Electricity Market Reform - Energy and Climate Change Contents

Examination of Witnesses (Questions 158-180)



  Q158  Chair: Good morning. Thank you very much for coming in. We have a big cast of characters and a limited amount of time. I know that you, Vincent, have got to go off, but we are allowing a substitute to come on to the field later on. We will try to let you say what you want to say first. Could I get you all to introduce yourselves for the benefit of people who do not necessarily know you? Ian, we have been upgraded as far as you are concerned.

  Ian Marchant: Yes. I was delegated upwards. I am Ian Marchant. I am the chief executive of Scottish and Southern Energy.

  Sara Vaughan: I am Sara Vaughan. I am director of regulation and energy policy at E.ON.

  Sarwjit Sambhi: I am Sarwjit Sambhi. I head up the power generation business at Centrica.

  John McElroy: John McElroy, RWE npower, with responsibility for policy and public affairs.

  John Campbell: John Campbell, director of energy wholesale at ScottishPower.

  Vincent de Rivaz: I am Vincent de Rivaz, chief executive at EDF Energy.

  Q159  Chair: Ofgem has told us that you have whacked your margins recently. Is that true?

  Ian Marchant: I wish that were true. Our gas supply business has lost money every year for the last five years. I am not sure that that is a sustainable business. So, yes, we are seeking to make profits in this business. We are generally failing. This is not a business that is awash with cash, as people would like to think. We put out a briefing to the City yesterday—it's in the public domain—that said our generation, supply and profits are going to be down year on year, despite putting prices up, despite having 300,000 extra customers and despite investing £1.2 billion this year in that business. I find it deeply frustrating that in this part of London I get criticised for making too much profit and I go two miles to the east and I get criticised for not making enough. I think we are probably getting the balance about right. I would rather be praised in both, but at least I am being criticised in both.

  Sara Vaughan: If I could echo that: in 2007 and 2008 we made a loss in our retail business; in 2009 we made a small profit in our retail business; the 2010 figures are not out. Even if you look at Ofgem's own document—its December report on margins—it talks about margins increasing but then it talks about the fact that wholesale costs are also increasing. So we would expect to see those margins shrinking as a result of that change. Really what Ofgem was picking up on was a timing point, rather than anything else. You have to be able to make a sustainable margin in a retail business.

  John Campbell: Our retail margins have been barely over 1%. Our last published results were for the first three quarters of 2010. The profit in our competitive business was down by 24% and our wholesale costs have increased by between 30% and 40% over the last year. So maintaining profitability in the retail business is a real challenge.

  John McElroy: I would agree with many of the points that have been made along the row. As Sara said, we made no profit in our retail business in 2009. 2010 does not look any different in many respects. The other thing is that we need to recognise that there are substantial cost pressures on the business from a range of things, including increasing network costs and a whole range of Government initiatives in terms of feed-in tariffs, RO, and various measures to support vulnerable customers. There is a whole host of issues that are substantially driving costs up as well.

  Vincent de Rivaz: I would like to say two things. First, when the cold weather started to bite, EDF Energy announced a winter price freeze. Secondly, overall issues of how the market works are precisely about having a fair balance between the interests of shareholders and the interests of customers, and that is why we are talking about electricity market reform.

  Q160  Chair: Several of you have mentioned that you are not making any money in your retail business, but since you are buying energy from yourselves, does that mean you are making a massive amount of money in the wholesale business?

  Ian Marchant: I talk very specifically about my gas supply business. I have no gas upstream assets. I may be closing on a deal today, but in the past five years I have had no gas upstream assets. I have had to buy all that gas in the market. There is no profit anywhere else, I can assure you. It is more complicated in electricity because obviously I am the generator as well, but in gas, absolutely, there is nothing anywhere else.

  John Campbell: The dark spread, which is what we call the profit that we make in generating from a coal unit, is currently less than £1. The spark spread, which is the equivalent number for gas—the profit per megawatt-hour—is about £5. To replace thermal plant in the future you would need spreads of £16 or £17. Generation spreads in the UK at the moment are not in a very healthy place. That is why the electricity market reform is so important to create the investment signals, because they are not there in the current market for thermal or renewable, or for any plant. The wholesale market is a very weak place.

    John McElroy: You were inferring a link between the generation and the supply businesses, and I would like to make the point that at least 90% of the generation and supply volumes that we deal with are traded in the market by our supply business, so everything is at arm's length. The other thing that you need to consider is that if we look at RWE npower's profits last year the amount that we invested in the UK was more than three times the level of profit. That is a very considerable factor that has to be taken into account.

  Q161  Chair: We will come on to some individual aspects of EMR in a moment. We are looking at a prospect over the next few years, however, of rising prices for a variety of reasons, and it looks as though a low-carbon element will drive costs up a bit further. There is already a suspicion among your consumers—although you are able to refute it, and you can say that investors are breathing down your necks because you are not making enough return—and a lack of trust in the price-setting process. Do you think there is a danger that if we are going to achieve the more secure, lower-carbon electricity that we want, which is an explicit objective for the Government, consumers will think that actually they will resist the price consequences of that, because of this lack of trust that already exists?

  Sara Vaughan: Can I hit that point head-on, because it's something that we have been tackling in our advertising? Some of you may have seen it; it heads up with "Why on earth would an energy company want me to use less energy?" That is exactly the point that we are trying to hit with that—the trust point, and the cynicism from consumers about the approach that energy companies have. We are trying to be very honest with consumers, and we are trying to explain to them exactly why prices are going to go up and the underlying reasons behind that. We are doing that through advertising; through talking to consumers in town hall meetings; and through our internet site, which has one of these blogs where people can come in and join conversations that are going on. We're perfectly aware that there is this lack of trust around energy companies.

  Returning to the point that was touched on previously concerning supply and generation, for many years—at least the last 10 years, and certainly before Ofgem mandated us to do it—we reported our generation business results and our supply business results separately and also from our regulated distribution business results. They were in our published accounts. Anybody could find them on the internet. So if people wanted to look at the relationship between those two issues, they could do so. I would absolutely support your point, Chairman, that trust is a key issue for this market going forward.

  Ian Marchant: I agree. It actually doesn't help that the first question that we've had on the investment climate is about profitability and prices. Actually, your side of the table doesn't help our side of the table either in the way that the debate is carried on. We have to raise that element of the debate to keep my consumers and your voters alongside the common agenda that we have to decarbonise our society. We have to work much more together, rather than fighting each other the whole time.  

  Chair: Let me absolutely assure you that one of the things that I have been consistently saying, as some of you will know, for the past three years is that prices are going to go up substantially. You cannot point to a single suggestion from me where I said that prices should not go up.

  Q162  Barry Gardiner: Does silence on the panel mean that those who are silent are doing rather well and didn't want to participate in that debate? This is an opportunity for Mr Sambhi to deal with such a suggestion.

  Sarwjit Sambhi: Thank you for the opportunity. In terms of the profitability and looking at the question of how much money is made downstream versus upstream, I will reinforce the point that the margins that British Gas has made over the past three years have fluctuated and have been as low as less than 2%. On average, over the past three years in energy, that has been around 7%. Compare that to other retailers—whether it's fixed-line telephony or mobile—and it is substantially lower than you would expect in any retail market. On the upstream, a measure of profitability is return on capital employed, and in terms of our return on that in investments that we've made, particularly in power, they are currently single digit. We cannot, therefore, be seen to be making excessive profits by a hard measure in the upstream.

  I would also point out that if you look at how much we've invested in UK energy infrastructure, for every pound of operating profit that we've made, we've invested £1.60 in UK energy infrastructure.

  Q163  Sir Robert Smith: I had better remind the Committee of my entry in the Register of Members' Financial Interests, which states that I am a shareholder in Shell. I just wondered why those businesses that are making a loss on the retail side still do it.

  Ian Marchant: Would you like to join my board? That is exactly the question that we struggle with, particularly with gas. We make a margin on electricity. The problem that we've had with gas is that the wholesale price has been so volatile. Just when we think we're going to make a profit, the wholesale price moves against and that hasn't happened. We're in it because it's a dual fuel market and we have to be in it, because that's what customers want. We tend to look at a dual fuel margin when we're looking at things, and that is a very small positive at the moment after the price rise. Whether we should stay in the gas retail business is a real challenge, because the evidence suggests that we cannot make a decent margin out of that.

  Sara Vaughan: Let's be clear, we have been making a loss, but we did make a small profit in 2009, and we would want to make a profit in 2010. We're not in the business to make a loss; we're in the business to make a profit.

  John Campbell: We have a commitment to be a UK generator and retailer. There's a lot of integrity in that business model. As someone else just said, we're not in it to make a loss; we're in it to make a fair return. That is certainly what we plan to do.

  Q164  Barry Gardiner: Was Ofgem accurate when it said that the recent price rises will increase profit margins from some £65 on a dual fuel tariff to £97? Is that right, or is Ofgem just wrong?

  Sarwjit Sambhi: Can I pick up on the analysis? The analysis is flawed to some extent, because Ofgem looks at current retail prices and compares that against projected forward wholesale prices. It is mixing apples with pears. The other thing it doesn't do is look at the additional costs that are incurred beyond just the wholesale commodity price, such as increase in transmission and distribution costs. So, at face value, there is more to the numbers that needs to be explained. I would argue that the analysis is flawed.

  Q165  Barry Gardiner: I would accept that, but none the less, that flawed analysis is still contained in the £65 figure, just as much as it is in the £97 figure.

  Ian Marchant: The data are right, but if the analysis came out with a suggestion to move it from minus £50 to plus £50, we'd be having a different debate, wouldn't we? It is the absolute level. Ofgem overstates revenue because it takes the highest-price customer and does not take account of loyalty discounts and various other things that we have. The average revenue that we earn from customers is lower. Ofgem understates the costs for the reasons said, and it understates the cost that we incur on risk-managing a fixed revenue stream with a variable cost. We end up requiring it to be long or short power and having to trade that out. Our view is that the absolute level of those margins is significantly lower than what Ofgem says. The change from the price increase is mathematically correct, but the analysis is where you start from.

  Sara Vaughan: Yes.

  Chair: I think we will move on to the EMR now. Thank you, Ian.

  Q166  Sir Robert Smith: Some of your earlier answers might have explained this, but one of the concerns about the market is the concentration and the difficulty for new entrants in both the generating and the retail sides. Do you see any barriers that can be removed to bring in more competition, or any benefits from more competition?

  Ian Marchant: The first thing to say is that this market is competitive compared with any in Europe. There are eight major generators and six major suppliers with more than 5% market share in the UK. In France, it is four and one, and in Spain it's four and four. So we are significantly more competitive before we start.

  Secondly, I actually don't like giving evidence with these five people. They're not my friends. I don't like them. People do not move between these companies. We have very different approaches to this industry, which is why when we get to the detail of the EMR, you will hear different views. Trying to get us to a common position is like herding cats—it's basically impossible.

  If I look at the liquidity of the market, I think it is pretty good in the first year or two, for gas and power. You can trade and hedge your position for a year or two. The issue is longer term. The barriers to entry are, I believe, threefold, and they are not related to anything that we do. The first barrier is the credit requirements of banks and companies, which have become significantly tighter since the financial crisis. Small new entrants cannot post a collateral to trade. That's the first thing.

  Secondly, in terms of the sheer size of the investments required to set up a supply business or a generator you're talking about hundreds of millions of pounds. Those are not typically the sorts of businesses that private equity generates. The third thing is that it's a risky business. New entrants have gone bust. People forget that the largest independent supply business, Independent Energy, went bust in 2002. Large independent generators, including Drax, effectively went bust and had to be rescued.

  My fourth reason out of three—this is like a Monty Python sketch—is that an awful lot of regulations are imposed on our sort of business that make it very difficult for someone to set up, which is why the new entrants you see in supply will typically use one of us to provide the services to meet all their compliance—for us that means M&S Energy, and I think British Gas has just done a deal with Sainsbury's. Even companies of that size struggle to meet all the regulatory compliances.

  Sara Vaughan: Can I pick up the point about liquidity that Ian touched on? I think there is a real misunderstanding about companies that have a generation arm and a supply arm, and in the concept that people have of vertical integration. They imagine that all that those generation arms do is supply their supply arms, and vice versa. That is absolutely not the case. If you look at a company such as E.ON, we have an independent trading business that sits in the middle. Effectively, we manage our generation and supply positions separately. Our own churn in 2010 has been, on average, around five times the market—five times physical. So, we are buying and selling that five times. The market throughout 2010 was around four times, so we are trading our generation and supply more than the market average is moving.

  John McElroy: The point has been well made—why would you come into the retail business given the margins at the moment—but on the generation side the simple fact of the matter is that the market is some 30% plus over capacity at the moment, the prices are nowhere near new entrant levels and we don't expect to see any significant change in terms of that overcapacity until post-2015. But if you look at other areas of activity, such as in the renewables business, there are around 18 players in the offshore market at the moment—there is lots of engagement there. You have to look at which part of the market you are dealing with and take a perspective on the environment in which those bits of the market are operating.

  Q167  Sir Robert Smith: Are you all similar—while being vertically integrated, you don't necessarily trade with yourselves?

  John McElroy: I have already said from our perspective that more than 90% of our generation supply volume is dealt with through our trading arm. It is independent, as it were, from the rest of the business.

  Ian Marchant: It varies. About five for power, and about seven or eight for gas, which we trade compared with our physical supply needs.

  John Campbell: We have a similar set-up. We have a trading organisation which has separate strategies for hedging and selling gas power for generation and retail. We typically trade up to four times the physical volume that we produce in power. We trade several times the gas sales we have. But we recognise that for smaller generators and suppliers it is a difficult market, with a lot of administrative complexity and credit issues.

  Ofgem has been trying to tackle the issue, and we have made simple commitments on providing simplified master trading agreements—the commercial framework—free trade notification services, initial lines of credit and streamlined financial regulatory compliance. I could go on, but the point is that there are measures we can take, and we do work with small generators and retailers. We actively try to find ways of making the market work for them by giving them access to the trading services we have as an internal business. We do so on the same basis as we trade with our own retail and generation businesses.

  Q168  Sir Robert Smith: But if you are all separated and not vertically trading in a narrow way, why are you vertically integrated companies?

  Ian Marchant: We run our business as an integrated business, but we absolutely trade with the market. They are not mutually exclusive. Why are we vertically integrated? For significant risk-management benefits. Why does virtually every power market in the world tend towards vertical integration? Because you need the generation to hedge your customer business. That is why it will happen.

  We don't just keep all of that to ourselves, and just trade internally. We need to be active in the market, because at every half hour I am either long or short, and I will need to trade with the physical players here. I also want risk-management tools, which the banks can offer. So, for the first two years going out in any point in time, we are very active in trading. The point about liquidity really starts to bite in year three onwards, when a market is significantly illiquid. That is the problem for a small supplier or generator—the longer term—but we have the same problem. How do I buy my 5 billion therms of gas in 2014? I can't, there isn't a liquid market there. So, you need to distinguish between short term, which is very liquid and vibrant, and long term, which is virtually non-existent.

  Sara Vaughan: The UK market isn't different from other markets from that perspective. If you look at a number of the other markets around Europe, which we do because we have a European trading business, then you will find most of the trade concentrated in the nearer term and, further out towards the third year, it will be much thinner.

  Sarwjit Sambhi: On the comment of why we strive for a level of vertical integration, I would say that one of the things that the corporation tries to do is to smooth out earnings volatility. Clearly, being concentrated in one part of the value chain versus the other would result in very volatile earnings, which we would not be rewarded for by the shareholder.

  Q169  Dan Byles: I want to come back to an issue that we have discussed quite a lot in this Committee, which is investment in the energy sector and this enormous requirement that we are all aware of—Ernst and Young recently suggested that £234 billion of investment was required by 2025. Alistair Buchanan recently told the Committee that the big energy companies are looking eastwards for investment rather than to Europe and the UK because of the potential for higher returns on investment. Do you agree with that?

  Vincent de Rivaz: No.

  Q170  Dan Byles: That is good. The subsequent question is whether EMR will help in any way.

    Vincent de Rivaz: Yes.

    Sara Vaughan: That's that then.

    Vincent de Rivaz: It is important that we focus on how to make the investment possible. I believe that we have in front of us, from the Government for consultation, something that is coherent, holistic as a package and fundamentally fair for moving on in our competitive market. Let me be more explicit about what are, in my view, the three principles that led me to answer yes to the question. Are we poised, with our co-investor Centrica, to make a major contribution—driving a multi-billion investment programme—in the UK? The answer is yes because in the proposals there are three principle elements that will be instrumental in delivering that. First, a carbon-price floor will remedy the failings of today's trading scheme. Our view on the so-called second scenario that the Government are proposing—the one where the price of the carbon will be the floor price of £30 in 2020—is that it strikes the right balance. Secondly, we think capacity payments will reward investment in firm, available generation. It will provide the security of supply that we need as more intermittent generation is placed on the grid.

  Finally, contracts for difference will address risk and volatility in the market, providing greater certainty for the customers and investors and the lowest possible costs. I think today that our shared challenge is to ensure that both the mechanics of this reform, which are complex and holistic, are right, and that the reform itself is delivered in a timetable that drives key investment decisions in new generation in good time. That is why my conviction is that, for this consultation, we need to reach the point where we can deliver reform in a very tight timetable.

  In my company, we are contemplating a multi-billion-pound investment programme. At the beginning of 2012, we will have to make some big financial investment decisions. The decisions we make will be very important for this country's growth agenda, investment agenda and jobs agenda as well as delivering what we have been looking for for years—market reform delivering secure, clean and affordable energy. That is a very important point. The reforms—we are discussing them in the Thatcher Room today—are the most important reforms proposed since the privatisation of the market. Some have said it is a seismic change; it is a holistic change. My priority is to make it happen.

  John Campbell: Just to answer your question, like other participants here, we're part of an international company—in our case, Iberdrola. The investment will go where the confidence and the returns are for that investment. The electricity market reform has the potential to improve the UK's attractiveness in that respect. It's trying to deliver two key things to drive low-carbon investment. The renewables obligation scheme is working. We need to be confident that what is coming along to replace it will not reduce the momentum and that there'll be no hiatus. There's another perspective on energy market reform—that it is to maintain security and affordability, as well. I'm sure we'll get into the detail of some these, but we have to make sure that capacity payments and carbon-price floors do not put at risk security of supply in the transition to the lower-carbon generation portfolio in the future. There's a lot of detail to be worked through, but we believe that EMR has the potential, if we get it right, to increase investor confidence in the UK. But there's a lot of detail to go through before we get there.

  John McElroy: RWE is one of the biggest investors in the UK at the moment, so we're not walking away from the UK. But, in response to your question, we need to recognise the scale of the challenge and the need to bring in new money, new sources of capital and new investors. Therefore, it is critical—the electricity market reform gives us the opportunity to do this, as others have said—to make certain that we have a regime that generates stable, predictable returns on investment that are commensurate with the risks of large low-carbon projects. Whatever else we do, the outcome of EMR needs to satisfy the criteria of investors to maintain the attractiveness of the UK going forward.

  Q171  Dan Byles: Do you think, from what you've seen, that it will do that?

  John McElroy: We would say that we're far from the end of the road, as it were, but what's on the table at the moment is certainly a good start, and we need to work together to make certain that we get the right outcome.

  Sara Vaughan: E.ON was one of the companies that Alistair spent quite a lot of time talking about in his evidence—

  Dan Byles: I gather you're selling half of your assets and running away.

  Sara Vaughan: I think he was suggesting that we were looking east rather than looking at the UK. When we announced our strategy in November last year, we made it clear that we were seeking to get 25% of our profits from other markets outside Europe by 2015. This reflects the opportunities for growth in those other markets, but it also means that we are looking to get 75% of our profits—very much the greater part, therefore—from Europe. The UK is a key market for E.ON. We are already investing in the UK. Over the last three years, we have invested more every year than we have taken out in profit. Since E.ON bought us in 2002, it's invested more than £7 billion in the UK, which is quite significant. We see no reason for that to change. We're just commissioning our combined heat and power plant on the Isle of Grain. We're investing in London Array, which, when built, will be one of the world's largest offshore wind farms. We have an option for a gas-fired power station at Drakelow. With RWE, we're a partner in Horizon Nuclear Power, which is looking to build 6 GW of nuclear power in the UK. None of that suggests a company that is anything other than committed to the UK.

  Ian Marchant: We are looking east, but probably not quite in the way you envisage. We are looking at the North sea, which is technically east. We are a UK company—we and Centrica are the only two UK-domiciled companies here—and 100% of our investment is in the UK and Ireland. So this market is absolutely crucial to the future of my company in a way that it is not as crucial to the four Europeans. They have choices for where they invest. I want this market to work. I am not as comfortable with the EMR package as some of my colleagues. There are two key points.

  First, it is only part of the problem—we have problems with planning; we have problems with the grid, both on access and on charging; we have problems with the supply chain; and we have problems with construction risk, which EMR does not tackle. Those are the biggest constraints on investment today.

  Secondly, the CfD principle will fundamentally undermine the importance and the nature of the market. The UK will live to regret that. The liberalised market has been a major driver of innovation and investment in this market and the EMR package significantly undermines that. We will look back and end up changing it. We will put the market back in the driving seat, rather than the state, as the CfD is doing in deciding what is built, by whom, where and when.

  Vincent de Rivaz: I understand that Ian thinks he can comment on the intentions of his competitors, but it is preferable that I speak on behalf of EDF Energy rather than him. We are a UK company. We are committed to this market. It is the second largest domestic market of the EDF group, which is an international group with a UK business.

  We should not isolate the contract for difference, which is part of the package, from the carbon price floor or the capacity payments. It is part of the better market for which we are all looking. It is not about a lesser market; it is about a market that works. The contract for difference will address the volatility and uncertainty, which has been a problem for many years. It should not exist in isolation, which is why I am also promoting the idea of the carbon price floor and the capacity payments. Those payments will be made to all plants that are available at times of peak demand, and not only to the peaking plants, which has the potential to distort wholesale market prices.

  Contracts for difference are about contracts, which are compatible with markets. The market is made of contracts every day, so I do not see why the simple idea of a contract is contrary to the idea of a market. It is a contract for difference, and it will be settled against the reference price in the wholesale market—which, yes, places a high premium on ensuring that market arrangements deliver a credible price. That is why it has to be part of a package.

  I really believe that the right combination of the contract for difference and the carbon price floor will ensure that consumers do not have to pay any more than necessary. The feed-in tariff, and a premium on the feed-in tariff, is the alternative option.

  I understand those who have been lobbying hard and successfully to have ROC banding. Two ROCs for an offshore wind farm is very favourable for such a premium on price, but it is more costly. If you take what the analysis is saying, the cost of capital, as it is today without the market reform, is 13.2%. With the feed-in tariff it will be 12.2%, and with the contract for difference it will be 11.2%.

  So that will make a big difference, because at the end of the day the lower the cost is, the lower the price for the customer will be. We have to accept that we are facing new challenges, which are not the same as 20 years ago, when we had over-capacity and oil and gas in the North sea. Nobody then was talking about climate change and CO2 and, thanks to privatisation, everybody was expecting downward trends for bills for ever.

  We are facing new challenges in the next two decades. One is security of supply; we no longer have any oil and gas reserves in the North sea and there are important geopolitical issues. Security of supply is important to keep the lights on. We have to tackle climate change. This country has made a binding commitment to reduce carbon emissions by 80% by 2050. We have to abide by that and at the end of the day we have to have the least-cost solution for the customers. These challenges are not the same as challenges in the past.

  Every day as companies we adapt our way of working to the changing environment; we are praised for that flexibility, adaptability and ability to react. It will be bizarre if we are not able to make the same changes to the electricity market. The package that the Government are proposing is credible, comprehensive and holistic. My feeling is that there is a momentum to get this investment under way. There is a large consensus, despite differences that we hear here and there, and my priority is to make it happen, to enter this consultation and then, with the working relationship we will have with the officials, to enter a process where the details will be fixed so that we can move from a period of debate to a period of action.

  John Campbell: May I follow the theme? ScottishPower is a local British company that is part of a global group. It has spent £3 billion in the last three years and will spend another £4 billion in the four years to come. So we are also very interested in the outcome of this market reform. For us, looking at the feed-in tariff issue, we think it is down to the detail. We are not prepared to say that the premium is right or that CfD is right.

  There is more detail to be explored on indexing and on returns. That will come out. These mechanisms can both potentially deliver a viable replacement to renewable obligation. Absolutely key is that the returns on investments already made under ROC are protected and that that ROC scheme is available right through 2017 until we are very clear about the alternative.

  I would differ a bit, as you might expect, in terms of the carbon price floor. We think that will be a very expensive tool for UK industry and UK consumers. If the feed-in tariff scheme is right, it will have a limited role to play, if any, in supporting low-carbon generation and it has the potential to push some of the plant off the bars, which will be required to keep the lights on in this country over the next 10 to 15 years. So our view on that is, go low and go relatively slow on any carbon price floor.

  We are a big supporter of capacity payments because the market needs to reward firm capacity—especially a market which may have more intermittency in future. We are not particularly happy about the initial proposals or discussion topics from DECC on that. Experience from all round the world says reward all firm capacity. If you try to target for peak periods, what tends to happen is you displace investment and end up with the scheme migrating towards all firm capacity being rewarded. We think we should make sure that we get that right from the beginning. It could be inefficient to see existing plant taken off the bars to be replaced by new build. Getting that capacity mechanism right and making sure that any emissions performance standard isn't biting too deep too soon is critical to maintaining security while we drive.

  One final point: the current scheme of transmission charging in the UK does not follow the objectives of UK energy policy on carbon reduction. Renewable plant and carbon capture and storage cannot follow that transmission price signal, and that issue needs to be addressed if the UK is going to hit its renewable targets. We have seen evidence from people like Oxera that we will get a lower-cost deployment of renewable generation, and the potential for carbon capture and storage demonstration, if we can sort out transmission charging.

  Vincent de Rivaz: Mr Chairman, I have to apologise because I must leave. The reason is not that I do not attach great importance to your Committee—just the opposite: I made a choice to come here despite this diary clash. But I have also to talk to my shareholders about electricity market reform, because the multi-billion investment will come from them. So Paul Spence will deputise for me.

  On the carbon price floor, one word: it is part of a package, not to be isolated from the rest. Carbon price floor support is not a new policy. It merely restores the carbon price signal that was expected from the EU ETS. The problem is that we all know that the EU ETS as it is today doesn't work and we have no certainty that it will work, so it's logical that there is a carbon price floor, which is going to reinforce both the principle that the polluter pays for what it pollutes and the intention of the people who designed the EU ETS, in delivering a credible signal to the market for the investors to invest in low-carbon technology. So for me the carbon price floor will not be contradictory to the market, as I have already said.

  I am very supportive of the second scenario of the Government proposals: a kind of gradual increase starting with a low level—just the carbon price as it is today, more or less; then in 2020, £30, and in 2030, £70. I have heard some comments saying if I am in favour of that, it will just come from benefits in the short term for the existing nuclear power plant. That is not true at all. My good friend Dorothy from Drax is defending a position against carbon price floor setting; it's detrimental for 4,000 MW of coal power. But I have exactly the same quantity of coal-fired power plants, so it's not something that will distort the competition between us.

  I will ask Paul Spence to step in. Many thanks.

   Chair: Thank you.

  Sarwjit Sambhi: I will just answer Dan's questions. So on the first one, clearly at Centrica we have nearly 90% of our business in the UK, so there is no question about it—like Ian, we are committed to investing in the UK market, and we plan to spend £15 billion over the next 10 years. There is no question about our commitment to this market.

  On the EMR reforms, I think we ought to step back a little bit and say "What's the problem that we're trying to solve?" It's a difficult conundrum that DECC has been posed. We want security of supply, low-carbon generation and renewable generation. The current market, as is, won't deliver all that, so something different has to be put in place.

  Do the EMR reforms, as proposed, deliver that? I think they do. Take each one quickly in turn. On carbon price support, we'd advocate that introducing the floor creates emissions reductions early and it's cheaper than other forms of carbon emission reductions. So we'd actually advocate that the sooner it comes in, the better. On the CfD or PFIT, we think that either could work. CfD has practical implications, especially in terms of how it interacts with the wholesale market. PFIT can work, and one could see that that's a natural extension of the current renewable obligation, albeit simplified.

  Capacity payments incentivise having security of supply in advance of having new nuclear or sufficient wind capacity on the system. In the long run, they are also good for ensuring that we have back-up to take up the slack when the wind isn't blowing. As a package, I think that the measures, as proposed, address the multiple objectives that we're trying to achieve. The devil is in the detail, however, and the key thing—returning to Vincent's point—is how it is all going to work. Implementation is now key.

  Sara Vaughan: Just on that one point about whether the carbon price floor reduces emissions earlier. In the UK, a carbon price floor is likely to cause a shift from coal to gas, but looked at across Europe as a whole it will not reduce emissions at all. All it will do is shift it out of the UK into somewhere else in Europe. Will it have a positive environmental benefit, looked at in larger terms? No, it won't have.

  Sarwjit Sambhi: I am sorry, but I have to come back, because that's true if the same number of allowances are allowed to be in the system. The UK could make a choice to reduce the number of allowances that are auctioned.

  John McElroy: You can't do that with phase 3.

  Sara Vaughan: That's not proposed at the moment.

  John McElroy: I've struggled with some of the arguments on a carbon price floor from Vincent and from National Grid. As a company, we have always believed in the EU ETS; ultimately, we believe that is the right instrument for putting a price on carbon, but it comes back to some of the points made about the impact of a carbon price floor on security of supply. Equally, if we go down a CfD track it's hard to see the relevance of a carbon price floor.

  Also, I would take issue with ScottishPower on its perspective on the need for broad-based capacity mechanisms. We do not believe that the case for a capacity mechanism has been made as yet—certainly not in the EMR consultation as we have seen it. We also agree with the view recently expressed by Centrica that it is premature to prejudge exactly what the balancing situation will be in the market in the 2020s. We don't know what the energy mix will be and we don't know the extent of interconnectedness, and there's a whole issue of how the demand side plays into this and how it responds.

  In our view, things could be done to strengthen the existing regime, particularly in terms of cash out prices, to make certain that we encourage players in the market to minimise the extent of imbalance. We believe that we have to work hard on delivering demand-side measures through smart metering. We agree that we really need to come up with a robust mechanism to monitor the capacity margin situation, but we would say it's premature to take action.

  Ian Marchant: I fully agree with Vincent on capacity. We need a capacity market in the UK, and it should be for all capacity. Any targeted mechanism anywhere in the world ends up being changed into all or nothing. We think that there should be a market for capacity, particularly when intermittency is increasing. The sooner we start, the better, although it could be at a low level.

  The carbon price should be absolutely central to our policy for decarbonising the economy from 2020 onwards. The sooner we can stop all other support mechanisms and focus on the carbon price, the better. I would start some form of carbon price support or floor early, at a nominal level, to start proving to ourselves that it works. At the same time, we should continue to seek to reform the ETS to make that bankable, because if that works it is still our best hope.

  As I said earlier on CfDs, I think that is the wrong way to go, because we need a vibrant, liquid energy market and CfDs go to the heart of that. A premium feed-in tariff is easier to do—it is less intrusive on the market and easier to remove when the technology of CCS, nuclear and offshore wind can compete against a carbon energy and capacity price. In a sense, as you're hearing, there are six different views. On each topic, some of us agree, but every one of the six positions is different. We thought that we would make your job difficult for you.

  Q172  Chair: On the timing, we need huge investment in nuclear and offshore wind, both of which are going to be pretty slow to bring to production. It is likely that some of the decisions about those investments will have to wait until the EMR process has been concluded. In your minds, is there a last possible date by which the Government need to decide—they are consulting, but they have to make a decision—to ensure that we get somewhere near achieving the 2020 targets?

  Ian Marchant: I have always felt that this year is crucial. I am not saying that December is a hard deadline, but if we have not got clarity by the end of this year, the risk is that the momentum that is clearly building up in all three technologies—CCS, on which projects are being developed; offshore wind, on which we have formed alliances and are attracting in new manufacturers; and nuclear, which three active consortia are developing—will start to reduce. So this year is crucial.

  Sara Vaughan: I absolutely agree with that. There is already a concern that we may be seeing slippage in the time scales. We were hoping that we would have legislation in this session and would get Royal Assent in 2012. More recently, it appears that that will not come into the current Session, and therefore, at the earliest, we are looking at its being introduced in May 2012. Therefore, we are probably looking at 2013 for Royal Assent.

  If that has already slipped, does that mean that you will have knock-on slippage when the date for the White Paper is no longer late May 2011, but suddenly turns into summer 2011? All those things are being watched not only in boardrooms in the UK, but in boardrooms in Germany and, I am sure, in Paris. I would agree with Ian on this point—the need to keep up the momentum and impetus is absolutely crucial.

  John McElroy: I would add that, in one sense, we need to understand the framework and as much of the detail as possible. On delivering the detail, that absolutely has to be done by the beginning of 2013, which is particularly important in the renewables world, as it has a lead time of four to five years on new renewables projects.

  With the RO terminating in 2017, investors in the renewables community will clearly need to know what the rules look like by the beginning of 2013. We want to see as much as we can this year, and when it gets down to the granularity, we have to have that level of detail by the end of 2012.

  John Campbell: We are in a very similar position. We have major investment decisions to make over the next 12 months—investment decisions on offshore wind, coal-life extension, carbon capture and storage, and potentially in new gas plant. Like other companies, I do not think that the UK can wait for three or four years to see where this all ends up. We need clarity over the next 12 months, and some of the fine detail, legal application and implementation can come later.

  On timing, in regard to the renewables obligation, we need to be absolutely clear that the current scheme will continue to reward. The changes through electricity market reform may impact on the current market, and hence impact on the rewards through renewables. We need to be absolutely firm and clear that our investment in low-carbon generation will be protected, and that we will ultimately have choices to make about when we transfer over to the new scheme, once we are absolutely confident. If we do not get that right, we risk having a hiatus in renewables deployment, which would be a terrible shame.

  Paul Spence: This is one area where there is heated agreement across the whole industry. As Vincent said before he left, we have a very major investment decision to take at the start of 2012. We need to be able to lay out for our investors and shareholders the basis on which they will take that decision. That means that we absolutely need to get on with the market reform. If the longer-term reform will take longer, we need to know what happens for people to take decisions in the meantime, so that we do not lose momentum.

  Chair: Achieving a rapid resolution of all this would be made easier if there was agreement between you on other aspects as well.

  Q173  Sir Robert Smith: Quickly returning to the carbon price, you've already dealt with the interaction with EU emission trading and the different views there, but if National Grid is right about the growing want of interconnectors, how can a British go-it-alone carbon price work with an interconnected electricity market?

  Ian Marchant: We think that if you get a difference of more than about £10 on a tonne of carbon between the UK and Europe, you will effectively get investment in Europe. It makes more sense to build a CCGT in France, the Netherlands or at the end of an interconnector. The frictional costs of the interconnector mean that you can have a small difference, but about £10 is unsustainable in a single market. We think that the interconnectors are going to be quite significant.

  In the earlier session, you were talking about the need for back-up capacity. I think interconnection can make quite a significant contribution to that. That's why we announced a study yesterday on linking the UK to Norway, because it partly depends on where the interconnection is with. Linking the UK and Ireland will not really change the dynamic, because its energy system is very similar to ours. If you go to different energy systems—Norway has hydro and different wind and weather patterns—we think that interconnection will make a difference. It means that getting the ETS right is absolutely the crucial thing, because there is a limit to how much the UK can or should go it alone on carbon price.

  Q174  Sir Robert Smith: Is the dilemma that the carbon price is really needed to get the nuclear investment, even if it means going it alone and damaging the other markets?

  Sara Vaughan: No. I come back to the point that was made quite strongly in the previous session. If you have a mechanism like a contract for difference in place, that effectively means that the role of any carbon-price floor is much lower, and some would say that it is not really having an impact at all. Looking at the Government's own document—the Redpoint document—that they published at the same time as the consultation, Redpoint said that adding a carbon price support, and the figure that they chose was £30 a tonne by 2020, to a fixed payment or a CfD makes little difference in terms of the amount of low-carbon investment that is produced by the market. So you then start asking, "Why are you adding that extra cost?" I can see some argument for having it there to make the reference price of the CfD more closely reflect the level under the CfD. Most investors, however, would be largely indifferent to the level of the carbon price if they had the CfD or premium FIT in place anyway.

  Ian Marchant: I think part of the issue with EMR is that, although we talk about high-level objectives of security of supply in energy, it has actually been designed to get nuclear built. If you design any energy system around nuclear—anywhere in the world apart from in France—it is a recipe for disaster, because nuclear is such a different technology. Don't get me wrong: I am not saying that nuclear should not be built, but if you design your market structures with that objective in mind, you get an awful lot of unintended consequences on capacity, other investment and prices. We should be much more honest. If subsidies are needed to get the first few nuclear plants built, let's be clear and let's make that happen—like we're doing with renewables and carbon capture—rather than designing a created market just to get something to happen.

  John McElroy: Can I respond to that? I take slight exception to it.

  Ian Marchant: I'm sure you do.

  John McElroy: The point I would make is that, because of the way that the market is structured in the UK at the moment, only renewables will be built as a low-carbon technology. We want a market that can bring forward a range of low-carbon technologies, because we need those to get anywhere near the targets. We need diversity in the energy mix. There are a whole host of reasons for doing it, and it isn't just because of nuclear in particular. We have to look at the whole range of technologies and bring them forward.

  Q175  Chair: I'm sure that you understand that the world of politics is not quite as rational as that of business. Therefore, there have to be devices to help coalition partners, in particular, get through the nuclear problem. We call it a feed-in tariff for the contract for difference. The average Liberal Democrat voter does not understand that that is actually a subsidy.

  Returning to Ian Marchant's point, what are the malign consequences of the systems that have been designed around nuclear? What has gone wrong in the rest of the energy market?

  Ian Marchant: My belief is that it will downgrade the role of the energy market to a simple half-hourly balancing, and that is no mechanism on which you can build gas plant. Again, I suspect that we would all agree that the UK needs to build some new combined cycle gas turbine plant in the next 10 to 15 years, to act as the flexible generation and provide the megawatt hours that we need.

  My concern is that we solve the nuclear problem and we ensure, in the way that we do it, that we solve the renewables problem, and actually we create a problem that nobody will build fossil plant, particularly with the way that the capacity price mechanism has been designed. So nobody will go and build a CCGT plant until they get the capacity support. So that is my first concern—that we have undermined the liberalised generation market.

  My second concern is about putting the state in as the buyer. Vincent is talking about contracts with markets. Let us be clear—the CfD is a contract with the state, or the state will create an energy agency. Goodness knows where from. I do not see any existing body that can do it. You have effectively put the state in the driving seat as to what happens. That is a fundamental shift from where we have been during the last 20 years. That will have unintended consequences—actually in a way that I cannot predict. I think that it will change the nature of supply as well, because at the moment supply is a combination of retail and risk management. Those are the two services that we provide. It becomes a pure retail business, because the state has taken on the risk management business, because the state is deciding the nature of the generation mix.

  I do not have confidence that the state will get that right. The state does not tend to. It has not got a good track record of making large, long-term procurement decisions and getting those judgments right. We still get it wrong, but on average we get it less wrong than the state does, because effectively you get the wisdom of crowds and you get individual diverse decision making.

  Q176  Sir Robert Smith: If you are going to have nuclear, the state is going to have make a decision. No one else is going to make it.

  Ian Marchant: But if your objective is to secure security supply and low carbon, if you price capacity and you price carbon, the market will decide what the right technology is. If that is nuclear, the market will deliver it.

  Sara Vaughan: It is still the investors who are bringing forward the projects. So, as an investor, we may be bringing forward an offshore wind project; we may be bringing forward a biomass project; or we may be bringing forward a nuclear project; and they will all be looking at the same market regime. So the state is not making that decision. The investor is making that decision, on the basis of their view of the market. Equally, we may be bringing forward a CCGT plant, depending on how attractive the market looks like for that technology at the time.

  Q177  Barry Gardiner: It does not affect your decisions at certain points—[Interruption.] To say the state is not taking that decision is a very bland way of describing what is going on.

  Sara Vaughan: Is that not the way that it is at the moment?

  Barry Gardiner: Yes.

  Sara Vaughan: So it is a continuation of the way—I can see that the state will have a larger role, but it is a continuation of the way it is at the moment.

  Q178  Barry Gardiner: Yes, but let us not paint two extremes here. The state is involved in this; it should be involved in this; and the incentives and market regulations that it sets inevitably structure the market in one way or another.

  Sara Vaughan: I would vehemently agree with you.

  Barry Gardiner: Good.

  Sarwjit Sambhi: On Ian's point about letting the market decide, I think that, with the current market, if we let the market decide, it goes to the lowest cost of generation, because we have a system that is based on marginal pricing. Where you have generation that has high fixed costs and therefore high average costs, like nuclear and wind, they will not get built if you just rely on BETTA to deliver it. In terms of the CfD and unintended consequences, it still has to function against a wholesale market, because the contract is set against a market index. So I understand Ian's concern, but some of it can be alleviated through how well you design the market index in the CfD.

  Also, when you project out and look at the amount of volume that will be covered by the CfD, it only becomes significant when you get into the back-end of the next decade. So are CfDs the right investment tool to get the things built to meet the objectives that we set out earlier—security of supply and lower-carbon renewables? I think they can, if designed correctly.

  Q179  Chair: Just to be clear about the way that the CfD prices are going to be certain, are you favouring auctions, as the Government seem to be?

  Sara Vaughan: No. When the EMR was launched, the Secretary of State said in terms that, if he was going to try to run an auction tomorrow, he would have a very small or indeed empty room in which to hold his auction. There are a number of problems with auctions, particularly when you're looking at these sorts of high capital technologies, because to even get a project to the point where you might enter it into an auction, you are talking about investing several hundreds of millions of pounds. Are people really going to do that against the possibility that their project will not be successful in an auction? The alternative is that you do an auction at a very early stage, and then you end up with a project that never gets consent and there isn't a viable project there, so they don't continue. We have had pretty poor experience in this country in the past of auctioning with the non-fossil fuel obligation auction system in the early 1990s, which brought forward loads of projects, but very few got built.

  Ian Marchant: The build rate was 25%. CfD without an auction is effectively a negotiated-behind-closed-doors process. You've got to convince the other party to sign the contract. You spend all your development money and if for whatever reason the other party doesn't want to sign the contract, you haven't got a project. As a developer, CfD means you've lost control of deciding whether to do that project or not. Today, I develop a wind farm. In other words, I decide to do it—it happens. Under a CfD, I do all that and then the energy agency is in purdah for an election period and can't sign a contract for six months, or it's changed its mind. It doesn't want to do a 300 MW contract. It wants to do a 600 MW contract and I have developed for a 300 MW project. The risk is that I've got a bureaucratic counterpart, and it will take me many years to learn how to predict how it will behave. Therefore, we will get a hiatus in development in the next few years. The organisation that doesn't exist today gets established, manned up and builds a track record. Of course, it slants to what comes forward, because if you ask for 300 MW of low-carbon energy, nuclear can't compete. If you ask for base load energy, wind won't compete. So how you go out procuring your CfD effectively decides what gets built.

  Sarwjit Sambhi: Economists would say that, theoretically, an auction is the perfect option. It works where the product is homogeneous, there are many sellers and the start-up costs are very low. In nuclear, and arguably in offshore wind, that is not the case. The start-up costs are quite high. You have to invest quite a lot of money before you've actually got a project. The sites are being developed at different rates. While theoretically plausible, in practice we find it very difficult to find a workable auction option. The possible exception might be on tendering for capacity.

  John Campbell: Take a nuclear site where the site has already been allocated to an organisation. Take offshore wind tranches as well. It is impossible to envisage how you can have price discovery through an auction process in those circumstances.

    Paul Spence: We echo that; in the real world, this is about negotiation, certainly at the early stage. I would just like to pick up some of the issues that Ian raises, and say that our view is that, yes, they are questions. The approach should be how we find a way to solve them to make sure that we have a credible process through that negotiation that allows investors to move ahead with the confidence that there is a body capable of doing that negotiation. That should be the next phase of the consultation. We should get on with making this work.

  John McElroy: I agree. There is overwhelming agreement on auctions, and I endorse the point that the devil is in the detail, so we need to get on with trying to sort it out and making it work.

  Chair: We are running out of time. Do any of my colleagues have any other questions?

  Dan Byles: Ian was absolutely right when he said that we would not get a single model answer.

  Q180  Sir Robert Smith: One very quick thing and on another matter that has a tight deadline: are we on track for the smart metering to actually be achieved?

  Ian Marchant: Our mantra is start well and finish early. It is right to get the central communications agents called the DCC, to use the technical jargon. That should be up and running as quick as possible. Once it is, our businesses are very good at mass deployment quickly. What we are less good at is fits and starts, so it is taking a little longer to get going, but we don't think that that is necessarily bad. We still think that we can finish by 2018.

  John Campbell: I agree that getting the DCC up and running and established, so we understand the protocol and don't have any issues of assets being stranded and also making sure that data security and information protection is a key part of the protocol are the key things to make it happen.

  Paul Spence: I absolutely agree with those points. While that is going on, the other thing is that we are all gearing up, getting ready and trying out different technologies. I know that we certainly are, and I watch what my competitors do.

  Sarwjit Sambhi: Getting the smart metering roll-out is key, but other things are important as well in terms of timing, such as green deal, and making sure that there are the right financial incentives to the technologies that we plan to put in homes.

  Chair: Thank you all very much.

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