most transparent of the suppliers and British Gas and its parent Centrica, have provided full disclosure of profits and costs, both upstream and downstream, in its audited accounts since privatisation.

Ofgem has also suggested margins may be excessive following this price rise. However, analysts are forecasting that British Gas margins in the second half of 2010 will be around 3-4% on residential energy sales, substantially less than the margin predicted by Ofgem for 2011. For the current Full Year (FY), only two weeks of which will be affected by increased revenue from the announced price rise, analysts are forecasting BGR operating margins of around 9%, which would be a little higher than the cycle target range of 6-7% over a gas price cycle. We've indicated that some years they will be below the range, as in 2008 at 4.9% and 2006 at just 1.3%, sometimes more (as in 7.6% for 2009).

British Gas needs to make a fair rate of return in order to ensure we deliver our planned investment of £15 billion by 2020 in new energy infrastructure. This includes £3 billion-£4 billion in offshore wind, £5 billion in gas production, £1.5 billion on gas storage and £4 billion-£5 billion in new nuclear.

Our investment programme is already underway. Over five years, we have invested 161% of our profits—that is for every £1 profit we've made, we've invested £1.60 in new energy infrastructure.

The Chart below shows our annual profits against annual investment:

There have been 17 different inquiries into the UK market since 2001 - but the problem has consistently been shown to be with Europe. The European Commission has found European markets to be "dysfunctional". A recent study comparing all EU member state markets found that the UK consumer has more choice and a greater ability to make savings through competitive markets.[11]

Since market liberalisation, energy suppliers have innovated by producing varied ranges of products providing consumers with value and choice. We offer fixed or variable prices, green energy deals and social tariffs, energy service packages and a wide range of incentive and reward deals. Suppliers have also responded in recent years to consumer demand for greater certainty by offering a range of fixed or capped price tariffs and we have 1.6 million customers on fixed rate tariffs who are protected from the recent price increase. Prepayment meters are popular with our customers who like the fact that they help them budget better. Customers who pay for their gas and electricity by prepayment incur no extra costs on average than quarterly cash cheque customers.

We have invested significantly in improving our customer services. This includes modernising our billing systems and improved training for our call centre and customer facing staff. This has seen a dramatic improvement in customers satisfaction levels.

The 2008 Ofgem probe made a number of recommendations to improve the market functionality which we have implemented. These included new standards for bills and statements, debt blocking, field sales, financial information reporting, regulatory reporting requirements and new micro business rules. We are also committed to providing information to our customers that is simple, straightforward and easy to understand. Both Which and Consumer Focus have singled us out for the quality of information on our bills. We now send out annual energy statements and increasingly customers are choosing to bill online.

We do see a need for increased simplicity for bill; however, over time the number of regulatory information requirements has increased to such an extent that now the majority of the bill contains information which customers are not interested in or don't understand, such as calorific value conversions. This restricts our ability to make changes to the format that would be more accessible to consumers without increasing the number of pages.

Recommendation 1: We recommend that a review of billing information should be carried out with a particular focus on removing calorific value and temperature and pressure data.

ENCOURAGING INVESTMENT IN NEW GENERATING CAPACITY

The energy market in the UK has delivered a secure supply of power to Britain's homes and businesses over past decades. Significant investment in new low-carbon generation is now needed to meet challenging carbon reduction targets whilst maintaining security of supply. To maximise security of supply, the UK needs a balanced technology mix including flexible back-up to wind (which generates power intermittently), and new baseload generation including nuclear and, if the technology can be proven, gas or coal with carbon capture and storage (CCS).

Government has recognised that the necessary investment will not be forthcoming under the current market regime. Changes are therefore proposed in two key complementary areas: underpinning the carbon price and broader energy market reform.

Low-carbon investment is typically more expensive and more capital-intensive than investment in gas or coal-fired generation. These investments must deliver reasonable returns for investors, whilst keeping costs as low as possible for consumers. Underpinning the carbon price and wider energy market reform is critical to achieving this.

Underpinning the carbon price: We welcome the Government's commitment to producing a consultation setting out ways to underpin the carbon price paid by generators through an upstream carbon price support mechanism. A carbon floor should provide a predictable trajectory for a minimum carbon price over investment timescales, giving certainty to investors in low-carbon generation.

Centrica believes that carbon price support needs to start early, be clearly durable to give investor confidence, and have a clear and increasing trajectory in line with investment decisions.

A carbon floor is welcome and consistent with the polluter pays principle, but is not on its own sufficient to encourage new low carbon investment.

New low carbon generation would require a very high carbon price if it were to rely solely on this mechanism. Since the carbon floor cost will be factored into the marginal cost of power production across all fossil generation, the resulting wholesale price would be raised significantly for all. This would be an inefficient way of supporting new low-carbon generation.

Energy market reform: We also welcome the Government's intention to publish an energy market reform consultation later this year. We believe that this should not open up the debate on the future of the energy market but should, as far as possible, focus on a small number of options that reward qualifying generation on the basis of desirable characteristics such that:

— in conjunction with a carbon floor, brings forward the necessary investment in new low-carbon generation from a wide range of technologies including renewables and nuclear, and also maintains security of supply by incentivising the right amount of flexible back-up generation to remain on the system;

— is consistent with the operation of a competitive wholesale power market so that competitive pressures continue to drive down costs, promote innovation and deliver operational efficiencies;

— is robust over the necessary timescales, and effective in reducing exposure to political and regulatory risk, so that investor confidence can be secured;

— is capable of practical implementation to a timescale consistent with necessary investments and their associated decision points; and

— recognises the existence of the renewables obligation (RO) mechanism and support for carbon capture and storage avoiding duplication.

Required support is likely to change over time. Many low-carbon technologies are still evolving and the costs of construction are not well-known. There is likely to be change in the construction costs of many of these technologies, as engineering requirements are better understood, as construction moves beyond first of a kind and as supply chains develop. This uncertainty will require any mechanism to be flexible over time with periodic reviews of the levels of support for new developments on the basis of prevailing conditions—while grandfathering arrangements for developments already under construction or in operation.

Recommendation 2: We believe it is vital that the Government's consultation on Energy Market Reform considers a small number of credible options that provide support over and above the wholesale market price. Like the existing Renewables commitment these can be obligations on suppliers that feed through into energy prices or capacity payments recorded through the bill rather than requiring public subsidy.

SUPPORT FOR THE FUEL POOR

Over the last decade, considerable effort has been made to eradicate fuel poverty at both Government and non governmental level. Since 2005, £20 billion has been spent in providing benefits and energy efficiency to assist the fuel poor whilst combined Government and energy supplier funding currently amounts to £4 billion per annum.[12] Yet 20% of homes are still in fuel poverty and energy bills are likely to continue to rise to pay for climate change policies.

British Gas has spent over £150 million over the last three years on social programmes. Last year's spend was £58 million—the biggest contribution of any supplier.[13] £53 million of this was spent on social and discounted tariffs for Essentials customers who are elderly, disabled or on low incomes, saving them £122 on the average annual dual fuel bill. We have over 300,000 customers on our Essentials tariff and these customers are protected from our price increase until spring 2011.

We share the view of many commentators that there needs to be a fundamental review of fuel poverty and welcome the establishment of an independent working group to look at the target and definition. Much of the currently funding towards fuel poverty is mistargeted. For example, £2.7 billion is spent on making winter fuel payments to pensioners when only 18% of the 12 million pensioners who receive the benefit are estimated to be fuel poor.[14] Against the backdrop of tighter public spending it is essential that the resources that are available are targeted at those who need the support most.

Energy suppliers are also seeking to better target the assistance they provide their customers. We have welcomed the Government's data sharing pilot which saw DWP share information on 250,000 pensioners on guaranteed pension income with the six major energy suppliers. Customers matched through this data sharing were credited with an £80 rebate on their electricity bill, registered on our Priority Services Register and offered free energy efficiency measures under our CERT programme. We hope that the data sharing measures will be extended further so that other groups most at risk from fuel poverty can benefit from our programmes.

Ultimately we believe that energy efficiency is the only sustainable solution to ensuring warm, well-lit homes. British Gas stands ready to deliver energy services to our customers and to radically improve the energy efficiency of Britain's homes. The energy efficiency of social housing is a particular priority given the higher levels of households on lower incomes and the relatively inefficient housing stock. The Government's Decent Homes programme has spent £4 billion on improving the energy efficiency of the social housing stock but the standard Government has been working to has not been high enough to ensure the household will not be in fuel poverty. Partnerships between local authorities and energy suppliers will be important to address this gap. Local authorities have "on-the-ground" trust and knowledge about the communities they operate in meaning they have the potential to play an important co ordination role in the delivery of energy efficiency, particularly by highlighting lower income areas. Programmes such as CESP are an important precedent. We believe the future Energy Company Obligation which is intended to replace CERT and CESP post 2012 must build on the CESP model of community based solutions.

Recommendation 3: Government needs to implement a wide ranging review of fuel poverty that looks at not only the definition and target but also how existing resources such as the Winter Fuel Allowance can be best applied to help the most vulnerable. Energy efficiency must also play an important part in any solution. The Energy Company Obligation will be critical to this and must build on the CESP model of community based solutions. However Government must make sure ECO is introduced in a way that does not put increasing upward pressure on customers' bills.

PROGRESS TOWARDS THE UK'S RENEWABLES AND EMISSION REDUCTION TARGETS

Under the 2008 Climate Change Act, the UK must cut its net greenhouse gases by 34% by 2020 and 80% by 2050. This is perhaps not as daunting a task as it first appeared as this is against a 1990 baseline and the UK has already reduced its greenhouse gas emissions by c. 22%.[15] In addition to this however, under the EU's legally binding Renewable Energy Directive, 15% of all UK energy must come from renewable sources by 2020. Renewable electricity generation will need to increase to around 31% of total power generation capacity to meet this target.[16]

Centrica believes that the UK's renewable and emission reduction targets are challenging but achievable. As discussed in the earlier section, the energy market needs to be reconstructed to encourage all forms of low carbon generation, including nuclear.

Uncertainty in the planning regime also presents a potential barrier to investment. It is essential that a clear and efficient planning process is in place to enable major projects to be consented. Following NPS consultation, early ratification by Parliament and swift implementation by the Government in 2011 is needed. The transition from the IPC to the Major Infrastructure Planning Unit must be smooth so that early applications are not disadvantaged.

In addition to decarbonising our electricity supply, energy companies must move away from supplying power alone to supplying energy efficiency and energy services. The shape of British Gas is already changing. Within just a few years our energy services business will be at least as big as our energy supply business.

We believe that generating electricity and heat on a small and micro scale will be important to achieving the Government's targets. We share the Government's enthusiasm for Renewable Heat and look forward to further details of the Renewable Heat Incentive (RHI), which was confirmed in the Comprehensive Spending Review. Centrica has recently been involved in a project that injected the first biomethane into the UK gas grid, which should be the first of many given a supportive RHI regime. Along with the confirmation that current Feed-in-Tariff levels will be maintained in the near-term, this should help take-up of small-scale renewables in the home.

Improving energy efficiency in homes and businesses is the cheapest way to achieve carbon reductions. We believe that the "Green Deal" programme represents a major opportunity to upgrade the UK's energy inefficient housing stock. Centrica is investing up to £30 million to trial Green Deal options ahead of legislation. Our work to date highlights some of the challenges involved in putting together a package which is attractive to customers, meets the golden rule (that is the instalment payment for the energy saving measures should not be greater than the cost savings on an average bill) and is commercially viable for us and any potential finance providers.

Energy company balance sheets are not big enough to carry the full costs of the Green Deal and need to pass on collected repayments to Green Deal financiers. In order to access sufficient funding, the Green Deal will likely need to access capital markets through a securitisation process. Raising finance for long-dated unsecured loans could prove very difficult. For the first two to three years, investors may be reluctant to engage in securitisation of a novel asset with no history. While the Green Deal aims to keep default rates low, there remains uncertainty around this. We think that the option should be kept open of using the Green Investment Bank to help kick-start the Green Deal by acting as a sponsor of Green Deal bonds, facilitating and encouraging growth in the market.

The operation of the golden rule and its implications for the term of the repayments is also not clear. For many products, the term will be shorter than the maximum 25 years, but others will need subsidy, eg through ECO for the golden rule to work within 25 years. In summary, we cannot be certain that securitising investment will kick in. In order to make the assets more attractive, the option should be kept open that the golden rule may not apply.

In order to make the package more attractive, we believe that microgeneration technologies must be included in the Green Deal. We also believe that additional "sticks and carrots" will be necessary and welcome the Government's plans to introduce reserve powers in the forthcoming Energy Security and Green Economy Bill to regulate for minimum standards in the private rented sector and to give the tenants the right to participate in the Green Deal. The regulation should also be applied to the social rented and business sectors. However, the Government could be bolder such as including incentives to new homeowners such a stamp duty relief and a time limited open-to-all incentive to kick start the Green Deal.

We also support the introduction of an Energy Company Obligation to provide additional support for vulnerable customers and "hard to treat" homes. However, at an estimated cost of £1.7 billion consideration needs to be given to ensure that the Obligation does not put an upward pressure on customers' bills.

Recommendation 4: We support the Government's Green Deal but believe more needs to be done to incentivise customers to take up the offer by including microgeneration and also financial incentives such as stamp duty reductions. The option of using the Green Investment Bank to help kick-start the Green Deal should be seriously considered.

SMART METER ROLL-OUT

Smart meters have the potential to transform the relationship between energy suppliers and customers by giving more accurate real-time information that can help change the way customers use their energy. Early deployments are key to delivering more value for customers and preparing our industry for the smart grid future.

Consequently, British Gas has already begun to roll out smart meters and has now installed over 200,000 smart meters across both domestic and business customers. We have spent £90 million in developing smart metering systems, smart trialling, and creating an installation business. We expect our smart metering business to create 2,600 jobs by 2012.

However many of the other large energy suppliers are seeking to delay progress, and are putting up obstacles to achieving the early start necessary for nation-wide roll-out by 2020 or earlier. In particular they are refusing to engage constructively in establishing interoperability approaches in the period before all the new industry arrangements—the central "DCC"—"Data Comms Co"—goes live. Ofgem's work with industry support has established that the DCC will not be ready before Autumn 2013 or more likely six months later. A three to four year hiatus in smart deployments would clearly be damaging for UK energy market developments, and for UK energy customers.

The fundamental principles agreed with Government and industry to date are that suppliers will lead the roll out and that meters will remain in the competitive market. Government has been admirably clear in stating its objective to expedite the start of smart metering in the UK. These principles have been central to our confidence in taking a leading position at attendant cost.

The Government is now coming to the end of the consultation period for smart (the "Smart Prospectus"), with a conclusion to the "Smart Prospectus" expected in January 2010. We believe that Government can keep Industry on track for a start to smart deployments in 2012 by restating their previous plans with more detail and certainty, and by taking three simple steps, which would both encourage industry to invest, and at the same time reduce the risk of those investments, as follows:

— Requiring all suppliers to collaborate and engage on developing low cost interim arrangements to accelerate the delivery of early benefits to customers ahead of the establishment of the Data Communication Company (DCC) expected in 2013-14.

— Stating now that smart meters meeting the certain criteria (technical capability, customer benefits) and deployed before a date when UK smart specification compliant meters are available to buy, should not be required to be replaced by the mandate cut-off date (of 2020 or earlier).

— Stating now that the DCC will accept "commonly used telecommunications methods" in meters already deployed into the market (eg mobile).

Recommendation 5: We would welcome the Select Committee support for the British Gas' "go- early" approach to ensure that the benefits of smart metering can be brought to UK consumers in time for the 2020 Government deadline.

December 2010

3 Electricity and Gas Supply Market Report September 2010, Ofgem Back

4 Electricity and Gas Supply Market Report September 2010, Ofgem Back

5 Securing the UK's energy future-meeting the financing challenge, Ernst and Young, February 2009; Project Discovery Scenarios Consultation Document, Ofgem, October 2009 Back

6 Electricity and Gas Supply Market Report September 2010, Ofgem Back

7 Project Discovery Scenarios Consultation Document, Ofgem, October 2009 Back

8 Transporting Britain's Energy (TBE) consultation process 2010-Development of Energy Scenarios, National Grid, July 2010 Back

9 Digest of UK Energy Statistics, DECC, 2010 Back

10 Digest of UK Energy Statistics, DECC, 2010 Back

11 EC Paper: The functioning of the retail electricity markets for consumers in the European Union, EC, November 2010 Back

12 House of Commons Library Briefing: http://www.parliament.uk/documents/commons/lib/research/key%20issues/Key%20Issues%20Energy%20price%20rises%20and%20fuel%20poverty.pdf Back

13 Monitoring suppliers' social programmes 2009-10, Ofgem, September 2010 Back