Select Committee on Trade and Industry Appendices to the Minutes of Evidence


APPENDIX 16

Memorandum by John Mitchell

  Part of the material in this submission has also been submitted to the House of Lords Committee on Energy, Industry and Transport, Sub-Committee B.

  John Mitchell is Chairman and Associate Fellow of the Energy and Environment Programme of the Royal Institute of International Affairs, Adviser to the Oxford Institute of Energy Studies and Honorary Fellow of the Centre of Petroleum and Mineral Law and Policy of the University of Dundee. He worked for BP from 1966 to 1993, where his positions included Head of the Policy Analysis Staff and Special Adviser to the Managing Directors. He makes this submission in his personal capacity and not as representative of any organisation.

OVERVIEW

  1.  Energy supply for Europe and the United Kingdom within it will be best secured by continuing participation in the global system of energy trade and investment.

  2.  This approach has three major advantages over the 1970s approach, which focussed on national supply and demand, and regarded imports as a problem rather than an opportunity.

    —  It is realistic, and likely to be the cheapest policy in the long term;

    —  It enables importers to benefit from competition between diverse suppliers across the world, and exporters to have access to markets which combine size and diversity;

    —  It can be meshed with the foreign and trade policy of the UK as a member of the EU and the WTO.

  3.  However, the "system" is nether perfect nor complete. It is necessary to be prepared for circumstances when it temporarily fails to deliver the expected benefits of competitive prices and flexible supply.

  4.  The September 11 attack on the US does not alter the merits of this approach. There has been no change in the long run availability of fossil fuels, their environmental effects, or the structural factors which support the maintenance of competitive energy markets. It may be necessary to address the risk that some oil exporting countries may find their gradual assimilation to the international trade and investment system interrupted or reversed by domestic reactions to the "war against terrorism".

  5.  It is inappropriate to try today to determine the mix of fuels in the UK which would maximise energy security for the UK over a fifty-year period. The priority should be to develop a framework of policy to maintain a diversity of UK and foreign supply options. Policies affecting investment in the UK in vehicles, roads, buildings, power stations and energy use which affect primary energy demand are of equal importance and because of the long lead times involved should receive priority: it is easier to switch fuel supplies than to change modes of transport, types of power generators, or the location of factories and cities.

  6.  The essential elements of such policies are the promotion of competition, proper attribution of direct and "external" costs, and the use of private investment consistent with the general structure of the economy. To maximise the freedom of suppliers and consumers the greatest possible diversity is likely to be achieved by participation in, and development of a competitive and liberal system of international trade and investment, with appropriate fail-safe mechanisms.

  7.  "Fail-safe" mechanisms may include government intervention either nationally or at an EU or international level. Such intervention may be necessary to protect competition and provide opportunities for certain types of investment—for example in infrastructure, reserve capacity and long-term research—which might not otherwise arise in liberalised competitive markets. Government—central or local, is also responsible for investment which shapes its own demand for public sector activities, for regulations which shape energy demand though protecting the environment, allocating rights to the use of land, air or sea by consumers, enterprises, and subsidiary levels of government.

THE INEVITABILITY OF INTERNATIONAL ENERGY TRADE

  8.  International trade remains a major source of energy supplies in most major consuming countries (see chart 1). The classic advantages of trade apply to fuels produced from natural resources: the resources are where they are, and cannot be reproduced by the application of labour and capital anywhere else. For the export-dependent energy producers, likewise, the economic benefits of the world market are enormous. Chart 2 shows their dependence on exports for their energy markets. China and the UK are exceptional in their low energy trade.

  9.  Even if countries like the UK and China were to introduce policies to maintain a rough balance between physical imports and exports of energy fuels, or reduce imports to zero, world energy trade would continue. World prices for traded sources of energy such as oil, gas and coal would affect the "self-sufficient" countries. Isolation from such prices could not be achieved without constructing trade barriers, which would be incompatible with the UK's membership of the EU and the WTO and China's forthcoming membership of the WTO.

  10.  Energy exporting countries have a strong interest in maintaining and expanding international energy markets. Without energy exports they could not achieve the GDP, and their government could not achieve the budgets, which they have. This is especially true in the case of oil, where prices in the international market significantly exceed the average cost of production in the main exporting countries. International oil trade is equivalent to roughly 60 per cent of production and consumption. Oil exporters are dependent on the international market. Chart 3 shows that 70 per cent of the world's oil exports originate in countries each of which depends on the international market to buy 70 per cent or more of its production.

Fail-Safety Scenarios

SHORT-TERM (12-18 MONTH)—DISRUPTIONS OF OIL SUPPLY

Price spikes and dips

  11.  Oil supplies (from a major exporter to the international market) have been seriously cut back or stopped for a period of 3-18 months at times during the past 50 years because of political disruptions (Iran 1951 and 1979-80, Iraq and Kuwait 1990-91, Suez canal crisis 1956, Arab oil embargo 1973). Price spikes may be generated by local and temporary supply problems (as in North-East-US heating oil, or US West-coast gasoline, in 2000). Commercial factors can also cause price spikes. Commercial factors may also cause price collapses (as in 1985 and 1998), which are damaging to investment in future oil and other energy supplies. Fluctuations in the spot price of oil spill over onto domestic oil and gas prices and imported gas prices.

  12.  Financial pressures have tended to minimise commercial stocks (both in the distribution chain and at the point of use). When local and temporary shortages occur there is intense bidding for marginal supplies and these prices are rapidly transmitted to the international oil market.

  13.  The probability of such spikes is high.

  14.  The main impact of future price spikes would be economic. In an inflationary situation there could be a knock-on effect through the RPI. The spike in transport costs would affect certain sectors such as haulage and farming, as in summer 2000.

  15.  Since government revenues in European countries will be boosted through VAT revenues on higher prices, there would be scope for mitigating the inflation effect by temporarily lowering fuel duties.

  16.  There may also be scope for considering some insurance-type mechanism by which those directly and immediately affected could access the government-controlled compulsory oil stocks (see para 19 below).

Physical shortage

  17.  IEA sharing mechanisms, including the release of government controlled compulsory stocks, should make it possible to mitigate the effects of very large disruptions of oil supply.

  18.  The probability of such disruptions is low but not zero.

  19.  There is a higher probability that oil supplies, and prices, can be temporarily affected by smaller political disruptions, as in 1980, or local disruptions caused by protests (as in Europe in 2000), or strikes (as in the UK in 1974). Price spikes can also be caused by extreme weather conditions affecting demand or distribution, or disasters (such as a nuclear accident) affecting other energy supplies.

  20.  For the UK the main physical response at the level of local distribution is the national emergency planning put in place in 2000. The price problem cannot be solved in the UK alone.

  21.  The level of IEA and national compulsory oil stocks may be less important than the rules about when and how they should be used. IEA mechanisms are automatically triggered only when supply shortfalls exceed seven per cent, either for the whole IEA group, or for an individual country. This means in practice that the compulsory stocks can be used only in an international emergency and under conditions and in quantities determined by agreement between governments acting through the IEA. They do not provide insurance against smaller disruptions which may nevertheless have significant effects on spot oil prices and all that depends on them.

  22.  There are many dangers in governments trying to target stock releases directly against prices. They become politically responsible for the prices. Their actions may be ineffective. Speculators will bet against the Government. However, there may be an alternative. Some of the compulsory stocks could be made available to distributors or large consumers under defined conditions of specific disruption. This possibility would reduce their uncertainties about future supply, and lessen the likelihood of their resorting to the spot market, while leaving the decisions of whether to call on the insurance or use the stocks as an individual commercial matter. A scheme of this kind was put to the IEA in the early 1980s. The idea should be re-examined.

Embargoes of supply

  23.  Unless very widely targeted and widely observed embargoes by oil exporting countries (as in 1973) will simply bring about reallocation of supplies in the international market. If widely targeted, the problem becomes a major political problem on the Gulf War model.

  24.  Distortion of international trade could also occur through a UN or US embargo against supplies from selected exporting countries or against foreign investment of funds or technology in their oil industries (UN sanctions on Iraq, US sanctions on Iran, Sudan, Burma, Libya). On the historic record, the probability of UN or US embargoes against exporters is higher than of exporters' embargoes against importers, which last occurred in 1973. The UK would be involved in the international political situation created by such embargoes even if the UK were not an importer.

  25.  The remedy is to focus on the political situations likely to give rise to embargoes.

MEDIUM TERM (3-5 YEARS)—OIL CARTEL ISSUES

  26.  The international trading and investment system will not guarantee stable oil prices over the medium term: investment cycles are inevitable.

  27.  The risk is that import prices could be distorted by collusion among major exporters.

  28.  Some degree of collusion can be expected to protect a floor price (as in 1999-2000). For the future, the scope for managing permanently higher prices by collusion among exporters is limited by the possibilities of international competition and demand response in liberalised domestic energy markets. Also, the uneven distribution of resources among exporters means that they have different interests in expanding supply and are likely to find it difficult to restrain expansion and competition between them. For a cartel to work it needs rules for sharing markets. In crises of over-supply and very low prices (1985-86, 1998-99) OPEC members have eventually cut production more or less in line with pre-crisis production. They have no precedent for allocating the expansion of production which is currently predicted for the period 2005 onwards. Different countries have different potential for expansion, and their oil reserves are not distributed according to their populations and needs for revenue, as Chart 4 shows. Competition is inevitable. Regional and national rivalries will also support such competition. [35]The probability of raising prices by sustained collusion is therefore low.

  29.  The (small) risks of successful medium-term collusion may be countered by enlarging the international market with policies to promote trade and investment. This involves understanding the energy exporters' problems, arising from insecurity of markets, and their need for broadly based development. A dialogue with energy exporters is more likely to be successful if it focuses on a common recognition of the benefits of continuing energy trade than if importing countries enter the dialogue with the objective of reducing their "import dependence".

LONG TERM (10-15 YEARS)—RESOURCE SHOCK

  30.  The risk is "short-termism". Oil and gas production capacity might "plateau" before sufficient investment has been made in long term projects for heavy oil, gas infrastructure, alternative energies, or less intensive energy demand. There would then be a prolonged period of high-energy prices which will cause avoidable economic damage before creating a surplus of new capacity—a prolonged and exaggerated version of a commodity investment cycle.

  31.  Probability is uncertain.

  32.  The policy debate is about the cost of anticipating a problem which might not occur versus the cost of catching up if everybody waits for trouble to happen. One of the main themes of The New Economy of Oil is that there are many options for "catching up" which would be economic if oil prices rise significantly above their 1986-99 average of about $20-22 in today's money. The small role of oil in the main importing economies now means that they could stand a period of prices above that range during the lead-time of new investments to correct the imbalance. The alternative, expensive anticipation, would be very difficult: it would require heavy government intervention, and the more successful it was, the more expensive it would appear, as the short term oil price against which the policy is measured would be lower.

LONG TERM (10-20 YEARS)—CLIMATE SHOCK

  33.  This scenario is one where damaging effects of climate change become politically credible in many countries and there is a rush to impose climate protection policies to make up for lost time. Demand restrictions policies would thus be severe, and based on "command and control" (rather than economic instruments) to achieve early, certain results.

  34.  Oil and energy prices would probably fall (from what they otherwise would be) in response to the demand measures. This in turn would create a need for even stronger intervention in demand. To the extent that taxes were used to reinforce demand restraints, there would be political challenges in recycling government revenue: hypothecation of money towards investment in demand reduction and alternate energies would be likely. If there is no co-ordination at least across the EU, broader trade and investment flows and open markets might be compromised.

  35.  This scenario thus presents a political and institutional threat to the multilateral and European open economic systems as well as a threat of economic damage through the "stranding" of old energy consuming technology and infrastructure, and a medium term welfare damage in diverting resources from consumption to new investment.

  36.  Probability—increasing with failure to develop real global climate protection policies.

  37.  The policy challenge from this scenario is like that of the "resource shock": anticipation versus "wait and see".

  38.  "Keeping options open" remedies would be:

    —  Avoiding early closedown of nuclear plants and recognising the climate benefits in proposals for new nuclear plants in the UK and elsewhere;

    —  To make early progress with globally acceptable climate protection policies;

    —  To construct mechanisms for establishing options (learning-by-doing, pilot schemes) and market oriented mechanisms for enabling the application of low energy technologies;

    —  For public authorities to take a lead in their unprivatisable responsibilities for transport systems: making the conditions for investment in infrastructure and in allocating space with a long term lower energy system in view.

POSSIBLE CONSEQUENCES OF SEPTEMBER 11 ATTACK ON US AND THE "WAR AGAINST TERRORISM"

  39.  In the short term the US and UK attacks against Afghanistan are unlikely to affect oil supplies. The main effect will be on demand through the effect of uncertainty on consumer spending and investment in many countries. This should lead to lower prices in the short term as OPEC governments are likely to delay cuts in production rather than being seen to add to the recession by trying to keep prices high.

  40.  In the medium term (up to five years from now) the main risk is in those oil exporting countries, which are exposed to internal conflicts about their government's relations with the US alliance against terrorism. In my book The New Geopolitics of Energy[36] I argued that the Middle East oil exporting states' relations with the rest of the world depend on the domestic equilibria between various conflicting forces: social (religious versus secular); constitutional (democratic versus monarchical); and relations with modern industrial countries (co-operation versus distancing). The US attacks on Afghanistan in response to the terrorist attacks on the US clearly add to these tensions. They also focus other hostility towards the US—notably regarding its support for Israel at the time when the "Peace process" has ceased and Palestinians are under continuous attack from superior Israeli forces.

  41.  Saudi Arabia has been uniquely successful in maintaining these internal and external balances. As a result Saudi Arabia has been able to get the western technology and investment that it wanted on its own terms. The Saudi ability to rebalance and continue balancing these domestic tensions is important. Saudi Arabia supplied 12 per cent of world oil production in 2000, but about 20 per cent of world exports. The existing spare production capacity in Saudi Arabia is a buffer against unexpected reductions in supply from other countries. Saudi Arabia's reserves account for over a quarter of the expansion of world oil supply foreseen by conventional projections over the next 20 years.

  42.  The international system of energy trade and investment which is the basis of global energy security is founded on co-operation between secular and democratic states with market economies, where the rule of law protects these characteristics. The extent to which the Middle Eastern oil exporting countries continue to increase their participation in this system will have a big effect on what the system can deliver and what needs to be done to strengthen it.

CONCLUSION

  43.  The international trade and financial markets will continue to provide the cheapest security of energy supply for the UK and Europe, but the short and medium term risks have increased. Consumers have to be prepared to deal with them without attempting the futile task of breaking up the international energy system. So, just as we have to get smarter about preventing terrorism, we have to get smarter about minimising market destabilisation in the future.

  44.  What to do? I believe the keys are:

    —  Reinforce the international energy trading and investment system: attack the obstacles (lack of open markets, problems of infrastructure investment);

    —  Strengthen the old safeguards—stocks, and infrastructure for diversification—through interventions which preserve competition and international access; the idea of allowing individual access to national compulsory stocks as an insurance against local or temporary disruptions should be examined;

    —  Review the determinants of long lead-time demand: especially in the transport and buildings: The EU Green Paper on Energy Supply Security suggests approaches to this problem;

    —  Attend to foreign policy, which now is critical to energy security for importers as well as exporters.

THE COMMITTEE'S QUESTIONS

  In the light of this analysis, my views of the questions set out in Press Notice 3 of 20 September are as follows:

Given the imminent dependence of the UK on energy imports, how can the UK maintain a secure energy supply? What mix of fuels would maximise security?

  45.  Security is relative. Reverting to the pre-1975 use of imports is still likely to leave the UK relatively less engaged in international energy trade and therefore less exposed to its risks.

Is there a conflict between achieving security of supply and environmental policy? What is the role for renewables, and Combined Heat and Power schemes?

  46.  Certain environmental policies—for example the reduction of greenhouse gas emissions—are likely to reduce the use of high-carbon fuels such as coal (whether domestic or imported). This would reduce the potential diversity of energy supply. On the other hand, carbon-targeted policies would increase the relative attractiveness of nuclear energy and the potential market for renewables. The merits of combined heat and power schemes are heavily dependent on the nature of the electricity supply system and its capacity to provide secure and competitively priced supplies from decentralised sources dependent either on the weather, on agricultural results, or on heat-using demand. The key is reasonable and consistent pricing of "externalities" such as carbon, the costs of decentralised versus central electricity generating systems, and the management of weather-dependent supplies.

What scope is there for further energy conservation?

  47.  There is always scope for further energy conservation: the question is at what cost. The EU Green Paper on Security of Energy Supply and its related initiatives on building and transport could have a long-term effect on the energy intensity of the European economy, if applied in the UK.

What impact would any changes have on industrial competitiveness and on efforts to tackle fuel poverty?

  48.  The impact on competitiveness depends on the changes. Policies aimed at exploiting the benefits of international energy trade and investment should minimise the risk of disadvantage.

  49.  Fuel poverty is a different problem: addressing the poor insulation and ventilation standard of the UK building stock—if necessary by direct subsidies or by tax incentives for redevelopment—will help the "fuel poor". The problem of the "transport poor" is more difficult, since UK fuel taxes—probably beyond the level justified by externalities, bear heavily on poor users of vehicles.

Is any change of Government policy necessary? How could/should Government influence commercial decisions in order to achieve a secure and diverse supply of energy?

  50.  My key recommendation is to focus on making the international energy trade and investment system work better rather than to try to reduce the UK participation in it.

  Necessarily this involves seeking a similar policy in the EU on the matters within EU competence.

  Specifically, I suggest consideration of the following:

    —  (para 12) Price spikes: Mitigating the inflationary effect of temporary price spikes in transport fuels by recycling the higher VAT revenues which they generate through reductions in motor fuel duties.

    —  (para 19) Local disruptions: Study possibility of using part of compulsory stocks to provide insurance of supplies for those specifically affected.

    —  (para 22) Embargoes: Focus on political remedies for situations likely to give rise to embargoes against exporters.

    —  (para 26) Cartel risk: Enlarge the international energy trade and investment system to engage countries with exportable cheap energy to engage more closely in it. This means abandoning the objective of "reducing import dependence" in favour of a policy of stabilising inter-dependence. Open, liberal energy markets facilitate the diversification of competing supplies and markets.

    —  Resource shock (para 29) and climate shock (para 35). The key is to keep options open: The EU Green paper recommends an approach to long lead-time demand in transport and buildings. This should be supported and made operational in ways consistent with competitive markets and consumer choice. On the supply side the main risk is the failure to provide policies which could in future support maintaining and possibly increasing the use of nuclear energy in Europe if a rapid reduction in carbon emissions is decided upon.

29 October 2001






35   This case is argued in detail in The New Economy of Oil, John V Mitchell and others, RIIA/Earthscan 2001, p 155-162. Back

36   with Peter Beck and Michael Grubb, RIIA/Earthscan, 1996. Back


 
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