Select Committee on Trade and Industry Minutes of Evidence

Memorandum by Ofgem


  1.  Ofgem welcomes the opportunity to contribute to the Committee's inquiry into energy policy and security of supply. On 29 October Ofgem published a detailed two-volume submission to the Performance and Innovation Unit in connection with their current energy policy review[1]. This sets out Ofgem's views on the bulk of the issues raised by the Committee. The purpose of this brief memorandum is to response to the five issues raised by the Committee in their press notice of 20 September, principally by cross-referencing to Ofgem's submission to the PIU.


  2.  The pro-competitive energy regulatory framework put in place by Parliament, and administered by Ofgem, combined with changing market conditions, has resulted in more competitive prices for all consumers and has led to Great Britain presently enjoying an unprecedented level of energy diversity and security of supply. Investment in new generation and gas production has been significant: the current generating margin over average demand is over 30 per cent. This has happened at a time of very rapid growth in the demand for and supply of gas. Investment in the gas and electricity networks has been high: over £31 billion has been invested since privatisation.

  3.  Ofgem's view of what security and diversity of supply should comprise is set out in paragraphs 3.7 to 3.11 of volume two of our PIU submission. This describes four components of security of supply: sufficient supply, sufficient transmission capacity, competition in supply and effective short-term operation of energy markets. Ofgem's PIU submission explains in detail why Ofgem believes that diversity and security of supply can best be achieved through competitive markets, and how effective regulation can ensure diversity and security of supply where the ability to introduce competition is limited.

  4.  Ofgem suggests that the present arrangements need to be improved in two important respects:

    —  traditional RPI-x regulation of the natural monopolies (including gas transportation and electricity transmission networks) concentrated on lowering costs through a revenue cap, without defining the outputs of the business. There is a need to define outputs better, and in particular to ensure that there are incentives for timely and adequate investment in the networks, against demand which is unpredictable. Ofgem is therefore working on a range of improvements to the price controls, to improve the signals of the need for investment and to improve the incentives to invest.

    —  the increasing interaction between gas and electricity supplies requires new approaches to a range of investment and operational arrangements for balancing the networks. Ofgem is therefore working on a range of measures to improve these arrangements.

  5.  There remain other threats which, unless addressed, will make it more difficult for competitive markets to deliver secure supply. These need to be addressed by Government. They are:

    (i)  planing procedures: planning processes can prolong the period between market signals clearly indicating the need for new investment and the time of the investment becoming productive. This is a particular problem for gas storage and for electricity and gas transmission;

    (ii)  European liberalisation: ensure sensible rules governing the transport of gas and electricity within and between Member States is important if Britain is to benefit from access to a wider energy market. Although Ofgem can and does assist in developing these rules, the primary responsibility lies elsewhere in Government;

    (iii)  abuse of market power: a feature of electricity trading is the ability of companies to exercise very short-term market power to the harm of an efficient competitive market. The DTI has consulted on proposed action against such abuse. Ofgem believes action to counter abuse, which is generally reckoned to have contributed to the Californian energy crisis, is justified and needed.

  6.  A number of issues have been raised about the ability of the current regime, developed as described in the previous two paragraphs, to continue to deliver security of supply. These are discussed in chapter five of volume 1 of Ofgem's PIU submission. This chapter explains that it is not possible with any certainty to forecast the extent to which Great Britain may become more dependent on has in the future, although such greater reliance may occur. Recent higher gas prices have led to the demand for gas to slow. In the generation market under NETA, changes in relative prices have seen coal-fired stations increasing their market share and mothballed coal stations are beginning to be brought back into service as gas plants are mothballed. Gas producers are responding to the new price signals with higher prices stimulating further investment in new UKCS production. In total, companies have announced plans to invest over £5.5 billion over the last two years in new UKCS exploration and production.

  7.  These responses to recent price signals call into question the extent to which Great Britain will actually become heavily reliant on gas imports in the near future. The DTI's estimate of potential undiscovered reserves in the UKCS range from 450 bcm to 1,400 bcm. Even if we do start to import in greater quantities, overall security of supply may be enhanced rather than reduced. Connection to European gas networks and use of the increasing global LNG market could make Great Britain more secure and diverse, not less.


  8.  The substantial contribution which pro-competitive regulation and effective regulation of gas and electricity networks can make not only by best safeguarding security of supply but also by saving resources and thereby protecting the environment is set out in chapter 6 of Volume 1 of Ofgem's PIU submission.

  9.  Examples of competition protecting the environment include the incentives created to make generating capacity more efficient, and the greater opportunities for electricity demand side management created by the New Electricity Trading Arrangements (NETA). In terms of the effective regulation of networks, Ofgem's current work on capacity prices to signal where transmission investment is and is not needed, on more cost reflective pricing for electricity transmission losses to encourage better use of existing power stations and the location of new plant closer to demand, and to ensure a fair and transparent regime for embedded generation will all have a positive environmental input.

  10.  Overall then, effective competition and economic regulation save resources, have favourable environmental effects and lower prices to consumers. Conversely, lack of competition and inefficient regulation waste resources, increase environmental impacts and raise prices unnecessarily. But difficulties can arise when environmental costs (such as air pollution) are not reflected in the costs incurred by producers, transporters and suppliers, or in the prices paid by consumers. Then lower prices that reflect efficient production but fail to reflect environmental costs can increase demand and encourage greater use of environmental resources. In these circumstances the introduction of environmental policy instruments to ensure environmental resources are properly priced is the appropriate way forward. Indeed lower prices from greater efficiency can enable environmental costs to be incorporated into prices without causing unduly high price increases, which can cause difficulties for consumers. The best way to meet environmental targets is through the use of market mechanisms and tradable permits. These provide the most efficient way of meeting defined levels of environmental improvement, and ensure environmental regulation does not undermine competition (and thus avoids detriment to customers) or security of supply (poorly designed environmental controls prevented generators producing in California).

  11.  The draft Ministerial guidance to Ofgem on social and environmental issues makes clear that "where the Government wishes to implement social or environmental measures which would have significant financial implications ..... these will be implemented by specific legal provision". Therefore the extent to which it might be desirable to invest in renewables or CHP to a greater extent than commercial decisions under a competitive framework would allow becomes a matter for Ministers. Ofgem has a major role in assisting Ministerial decisions in this area through its responsibilities for administering the Renewables Obligation, the renewables exemption to the Climate Change Levy and the Non Fossil Fuel Obligation. The analytical basis for Ministers taking such decisions on supporting renewables and CHP is discussed further in paragraph 15 below. The impact on NETA on renewables and CHP has been widely discussed. Ofgem set out its analysis of this in its review of the impact of the first two months on NETA on smaller generators (published on 31 August). The DTI published a consultation document on 1 November in response.


  12.  There clearly remains substantial scope in this country for the adoption of further cost effective energy efficiency measures. Ofgem seeks to make its specific contribution in the context of its statutory duties. Amongst the examples given in paragraph 8 where Ofgem's work has directly promoted greater energy efficiency, the fact that average electricity generation system efficiency has increased by over 14 per cent since privatisation, and that Ofgem's work on more cost-reflective transmission pricing and better locational pricing will contribute to reducing the 9 per cent of electricity lost in transmission and distribution, stand out.

  13.  The relative unwillingness of domestic and larger consumers to make investments in energy efficiency measures is well documented. DEFRA have the responsibility for leading on the Government's involvement in this area. Ofgem has a major role to play in administering the new Energy Efficiency Commitment set by DEFRA from next April, which is due to triple the size of Ofgem's current Energy Efficiency Standards on Performance programme.


  14.  Given the responses to previous questions, namely that Ofgem believes that diversity and security of supply can best be achieved through competitive markets and effective regulation, if this approach continues to be followed there will be no particular concerns as a result for industrial competitiveness or in relation to fuel poverty.

  15.  Previous responses have already explained that in many circumstances this approach also produces environmental benefits. There are however policies which the Government may choose to adopt which would require industrial competitiveness and the fuel poor to be considered carefully. Because of this, Ofgem has urged the PIU to develop a stronger analytical framework to assist the Government in evaluating the relative economic consequences of differing ways of meeting environmental objectives. For example, the use of tradable emission permits in relation to carbon emissions, sulphur dioxide and NOx could be an efficient method of incorporating environmental costs into gas and electricity production in a way which is compatible with competition. The danger for Government in developing methods of support for particular technologies in relation to environmental improvements is that such methods may turn out to be much more expensive for consumers in terms of providing a given level of environmental improvement than more market based instruments.

  16.  This will be particularly relevant for the Government when formulating its response to the report last year of the Royal Commission on Environmental Pollution. In any event, since the UK is only responsible for a tiny proportion of the world's emissions, it seems highly desirable for the UK's involvement in environmental initiatives to be coherent with comprehensive international action, given considerations of industrial competitiveness and fuel poverty.

  17.  Ofgem has particular social responsibilities which it has taken forward very seriously as part of the Ministerial Task Force on Fuel Poverty and by developing Ofgem's own Social Action Plan published in March 2000. The first annual review of that Plan, published this March, sets out our current programme of specific measures to protect vulnerable consumers.


  18.  Chapter 2 of Volume 2 of Ofgem's PIU submission sets out the range of responsibilities which Ofgem and others parts of Government have in relation to security of supply. Ofgem takes its responsibilities in this area very seriously, and for this reason agreed with the DTI in July that a joint committee should be established to monitor this country's energy security of supply position carefully.

  19.  Chapter 3 of Volume 2 of Ofgem's submission contrasts the benefits of relying on competition and effective regulation—properly monitored—to safeguard security of supply by comparison with an approach of planning or Government direction. Paragraph 3.33 of that volume notes that the tendency for centralised decision making to produce less diversity than competitive markets is shown by historical experience. Centrally managed electricity systems, for example, have in the past often placed very heavy reliance on particular generation technologies, such as coal in Great Britain and nuclear in France. Reliance on one or few technologies can lessen security of supply (a single problem runs greater risk of serious supply difficulties). In both Brazil and California this has contributed to insecure supply.

  20.  One of the essential prerequisites for ensuring the effective functioning of the incentive mechanism provided by competitive markets is that regulators and governments do not seek to control price in periods of genuine supply shocks. The ability to command high prices following supply and demand shocks provides the incentive for companies to invest and maintain production capacity that only operates at times of supply and demand constraints. The risks associated with high prices during periods of peak demand or in response to a supply shock provide the incentives for suppliers and customers to contract ahead with producers to hedge these risks. Any government attempt, however well intentioned, to dampen these price effects runs the risk of undermining the incentives and signals that competition creates and which ensure security of supply.

  21.  A review of previous exercises in scenario construction under a more centrally planned era shows how difficult it is to plan for the future. Annex 2 of Volume 2 of Ofgem's PIU submission reviews the forecasts made at the time of the Sizewell B and Hinckley enquiries. The prevailing conditions at the time of making forecasts are a strong influence on projections of the future. In energy related forecasting, it is very hard to anticipate changes in fuel supply, demand and prices or to predict technological progress and developments in infrastructure. All of these factors are capable of significant change even in the short term. Even small errors in the assumptions underlying such forecasts can lead to large errors in forecasting future trends and their implications. More importantly, such changes can have profound impacts on future movements in price, demand and supply in the longer term.

8 November 2001

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