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CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 742-iii
HOUSE OF COMMONS
TAKEN BEFORE THE
ENERGY AND CLIMATE CHANGE COMMITTEE
ELECTRICITY MARKET REFORM
WEDNESDAY 2 FEBRUARY 2011
JULIET DAVENPORT, DARREN BRAHAM, DOROTHY THOMPSON, DR STEVE RILEY and DR GORDON EDGE
SARWJIT SAMBHI, JOHN McELROY, SARA VAUGHAN, IAN MARCHANT, JOHN CAMPBELL, VINCENT de RIVAZ and PAUL SPENCE
USE OF THE TRANSCRIPT
Taken before the Energy and Climate Change Committee
on Wednesday 2 February 2011
Mr Tim Yeo (Chair)
Dr Phillip Lee
Sir Robert Smith
Dr Ala n Whitehead
Examination of Witnesses
Witnesses: Juliet Davenport , CEO, Good Energy, Darren Braham , Chief Financial Officer, first:utility, Dorothy Thompson , CEO, Drax Power, Dr Steve Riley , Executive Director, Europe, International Power, and Dr Gordon Edge , Director of Policy, RenewableUK, gave evidence.
Q 116 Chair: Good morning and welcome. Thank you very much for coming in. We’ve quite a lot to cover and about an hour to do it, because we have a second set of witnesses, whom we expect to move on to at about 10.45 am. We will try to reflect that sense of urgency and time pressure in our questions, and we would obviously much appreciate it if you did the same in your answers. You can by all means all respond to the questions, but don’t feel you have to each time if you don’t have a burning view you want to get off your chest.
Let me start with a general question. Is it your view that this whole electricity market reform process is necessary if we are to achieve more secure and more low-carbon electricity generation?
Dr Riley: The short answer is yes.
Dorothy Thompson: I would strongly agree.
Juliet Davenport: I think that there are definitely parts of the current market that will not allow the significant changes that we need to see, and they are not fit for purpose to precipitate that change. It is not all broken, but if you really want to get to the low-carbon economy, quite a lot of things need fixing.
Q 117 Chair: We will get on to some of the details of it in a moment, but are there any omissions-any big elements-that should have been in the consultation that are not there?
Darren Braham: It is important to have a co-ordinated approach, so we have a lot of work on the generational and supply side, but we need to focus on the demand side, and to bring in the work that Ofgem is doing on liquidity, which is a big piece that is missing from this area of work. Unless you free up the wholesale market and generate liquidity, it is very difficult to encourage competition at the retail level.
Dorothy Thompson: I strongly agree on the liquidity point. I would also suggest that, in terms of capacity, the consultation looks only at peak capacity and does not consider the problem of intermittency.
Dr Edge: We are quite disappointed that the benefits of continuity in the policy that is out there, particularly the renewables obligation, are not reflected in the consultation. As an industry, we will work with what is on the table, but we would have preferred the option of keeping that mechanism, which is working. It should have been kept in the mix, and it should have been meaningfully assessed in the consultation process.
Q 118 Chair: Right. You all come from quite different businesses, so you are likely to have divergent views on some questions. Do you think that what is proposed offers enough improved support for small and decentralised generation and for other low-carbon electricity sources?
Juliet Davenport: What is interesting about the document is that it does not seem to consider size in its conversation. We discuss three types of FIT mechanism, but not how those are implemented, which depends on the size of technology that you are talking about. We currently have two FIT mechanisms: a fixed FIT for very small; and a premium FIT for slightly larger. The size of the technology is quite important, so something like a CfD will be very hard for small generators to manage, and potentially the administration costs will be significant. We represent quite a lot of small generators-we have about 10% of the microgeneration market-and from our point of view, the document does not consider the impacts depending on the size of technology being considered.
Dr Edge: From our point of view, having a single support mechanism for all low-carbon generators is a little bit problematic, because "one size fits all" means that it does not fit everyone, because not everyone is the same size. That is particularly the case with smaller onshore wind developers, who perhaps have a small portfolio of projects, as opposed to 1,600 MW nuclear power plants at the other end of the scale. The system is supposed to work for the entire spectrum, and it is very difficult to see how something could be designed to fit everyone. The proposals about auctions are particularly problematic at the smaller end of the scale, and we are not very keen on those.
Dorothy Thompson: I suspect, though, that this subject is all about the detail of implementation, because a lot is to do with the concept of whether you are going to have a market to which all have access openly, or a market that you have to access through the supplier. That is the difference between having a feed-in tariff and an obligation through the supplier. We strongly support open market access because that is better for new entrants and independents. On size, I know that the Government are considering whether to differentiate between large and small biomass stations. There is no reason in a FIT structure why you cannot do the same. I think that this is in the detail of the implementation.
Q 119 Sir Robert Smith: One of the concerns raised about the working of the market is the potential for new entrants and the domination by large generators. What sort of capacity is provided by the smaller players, and what would be the benefits of increasing the number of smaller players?
Dr Riley: There might be an issue of definition around the smaller players as well. I would like to think that International Power is a large generator. The independent generators as a whole are about 20% of the market in the UK . It is important that the outworkings of the energy market review provide the right incentives and encouragement for the independent generators to invest, because the amounts of investment are huge. The key outcome for this, particularly for an international company, is to get the regulatory framework right so that we are encouraged to make investments in the United Kingdom rather than in some of the other countries that we can choose for our capital.
Q 120 Sir Robert Smith: What sort of incentive?
Dr Riley: A good outcome for us would be if the energy market review took a holistic view. We have talked about low carbon. There are a lot of incentives in the proposals to incentivise low-carbon generation, but we must maintain a viable system going forward not only from 2030 onwards, but between now and then, so some of the other things-capacity mechanisms to make sure that there is reliable security of supply in the market and responsive plant, which will be needed when base-load nuclear and intermittent wind resource are rewarded-will continue to play an important part in the system going forward. A lot needs to be taken into account in the whole review.
Dorothy Thompson: We at Drax have been working for two years on a joint project with Siemens Project Ventures to build three large new biomass plants. One of the key challenges in putting together that project is finding some way to get security of income over time against our fuel sources. It is not possible in the current market, because the ROC is a short market and the power market trades only two and a half years forward, whereas the build takes three years. A structure like a CfD, which effectively gives stability of income, is a very good basis to go about financing and raising capital to build new stations.
Dr Edge: I think you need to be clear about which new entrants you are trying to encourage. We see a lot of new entrants into the generation market with renewables, because that gives a low barrier to entry, and there are lots of independent developers in our membership. The Government want to encourage both that and new entrants in the form of large institutional investors, but they are different things. You need to be clear about who you are trying to entice into the market and what it is you are offering them.
Juliet Davenport: The other thing is that people already in the marketplace will try to offset their risk, so if you increase the risks in the market, such as by increasing buy-up prices so they are spikier, you will have investment from incumbents. If you are looking at encouraging new investment, you must have a look at giving certain returns-that is really the difference. If you are looking to get new investment in, you need to consider what they will look at, and they will not be trying to offset the risks of the existing incumbents.
Q 121 Sir Robert Smith: Does anyone have views on getting new entrants into the retail side?
Juliet Davenport: We are not that new any more. We have been around for about 10 years, but we are probably one of the smaller retailers in the electricity side of the marketplace. Having more generators to trade with is an important part, as are the credit terms you can establish. When you come in as a small supplier and talk to very large generators, they will look at you and say, "We’re not that interested," whereas if you talk to generators of a similar size to you, they will offer you much better credit terms. A real diversity of generators coming in place is a really positive thing to bring in new retail.
Darren Braham: Liquidity and, probably, the lack of independent generation have a big bearing on the development of retail competition. In our experience, there were a limited number of people to talk to.
Q 122 Ian Lavery: Liquidity has been mentioned on numerous occasions from the beginning, so it is obviously very important. It will have a huge influence on competition. With regard to liquidity, will the electricity market reform improve the risk-reward outlook for new entrants in the supply and generation market?
Darren Braham: The risk with some of the measures is that they remove liquidity further down the curve. What might end up happening, particularly with the CfD approach, if renewables trade out at the spot market, is that you are left with lack of liquidity further down the curve. An issue for us as a supply business is that we need to hedge out 18 months to two years. It is thinly traded today, so anything that aggravates that position will be to the real detriment to an independent retailer.
Dorothy Thompson: We are all agreed that the principal driver of low liquidity in the UK is the fact that roughly 80% of generation is actually owned by companies that control 90% of the supply. Vertical integration in itself does not necessarily mean you have low liquidity, but the fact that there is no action, need or requirement to put larger percentages of generation capacity or generation output through the market causes the low liquidity.
Q 123 Ian Lavery: Will Ofgem be able to create sufficient liquidity to support new entrants?
Darren Braham: It is within its gift to take the requisite action, but that is really a question for Ofgem. It is something that we have made representations about in the past three or four years since we went to the market.
Q 124 Ian Lavery: Do you believe that it will be able to?
Darren Braham: As I say, it has the capacity to do it. One of the key solutions is a requirement on the integrated players to offer their power on a wholesale market.
Q 125 Ian Lavery: Has anybody else got a view on that?
Dr Edge: If DECC wants it, DECC will have to do it itself. Ofgem has powers to try to take this, but this way lies perhaps a lot of litigation. I would use the example of the transmission access review, in which there was an industry process, with Ofgem in the lead, to try to work out what the arrangements should be for connecting to the grid, and it ground to a halt. Ofgem said, "Can’t do it," and handed it over to DECC, and it had to legislate to make it happen. I suspect that this is exactly the same kind of situation. Unless DECC grasps the nettle, it could take a very long time to do it.
Juliet Davenport: Some fundamental changes are needed to the balancing and settlement code. I do not think that you will achieve that through the current change processes that we have, so I agree that it would possibly need legislation to push it forward, because I don’t think that you can achieve it through a normal change process.
Dr Riley: There are two ways in which you could try and improve liquidity in this market. You could do what I think you’re suggesting, which is to use the regulator to intervene in the current market arrangements and try to put in some measures that will improve liquidity. On the other hand, we have a great opportunity now-through getting the energy market reform right and through putting the right incentives in place to encourage independent generators into the market-to encourage that part of the market to grow. You would hope that liquidity would improve on the back of that.
Q 126 Ian Lavery: How much capacity will be contracted in the proposed capacity market, and how will that affect liquidity in the wholesale market?
Dorothy Thompson: As I understand it, the current forecast is that you’d have about 5 GW capacity contracted in the capacity market-I hope that my memory is right. But it is a complicated number, because what you’re actually taking is a very big number for the demand forecast and a big number for supply, and then looking at the difference and trying to work out the gap. We would say that that isn’t really the capacity issue; the capacity issue is on a more regular basis. Intermittency is the biggest issue. Do you realise that every winter morning our demand goes up by about 50% between 5 am and 9 am? That is just today; add in more wind intermittency and more inflexible plant and we’ve got another problem. The capacity market that is being proposed is way out-probably at the end of the decade-and for a very small element of the market for a relatively limited amount of time. I think it will have an impact on liquidity, because it will take out some of the demand and some of the supply of the market, but it is actually only a small amount.
Juliet Davenport: I think there is a missed opportunity to talk about increasing transmission interconnectability and looking at capacity trading between countries as well. Significant capacity trading already exists between Italy and some of the northern states, and obviously between France . We have quite limited interconnectability at the moment, and I think that that could provide us another route to providing more security going forwards.
Dr Edge: There is also an important confusion in the security of supply and capacity mechanism proposals. DECC seems to want to cover the fact that we need enough capacity to manage supply and demand overall, but also flexible capacity to deal with a lot of variable generation like wind down the line. There are two distinct things, but it seems to want both at the same time.
A couple of colleagues have been talking to EirGriD in Ireland , where it has a capacity mechanism. Its advice was, "Don’t have a capacity mechanism, but you need a lot more ancillary service markets," so more frequency control and voltage control. That is the kind of thing that the National Grid already contracts for in the short-term operating reserve market. Perhaps that is what we need to do the flexibility bit, and the capacity bit can take care of itself. There is the important message that DECC needs to work out exactly what it wants in this area and then work out the right mechanism to get that, rather than confusing the two.
Q 127 Dan Byles: For some time, I have been quite interested in, and a bit concerned about, the potential medium to long-term impact on consumer prices. I often get the feeling that industry, DECC and the Government-everyone-are sitting around with a consensus that this is the way forward. We are building structurally high consumer prices into the system, but who has had that conversation with consumers? The EMR consultation document has suggested that prices could rise from £80/MWh to as much as £150/MWh. Do you agree with that analysis? Is that the sort of impact on consumer prices that we will see?
Juliet Davenport: When trying to make long-term forecasts for the impact on consumer prices, you have to look at a range. It is very hard to get precisely the right number, because there will unexpected consequences as a result of some of the market coming in. The document in the EMR talks very much about gas setting the marginal price. Obviously, as you bring in significant amounts of renewable energy, you begin to see that it will not always be setting the marginal price. You might have the marginal price being set by wind at some point in time, which I know sounds rather odd to some people.
We are seeing that, potentially, you could see certain reductions in cost, depending on the impact of external world market prices. That really is not taken into account within the considerations that we have seen so far. I think that you have to look at the risk around future prices, as well as what the actual future price might be. The investment ideas behind EMR are about trying to reduce those risks going forward. Although we could see some initial price increases, the long-term risk might actually be reduced.
Dr Edge: The issue is that prices will rise and we will need to have investment. We have been behind for a long time and we need to put a lot of investment in, but the prices as they are now are below the level that you would need to support the investment, so prices are going to rise.
A high level of low-carbon generation should be a lower risk. It might be a higher price, but the chances of that moving around are a lot lower, because you have high capital costs and low running costs-you know essentially what the up-front costs are from day one. If you go down a high-fuel route with a lot of gas and coal, however, you are exposed to a lot of price volatility, so it is important to put that into the equation.
Dorothy Thompson: We have set ourselves, as a nation, some very clear climate change objectives, and we need to recognise that, at least through the electricity market, there is going to be a price for that. On the other hand, the nation believes there is a benefit from that as well, so it is a price we have to face.
As for the specific proposals, in terms of the FIT, the market is designed to be more competitive than the current renewables support we have, so that should deliver a better price to the customer. In terms of the carbon floor, I find that a little more challenging, because you already have the FIT to support low-carbon generation-I don’t quite understand why you have the two. I think the general commentary is that there is less confidence in the carbon floor as an indicator for investment, so it is less clear that it will drive through the value through the investment. What is clear is that if you do have a carbon floor and that is introduced now, it will provide a windfall to existing renewables, to existing nuclear and, to an extent-until coal has shifted in the system-to existing gas. That windfall will be paid for by the consumer, so I think it’s a bit mixed.
Q 128 Christopher Pincher: I agree that we certainly need to focus the challenge, but if you are asking certain constituents of mine in Tamworth to face that challenge and pay that price, they might balk at the prospect, so we need to demonstrate that we have consumer interests, as well as our climate change objectives, at heart. Do you feel that the green deal and its pay-as-you-save proposals are an opportunity to offset some of that risk that we are shifting away from the providers of energy to the consumers?
Dorothy Thompson: There is no question but that the more we can improve energy efficiency, the better we are at delivering a reduced total bill to the customer. The challenge is how to get consumers to change their behaviour; people seem to like more and more flat-screen televisions, or whatever it might be. I believe in the green deal, but I think it is a big challenge.
Juliet Davenport: May I add to that? I think that one of the areas where EMR could go a little further than it has is in looking at what demand-side response individual consumers could start to bring to this marketplace. What is interesting in the microgeneration area, particularly with solar PV-we are working with a lot of social housing in which solar PV has been installed-is that behavioural change is driven by having generation in situ. The green deal is great, but it doesn’t address some of the other sides where you could get significant behavioural change by incentivising people to use power at different times of the day.
Dr Edge: If I can widen that a little bit, there is a wider economic bonus if we get it right. We may be paying more through our bills, but we may get more economic development. I am thinking particularly of the manufacturing opportunities in offshore wind, but there are also other employment opportunities in the renewable energy industry more broadly. If we can get that benefit for the price we are paying, that is an equation that would allow people to see that it is a price worth paying, but we have to ensure that we capture that. It is very disappointing that in the market reform consultation, there was no recognition of that as an opportunity for the UK economy-it was purely focused on the electricity sector and its market, which I think was an opportunity missed.
Q 129 Sir Robert Smith: I appreciate the importance of energy use and the potential for renewables, especially in my constituency, but when it comes to Government electricity policy, shouldn’t it be about the lights being on in a low-carbon way that is as affordable as possible for the consumer?
Dr Edge: There needs to be a wider cost-benefit analysis that says, "We could go down this route, which might cost us a certain amount, but the wider economic benefit is very limited; or we could down another route, which might cost a little bit more, but you get a lot more from it." That kind of judgment is absent from this, and there does at least need to be recognition that one of the reasons we are doing this is that we think there is a wider benefit to the UK economy.
Q 130 Christopher Pincher: We were talking earlier about liquidity being a key element. Do you not think that increased liquidity in the marketplace is another element that could drive down price for the consumer? Surely we don’t want to give the impression to the consumer that this has to fall solely on their back. Their behavioural change is the only way that prices can be reduced for them.
Dorothy Thompson: We would connect increased liquidity with increased efficiency, a better relationship between generator and supplier, and more open opportunities for suppliers. We believe, therefore, that it would have a positive impact on prices.
Juliet Davenport: As a result you may have a lower cost of credit, too. That is one of the key issues for suppliers. One of the barriers to growth for suppliers is how much they have to spend on having credit lines in place to be able to deal with generators.
Q 131 Barry Gardiner: Whichever way we look at the figures, there will inevitably be a huge amount of investment over the next 10 years. How much of that investment do you think can come from the independent sector, if I may call you that? What investment plans do you have? How much are you going to bring to this party?
Dr Riley: I guess the answer to that largely depends on the outcome of this energy market review, because at the moment I don’t think any of us would have serious plans to invest very much. The market signals just aren’t there. If you look at the often quoted £200 billion that is needed over the next decade or so, perhaps £100 billion 1 is in low-carbon technology. The independent generators represent some 20% of the market, so if the framework is right, there is no reason why they couldn’t invest their fair share.
Dorothy Thompson: We’re actively looking at two sorts of investment. I shall first tell you a little about Drax. Drax is the largest coal plant in the UK . It produces 7% of UK power, but we burn a lot of biomass. We have made a major investment over the past two years, and we can now burn an eighth of our capacity in biomass. That was a large investment, and last year we were, plant-wise, the largest renewable generator in the UK . With the right policies, there is an opportunity to change our coal station into a renewable station. To do that, we would need the right support from our equity investors as well as debt providers.
As I mentioned earlier, we have also been looking at new-build plants, which we have found challenging. What we have not found challenging is finding access to capital when we can put the right structure in place; we have found it challenging to find the right structure to make it financeable.
Juliet Davenport: We deal with about 1,700 renewable generators in the UK . In terms of recent policy changes, it has been really interesting to see the difference in attraction of external capital. There is significant debate around the current feed-in tariff, but it has very successfully pricked up the ears of various equity investors to make them come into this marketplace; it has done that very successfully. From our point of view, it has also been interesting to talk to investors and find that many are still very interested in renewables post-planning, but not pre-planning. So it depends what you are talking about; there are things other than electricity market reform that still affect incoming equity.
Q 132 Barry Gardiner: What effect will the instruments that have been proposed in the consultation have on the different types of risk that you are facing?
Dr Edge: If I may jump in, from the figures that I have seen, of that £200 billion only about £45 billion is possible, via the Big Six’s balance sheets. Other forms of finance, such as conventional project finance, are only going to take that up to, perhaps, £105 billion, so a large chunk-£95 billion-must come from somewhere else. Obviously, the big ones that everyone points at are the institutional investors-the pensions fund and insurance companies-but to get them in, you need more simplicity and ease of understanding. People say that the renewables obligation that they are being offered is complex, difficult to understand and unique to the UK , so we are not sure how that will appeal to those new institutional investors.
Dorothy Thompson: We are owned by institutional investors, and we have had some dialogue with them. The message that comes out to me is concern that the EMR document itself does not think hard enough about investors. The situation is ultimately value versus risk versus return, and any institutional investor will say that there are many different places in which they can put their investment; they will only invest in this sector if it is attractive, relative to the opportunities. That is about return as much as risk.
Certainly, the investors that we have been talking to recognise the attraction of the stability, and contract nature, of a contract for differences, as opposed to the current regime, in which there is-I don’t like to say this in the UK-an element of political risk. I strongly agree with Gordon that the real key is to keep it simple. The more you do that, the more investors can understand and money can be attracted.
Q 133 Barry Gardiner: So how will what is proposed in the EMR affect the cost of capital for your investment?
Dorothy Thompson: There is no question but that our analysis shows that if there is a contract for difference with the right level of return in it, there will be a lower cost of capital for us to create an investment, when compared with the RO, where we had risk on both the electricity price and the final ROC value.
Juliet Davenport: At the smaller end of the market, however, a CfD instrument may have the opposite effect. It may drive investment upwards into much larger projects and away from some of the smaller ones because of the transactional costs that are related to the proposed instruments.
Dr Edge: It has been well proven in a number of markets that when there is a lot of wind on the market, the price goes down. With the CfD, because variable generators such as wind are price takers, there is a risk that you will not get the index against which the CfD would be judged. You will not, therefore, get the strike price-it will be at some level below that, which you may not be able to predict with much accuracy, so although it promises price stability, it may not deliver that fully, which is a key risk for us.
Juliet Davenport: Which I think is a big dilemma full stop, because we need to have that pricing signal right at the end, at the dispatch. Otherwise, we will not have cost-effective dispatch, which will not be cost-effective for consumers. The only way to have efficient dispatch is to have the market price in it, and then you are left with the problem of how generators deal with that. At the moment, under the ROC regime, there is no protection, and the only way to get it is to go to a large supplier who will buy the risk. Under a CfD, you will be in exactly the same position-the only way to get protection for that last-minute dispatch risk is to go to a large supplier.
Q 134 Sir Robert Smith: We have already touched on carbon price support in one review of those proposals. How do the rest of you see carbon price affecting your business?
Dr Riley: I think the important point is that if there’s a feed-in tariff of some sort that’s going to be used to incentivise investment in low-carbon generation, there is a question mark around why the carbon floor price would be needed at all, because you’ve effectively then got two different mechanisms incentivising. If you’ve got a capacity mechanism as well, you’ve got a third, maybe, so there’s a question as to whether it’s needed at all.
Q 135 Sir Robert Smith: I was thinking you’ve got the EU ETS.
Dr Riley: Yes, okay, so you’ve got a carbon price already-potentially a carbon floor price; it depends on the level at which that’s set. But if it’s already incentivised by a feed-in tariff, then why is it necessary? To the extent that it’s decided that it is necessary, again we would make the same comments that were made earlier: it should only come into force when the generation that it’s trying to incentivise is actually on the bars and generating, and not earlier-and at a sensible level that doesn’t put too much of a burden on the consumer.
Darren Braham: Our concern would be a straight pass through to the consumer’s electricity bill. Some of the numbers that are being talked about would imply a 25% or 30% increase in electricity retail costs.
Dr Edge: In general terms, we think that having more certainty in the carbon price would be a good thing. Our preference would be for some kind of EU-wide mechanism to do that-perhaps a reserve price on EUA auctions-but at the moment we’re a little bit agnostic around this one. As Steve said, if there is a CfD it’s a bit irrelevant, in terms of what our members actually see as their income at the end of the day.
Juliet Davenport: Can I come in on that? I must admit that I came at this a slightly different way round, and maybe my thinking was just slightly back to front, but I felt that the reason for the CfD was the carbon price. Given the fact that you were putting a long-term price indicator into the market on carbon, the CfD mechanism was there precisely to make sure that you didn’t overcompensate some of the technologies. If you don’t have a carbon price, I’m not entirely sure why we’re having the CfD, but maybe that’s just me misreading it. I felt that a long-term price indicator that gently ramped up and gave long-term indication in the market would be a good thing, finally, and some kind of translation mechanism between the existing mechanisms we’ve got and a carbon price in the future would be the way that we should go eventually.
Q 136 Sir Robert Smith: Do you think the UK can go it alone with its own carbon price floor when it’s got a trading mechanism for emissions and is also about to, possibly, have more interconnectors with other countries?
Juliet Davenport: No, I think it has to be negotiated at a European level, and I think it has to be brought into a European type. There are already forms of carbon taxation across structures, across Europe , and I think considering how those interact would be an important part of it.
Q 137 Sir Robert Smith: Just one thing-a slight red herring: Professor Dieter Helm put it to us that the gas supply was becoming almost infinite and that a way of going quickly to a low-carbon situation would be to close all the coal-fired power stations and build lots of gas-fired stations, and then mothball the gas-fired power stations when future technologies become available. Does his analysis strike any chords?
Dr Edge: I can’t see how anyone would want to invest in a gas-fired power plant on that kind of basis-that at some time in the 2020s they would forcibly shut it. It does seem like a very odd way of going on.
Q 138 Dan Byles: I think his logic was that investing £100 billion in offshore wind in nine years is so staggeringly expensive that even turning a gas-fired power station off in 10 years would be cheaper.
Dr Edge: But then you would get no benefit, in terms of all the things I was talking about-in terms of the industrial side-and you would be wide open to the gas market. Okay, there may be some kind of global glut at the minute, but there’s no guarantee of that. It may be that shale gas turns out to be so environmentally horrific that you just can’t rely on it and we’re back again at square one with dependence on Gazprom.
Darren Braham: Yes, I think you are moving the risk somewhere else, and in the absence of creating more storage, I think it’s a very risky way forward.
Q 139 Chair: Going back to FITs, do you support the Government’s view that FITs with a CfD is the right way to do it?
Dr Edge: We think that’s a slightly higher-risk strategy than the premium FIT, which is their back-up. We see there are a lot of details that need to be got in there with the CfD for it to be a fully workable system. At the moment, we are trying to work through those details and see if we, internally, in our industry, can come up with a system, within the parameters that are set out, that we think is fully workable. We have not, however, got to the end of that process. At the moment, we are not saying yea or nay to that option. The premium FIT is lower risk for us. The transition to that would be less disruptive.
Juliet Davenport: The CfD is interesting. The examples that are given within the document relate to a one-sided CfD, as far as we can see, and particularly to ensuring that there is no downside to the investment, rather than to trying to pay back some of the upside. They particularly look at large-scale technology such as offshore wind. I come back to the point that CfD is not workable for smaller-scale generation. My feeling is that we have two types of FIT already, fixed and premium. Perhaps you could go with three types of FIT: a fixed, a premium for the mid-sized generators and a CfD for the very large ones. That would allow the trading teams that you require to manage a CfD. The overhead of that would match the larger-scale sites. You could have the review on a CfD-type basis for the premium side.
Q 140 Chair: The CfD FIT gives predictability on income, doesn’t it?
Juliet Davenport: It is not about the predictability; it is about the transaction costs of managing that predictability, and about being able to get the strike price, as was mentioned earlier, for the smaller generators in a marketplace at the rate that is perceived by the market index.
Q 141 Chair: When you say "transaction costs", what do you mean?
Juliet Davenport: I am referring to the fact that under the consideration-admittedly, there is not much detail here yet-you would need to be trading on a regular basis, whereas generally, a smaller generator tends to put a 10-year PPA in place, does one trade and allows somebody else to take that over. The CfD proposal is expecting a much more active trading position. Therefore, if you are asking for that, you will have to carry another overhead or pay somebody else to be able to do that.
Dr Riley: From International Power’s perspective, the preference would be for a premium FIT. While a straightforward, full FIT would give absolute certainty for that investment, we would not support that because it does not take account of the impact that would have on the market as a whole, once you are looking at the amount of renewables likely to be on the system. We have a preference for the premium FIT over the CfD because it is simpler.
Q 142 Chair: Even though it takes away the certainty?
Dr Riley: We would argue that investors in the energy market should be prepared to have some degree of energy market risk that they are willing to manage. I do not want to confuse looking for a risk-free investment with looking for a lower-risk investment that should be managed. It is important to maintain a liquid wholesale market and, therefore, a transparent wholesale price. The premium FIT would be more likely to do that.
Q 143 Chair: But almost every prospective generator of low-carbon energy says to me, "The reason we are not investing is that there is no certainty about the price." You’re saying that you want the choice that doesn’t give you that certainty.
Dr Edge: I think it is fair to say that people are investing against the RO, which supposedly does not have that certainty of price, but it has the familiarity of the mechanism, which allows people to make a judgment on whether it is an investment worth making. People have been investing, particularly in wind power, in this country.
Q 144 Chair: But nothing like enough.
Dr Edge: That’s not the fault of the RO. It’s because we have not been able to get enough through the planning and grid connection systems. The fact that 20,000 MW of onshore wind has entered the planning system since the start of the RO in 2002 says to me that the mechanism works.
Q 145 Chair: This is not about onshore wind. I see that there is a planning problem with onshore wind, but onshore wind is virtually a marketable technology anyway. We are looking at the other ones that are not marketable without some help. You are all saying that the one system that you want to choose is the one that takes away the thing that everyone else says they want, which is predictability on the price.
Dorothy Thompson: Excuse me, but I am not saying that. We support the CfD FIT. The premium FIT also works, but the problem is the cost to the consumer. To encourage investment, the investors will have to assume a certain power price. They will have to look for a safe enough power price, relative to the volatile power prices, to be confident of their income. Please excuse me if I’m getting too complicated. If you think the power market will be at one level, you will have to assume it to be at a lower level to make your investment, which means more support will be needed. We think it is a consumer issue, but from an investor point of view, it’s all about the level of support. In terms of the small dispatch, it is definitely the case that it will be difficult for the small generators to manage. It’s exactly like the RO today; under the RO today, the small generators have to go to a supplier and say, "Give us a contract." Under the CfD, we’ll be in the same position; if they don’t want to face the transaction cost, they will have to go to a supplier and say, "Give us a contract."
Juliet Davenport: I agree that the CfD, in principle, is a good mechanism for the larger generators, but I see it as a transactional cost for the smaller generators.
Dr Riley: May I have one more go? If this was a single-issue review, and you just wanted to incentivise low-carbon generation to a particular level, a straightforward feed-in tariff would do that; that would give absolute certainty for those investments. What it wouldn’t do is take account of the market as a whole. We had a conversation earlier about the importance of liquidity in the markets and thinking about a viable system going forward. That’s why we’d like to think-to answer your question about why we don’t go for something that gives absolute certainty for a particular investment-that the system will consider the market as a whole.
Q 146 Barry Gardiner: Is either of the two proposals for emissions performance standards worth the paper it is written on? Dr Riley, you had something to say on this in your submission.
Dr Riley: I think we’re already on record as saying that we think the emissions performance standard is an unnecessary regulation. Certainly, existing coal plant has enough constraints on it through the large combustion plant directive, the industrial emissions directive and the emissions trading scheme to ensure that there’s a fairly low level of generation unabated going forward. Given the level at which the emissions performance standard is set in this document, it’s very much a back-stop and probably an unnecessary piece of legislation.
Dorothy Thompson: We would completely agree.
Q 147 Barry Gardiner: Would anybody disagree?
Juliet Davenport: I don’t know enough about it, but in principle, I would agree as well.
Q 148 Barry Gardiner: Let’s imagine a scenario where the level was brought down from 600 or 450 grams per kWh to something that might seem to have a bit more teeth and that might actually bite into gas as well. What would the effect be? Might it be worth having that?
Dr Edge: Philosophically, our view would be that you’d want something in the short to medium term that incentivises the low-carbon, while in the longer term you have something like the EPS to squeeze out the rest of the carbon in the system. I’d have thought, as part of an overall mix, an EPS that does indeed bite down into unabated gas eventually is what you’d want. Certainly, from our point of view, for the low-carbon, we’re much more focused on the carrot bit of this than on the stick of the EPS, which may be necessary in the longer term.
Q 149 Barry Gardiner: In a sense, the carrot and the stick are just the obverse of each other, aren’t they? If the EPS is biting down, it is increasing the attractiveness of the investment proposition for your sector.
Dr Edge: That would be, to mix metaphors, a bit of a blunt carrot; it would be an incentive, but it would be rather indirect.
Q 150 Dan Byles: I just want to come on to capacity mechanisms. A number of respondents to the Committee have suggested some uncertainty about exactly what the capacity mechanism is supposed to achieve. Is it supposed to achieve a certain amount of capacity of any type, a certain amount of capacity of particular types or something else? I would welcome your views on that.
Dr Riley: If the capacity mechanism is there to ensure security of supply, that means you need a wide range of technologies in the system. It should, therefore, be a broad mechanism that ensures you keep the capacity in the system for reliability and security of supply.
Q 151 Dan Byles: A technology-blind system?
Dr Riley: Correct.
Dorothy Thompson: And also supply and demand blind.
Juliet Davenport: Yes.
Dr Riley: I’m sorry, but I have one more point on this. We have seen this effect in some of the other markets in which we operate. Clearly, demand-side participation would be an important part of the market going forward, as well, but that also needs to be real. In some of the other capacity markets in which we operate, demand-side bidding is there and participates at the auction stage. However, it isn’t necessarily there when it’s intended to be, and the penalties for non-performance aren’t that great. There is a lot of devil in the detail around thinking through capacity mechanisms where demand-side participation is used as well.
Q 152 Dan Byles: Do you think it’s possible to design a system that will reward both generation and demand-side measures?
Dr Riley: Yes, there are systems around the world. There’s the PJM 2 in the US , where there is a functioning capacity market, and I thought the all-island market 3 was quite a good capacity market as well, in contrast to the comments made earlier. The markets exist, and it is possible to learn lessons from some of the detail of those markets as they’ve operated.
Juliet Davenport: Bringing in the demand side is very important. Part of that needs to look at how the settlement system brings in the demand side and what the opportunities are for aggregating the smaller-scale demand, not only the larger scale. It is also about looking at the technology links into that. We talk about smart metering and smart grid, but we are not really talking about connecting it to a smart settlement yet. I think you need all of those aligned, and a bit more creativity and imagination could go a long way towards bringing in other areas.
Q 153 Dan Byles: Do you have a view on the level of capacity mechanism that we would require? Pöyry Energy Consulting did some modelling that threw up the idea that we might need up to 40 GW of back-up or demand-side measures. Do you have a view on what level might be required?
Dr Edge: It rather depends on the rest of the mix. It also depends on how much you can bring in on the demand side and how much interconnection capacity you can build with the rest of Europe . I am afraid such estimates are a little like asking, how long is a piece of string?
Q 154 Dan Byles: Do we not need an idea, or at least a working ballpark figure, if we’re going to design a system that will generate the capacity required?
Dr Edge: I certainly think that we need to focus much more on post-2020 scenarios. Our industry has been very focused on 2020 because we have a very hard target to meet, but beyond that is a really important debate that we are only just starting to have, which those questions would come out of. DECC has been trying to do it through its 2050 pathways work; we can argue about the usefulness of that, but we need to have the conversation and we’re not really down that path.
Q 155 Dan Byles: Do you think it’s too early for DECC to be looking at trying to create a capacity mechanism?
Dr Edge: No, but knowing how much it wants to deliver is another debate that may have started but certainly has not finished.
Dorothy Thompson: There are two different time frames here. I strongly agree on 2050, but the thing to remember is that our new nuclear plant will probably be load following. The profile of what our plant can do will change, and that will be a big advantage if we achieve what we want to achieve in nuclear by 2050. There is a risk in the transition. We read recently that it is estimated that by 2020 the hourly swing will go from 5 GW in 2009 to 17 GW in 2020-that is if we achieve what we expect to achieve on wind and so on. It is an enormous figure; 17 GW is like every household in the UK going from no power to almost full power within an hour. It is a major swing.
I think we have to worry quite a lot about what the transition will be. There is no question but that by 2020 most of our coal plant will come off the system. Our coal plant is providing an awful lot of that flexibility. We are a very strategic asset, so I see it day by day. We spend a lot of time providing frequency response and balancing support services, and on special contracts to National Grid just for that support. The coal will go, or a large part of it. That is simply a feature of the industrial emissions directive. You will also find that some of the older plant will go, which is also providing some of the flexibility, and we will have much less fossil fuel plant to balance the system. I don’t know what the answer is, but I believe it is something we should worry about. As you said, people should be trying to estimate exactly what the problem is so we can work out how to solve it.
Juliet Davenport: Just to add to that, one small thing is that we’re quite mute about electric vehicles at the moment and consideration of what that load may do to the system. I am concerned that there is no consideration at the moment for restricting electrical vehicles, and when they can charge and how they can charge-we are talking about speed charging. Those types of loads could make much bigger swings than we are talking about in this context. So, I think that needs to be considered to make sure that we don’t add to the problem that may be coming towards us.
Q 156 Chair: We touched on interconnections earlier-some of us were at National Grid yesterday, as it happens, and they are very keen on seeing more investment in interconnectors. Do you think that there is a limit as to how much we should regard interconnection as part of the answer? I know that it is a two-way process; obviously, we are supplying them sometimes as well. However, do you have a view about the theoretical maximum?
Dr Riley: I am sure that there is a limit, but I wouldn’t have a number. Again, I would have thought that there is evidence from some of the interconnected markets in continental Europe , where the peak in demand is actually coincident, and therefore, the effectiveness of an interconnector may be more limited than its nameplate capacity. As long as that sort of effect is taken into account, interconnection has an important role to play.
Juliet Davenport: I think renewable resource interconnection is quite interesting. If you look at the disperse of weather systems across Europe , when you are generating, you look at your generating capacity. When we buy power in the UK we try not to buy it in one region; we buy it across the UK . So, our 1,700 generators are spread, because that spreads our weather risk. Essentially, if we are going to move to a much windier portfolio, which we will, having larger interconnection means that-although I agree with the point about demand-in terms of wind, you will get spread.
Dr Edge: You might estimate some kind of limit, but by the time we get towards that, technology will have advanced, so the limit will have extended further. So, in some ways, you might regard it as essentially infinite, although I cannot predict the future. It is always difficult.
Q 157 Chair: The other point that was raised right at the start was about coherence of the package. There are several elements in it, but do they all fit together? Are they all necessary? Do you need a carbon price mechanism if you have a feed-in tariff, and so on? Do you think that those elements are not really consistent?
Dorothy Thompson: I echo what Steve said. If you are supporting your low-carbon generation through a feed-in tariff, I would question the role of the carbon floor.
Dr Riley: Again, the devil is in the detail. It would be quite easy, with some of these measures, to not think about the impact that a single measure has on some other important attributes of the market. At the same time, however, with enough considered thought, it is possible to bring this package together so that it is coherent and protects the good elements of the market that we have so far, as well as improving it and encouraging the right investment.
Dr Edge: I would have concerns about the reliability and security of supply measures, and the low-carbon support measures. It is possible that, through the capacity mechanism, you could really affect the wholesale price of power and that would impact on your low-carbon support mechanism. So, those bits need to fit together.
Chair: Okay. We have reached the end of our allotted time. Thank you for coming in, and I am sure we shall see you again individually or collectively on other matters before long.
Examination of Witnesses
Witnesses: Sarwjit Sambhi , Managing Director of Power Generation, Centrica Energy, John McElroy , Head of Policy and Public Affairs, RWE npower, Sara Vaughan , Director of Regulation and Energy Policy, E.ON, Ian Marchant , CEO, Scottish and Southern Energy, John Campbell , Director of Energy Wholesale Business, ScottishPower, Vincent de Rivaz , CEO, EDF Energy, and Paul Spence , Director of Strategy and Regulation, EDF Energy, gave evidence.
Q 158 Chair: Good morning. Thank you very much for coming in. We have a big cast of characters and a limited amount of time. I know that you, Vincent, have got to go off, but we are allowing a substitute to come on to the field later on. We will try to let you say what you want to say first. Could I get you all to introduce yourselves for the benefit of people who do not necessarily know you? Ian, we have been upgraded as far as you are concerned.
Ian Marchant: Yes. I was delegated upwards. I am Ian Marchant. I am the chief executive of Scottish and Southern Energy.
Sara Vaughan: I am Sara Vaughan. I am director of regulation and energy policy at E.ON.
Sarwjit Sambhi: I am Sarwjit Sambhi. I head up the power generation business at Centrica.
John McElroy: John McElroy, RWE npower, with responsibility for policy and public affairs.
John Campbell: John Campbell, director of energy wholesale at ScottishPower.
Vincent de Rivaz: I am Vincent de Rivaz, chief executive at EDF Energy.
Q 159 Chair: Ofgem has told us that you have whacked your margins recently. Is that true?
Ian Marchant: I wish that were true. Our gas supply business has lost money every year for the last five years. I am not sure that that is a sustainable business. So, yes, we are seeking to make profits in this business. We are generally failing. This is not a business that is awash with cash, as people would like to think. We put out a briefing to the City yesterday-it’s in the public domain-that said our generation, supply and profits are going to be down year on year, despite putting prices up, despite having 300,000 extra customers and despite investing £1.2 billion this year in that business. I find it deeply frustrating that in this part of London I get criticised for making too much profit and I go two miles to the east and I get criticised for not making enough. I think we are probably getting the balance about right. I would rather be praised in both, but at least I am being criticised in both.
Sara Vaughan: If I could echo that: in 2007 and 2008 we made a loss in our retail business; in 2009 we made a small profit in our retail business; the 2010 figures are not out. Even if you look at Ofgem’s own document-its December report on margins-it talks about margins increasing but then it talks about the fact that wholesale costs are also increasing. So we would expect to see those margins shrinking as a result of that change. Really what Ofgem was picking up on was a timing point, rather than anything else. You have to be able to make a sustainable margin in a retail business.
John Campbell: Our retail margins have been barely over 1%. Our last published results were for the first three quarters of 2010. The profit in our competitive business was down by 24% and our wholesale costs have increased by between 30% and 40% over the last year. So maintaining profitability in the retail business is a real challenge.
John McElroy: I would agree with many of the points that have been made along the row. As Sara said, we made no profit in our retail business in 2009. 2010 does not look any different in many respects. The other thing is that we need to recognise that there are substantial cost pressures on the business from a range of things, including increasing network costs and a whole range of Government initiatives in terms of feed-in tariffs, RO, and various measures to support vulnerable customers. There is a whole host of issues that are substantially driving costs up as well.
Vincent de Rivaz: I would like to say two things. First, when the cold weather started to bite, EDF Energy announced a winter price freeze. Secondly, overall issues of how the market works are precisely about having a fair balance between the interests of shareholders and the interests of customers, and that is why we are talking about electricity market reform.
Q 160 Chair: Several of you have mentioned that you are not making any money in your retail business, but since you are buying energy from yourselves, does that mean you are making a massive amount of money in the wholesale business?
Ian Marchant: I talk very specifically about my gas supply business. I have no gas upstream assets. I may be closing on a deal today, but in the past five years I have had no gas upstream assets. I have had to buy all that gas in the market. There is no profit anywhere else, I can assure you. It is more complicated in electricity because obviously I am the generator as well, but in gas, absolutely, there is nothing anywhere else.
John Campbell: The dark spread, which is what we call the profit that we make in generating from a coal unit, is currently less than £1. The spark spread, which is the equivalent number for gas-the profit per megawatt-hour-is about £5. To replace thermal plant in the future you would need spreads of £16 or £17. Generation spreads in the UK at the moment are not in a very healthy place. That is why the electricity market reform is so important to create the investment signals, because they are not there in the current market for thermal or renewable, or for any plant. The wholesale market is a very weak place.
John McElroy: You were inferring a link between the generation and the supply businesses, and I would like to make the point that at least 90% of the generation and supply volumes that we deal with are traded in the market by our supply business, so everything is at arm’s length. The other thing that you need to consider is that if we look at RWE npower’s profits last year the amount that we invested in the UK was more than three times the level of profit. That is a very considerable factor that has to be taken into account.
Q 161 Chair: We will come on to some individual aspects of EMR in a moment. We are looking at a prospect over the next few years, however, of rising prices for a variety of reasons, and it looks as though a low-carbon element will drive costs up a bit further. There is already a suspicion among your consumers-although you are able to refute it, and you can say that investors are breathing down your necks because you are not making enough return-and a lack of trust in the price-setting process. Do you think there is a danger that if we are going to achieve the more secure, lower-carbon electricity that we want, which is an explicit objective for the Government, consumers will think that actually they will resist the price consequences of that, because of this lack of trust that already exists?
Sara Vaughan: Can I hit that point head-on, because it’s something that we have been tackling in our advertising? Some of you may have seen it; it heads up with "Why on earth would an energy company want me to use less energy?" That is exactly the point that we are trying to hit with that-the trust point, and the cynicism from consumers about the approach that energy companies have. We are trying to be very honest with consumers, and we are trying to explain to them exactly why prices are going to go up and the underlying reasons behind that. We are doing that through advertising; through talking to consumers in town hall meetings; and through our internet site, which has one of these blogs where people can come in and join conversations that are going on. We’re perfectly aware that there is this lack of trust around energy companies.
Returning to the point that was touched on previously concerning supply and generation, for many years-at least the last 10 years, and certainly before Ofgem mandated us to do it-we reported our generation business results and our supply business results separately and also from our regulated distribution business results. They were in our published accounts. Anybody could find them on the internet. So if people wanted to look at the relationship between those two issues, they could do so. I would absolutely support your point, Chairman, that trust is a key issue for this market going forward.
Ian Marchant: I agree. It actually doesn’t help that the first question that we’ve had on the investment climate is about profitability and prices. Actually, your side of the table doesn’t help our side of the table either in the way that the debate is carried on. We have to raise that element of the debate to keep my consumers and your voters alongside the common agenda that we have to decarbonise our society. We have to work much more together, rather than fighting each other the whole time.
Chair: Let me absolutely assure you that one of the things that I have been consistently saying, as some of you will know, for the past three years is that prices are going to go up substantially. You cannot point to a single suggestion from me where I said that prices should not go up.
Q 162 Barry Gardiner: Does silence on the panel mean that those who are silent are doing rather well and didn’t want to participate in that debate? This is an opportunity for Mr Sambhi to deal with such a suggestion.
Sarwjit Sambhi: Thank you for the opportunity. In terms of the profitability and looking at the question of how much money is made downstream versus upstream, I will reinforce the point that the margins that British Gas has made over the past three years have fluctuated and have been as low as less than 2%. On average, over the past three years in energy, that has been around 7%. Compare that to other retailers-whether it’s fixed-line telephony or mobile-and it is substantially lower than you would expect in any retail market. On the upstream, a measure of profitability is return on capital employed, and in terms of our return on that in investments that we’ve made, particularly in power, they are currently single digit. We cannot, therefore, be seen to be making excessive profits by a hard measure in the upstream.
I would also point out that if you look at how much we’ve invested in UK energy infrastructure, for every pound of operating profit that we’ve made, we’ve invested £1.60 in UK energy infrastructure.
Q 163 Sir Robert Smith: I had better remind the Committee of my entry in the Register of Members’ Financial Interests, which states that I am a shareholder in Shell. I just wondered why those businesses that are making a loss on the retail side still do it.
Ian Marchant: Would you like to join my board? That is exactly the question that we struggle with, particularly with gas. We make a margin on electricity. The problem that we’ve had with gas is that the wholesale price has been so volatile. Just when we think we’re going to make a profit, the wholesale price moves against and that hasn’t happened. We’re in it because it’s a dual fuel market and we have to be in it, because that’s what customers want. We tend to look at a dual fuel margin when we’re looking at things, and that is a very small positive at the moment after the price rise. Whether we should stay in the gas retail business is a real challenge, because the evidence suggests that we cannot make a decent margin out of that.
Sara Vaughan: Let’s be clear, we have been making a loss, but we did make a small profit in 2009, and we would want to make a profit in 2010. We’re not in the business to make a loss; we’re in the business to make a profit.
John Campbell: We have a commitment to be a UK generator and retailer. There’s a lot of integrity in that business model. As someone else just said, we’re not in it to make a loss; we’re in it to make a fair return. That is certainly what we plan to do.
Q 164 Barry Gardiner: Was Ofgem accurate when it said that the recent price rises will increase profit margins from some £65 on a dual fuel tariff to £97? Is that right, or is Ofgem just wrong?
Sarwjit Sambhi: Can I pick up on the analysis? The analysis is flawed to some extent, because Ofgem looks at current retail prices and compares that against projected forward wholesale prices. It is mixing apples with pears. The other thing it doesn’t do is look at the additional costs that are incurred beyond just the wholesale commodity price, such as increase in transmission and distribution costs. So, at face value, there is more to the numbers that needs to be explained. I would argue that the analysis is flawed.
Q 165 Barry Gardiner: I would accept that, but none the less, that flawed analysis is still contained in the £65 figure, just as much as it is in the £97 figure.
Ian Marchant: The data are right, but if the analysis came out with a suggestion to move it from minus £50 to plus £50, we’d be having a different debate, wouldn’t we? It is the absolute level. Ofgem overstates revenue because it takes the highest-price customer and does not take account of loyalty discounts and various other things that we have. The average revenue that we earn from customers is lower. Ofgem understates the costs for the reasons said, and it understates the cost that we incur on risk-managing a fixed revenue stream with a variable cost. We end up requiring it to be long or short power and having to trade that out. Our view is that the absolute level of those margins is significantly lower than what Ofgem says. The change from the price increase is mathematically correct, but the analysis is where you start from.
Sara Vaughan: Yes.
Chair: I think we will move on to the EMR now. Thank you, Ian.
Q 166 Sir Robert Smith: Some of your earlier answers might have explained this, but one of the concerns about the market is the concentration and the difficulty for new entrants in both the generating and the retail sides. Do you see any barriers that can be removed to bring in more competition, or any benefits from more competition?
Ian Marchant: The first thing to say is that this market is competitive compared with any in Europe . There are eight major generators and six major suppliers with more than 5% market share in the UK . In France , it is four and one, and in Spain it’s four and four. So we are significantly more competitive before we start.
Secondly, I actually don’t like giving evidence with these five people. They’re not my friends. I don’t like them. People do not move between these companies. We have very different approaches to this industry, which is why when we get to the detail of the EMR, you will hear different views. Trying to get us to a common position is like herding cats-it’s basically impossible.
If I look at the liquidity of the market, I think it is pretty good in the first year or two, for gas and power. You can trade and hedge your position for a year or two. The issue is longer term. The barriers to entry are, I believe, threefold, and they are not related to anything that we do. The first barrier is the credit requirements of banks and companies, which have become significantly tighter since the financial crisis. Small new entrants cannot post a collateral to trade. That’s the first thing.
Secondly, in terms of the sheer size of the investments required to set up a supply business or a generator you’re talking about hundreds of millions of pounds. Those are not typically the sorts of businesses that private equity generates. The third thing is that it’s a risky business. New entrants have gone bust. People forget that the largest independent supply business, Independent Energy, went bust in 2002. Large independent generators, including Drax, effectively went bust and had to be rescued.
My fourth reason out of three-this is like a Monty Python sketch-is that an awful lot of regulations are imposed on our sort of business that make it very difficult for someone to set up, which is why the new entrants you see in supply will typically use one of us to provide the services to meet all their compliance-for us that means M&S Energy, and I think British Gas has just done a deal with Sainsbury’s. Even companies of that size struggle to meet all the regulatory compliances.
Sara Vaughan: Can I pick up the point about liquidity that Ian touched on? I think there is a real misunderstanding about companies that have a generation arm and a supply arm, and in the concept that people have of vertical integration. They imagine that all that those generation arms do is supply their supply arms, and vice versa. That is absolutely not the case. If you look at a company such as E.ON, we have an independent trading business that sits in the middle. Effectively, we manage our generation and supply positions separately. Our own churn in 2010 has been, on average, around five times the market-five times physical. So, we are buying and selling that five times. The market throughout 2010 was around four times, so we are trading our generation and supply more than the market average is moving.
John McElroy: The point has been well made-why would you come into the retail business given the margins at the moment-but on the generation side the simple fact of the matter is that the market is some 30% plus over capacity at the moment, the prices are nowhere near new entrant levels and we don’t expect to see any significant change in terms of that overcapacity until post-2015. But if you look at other areas of activity, such as in the renewables business, there are around 18 players in the offshore market at the moment-there is lots of engagement there. You have to look at which part of the market you are dealing with and take a perspective on the environment in which those bits of the market are operating.
Q 167 Sir Robert Smith: Are you all similar-while being vertically integrated, you don’t necessarily trade with yourselves?
John McElroy: I have already said from our perspective that more than 90% of our generation supply volume is dealt with through our trading arm. It is independent, as it were, from the rest of the business.
Ian Marchant: It varies. About five for power, and about seven or eight for gas, which we trade compared with our physical supply needs.
John Campbell: We have a similar set-up. We have a trading organisation which has separate strategies for hedging and selling gas power for generation and retail. We typically trade up to four times the physical volume that we produce in power. We trade several times the gas sales we have. But we recognise that for smaller generators and suppliers it is a difficult market, with a lot of administrative complexity and credit issues.
Ofgem has been trying to tackle the issue, and we have made simple commitments on providing simplified master trading agreements-the commercial framework-free trade notification services, initial lines of credit and streamlined financial regulatory compliance. I could go on, but the point is that there are measures we can take, and we do work with small generators and retailers. We actively try to find ways of making the market work for them by giving them access to the trading services we have as an internal business. We do so on the same basis as we trade with our own retail and generation businesses.
Q 168 Sir Robert Smith: But if you are all separated and not vertically trading in a narrow way, why are you vertically integrated companies?
Ian Marchant: We run our business as an integrated business, but we absolutely trade with the market. They are not mutually exclusive. Why are we vertically integrated? For significant risk-management benefits. Why does virtually every power market in the world tend towards vertical integration? Because you need the generation to hedge your customer business. That is why it will happen.
We don’t just keep all of that to ourselves, and just trade internally. We need to be active in the market, because at every half hour I am either long or short, and I will need to trade with the physical players here. I also want risk-management tools, which the banks can offer. So, for the first two years going out in any point in time, we are very active in trading. The point about liquidity really starts to bite in year three onwards, when a market is significantly illiquid. That is the problem for a small supplier or generator-the longer term-but we have the same problem. How do I buy my 5 billion therms of gas in 2014? I can’t, there isn’t a liquid market there. So, you need to distinguish between short term, which is very liquid and vibrant, and long term, which is virtually non-existent.
Sara Vaughan: The UK market isn’t different from other markets from that perspective. If you look at a number of the other markets around Europe, which we do because we have a European trading business, then you will find most of the trade concentrated in the nearer term and, further out towards the third year, it will be much thinner.
Sarwjit Sambhi: On the comment of why we strive for a level of vertical integration, I would say that one of the things that the corporation tries to do is to smooth out earnings volatility. Clearly, being concentrated in one part of the value chain versus the other would result in very volatile earnings, which we would not be rewarded for by the shareholder.
Q 169 Dan Byles: I want to come back to an issue that we have discussed quite a lot in this Committee, which is investment in the energy sector and this enormous requirement that we are all aware of-Ernst and Young recently suggested that £234 billion of investment was required by 2025. Alistair Buchanan recently told the Committee that the big energy companies are looking eastwards for investment rather than to Europe and the UK because of the potential for higher returns on investment. Do you agree with that?
Vincent de Rivaz: No.
Q 170 Dan Byles: That is good. The subsequent question is whether EMR will help in any way.
Vincent de Rivaz: Yes.
Sara Vaughan: That’s that then.
Vincent de Rivaz: It is important that we focus on how to make the investment possible. I believe that we have in front of us, from the Government for consultation, something that is coherent, holistic as a package and fundamentally fair for moving on in our competitive market. Let me be more explicit about what are, in my view, the three principles that led me to answer yes to the question. Are we poised, with our co-investor Centrica, to make a major contribution-driving a multi-billion investment programme-in the UK ? The answer is yes because in the proposals there are three principle elements that will be instrumental in delivering that. First, a carbon-price floor will remedy the failings of today’s trading scheme. Our view on the so-called second scenario that the Government are proposing-the one where the price of the carbon will be the floor price of £30 in 2020-is that it strikes the right balance. Secondly, we think capacity payments will reward investment in firm, available generation. It will provide the security of supply that we need as more intermittent generation is placed on the grid.
Finally, contracts for difference will address risk and volatility in the market, providing greater certainty for the customers and investors and the lowest possible costs. I think today that our shared challenge is to ensure that both the mechanics of this reform, which are complex and holistic, are right, and that the reform itself is delivered in a timetable that drives key investment decisions in new generation in good time. That is why my conviction is that, for this consultation, we need to reach the point where we can deliver reform in a very tight timetable.
In my company, we are contemplating a multi-billion-pound investment programme. At the beginning of 2012, we will have to make some big financial investment decisions. The decisions we make will be very important for this country’s growth agenda, investment agenda and jobs agenda as well as delivering what we have been looking for for years-market reform delivering secure, clean and affordable energy. That is a very important point. The reforms-we are discussing them in the Thatcher Room today-are the most important reforms proposed since the privatisation of the market. Some have said it is a seismic change; it is a holistic change. My priority is to make it happen.
John Campbell: Just to answer your question, like other participants here, we’re part of an international company-in our case, Iberdrola. The investment will go where the confidence and the returns are for that investment. The electricity market reform has the potential to improve the UK ’s attractiveness in that respect. It’s trying to deliver two key things to drive low-carbon investment. The renewables obligation scheme is working. We need to be confident that what is coming along to replace it will not reduce the momentum and that there’ll be no hiatus. There’s another perspective on energy market reform-that it is to maintain security and affordability, as well. I’m sure we’ll get into the detail of some these, but we have to make sure that capacity payments and carbon-price floors do not put at risk security of supply in the transition to the lower-carbon generation portfolio in the future. There’s a lot of detail to be worked through, but we believe that EMR has the potential, if we get it right, to increase investor confidence in the UK . But there’s a lot of detail to go through before we get there.
John McElroy: RWE is one of the biggest investors in the UK at the moment, so we’re not walking away from the UK . But, in response to your question, we need to recognise the scale of the challenge and the need to bring in new money, new sources of capital and new investors. Therefore, it is critical-the electricity market reform gives us the opportunity to do this, as others have said-to make certain that we have a regime that generates stable, predictable returns on investment that are commensurate with the risks of large low-carbon projects. Whatever else we do, the outcome of EMR needs to satisfy the criteria of investors to maintain the attractiveness of the UK going forward.
Q 171 Dan Byles: Do you think, from what you’ve seen, that it will do that?
John McElroy: We would say that we’re far from the end of the road, as it were, but what’s on the table at the moment is certainly a good start, and we need to work together to make certain that we get the right outcome.
Sara Vaughan: E.ON was one of the companies that Alistair spent quite a lot of time talking about in his evidence-
Dan Byles: I gather you’re selling half of your assets and running away.
Sara Vaughan: I think he was suggesting that we were looking east rather than looking at the UK . When we announced our strategy in November last year, we made it clear that we were seeking to get 25% of our profits from other markets outside Europe by 2015. This reflects the opportunities for growth in those other markets, but it also means that we are looking to get 75% of our profits-very much the greater part, therefore-from Europe . The UK is a key market for E.ON. We are already investing in the UK . Over the last three years, we have invested more every year than we have taken out in profit. Since E.ON bought us in 2002, it’s invested more than £7 billion in the UK , which is quite significant. We see no reason for that to change. We’re just commissioning our combined heat and power plant on the Isle of Grain. We’re investing in London Array, which, when built, will be one of the world’s largest offshore wind farms. We have an option for a gas-fired power station at Drakelow. With RWE, we’re a partner in Horizon Nuclear Power, which is looking to build 6 GW of nuclear power in the UK . None of that suggests a company that is anything other than committed to the UK .
Ian Marchant: We are looking east, but probably not quite in the way you envisage. We are looking at the North sea , which is technically east. We are a UK company-we and Centrica are the only two UK-domiciled companies here-and 100% of our investment is in the UK and Ireland . So this market is absolutely crucial to the future of my company in a way that it is not as crucial to the four Europeans. They have choices for where they invest. I want this market to work. I am not as comfortable with the EMR package as some of my colleagues. There are two key points.
First, it is only part of the problem-we have problems with planning; we have problems with the grid, both on access and on charging; we have problems with the supply chain; and we have problems with construction risk, which EMR does not tackle. Those are the biggest constraints on investment today.
Secondly, the CfD principle will fundamentally undermine the importance and the nature of the market. The UK will live to regret that. The liberalised market has been a major driver of innovation and investment in this market and the EMR package significantly undermines that. We will look back and end up changing it. We will put the market back in the driving seat, rather than the state, as the CfD is doing in deciding what is built, by whom, where and when.
Vincent de Rivaz: I understand that Ian thinks he can comment on the intentions of his competitors, but it is preferable that I speak on behalf of EDF Energy rather than him. We are a UK company. We are committed to this market. It is the second largest domestic market of the EDF group, which is an international group with a UK business.
We should not isolate the contract for difference, which is part of the package, from the carbon price floor or the capacity payments. It is part of the better market for which we are all looking. It is not about a lesser market; it is about a market that works. The contract for difference will address the volatility and uncertainty, which has been a problem for many years. It should not exist in isolation, which is why I am also promoting the idea of the carbon price floor and the capacity payments. Those payments will be made to all plants that are available at times of peak demand, and not only to the peaking plants, which has the potential to distort wholesale market prices.
Contracts for difference are about contracts, which are compatible with markets. The market is made of contracts every day, so I do not see why the simple idea of a contract is contrary to the idea of a market. It is a contract for difference, and it will be settled against the reference price in the wholesale market-which, yes, places a high premium on ensuring that market arrangements deliver a credible price. That is why it has to be part of a package.
I really believe that the right combination of the contract for difference and the carbon price floor will ensure that consumers do not have to pay any more than necessary. The feed-in tariff, and a premium on the feed-in tariff, is the alternative option.
I understand those who have been lobbying hard and successfully to have ROC banding. Two ROCs for an offshore wind farm is very favourable for such a premium on price, but it is more costly. If you take what the analysis is saying, the cost of capital, as it is today without the market reform, is 13.2%. With the feed-in tariff it will be 12.2%, and with the contract for difference it will be 11.2%.
So that will make a big difference, because at the end of the day the lower the cost is, the lower the price for the customer will be. We have to accept that we are facing new challenges, which are not the same as 20 years ago, when we had over-capacity and oil and gas in the North sea . Nobody then was talking about climate change and CO 2 and, thanks to privatisation, everybody was expecting downward trends for bills for ever.
We are facing new challenges in the next two decades. One is security of supply; we no longer have any oil and gas reserves in the North sea and there are important geopolitical issues. Security of supply is important to keep the lights on. We have to tackle climate change. This country has made a binding commitment to reduce carbon emissions by 80% by 2050. We have to abide by that and at the end of the day we have to have the least-cost solution for the customers. These challenges are not the same as challenges in the past.
Every day as companies we adapt our way of working to the changing environment; we are praised for that flexibility, adaptability and ability to react. It will be bizarre if we are not able to make the same changes to the electricity market. The package that the Government are proposing is credible, comprehensive and holistic. My feeling is that there is a momentum to get this investment under way. There is a large consensus, despite differences that we hear here and there, and my priority is to make it happen, to enter this consultation and then, with the working relationship we will have with the officials, to enter a process where the details will be fixed so that we can move from a period of debate to a period of action.
John Campbell: May I follow the theme? ScottishPower is a local British company that is part of a global group. It has spent £3 billion in the last three years and will spend another £4 billion in the four years to come. So we are also very interested in the outcome of this market reform. For us, looking at the feed-in tariff issue, we think it is down to the detail. We are not prepared to say that the premium is right or that CfD is right.
There is more detail to be explored on indexing and on returns. That will come out. These mechanisms can both potentially deliver a viable replacement to renewable obligation. Absolutely key is that the returns on investments already made under ROC are protected and that that ROC scheme is available right through 2017 until we are very clear about the alternative.
I would differ a bit, as you might expect, in terms of the carbon price floor. We think that will be a very expensive tool for UK industry and UK consumers. If the feed-in tariff scheme is right, it will have a limited role to play, if any, in supporting low-carbon generation and it has the potential to push some of the plant off the bars, which will be required to keep the lights on in this country over the next 10 to 15 years. So our view on that is, go low and go relatively slow on any carbon price floor.
We are a big supporter of capacity payments because the market needs to reward firm capacity-especially a market which may have more intermittency in future. We are not particularly happy about the initial proposals or discussion topics from DECC on that. Experience from all round the world says reward all firm capacity. If you try to target for peak periods, what tends to happen is you displace investment and end up with the scheme migrating towards all firm capacity being rewarded. We think we should make sure that we get that right from the beginning. It could be inefficient to see existing plant taken off the bars to be replaced by new build. Getting that capacity mechanism right and making sure that any emissions performance standard isn’t biting too deep too soon is critical to maintaining security while we drive.
One final point: the current scheme of transmission charging in the UK does not follow the objectives of UK energy policy on carbon reduction. Renewable plant and carbon capture and storage cannot follow that transmission price signal, and that issue needs to be addressed if the UK is going to hit its renewable targets. We have seen evidence from people like Oxera that we will get a lower-cost deployment of renewable generation, and the potential for carbon capture and storage demonstration, if we can sort out transmission charging.
Vincent de Rivaz: Mr Chairman, I have to apologise because I must leave. The reason is not that I do not attach great importance to your Committee-just the opposite: I made a choice to come here despite this diary clash. But I have also to talk to my shareholders about electricity market reform, because the multi-billion investment will come from them. So Paul Spence will deputise for me.
On the carbon price floor, one word: it is part of a package, not to be isolated from the rest. Carbon price floor support is not a new policy. It merely restores the carbon price signal that was expected from the EU ETS. The problem is that we all know that the EU ETS as it is today doesn’t work and we have no certainty that it will work, so it’s logical that there is a carbon price floor, which is going to reinforce both the principle that the polluter pays for what it pollutes and the intention of the people who designed the EU ETS, in delivering a credible signal to the market for the investors to invest in low-carbon technology. So for me the carbon price floor will not be contradictory to the market, as I have already said.
I am very supportive of the second scenario of the Government proposals: a kind of gradual increase starting with a low level-just the carbon price as it is today, more or less; then in 2020, £30, and in 2030, £70. I have heard some comments saying if I am in favour of that, it will just come from benefits in the short term for the existing nuclear power plant. That is not true at all. My good friend Dorothy from Drax is defending a position against carbon price floor setting; it’s detrimental for 4,000 MW of coal power. But I have exactly the same quantity of coal-fired power plants, so it’s not something that will distort the competition between us.
I will ask Paul Spence to step in. Many thanks.
Chair: Thank you.
Sarwjit Sambhi: I will just answer Dan’s questions. So on the first one, clearly at Centrica we have nearly 90% of our business in the UK, so there is no question about it-like Ian, we are committed to investing in the UK market, and we plan to spend £15 billion over the next 10 years. There is no question about our commitment to this market.
On the EMR reforms, I think we ought to step back a little bit and say "What’s the problem that we’re trying to solve?" It’s a difficult conundrum that DECC has been posed. We want security of supply, low-carbon generation and renewable generation. The current market, as is, won’t deliver all that, so something different has to be put in place.
Do the EMR reforms, as proposed, deliver that? I think they do. Take each one quickly in turn. On carbon price support, we’d advocate that introducing the floor creates emissions reductions early and it’s cheaper than other forms of carbon emission reductions. So we’d actually advocate that the sooner it comes in, the better. On the CfD or PFIT, we think that either could work. CfD has practical implications, especially in terms of how it interacts with the wholesale market. PFIT can work, and one could see that that’s a natural extension of the current renewable obligation, albeit simplified.
Capacity payments incentivise having security of supply in advance of having new nuclear or sufficient wind capacity on the system. In the long run, they are also good for ensuring that we have back-up to take up the slack when the wind isn’t blowing. As a package, I think that the measures, as proposed, address the multiple objectives that we’re trying to achieve. The devil is in the detail, however, and the key thing-returning to Vincent’s point-is how it is all going to work. Implementation is now key.
Sara Vaughan: Just on that one point about whether the carbon price floor reduces emissions earlier. In the UK , a carbon price floor is likely to cause a shift from coal to gas, but looked at across Europe as a whole it will not reduce emissions at all. All it will do is shift it out of the UK into somewhere else in Europe . Will it have a positive environmental benefit, looked at in larger terms? No, it won’t have.
Sarwjit Sambhi: I am sorry, but I have to come back, because that’s true if the same number of allowances are allowed to be in the system. The UK could make a choice to reduce the number of allowances that are auctioned.
John McElroy: You can’t do that with phase 3.
Sara Vaughan: That’s not proposed at the moment.
John McElroy: I’ve struggled with some of the arguments on a carbon price floor from Vincent and from National Grid. As a company, we have always believed in the EU ETS; ultimately, we believe that is the right instrument for putting a price on carbon, but it comes back to some of the points made about the impact of a carbon price floor on security of supply. Equally, if we go down a CfD track it’s hard to see the relevance of a carbon price floor.
Also, I would take issue with ScottishPower on its perspective on the need for broad-based capacity mechanisms. We do not believe that the case for a capacity mechanism has been made as yet-certainly not in the EMR consultation as we have seen it. We also agree with the view recently expressed by Centrica that it is premature to prejudge exactly what the balancing situation will be in the market in the 2020s. We don’t know what the energy mix will be and we don’t know the extent of interconnectedness, and there’s a whole issue of how the demand side plays into this and how it responds.
In our view, things could be done to strengthen the existing regime, particularly in terms of cash out prices, to make certain that we encourage players in the market to minimise the extent of imbalance. We believe that we have to work hard on delivering demand-side measures through smart metering. We agree that we really need to come up with a robust mechanism to monitor the capacity margin situation, but we would say it’s premature to take action.
Ian Marchant: I fully agree with Vincent on capacity. We need a capacity market in the UK , and it should be for all capacity. Any targeted mechanism anywhere in the world ends up being changed into all or nothing. We think that there should be a market for capacity, particularly when intermittency is increasing. The sooner we start, the better, although it could be at a low level.
The carbon price should be absolutely central to our policy for decarbonising the economy from 2020 onwards. The sooner we can stop all other support mechanisms and focus on the carbon price, the better. I would start some form of carbon price support or floor early, at a nominal level, to start proving to ourselves that it works. At the same time, we should continue to seek to reform the ETS to make that bankable, because if that works it is still our best hope.
As I said earlier on CfDs, I think that is the wrong way to go, because we need a vibrant, liquid energy market and CfDs go to the heart of that. A premium feed-in tariff is easier to do-it is less intrusive on the market and easier to remove when the technology of CCS, nuclear and offshore wind can compete against a carbon energy and capacity price. In a sense, as you’re hearing, there are six different views. On each topic, some of us agree, but every one of the six positions is different. We thought that we would make your job difficult for you.
Q 172 Chair: On the timing, we need huge investment in nuclear and offshore wind, both of which are going to be pretty slow to bring to production. It is likely that some of the decisions about those investments will have to wait until the EMR process has been concluded. In your minds, is there a last possible date by which the Government need to decide-they are consulting, but they have to make a decision-to ensure that we get somewhere near achieving the 2020 targets?
Ian Marchant: I have always felt that this year is crucial. I am not saying that December is a hard deadline, but if we have not got clarity by the end of this year, the risk is that the momentum that is clearly building up in all three technologies-CCS, on which projects are being developed; offshore wind, on which we have formed alliances and are attracting in new manufacturers; and nuclear, which three active consortia are developing-will start to reduce. So this year is crucial.
Sara Vaughan: I absolutely agree with that. There is already a concern that we may be seeing slippage in the time scales. We were hoping that we would have legislation in this session and would get Royal Assent in 2012. More recently, it appears that that will not come into the current Session, and therefore, at the earliest, we are looking at its being introduced in May 2012. Therefore, we are probably looking at 2013 for Royal Assent.
If that has already slipped, does that mean that you will have knock-on slippage when the date for the White Paper is no longer late May 2011, but suddenly turns into summer 2011? All those things are being watched not only in boardrooms in the UK , but in boardrooms in Germany and, I am sure, in Paris . I would agree with Ian on this point-the need to keep up the momentum and impetus is absolutely crucial.
John McElroy: I would add that, in one sense, we need to understand the framework and as much of the detail as possible. On delivering the detail, that absolutely has to be done by the beginning of 2013, which is particularly important in the renewables world, as it has a lead time of four to five years on new renewables projects.
With the RO terminating in 2017, investors in the renewables community will clearly need to know what the rules look like by the beginning of 2013. We want to see as much as we can this year, and when it gets down to the granularity, we have to have that level of detail by the end of 2012.
John Campbell: We are in a very similar position. We have major investment decisions to make over the next 12 months-investment decisions on offshore wind, coal-life extension, carbon capture and storage, and potentially in new gas plant. Like other companies, I do not think that the UK can wait for three or four years to see where this all ends up. We need clarity over the next 12 months, and some of the fine detail, legal application and implementation can come later.
On timing, in regard to the renewables obligation, we need to be absolutely clear that the current scheme will continue to reward. The changes through electricity market reform may impact on the current market, and hence impact on the rewards through renewables. We need to be absolutely firm and clear that our investment in low-carbon generation will be protected, and that we will ultimately have choices to make about when we transfer over to the new scheme, once we are absolutely confident. If we do not get that right, we risk having a hiatus in renewables deployment, which would be a terrible shame.
Paul Spence: This is one area where there is heated agreement across the whole industry. As Vincent said before he left, we have a very major investment decision to take at the start of 2012. We need to be able to lay out for our investors and shareholders the basis on which they will take that decision. That means that we absolutely need to get on with the market reform. If the longer-term reform will take longer, we need to know what happens for people to take decisions in the meantime, so that we do not lose momentum.
Chair: Achieving a rapid resolution of all this would be made easier if there was agreement between you on other aspects as well.
Q 173 Sir Robert Smith: Quickly returning to the carbon price, you’ve already dealt with the interaction with EU emission trading and the different views there, but if National Grid is right about the growing want of interconnectors, how can a British go-it-alone carbon price work with an interconnected electricity market?
Ian Marchant: We think that if you get a difference of more than about £10 on a tonne of carbon between the UK and Europe, you will effectively get investment in Europe . It makes more sense to build a CCGT in France , the Netherlands or at the end of an interconnector. The frictional costs of the interconnector mean that you can have a small difference, but about £10 is unsustainable in a single market. We think that the interconnectors are going to be quite significant.
In the earlier session, you were talking about the need for back-up capacity. I think interconnection can make quite a significant contribution to that. That’s why we announced a study yesterday on linking the UK to Norway , because it partly depends on where the interconnection is with. Linking the UK and Ireland will not really change the dynamic, because its energy system is very similar to ours. If you go to different energy systems- Norway has hydro and different wind and weather patterns-we think that interconnection will make a difference. It means that getting the ETS right is absolutely the crucial thing, because there is a limit to how much the UK can or should go it alone on carbon price.
Q 174 Sir Robert Smith: Is the dilemma that the carbon price is really needed to get the nuclear investment, even if it means going it alone and damaging the other markets?
Sara Vaughan: No. I come back to the point that was made quite strongly in the previous session. If you have a mechanism like a contract for difference in place, that effectively means that the role of any carbon-price floor is much lower, and some would say that it is not really having an impact at all. Looking at the Government’s own document-the Redpoint document-that they published at the same time as the consultation, Redpoint said that adding a carbon price support, and the figure that they chose was £30 a tonne by 2020, to a fixed payment or a CfD makes little difference in terms of the amount of low-carbon investment that is produced by the market. So you then start asking, "Why are you adding that extra cost?" I can see some argument for having it there to make the reference price of the CfD more closely reflect the level under the CfD. Most investors, however, would be largely indifferent to the level of the carbon price if they had the CfD or premium FIT in place anyway.
Ian Marchant: I think part of the issue with EMR is that, although we talk about high-level objectives of security of supply in energy, it has actually been designed to get nuclear built. If you design any energy system around nuclear-anywhere in the world apart from in France -it is a recipe for disaster, because nuclear is such a different technology. Don’t get me wrong: I am not saying that nuclear should not be built, but if you design your market structures with that objective in mind, you get an awful lot of unintended consequences on capacity, other investment and prices. We should be much more honest. If subsidies are needed to get the first few nuclear plants built, let’s be clear and let’s make that happen-like we’re doing with renewables and carbon capture-rather than designing a created market just to get something to happen.
John McElroy: Can I respond to that? I take slight exception to it.
Ian Marchant: I’m sure you do.
John McElroy: The point I would make is that, because of the way that the market is structured in the UK at the moment, only renewables will be built as a low-carbon technology. We want a market that can bring forward a range of low-carbon technologies, because we need those to get anywhere near the targets. We need diversity in the energy mix. There are a whole host of reasons for doing it, and it isn’t just because of nuclear in particular. We have to look at the whole range of technologies and bring them forward.
Q 175 Chair: I’m sure that you understand that the world of politics is not quite as rational as that of business. Therefore, there have to be devices to help coalition partners, in particular, get through the nuclear problem. We call it a feed-in tariff for the contract for difference. The average Liberal Democrat voter does not understand that that is actually a subsidy.
Returning to Ian Marchant’s point, what are the malign consequences of the systems that have been designed around nuclear? What has gone wrong in the rest of the energy market?
Ian Marchant: My belief is that it will downgrade the role of the energy market to a simple half-hourly balancing, and that is no mechanism on which you can build gas plant. Again, I suspect that we would all agree that the UK needs to build some new combined cycle gas turbine plant in the next 10 to 15 years, to act as the flexible generation and provide the megawatt hours that we need.
My concern is that we solve the nuclear problem and we ensure, in the way that we do it, that we solve the renewables problem, and actually we create a problem that nobody will build fossil plant, particularly with the way that the capacity price mechanism has been designed. So nobody will go and build a CCGT plant until they get the capacity support. So that is my first concern-that we have undermined the liberalised generation market.
My second concern is about putting the state in as the buyer. Vincent is talking about contracts with markets. Let us be clear-the CfD is a contract with the state, or the state will create an energy agency. Goodness knows where from. I do not see any existing body that can do it. You have effectively put the state in the driving seat as to what happens. That is a fundamental shift from where we have been during the last 20 years. That will have unintended consequences-actually in a way that I cannot predict. I think that it will change the nature of supply as well, because at the moment supply is a combination of retail and risk management. Those are the two services that we provide. It becomes a pure retail business, because the state has taken on the risk management business, because the state is deciding the nature of the generation mix.
I do not have confidence that the state will get that right. The state does not tend to. It has not got a good track record of making large, long-term procurement decisions and getting those judgments right. We still get it wrong, but on average we get it less wrong than the state does, because effectively you get the wisdom of crowds and you get individual diverse decision making.
Q 176 Sir Robert Smith: If you are going to have nuclear, the state is going to have make a decision. No one else is going to make it.
Ian Marchant: But if your objective is to secure security supply and low carbon, if you price capacity and you price carbon, the market will decide what the right technology is. If that is nuclear, the market will deliver it.
Sara Vaughan: It is still the investors who are bringing forward the projects. So, as an investor, we may be bringing forward an offshore wind project; we may be bringing forward a biomass project; or we may be bringing forward a nuclear project; and they will all be looking at the same market regime. So the state is not making that decision. The investor is making that decision, on the basis of their view of the market. Equally, we may be bringing forward a CCGT plant, depending on how attractive the market looks like for that technology at the time.
Q 177 Barry Gardiner: It does not affect your decisions at certain points- [ Interruption. ] To say the state is not taking that decision is a very bland way of describing what is going on.
Sara Vaughan: Is that not the way that it is at the moment?
Barry Gardiner: Yes.
Sara Vaughan: So it is a continuation of the way-I can see that the state will have a larger role, but it is a continuation of the way it is at the moment.
Q 178 Barry Gardiner: Yes, but let us not paint two extremes here. The state is involved in this; it should be involved in this; and the incentives and market regulations that it sets inevitably structure the market in one way or another.
Sara Vaughan: I would vehemently agree with you.
Barry Gardiner: Good.
Sarwjit Sambhi: On Ian’s point about letting the market decide, I think that, with the current market, if we let the market decide, it goes to the lowest cost of generation, because we have a system that is based on marginal pricing. Where you have generation that has high fixed costs and therefore high average costs, like nuclear and wind, they will not get built if you just rely on BETTA to deliver it. In terms of the CfD and unintended consequences, it still has to function against a wholesale market, because the contract is set against a market index. So I understand Ian’s concern, but some of it can be alleviated through how well you design the market index in the CfD.
Also, when you project out and look at the amount of volume that will be covered by the CfD, it only becomes significant when you get into the back-end of the next decade. So are CfDs the right investment tool to get the things built to meet the objectives that we set out earlier-security of supply and lower-carbon renewables? I think they can, if designed correctly.
Q 179 Chair: Just to be clear about the way that the CfD prices are going to be certain, are you favouring auctions, as the Government seem to be?
Sara Vaughan: No. When the EMR was launched, the Secretary of State said in terms that, if he was going to try to run an auction tomorrow, he would have a very small or indeed empty room in which to hold his auction. There are a number of problems with auctions, particularly when you’re looking at these sorts of high capital technologies, because to even get a project to the point where you might enter it into an auction, you are talking about investing several hundreds of millions of pounds. Are people really going to do that against the possibility that their project will not be successful in an auction? The alternative is that you do an auction at a very early stage, and then you end up with a project that never gets consent and there isn’t a viable project there, so they don’t continue. We have had pretty poor experience in this country in the past of auctioning with the non-fossil fuel obligation auction system in the early 1990s, which brought forward loads of projects, but very few got built.
Ian Marchant: The build rate was 25%. CfD without an auction is effectively a negotiated-behind-closed-doors process. You’ve got to convince the other party to sign the contract. You spend all your development money and if for whatever reason the other party doesn’t want to sign the contract, you haven’t got a project. As a developer, CfD means you’ve lost control of deciding whether to do that project or not. Today, I develop a wind farm. In other words, I decide to do it-it happens. Under a CfD, I do all that and then the energy agency is in purdah for an election period and can’t sign a contract for six months, or it’s changed its mind. It doesn’t want to do a 300 MW contract. It wants to do a 600 MW contract and I have developed for a 300 MW project. The risk is that I’ve got a bureaucratic counterpart, and it will take me many years to learn how to predict how it will behave. Therefore, we will get a hiatus in development in the next few years. The organisation that doesn’t exist today gets established, manned up and builds a track record. Of course, it slants to what comes forward, because if you ask for 300 MW of low-carbon energy, nuclear can’t compete. If you ask for base load energy, wind won’t compete. So how you go out procuring your CfD effectively decides what gets built.
Sarwjit Sambhi: Economists would say that, theoretically, an auction is the perfect option. It works where the product is homogeneous, there are many sellers and the start-up costs are very low. In nuclear, and arguably in offshore wind, that is not the case. The start-up costs are quite high. You have to invest quite a lot of money before you’ve actually got a project. The sites are being developed at different rates. While theoretically plausible, in practice we find it very difficult to find a workable auction option. The possible exception might be on tendering for capacity.
John Campbell: Take a nuclear site where the site has already been allocated to an organisation. Take offshore wind tranches as well. It is impossible to envisage how you can have price discovery through an auction process in those circumstances.
Paul Spence: We echo that; in the real world, this is about negotiation, certainly at the early stage. I would just like to pick up some of the issues that Ian raises, and say that our view is that, yes, they are questions. The approach should be how we find a way to solve them to make sure that we have a credible process through that negotiation that allows investors to move ahead with the confidence that there is a body capable of doing that negotiation. That should be the next phase of the consultation. We should get on with making this work.
John McElroy: I agree. There is overwhelming agreement on auctions, and I endorse the point that the devil is in the detail, so we need to get on with trying to sort it out and making it work.
Chair: We are running out of time. Do any of my colleagues have any other questions?
Dan Byles: Ian was absolutely right when he said that we would not get a single model answer.
Q 180 Sir Robert Smith: One very quick thing and on another matter that has a tight deadline: are we on track for the smart metering to actually be achieved?
Ian Marchant: Our mantra is start well and finish early. It is right to get the central communications agents called the DCC, to use the technical jargon. That should be up and running as quick as possible. Once it is, our businesses are very good at mass deployment quickly. What we are less good at is fits and starts, so it is taking a little longer to get going, but we don’t think that that is necessarily bad. We still think that we can finish by 2018.
John Campbell: I agree that getting the DCC up and running and established, so we understand the protocol and don’t have any issues of assets being stranded and also making sure that data security and information protection is a key part of the protocol are the key things to make it happen.
Paul Spence: I absolutely agree with those points. While that is going on, the other thing is that we are all gearing up, getting ready and trying out different technologies. I know that we certainly are, and I watch what my competitors do.
Sarwjit Sambhi: Getting the smart metering roll-out is key, but other things are important as well in terms of timing, such as green deal, and making sure that there are the right financial incentives to the technologies that we plan to put in homes.
Chair: Thank you all very much.
 Note from the witness: “actually about £130 billion”
 Note from the witness: “Pennsylvania, Jersey, Maryland”
 Note from the witness: “all-island (Irish) market”
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