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


APPENDIX 23

Memorandum by Innogy

  Innogy is a leading integrated UK energy company. We generate electricity and supply gas, electricity and other essential borne services through our retail business npower. We operate and manage our flexible portfolio of power stations, run our own trading business and are developing innovative energy-related technologies. We are also the market leaders in renewable energy production. We welcome the opportunity to contribute to the Committee's inquiry.

1.  OVERVIEW

  Security of supply in the provision of energy to end-users is a complex issue. As with the supply of any product or commodity there is a supply chain and, in the case of energy, a significant and diverse one.

  Security of supply to the end user is, therefore, dependent on the security of each link in the chain, the interactions between links and the process for providing and delivering contingency in the event of failure.

  There are numerous variables impacting each link in the supply chain, which itself will have different components depending on inputs and the type of energy being delivered. For example, coal can come from the UK or be imported, it has different storage characteristics to gas and UK continental shelf (UKCS) gas has a different delivery route to imported gas. Similarly, different generating technologies have different reliability characteristics and flexibility of response characteristics. Transporting gas (underground pipeline) carries different risks to transporting electricity (overland or underground wires).

  The permutations on the physical side of the supply chain are myriad. In addition the financial elements in the chain need to operate smoothly, openly and without distortion to encourage efficiency in extraction, generation and delivery of energy. Investment in new physical assets will be driven by appropriate market signals. It is important, therefore, that market signals are not suppressed, as was the case in California (see Section 6.2).

  To illustrate the complexity of the supply chain, the diagram below shows how natural resources are extracted, converted and transported to deliver usable energy to consumers using, as an example, electricity delivered through gas-fired generation.


  In summary, the issue of security of supply cannot be broken down into discrete questions such as, will there be enough fuel, what should the fuel mix be, is the infrastructure adequate, is there sufficient capacity, etc? All of these issues are important in their own right but only when considered together can a realistic picture of the risks to secure energy delivery be fully appreciated. Secure energy delivery depends on the efficient interaction of the physical and financial aspects of energy production, energy conversion, delivery and consumption.

  The remainder of this document outlines Innogy's view on aspects relevant to deliberations on the security of supply question.

  Detailed comments on security issues have been set out in sections corresponding with specific questions raised by the inquiry. The responses, however, should not be considered in isolation, as the issues raised are inter-related and need to be considered in the round.

COMMITTEE QUESTION

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?

  The key factors affecting security of supply are fuel diversity, security and longevity of fuel supplies, delivery to consumers and generation capacity. In any supply chain, the ability to store raw materials (fuel) and product (electricity) is a key factor in protecting against interruptions further up that chain.

2.1  Fuel Diversity

  Fuel diversity is merely a means to an end in respect of security of supply. It is not an end in itself but contributes to secure supply by (a) mitigating against over reliance and (b) contributing to flexibility of response.

(a)  Mitigating against over reliance

  Over reliance on any single fuel type carries with it significant risk of system failure. At present, and for the foreseeable future, the majority of generation relies on the burning of fossil fuels. Much of this fuel, be it gas, oil or coal is imported and whilst indigenous reserves exist, in the case of oil and gas in particular, reserves are anticipated to diminish to the point where the UK is a consistent net importer in the near or medium term. In addition, the transmission mechanism for oil and gas can be interrupted and it is both difficult and expensive to carry large stocks of oil and gas.

  The emergence of renewables as a significant contributor to meeting future energy demand will help diversity.

(b)  Contributing to flexibility of response

  The other key factor in the choice of generation plant is its ability to meet the variable demand for electricity. In assessing this, it is not just the inherent abilities of the plant that matter, but also the ability of the fuel delivery system and the electricity transmission system. Nuclear plant has poor system response characteristics. Gas-fired CCGTs can be responsive but there are real concerns as to the capability of the gas National Transmission System to cope. Coal plant is responsive and has stored fuel. Most forms of renewable generation generate intermittently due to the nature of the "fuel" source.

  The concept of maximising security of supply would, inevitably, lead to conflict with other policy objectives. Maximising security of supply would create inefficiencies through requiring excessive capacity throughout the supply chain, leading to high prices and potential unnecessary environmental impairment.

2.2  The Role of Gas-Fired Generation

  We recognise the Government's concerns about a further expansion of gas-fired generation. Whilst we believe that UK gas resources are likely to prove to be greater than some current estimates, there is a legitimate concern about becoming over-dependent on a single fuel type.

  Gas burned in CCGTs provides medium-carbon generation and it is arguable whether the CO2 benefits of further CCGTs outweigh the security of supply concerns. As a major domestic gas supplier, we are also concerned that increased gas demand for generation will push up prices.

  The arguments for further gas-fired CHP/cogeneration are stronger. This high efficiency use of gas has greater CO2 benefits and will help reduce the costs of other industries meeting environmental targets. The Government has already recognised the important contribution that CHP/cogeneration could make and set out ambitious targets for this sector. The combination of high gas prices and low electricity prices, together with structural issues with NETA, CCL and Renewables Obligation, mean that these targets are unlikely to be met without positive action.

2.3  The Role of Coal-Fired Generation

  Innogy believes that coal has a significant role to play in the long-term energy profile of the UK. It retains several specific advantages:

    —  Coal reserves will outlast those of gas and oil;

    —  International coal is available from many diverse countries;

    —  On site storage is easier than other fossil fuels;

    —  Diverse delivery options (rail, road, ship) reduces the risk of interruption;

    —  Flexibility.

  Coal-fired power stations make by far the greatest contribution to the security of electricity production. They can operate very flexibly and so mitigate short-term problems with other generating plant or the transmission system. They can also switch to running at high load factors for a sustained period to cover long-term problems. The under-utilised oil plant provided such a role during the coal strikes. Without them, there would have been substantial power cuts.

  Ever-tightening environmental limits (particularly SOx and NOx) will rapidly reduce the amount of generation from coal-fired stations over the next five years and could lead to the closure of a substantial proportion of those stations by 2010. Under normal generating conditions the energy production from these plant will be picked up by other stations, including new renewable generation. The contribution to security of supply is not currently rewarded in the market and so plant will close because its fixed costs cannot be met when operating at low load factors. We have suggested in Section 6 how this might be addressed.

2.4  The Role of Nuclear Power

  We recognise the valuable contribution that nuclear generation makes in reducing CO2 emissions. However, its long-term effects and irreversible impact mean that it cannot yet be considered as a sustainable technology. We believe that new nuclear build is a potential option for the future and should compete alongside other low-carbon options. It has been argued that nuclear is disadvantaged as it fully internalises all external impacts. Whilst there may be some substance in this argument relative to fossil-fired plant, it is not true in the low-carbon sector. The impact of routine radioactive emissions is not fully internalised nor is the potential impact of emergency events fully insured by the industry.

  There have been calls for early decisions on the likely role of nuclear power in the generation mix beyond the expected lifetime of existing plant. This has mainly been fuelled by the stated long lead-time for nuclear build, which is currently around 10 to 12 years.

  In reality, there is no requirement for a rushed decision on the future of nuclear and any consequent build programmes. The main reasons are:

    —  The frequently quoted lifespan of existing AGR nuclear plant, ie decommissioning mainly between 2010 and 2020, is based on the accounting lifetime of the plant not its technical lifespan, which can be extended beyond this timeframe;

    —  Ordinarily, it is more cost effective, quicker and lower risk to refurbish old plant than to incur the full costs of new build. If a policy of refurbishment is followed, a decision on new build need not be taken at this time;

    —  The Government review into nuclear waste policy has not yet been completed;

    —  UK design and build standards differ from those in other countries. This leads to increased costs when developing designs for international markets. Standards should be harmonised internationally.

  In summary, we believe that new nuclear build should be permitted to compete as a low-carbon technology. However, the high cost of nuclear, together with its long lead-time and future liabilities, mean that it is unlikely to be competitive in the short to medium term. In the longer term, new designs may make it commercially viable.

  Nuclear power plants are inflexible in their operation and run at high load factor. There is no scope to increase output to cover unforeseen events. Whilst new nuclear plant would contribute to long-term fuel diversity, it is potentially a very expensive way to improve overall security.

2.5  The Role of Renewables

  Renewable technologies can and should play a significant role in the future fuel mix of the UK energy sector.

  The Committee has asked a specific question on the role of renewables and, accordingly, Innogy's comments on this important issue are included in that section. Readers are therefore referred to Section 3 for detailed comment on renewables.

2.6  Projected Future Fuel Mix

  Throughout the 1990s gas-fired CCGTs made a substantial contribution to achieving reductions in environmental emissions. The major shift towards this medium-carbon generation source has been the key factor in enabling the UK to meet its international obligations. At the same time it has increased fuel source diversity and helped reduce prices to all customer groups.

  Whilst it is tempting to assume that a "more of the same" approach will deliver further benefits, we share the Government's concerns about becoming over-reliant on a single and imported fuel type. Furthermore, we believe that substantial further reductions in CO2 will only be achieved by moving the focus from medium-carbon gas to low- or zero-carbon generation sources.

  By introducing the Renewables Obligation on suppliers, the Government has recognised that low-carbon generation is not currently economically viable against fossil-fired plant. The market would not, therefore, deliver a low-carbon future. The Renewables Obligation has the effect of creating a low-carbon market alongside the existing market. We fully support this approach as it enables the market to deliver the optimum solution within a framework that will ensure overall objectives are met.

  Whilst it is useful to look to 2050 as over that timeframe the whole infrastructure will have been renewed, it is futile to speculate as to the precise plant mix in 50 years' time. An attempt to predetermine a technology mix will be economically inefficient, resulting in higher prices and potentially lower supply security.

  Having created a separate low-carbon market sector through the Renewables Obligation, technologies should compete freely to supply the needs of that sector. Whilst we will not speculate as to the low-carbon technology of choice in 50 years' time, we do have views on how the low-carbon market is likely to develop over the next 20 years. We also have views on the continuing role of fossil-fired plant over that period.

  Competitive forces will determine the optimal plant mix within the framework set by Government. However, we have set out in the table below our view of the split of generation by fuel source in 2010 and 2020:

Electricity Generation by Fuel Type (Based on CH case in Energy Paper 68 adjusted for steady renewables build and AGR life extension)
Market Share (%) 20002010 2020
Coal  30  22   13
Oil    1    0     0
Gas  38  45   43
Nuclear  23  22   18
Renewables    3     9  24
Imports    5  2     2
Total100100 100


2.7  Security and Longevity of Fuel Supplies

  In this section we consider fuel supply, to include availability of fuels and the delivery of it to UK generating facilities or, in the case of gas, to the beach.

  The key aspects of security of fuel supply are that of interruptibility/continuity of supply, generation reliability, storage and import dependency.

  Different fuels have different risks attached to their use in these respects. For example, wind energy has strong continuity of supply (it being impossible to interrupt its delivery) and zero import dependency but lower generation reliability (a minimum wind speed being required), whereas nuclear has strong generation reliability and coal has easy storage capability with strong UK reserves and diverse international sourcing.

  Obviously, these aspects will change over time, for example tidal wave energy is likely to see a growth in generation reliability as its technology develops and the import dependency of gas and oil will change as domestic reserves diminish.

  For illustration, the table below sets out various merits of different fuel types with indications, where appropriate, of how these may change in time.
FuelReliability SecurityCO2 Other Environmental Considerations[45] EconomicsPublic Acceptability
GasGMGG
OilGPMP M
CoalGG PMM › G
NuclearGG GPP › P
WindPG GGM › M ›
HydroGG GMMM
TidalGG GPPP
WasteGG PPMP


Key:
GoodG
MediumM
PoorP
Improve over time
œDecline over time


  Clearly, the reliability and security ratings would reduce as the quantity being relied upon increases and the consequences of an interruption therefore increase.

2.8  Delivery of Energy to Users

  In this section we consider delivery of energy to end users being, in the case of gas the UK distribution network, and in the case of electricity the national network and local distribution networks.

  The two key aspects of the secure delivery of energy to users are:

    (a)  The capacity and integrity of the distribution networks; and

    (b)  Having sufficient resources upstream to meet demand.

(a)   The capacity, integrity and efficiency of the distribution networks

ELECTRICITY

  There are both physical and financial aspects to the integrity and efficiency of the transmission and distribution networks which, for historic reasons, operate with different characteristics. The transmission system, operated by the National Grid Company (NGC), links power stations through a network to distribution hubs. Power can flow along the wires in either direction so that it can be supplied, if needs be, over large distances with geographically diverse generation supporting the integrity of the network. From the distribution hubs power flows in only one direction—from the hub to end-users. This distinction has particular relevance if the future electricity system is to shift from this distributed generation model to one with significant amounts of embedded generation. Because of the different natures of the transmission and distribution networks we have addressed them separately below.


ELECTRICITY TRANSMISSION

  Standards for Transmission Security are enshrined in a single document[46] and are built around the concept of guarding against a single large loss of capacity. The physical standards already set should be maintained but should also be subject to an economic test. For example, if the cost of holding reserve is low then it may be economic to hold a higher level of generating reserve on the system and permit a larger loss as a result of a transmission failure.

  To enable this economic efficiency it is necessary to encourage a market in reserve running alongside the conventional electricity market. The current monopoly position of NGC in purchasing reserve makes it difficult to ensure that the system is being configured economically. The provision of the frequency response service under extremes of systems conditions would be more reliable, and thus the transmission system more secure, if a market approach were introduced.

  Operation of the core transmission system is a monopoly activity, however we believe competition at the fringes should be encouraged to increase economic efficiency and contribute to security of supply.

  Similarly, transmission security will be enhanced if transmission charges provide clear economic signals to market participants. Currently, there is no mechanism under NETA that rewards the despatch of plant to reduce transmission losses. Including such a mechanism will influence the siting of new plant-to bring plant close to load—contributing to economic efficiency and security.

  With the transmission network being an integrated system and no alternative physical route to market it is essential that access rights to the transmission system are unambiguous. Uncertainty on access rights will influence investment decisions and, potentially, impact long term capacity and security. The auctioning of transmission access rights would increase uncertainty over the longer term and is an inappropriate method of allocating access rights.

ELECTRICITY DISTRIBUTION

  In line with its environmental objectives, the Government has promoted the twin targets of 10 per cent of generation being embedded in the distribution system and 10 per cent of electricity being produced from renewable sources by 2010. Achieving these aims may require distribution systems to be operated in a different manner than currently, because of the current unidirectional flow.

  We support the renewable generation objective but have concerns over promoting localised generation on grounds other than the low carbon content of its fuel because:

    —  Local, predominantly gas fired generation would require significant small scale build, creating problem areas around planning consents and may not deliver a low carbon outcome;

    —  Significant numbers of developments of this type could lead to a heavy reliance on gas as a fuel source in the overall mix;

    —  Local generation would still require back-up support and therefore a grid of some form would still be required to ensure security of supply and despatchable generation to cover shortfalls would still be required;

    —  Economies of scale in generation would be lost;

    —  Local plant would be relatively costly to build, both because of the cost of obtaining planning consents and the costs of installing appropriate emissions controls on a small scale.

  Innogy believes an alternative scenario has significant attractions and warrants investigation. The scenario is based on an incremental approach and runs as follows:

    —  Local demand requirements are supported from renewable sources and localised electricity storage facilities wherever possible;

    —  Storage facilities are recharged when required from large scale generation plants which enjoy economies of scale both in terms of economic and environmental efficiency;

    —  Because of the potential of storage the large scale plant can be scheduled to operate at off peak hours, for example when demand for gas is low, helping keep prices down.

  Under this scenario plant remains available to cover outages, efficiencies are encouraged and the use of less dependable forms of renewable energy are not discriminated against.

GAS

  Transco, a subsidiary of the Lattice Group, is the owner and operator of the National Transmission System (NTS) for gas. In its submission to the PIU Energy Review it makes the following points (which we have paraphrased) with which we concur:

    —  Gas requires fixed infrastructure which is capital intensive and long term in nature. The adequacy of Britain's infrastructure in combination with the wider pan-European systems will have an important bearing on supply security;

    —  The capacity of the NTS will need to be expanded significantly to accommodate anticipated future demand supply patterns;

    —  Developments such as the promotion of embedded generation are likely to reinforce the need for increased NTS investment.

  It is unclear whether market mechanisms alone will provide sufficient signals and incentives to induce these required investment levels in a timely way. We remain concerned about the ability of the NTS to cope with the dynamic changes in demand as existing plant starts to two-shift.

HYDROGEN

  We include in this section views on the use of hydrogen as an energy distribution vector. This is because hydrogen is not, in itself, a primary fuel source and, for use as fuel, has to be generated from primary fuels such as fossil fuel, renewable or nuclear sources. As such, in many cases it is only CO2 free at the point of use and not over the entire generation chain.

  To date, no large efficient power plants have been run with 100 per cent hydrogen and the technology to run large turbines using hydrogen remains undeveloped. Use of hydrogen in smaller combined heat and power plants, if run on a heat demand basis, is more efficient than use in large plants. However, under today's technology the capital cost of the total system will be considerably more than for total systems of electricity generation and transmission. Total system efficiency will only exceed that of electricity as an energy vector if heat utilisation at the delivery point is efficient and even then it is doubtful if overall efficiencies will exceed that for electricity use in a heat pump for the heat load. Under today's technology, overall efficiencies will certainly be lower than use of natural gas as an energy vector.

  The most significant aspect of hydrogen use as an energy vector is, however, safety. Hydrogen has an extremely wide flammability/explosive limit range and high energy density. Add to this its tendency to rise and become trapped under containment means hydrogen is a dangerous fuel to store and transport. The wider the transportation network the greater the risk of accidents, mal-operation of equipment or malicious behaviour. Whilst the technology to achieve this is known, ensuring its integrity during build and operation is expensive.

  In summary:

    —  Hydrogen is not a primary fuel and needs to be generated using other primary fuels;

    —  The use of hydrogen as a viable energy vector in electricity generation would require significant technological breakthrough;

    —  Overall efficiencies of using hydrogen as an energy vector will be lower than those of using natural gas;

    —  The use of hydrogen as an energy vector for transport applications would incur high costs of fuel storage and transportation to ensure safety.

(b)   Upstream resources

  The issue of electricity generation capacity is critical to security of supply and is dealt with in more detail in the next section. However, the other main aspects of upstream resources, the storage of gas and the storage of electricity, are dealt with here.

  Utility scale power storage is now technically proven and is expected to enter commercial service in the near future. Storage has the potential to transform the design and operation of transmission and distribution systems. Equally, it has the potential to have a profound impact on the mix of generation assets and their operational regimes. Until there is sufficient storage, the natural fluctuations in demand require the system to include generation plant which can be operated flexibly and which can be remunerated from only short periods of operation. It is not yet clear that the present system adequately remunerates such plant-this may develop into a more serious problem if the surplus of capacity declines in the future.

  Utility scale electricity storage can contribute directly to security of supply by providing cover in the event of outages or peak demand. Its use for this purpose will not only provide cover cost effectively but also reduce reliance on fossil fuel peaking plant.

  All other commodities use storage at various points in the supply chain as a key element in providing security of supply at lowest cost. We believe that electricity storage is a key ingredient in the development of the future electricity system. Not only will it enable inflexible or intermittent low-carbon generation to play a greater role, but also it will contribute to security of supply and will improve substantially the utilisation of capital assets, leading to lower costs.

  The anticipated increase in reliance on imported gas has implications for the volume of storage facilities that will be required to ensure future security of supply downstream.

  Gas storage operates in a deregulated environment and, since deregulation, there has been little investment in new gas storage. It is unclear at this time whether market mechanisms will provide sufficient signals and incentives to ensure adequate and timely investment in gas storage.

2.9  Generation Capacity

  Demand growth is difficult to forecast precisely, as it depends on a number of criteria, that includes:

    —  the growth of the national economy;

    —  the future mix of the national economy;

    —  future developments in environmental and market regulation;

    —  the impact on power prices of competition in generation and supply;

    —  international fuel prices;

    —  the effect of power prices and government incentives on demand management; and

    —  the introduction of new technologies such as renewables and storage.

  However, the UK economy is much less energy-intensive than California and so the credible range of electricity demand scenarios and rates of growth are much narrower. An economic boom in California led to a rapid rise in electricity demand, the energy impact of economic growth in the UK is much less severe.

  In the UK, the current excess of supply over demand is resulting in low electricity prices and a decline in the rate of new plant construction. However, the combination of low electricity prices and high fuel prices results in reduced incentive to invest in generation assets in the short term. If new investment is not encouraged, supply capacity will reduce in the medium term as older plant reaches the end of its life and the economics of coal plant is affected by the tightening of environmental constraints. If overall demand continues to grow at historical rates then in the longer term new plant construction will be required to meet this demand. It is expected that before new plant is built the balance between supply and demand will have to shift to the point where power prices have risen to the level at which such new build can be remunerated by the market.

  The introduction of New Electricity Trading Arrangements (NETA) in Spring 2001 has stimulated liquidity in the forward market for electricity but is only a partial design. It needs to be further developed by reducing the timescale in which the System Operator intervenes, and evolving the balancing services of response and reserve into market based arrangements before it can hope to deliver some of the efficiency gains expected of it.

  Price volatility in the prompt market and balancing mechanisms are an inevitable and essential feature of the electricity market. It is these price signals that provide the market with indicators of system stress and are, therefore, a stimulus to investment. If this volatility is suppressed, as some have suggested, either through market distortion or regulation, then the risk of market failure, and consequently future capacity shortages, is increased.

  Another significant weakness of the NETA design is the removal of any form of capacity credit. Some peaking and reserve plant is called upon only intermittently and for short periods. Currently, such plant has to cover its fixed as well as marginal costs and generate reasonable profit over short bursts of utilisation making investment in it unattractive. There is the potential to compromise system security if this peaking and reserve capacity is not maintained and, therefore, there is a need to ensure it is adequately remunerated. We have suggested a simple commercial solution to this problem in section 6.1.

COMMITTEE QUESTION

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

3.1 Renewables

  There is no inherent conflict between the broad objectives of achieving security of supply and environmental policy, Indeed, the development of renewables can contribute significantly to security of supply through increased diversity and by using indigenous and uninterruptible energy sources such as wind, wave and tidal movements. Similarly, the application of emissions controls need not conflict with security of supply so long as emissions reductions are applied consistently and in a manner which allows markets to ensure the efficacy of their achievement.

  The expansion of generation from renewable sources is a key element in improving fuel diversity and ensuring national self-sufficiency.

  The volume of potential generation from renewables is very large and, by definition, inexhaustible. For instance, offshore wind alone could readily fulfil the UK's average annual electrical energy demand. Denmark currently generates some 15 per cent from wind and has set a national target of 50 per cent. Wind generation today accounts for 0.3 per cent of UK generation within a total of 2.8 per cent for all renewables, and yet the UK has the largest wind resource in Europe.

  The cost of renewable generation, particularly wind, has fallen dramatically in the last decade. Generation costs have more than halved as volume production has increased and machine sizes have increased into the 1 megawatt-plus range. However the lifetime cost depends critically on average wind speed and this cost will rise as lower wind speed sites are developed on shore. The cost of offshore wind, currently in its infancy, is likely to drop significantly for the same reasons as experienced on-land in the past.

  We believe that of the existing technologies, wind generation is currently the most viable form of renewable generation. We would, therefore, expect that windpower will meet the majority of the increased need for low-carbon electricity over the next 20 years. The advantages of windpower are clear.

    —  It offers a virtually limitless supply of energy;

    —  It is truly sustainable, with no long-term or irreversible adverse impacts and with all its costs internalised;

    —  Projects have short lead-times and can be on-line in less than 12 months;

    —  It will develop in "bite-sized chunks", giving investment flexibility which allows the rate of expansion to be adjusted quickly in response to market signals;

    —  Not only does it exploit an abundant national resource, it offers the potential to exploit core national skills in manufacturing, construction and offshore engineering.

  The main drawback of windpower is the intermittent nature of its output. We accept that the current electricity infrastructure could only support some 20-30 per cent of energy being from intermittent sources. However, we anticipate that such a limit would not be reached for 20-30 years by which time economic storage will be a substantial feature of the electricity infrastructure. Hence, we do not believe that a steady expansion of windpower would actually lead to any system security concerns.

  We believe that windpower has the potential to expand at an average rate of 1GW pa of installed capacity, over the next 20 years. (1GW of wind capacity is equivalent to around 1 per cent of electricity demand.)

  Whilst such a growth rate would increasingly be met from offshore resources, onshore development will be a key element over the next 10 years. We welcome the recent initiative to allow NFFO contracts to be transferred but remain concerned that the planning process is slow and does not take proper account of windpower's role in combating global warming and contributing to the Government's wider sustainable development objectives. However, it is all too easy to dismiss the potential environmental contribution of an individual proposed wind farm. It is for Government to ensure that the planning system recognises the wider context of an individual project.

  The cost of other renewables is significantly above that of wind, with the exception of landfill gas and waste-to-energy. The volume of the landfill is small and mostly already utilised. Waste burning is controversial but will have its place in energy production; its generation cost will be driven by the price of alternative means of waste disposal. Small hydro development has potential although the volume is likely to remain small. The operating costs for energy crops are currently expensive; subsidies from outside the energy market, eg agricultural credits, will be necessary to encourage significant development. Photovoltaics, tidal flow and wave power are very expensive and will need a technology breakthrough to compete in the UK.

  In principle, Innogy supports the proposed Renewables Obligation on electricity suppliers. It is too early to judge the success of the Obligation, but Innogy believes that the UK target of 10 per cent renewables by 2010, whilst achievable, is at risk of not being met in full due to the current barriers surrounding gaining planning permission. This is an industry wide view.

  Ofgem's review on NETA's performance recognised the exposure of renewables and embedded generation in the current market: Mr McCarthy concluded that "if for wider environmental reasons the Government wishes to encourage forms of renewable generation whose output is less predictable or less reliable, there is a need for the Government to consider additional support for these types of generators."

  In summary, we believe the combination of renewables and electricity storage can make a significant contribution towards moving to a low-carbon energy system, whilst contributing to diversity of supply.

3.2  Emissions Control

  Government objectives in respect of environmentally damaging emissions need not conflict with security of supply. However, to ensure this is the case, policies to address emissions must be applied through appropriate means and must not lead to distortions in energy markets which may knock on to compromise security of supply.

  Incentives to achieve government energy and environmental objectives inevitably have an economic cost and the financial impact of these measures on the consumer is minimised in a liberal market structure.

  In particular it is our view that efficiency in emissions control is best achieved through market mechanisms such as tradable emissions permits. The larger the market for these permits, the more efficient the resultant market solution. For these reasons Innogy strongly supports continuing efforts to achieve Europe-wide market liberalisation.

3.3  Climate Change Levy

  Innogy believes that the Climate Change Levy (CCL) is poorly designed as an instrument for delivering reductions in greenhouse gases (GHG) emissions and will ultimately prove incompatible with international measures, requiring its replacement by an alternative economic instrument.

  Its deficiencies have been demonstrated by the exclusion of the electricity generators from the UK voluntary carbon emissions trading scheme, which has had to be designed around the requirements of CCL Negotiated Agreements. This is despite the widespread recognition that the generators' participation will be an essential component of any international emissions trading system. The proposed EU emissions trading scheme will require fundamental changes to the UK scheme.

  In the short term CHP plant meeting the Government's "Good Quality CHP" criteria should be exempt from CCL without the need for a supply licence. At present exports are only CCL exempt where supply is direct to the end user. If a supply licence is needed CHP operators should be allowed to use the customer support infrastructure of other licensed suppliers in order to minimise the burden of having to become a licensed supplier themselves.

3.4  CHP

  We recognise the benefits which CHP offers and support its promotion through continuing exemption from the Climate Change Levy for good quality CHP.

  However, when the Renewables Obligation (RO) is introduced it will be applied to all the output supplied from sites. The cost burden associated with the RO will negate the benefit derived from supplying CCL free electricity and so the CHP incentive of CCL exemption will in practice be removed. The process of the CCL exempt route to market had been complicated and expensive. To have the effort wasted because of the conflicting regulations relating to two Government environmental initiatives that have been introduced within a short period of time cannot be in the interests of either industry or Government.

  A move to an environment of high penetration of micro-CHP carries with it certain risks. Most significantly, it will accelerate the process of the UK becoming dependent on gas.

  In addition, with current technologies micro-CHP is less fuel efficient in generating electricity than large scale gas-fired generation leading to more fuel being burnt for the same electricity output, thus offsetting much of the intuitive benefit of micro-CHP and which conflicts with the delivery of a low-carbon outcome.

COMMITTEE QUESTION

What scope is there for further energy conservation?

4.1  Industrial and Commercial Use

  Industrial and commercial customers are aware of the importance of reducing consumption, particularly when energy is a significant proportion of their controllable costs. Many have designed and amended their operations for economic reasons and have achieved up to 80 per cent exemption from CCL as a result. In theory, CCL exemptions should help to promote CHP development, but in practice large consumers have secured exemptions from CCL without implementing CHP.

  Smaller companies face a real increase in their annual cost of energy of 10-20 per cent as a result of the CCL[47]. Although these firms are becoming increasingly aware of the need to monitor energy consumption, many are powerless to act, either through a lack of expertise, or because their processes are difficult to improve. Some will turn for help to specialised energy management companies, but energy suppliers could also play a role to help businesses lower their energy costs—by scrutinising energy consumption, and devising more efficient working practices and processes.

  As yet, many businesses lack the financial incentive to act, and a combination of initiatives are required by way of loans, grants, and access to credible energy efficiency advice in order to deliver the savings. Sourcing this advice from proven energy suppliers could also provide a route for customers to access grants.

4.2  Domestic Use

  The Government already encourages domestic energy efficiency through its Energy Efficiency Standards of Performance (EESOPs) programme and is currently continuing its commitment with its planned replacement for EESOPs, the Energy Efficiency Commitment (EEC), to come into effect in April 2002. In effect, the programme places an obligation on energy suppliers to encourage or assist consumers to take up energy saving opportunities.

  We agree that suppliers have a role to play in promoting energy efficiency, however, this role is limited as the majority of actions that would lead to significant improvements in domestic energy efficiency are outside the sphere of influence of suppliers. In particular, the design of appliances and the selection of individual appliances by consumers and decisions over replacement of older appliances. At the consumer level, especially in respect of electrical appliances, energy efficiency is merely one of many selection criteria including price, appearance, size, performance, capacity, functionality, reliability and even fashion, with energy efficiency normally being considered one of the lower ranking selection criteria. Even at the commodity end of the appliance market, for example light bulbs, the role of the energy supplier is limited as it is consumer choice—in this case price driven—that dictates selection of standard or high efficiency appliances.

  Other factors also limit the scope of energy suppliers to improve domestic energy efficiency such as the decline in the number of cavity wall insulators and number of CORGI registered installers for high efficiency boilers.

  Energy suppliers have a role in promoting domestic energy efficiency but can only influence the decision making of domestic users marginally. This limitation needs to be recognised when developing energy policy and designing incentives for consumers to make the right energy efficiency choices.


COMMITTEE QUESTION

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

5.1  Industrial Competitiveness

  Energy costs have a major bearing on factory output prices and are, therefore, highly significant to international industrial competitiveness.

  The fuel mix in the UK is not markedly different from that in other advanced industrialised countries (eg Europe, USA, Japan) and, therefore, under liberalised markets energy costs should be broadly similar. Consequently, energy costs are likely to differ markedly only if extraneous factors are imposed on energy markets.

  Industrial energy prices internationally will be significantly influenced by the imposition of emissions controls. With the US not signing up to the Kyoto protocol price differentials between EU and US energy prices could impact industrial competitiveness.

  Within Europe, it may be in the UK's interest to push for unilateral EU action up to 2010, given its strong position with respect to Kyoto. However, major barriers remain to achieving full energy market liberalisation within the EU and can only hinder the introduction of measures to reduce GHG emissions. Increasing concerns among Member States regarding security of supply issues will also impede progress.

  It is important to remember that the UK energy sector is a relatively small polluter. Overall, the UK accounts for about 2 per cent of global GHG emissions and the CO2 emissions from UK energy consumption are forecast to rise by 0.01 per cent-0.3 per cent pa to 2050 compared with a global rise of 1-3 per cent. This is not a justification for complacency; however, UK action must take due account of the impact on international competitiveness.

5.2  Fuel Poverty

  The issue of fuel poverty is being addressed in a dedicated Government initiative—The Governments UK Fuel Poverty Strategy. We applaud this initiative and are playing our part in it, but it is also our view that these very important issues should be considered in this inquiry. For example, the strategy as it stands sets out a range of programmes including inter alia "Continuing action to maintain downward pressure on fuel bills, ensuring fair treatment for the less well off as supporting the development of energy initiatives to combat fuel poverty."

  This is potentially at odds with other Government objectives such as security of supply and emissions control, where it may be concluded that in order to achieve the necessary energy policy, energy prices may have to rise in order to attract the appropriate investment in plant and internalisation of costs.

  Government policy should therefore recognise that industry should accept responsibility where it can, but it is the Government via the tax/benefit regime who have primary responsibility for addressing the issue of the fuel poor.

COMMITTEE QUESTION

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?

  6.  Government policy should recognise the conflicting nature of disparate policy objectives and the need for changes in policy in the pursuit of long-term objectives to be evolutionary not revolutionary.

  To assist the Committee in assessing policy options and evaluating appropriate means of affecting any changes we have set out our views on five key aspects of the market and provided a series of proposed policy guidelines to underpin deliberations. Accordingly, our response to this question is split into six sections as follows:

    —  Security of Supply.

    —  The Value of a Competitive and Efficient Market Structure.

    —  The Current Regulatory Environment.

    —  The Future Regulatory Environment.

    —  The Use of Economic Instruments to Achieve Objectives.

    —  Suggested Energy Policy Guidelines.

6.1  Security of Supply

  In order to underpin security of electricity supply, Government should recognise and facilitate the following key issues:

    —  An appropriate framework that allows market-based incentives to be developed which facilitates proper remuneration of both plant capable of delivering a fast response to grid system and customer requirements, and plant capable of substantially increasing production in response to major fuel supply or generation problems.

    —  Recognise the development of new power storage technologies which would allow operational flexibility and security with a smaller overall system capacity.

    —  Ensure an appropriate flexible framework allowing the market to deliver innovative solutions.

  The emergence of a system for properly rewarding capacity would tend to encourage fuel diversity. If capacity is economically rewarded then investment in generation could hedge the risk of a divergence in fuel prices by holding a portfolio of plant with different fuel types in the knowledge that low merit should still be able to recover its avoidable costs from year to year, unless there was a surplus of capacity beyond the required planning margin.

  Government should therefore encourage:

    —  The establishment of an appropriate system for rewarding capacity that properly reflects contribution to supply security.

    —  The introduction of market-based arrangements for response and reserve.

    —  Enshrining suitable standards for transmission security (and not leave them to the vagaries of any experimentation in auctioning transmission access).

  In order to properly remunerate capacity that is able to contribute to security of supply over a sustained period, we suggest the following structure.

  (1)  All power plant that can contribute to security in the short-term, through having at least six hours of fuel stored on site, should be eligible for a fixed annual "fuel security capacity payment" per MW of electrical output.

  (2)  All power plant with fuel stored on site would be eligible for a further "fuel security energy payment" based on the MW hours of electricity it could generate from that stored fuel. This payment would be capped at, say, 28 days of baseload generation.

  (3)  All power plant would pay back the "fuel security energy payment" for each MW hour actually generated.

  Through this mechanism, plant would be incentivised to stay open and to hold stocks which could be used to replace lost generation from other plant due to unforeseen events. Payments would be targeted on reserve energy production, as normal running would be on a commercial basis. Stored fuel could be coal, oil, gas, water, nuclear or electricity provided that it is stored on site and available to be used as required. Payments could be administered through the existing ancillary services arrangements in a similar way to blackstart security payments.

6.2  The Value of a Competitive and Efficient Market Structure

  Since privatisation the face of the energy market in the UK has changed dramatically. Innovation has been allowed to flourish and new entrants have produced increased competition and, consequently, downward pressure on prices. Today, the UK market is amongst the most competitive in the world in both generation and supply.

  Prices for electricity in the UK are generally below those elsewhere in Europe. For industrial customers prices tend to be slightly lower in France and the Netherlands, but slightly higher in Belgium and Germany. UK prices to industry are significantly lower than those found in Italy. For domestic customers prices in the UK are generally the lowest in Europe. The average UK domestic customer currently sees prices that are more than 40 per cent lower than in Italy, almost 30 per cent lower than those in Germany, and even 6 per cent lower than those in France[48] (comparisons are made excluding VAT for industrial customers, but including it for domestic customers.)

  Competitive markets, if left to operate without onerous constraints or regulation will drive efficiency and provide appropriate signals to encourage investment. In its report on the California power crisis[49] the World Bank drew three main conclusions:


    —  "The flaws in the design of the California market contributed substantially to the financial crisis of California's main utilities;

    —  Efforts to deal with the crisis in the presence of these flaws could not have succeeded;

    —  A properly designed power market could have coped with the factors leading to the crisis. Because the reforms already undertaken in the California power market prevent a return to the pre-reform structure, the state's only option is to correct these flaws and move forward to a better-designed market."

  Among the flaws stated as contributing to the failure of that market to deliver security were:

    —  A mismatch between the regulated retail market and the deregulated wholesale market;

    —  Lack of economic incentives for adequate capacity to maintain supply reliability standards;

    —  Price caps.

6.3  The Current Regulatory Environment

  It is difficult to argue that the regulatory environment discourages market competition, given that one of Ofgem's primary functions is to facilitate competition. In electricity, it has been achieved, but in the gas market Ofgem has yet to address structural issues inherited from privatisation which now have the potential to undermine the achievements in the electricity sector. Unlike other energy markets, the UK has over a decade of experience of operating a liberalised and competitive market and we clearly lead the way in terms of cost-effective production and supply. Innogy believes that the market will deliver the optimum solution within a very clear framework set by Government. Regulation has played its part, but in order to achieve the full benefits of competition, we should now lead the way by retreating regulation from competitive markets.

  As a consequence of the UK's leading role, and experience gained from the competitive energy market, Innogy is profitably selling its expertise in the US and Europe where others are keen to learn from the UK experience. Being at the forefront of these developments does mean, of course, that that there is no "model" to follow and that we have to develop a UK solution that preserves our unique and leading position. In this context we would also highlight the point that our overseas competitors find it far easier to operate in the UK than we would under many of their regulatory regimes.

  There have been some important developments in the UK in recent months with the introduction of the New Trading Arrangements, which we welcome. However, we believe that it is essential that the implications of these changes be taken into account before further radical changes are proposed. The industry needs a stable regulatory environment if it is to develop and if participants are to make the necessary long-term investment decisions to ensure security of supply.

6.4  The Future Regulatory Environment

  The Better Regulation Task Force is already taking a look at this issue, and has come up with five key recommendations, of which four could be applied to this regulatory environment:

    —  Regulators' annual business plans should include a clear explanation of how they will prioritise their different objectives. Regulators should also explain how the decisions they take relate to their objectives.

    —  Regulators should be required to produce assessments of costs and benefits for proposals with significant impact on business activity.

    —  Regulators should include in their work plans proposals to encourage an innovative approach to consultation, to allow a real dialogue between different stakeholders and demonstrate how proposals have been amended following consultation.

    —  Regulators should set out a programme in their annual work plans to review market sectors for lifting price controls and the removal of outdated licence conditions. Companies should be able to challenge failure to complete these programmes.

  It is clear that the regulatory environment that was introduced at privatisation has facilitated competition. However, now that competition has been introduced, it is important that the market is allowed to operate without the fear/uncertainty of further regulatory intervention. For example, the recent decision by the Regulator to increase his powers through a Market Abuse Licence Condition (overturned by the Competition Commission) is, in our view, an example of excessive regulatory interference which could impact negatively on market confidence and investment in much-needed new capacity.

6.5  The Use of Economic Instruments to Achieve Environmental and Energy Policy Objectives

  Innogy supports the use of economic instruments to achieve environmental and energy policy goals provided that they achieve this in the most cost-effective way and do not lead to market distortions. It is important that in designing such instruments the following criteria are satisfied:

    —  The mechanism must be designed to ensure delivery of the primary environmental or energy policy objectives rather than for the sake of political expediency.

    —  The mechanism must cover all relevant sectors to ensure delivery of the optimum cost solution.

    —  Where techniques are already commercially available, the market should determine which technical solutions are most appropriate.

    —  Specific measures such as capital or R&D grants should be used to support emerging technologies, rather than segmenting or distorting the market.

    —  Government must not second-guess the market, by imposing artificial sector caps or targets, which can lead to distortions and sub-optimal solutions.

    —  The polluter pays principle has to be balanced by the recognition that the consumer ultimately pays and investors require a sensible return on their investment.

    —  Achieving environmental and energy policy goals will require significant levels of investment over an extended period. Economic instruments must be designed to provide a stable framework whereby investors can invest with confidence.

    —  Government must ensure that, in addition to appropriate economic instruments, other barriers to delivering its objectives are managed (eg planning, manufacturing capability, skilled labour etc.)

  In general, Innogy supports the use of financial incentives to encourage investment in cleaner power plant, renewable technologies, energy efficiency and electricity energy storage. In contrast, experience has shown that policies to interfere in the operation of the competitive markets to discriminate in favour of a particular source of power are likely to be counter-productive.

6.6  Suggested Energy Policy Guidelines

The Importance of Competition

  As a leading UK energy supplier, Innogy is determined to provide its customers with electricity and gas at competitive prices. We believe that competitive markets are the best means of delivering choice and value for money to the consumer. Maintaining and enhancing competition in the UK should, therefore, be at the heart of the Government's energy policy.

The Proper Role of Government

  Innogy believes that Government has a key role to play by establishing a framework which balances the potentially conflicting policy aims of secure, affordable energy supply and tightening environmental targets. A key ingredient of this framework is the maintenance of a stable, complementary and predictable regulatory regime.

Avoiding Market Distortions

  Having established the policy framework, we believe that it is imperative that the market and industry are given the opportunity to deliver innovative, market-based solutions free from Government interference.

  The use of ad hoc or short-term policy measures aimed at increasing supply (eg generation) or reducing demand (eg consumption of energy) can have unpredictable and costly implications. Therefore the aim should be to create a long term and consistent set of sustainable energy objectives to which the market can respond.

Limits to Unilateral Action

  Government policy must be set within the context of the European energy market. It should be recognised that the competitive market in the UK can be constrained by the lack of competition elsewhere in Europe. The UK leads the world in market liberalisation and cost-effective energy production and supply. Nothing must be done, therefore, which jeopardises this competitive position, by forcing up energy prices to unacceptable levels, or by helping overseas companies to operate in our market more easily than we can in theirs.

Avoid Step Changes

  The Government has made an excellent start in addressing the issues associated with moving towards a sustainable future in energy. What is required going forward is an incremental approach which will allow industry to make the necessary long-term investment decisions which will be in the best interests of consumers and other stakeholders. For example, the Renewables Obligation has set out a 10 year framework for reducing carbon emissions, whilst giving the industry flexibility in the choice of zero-carbon technologies.

Innogy

October 2001


45   Includes considerations such as SOx, NOx, nuclear waste, particulate emissions, impact on water tables, etc. Back

46   NGC Transmission Systems Security and Quality of Supply Standard-see NGC Licence. Back

47   Datamonitor, August 2001. Back

48   Source: Energy Advice Comparison, May 2001. Back

49   The California Power Crisis: Lessons for Developing Countries, The World Bank, April 2001. Back


 
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