Frank Holden must be wondering if he is living in the same country as the gas and electricity regulator Ofgem.
Holden, the managing director of Rigid Paper, which operates a small paper mill in Selby, North Yorkshire, is near to signing a 12-month contract for the electricity he will need to buy over the next year. He says the deal he will sign this month will save him just £16,000 on his annual bill – between 1% and 2%.
Yet at the end of last month, Ofgem was proudly announcing that the New Electricity Trading Arrangements (Neta) it introduced at the end of March had achieved 20-25% savings in wholesale prices compared with last year.
The disparity between the regulator’s claim and Holden’s experience suggests that energy-intensive industries have received less benefit from the new regime than electricity suppliers and domestic consumers. The Energy Intensive Users’ Group, the UK lobby for big consumers, believes the Ofgem figures overstate the case as far as its members are concerned.
Jeremy Nicholson, economic adviser to the EIUG, says: ‘In the run-up to Neta going live, our members were seeing reductions of 10% to 15% in the round for year-ahead contracts. Since then, prices have started to edge up again. We think Ofgem is exaggerating the case.’
Nicholson says Neta may have produced an aggregate saving for EIUG members of around £60m, but he adds that this figure needs to be set in the context of the £500m increase in his membership’s total gas bill over the past year. However, he acknowledges the new regime has kept electricity prices lower than they would have been under the pool system it replaced. ‘It may not be perfect, but it’s a step in the right direction.’
There are two main reasons why industry is not gaining as much from the new system as it should. One is the difficulties small generators, notably operators of combined heat and power plants (CHPs) and renewable technologies (such as wind or wave power), are experiencing under a regime that rewards reliable generation. The other is the failure so far to develop the ‘demand’ side of the system.
This is intended to achieve a balance in the market by enabling large users to ‘shed’ load at peak periods by rescheduling their industrial processes, allowing the total electricity required at local level to be provided in the most efficient manner. But none of the electricity firms has developed the ‘demand management’ systems which are required to make this possible.
Yorkshire Electricity was the only company that made real progress in this direction, before it was taken over by Innogy. David Gillett, head of environment at the Paper Makers’ Federation of Great Britain, says the development of demand management systems was meant to be a crucial buffer to prevent the supply side dominating the industry: ‘The fact that they haven’t appeared means the buffer doesn’t exist.’
Ofgem has acknowledged in recent reports that the prices at which small generators are able to sell electricity to the National Grid has dropped by 17%.
But for many others the experience has been worse. This seems especially true for operators of CHPs designed to meet the needs of a particular site and sell surplus electricity to the grid.
One such generator is property company Slough Estates. It operates a multi-fuel 100MW CHP complex, which has about 40MW of electrical capacity available for sale to the National Grid. Chief executive Derek Wilson said at the end of July that the company’s generating arm, Slough Heat and Power, had lost £4.6m in the first half of the year and could face a shortfall in revenues for the full year of up to £15m.
‘We’ve basically exported nothing since Neta was introduced,’ says Dr Philip Jackson, Slough Heat and Power managing director. The reason is simple, he says. ‘We’re being offered on average 40% less than we were under the pool.’
Under the pool system, the National Grid decided a day ahead how much electricity it would need to meet demand, in half-hour blocks. At the same time, generators would name a price for each half-hour block of electricity they wanted to supply. The grid then took up these offers, starting at the cheapest, until it bought enough electricity to meet demand. It would then pay all the generators based on the price of the last offer it took up. Alternatively, in many cases the grid would have a hedging contract direct with a supplier, based on pool prices.
Now, however, generators are obliged to sell their power under contract – with a three-and-a-half-hour lead time, rather than 24 hours – or sell into the balancing mechanism operated by the grid to ensure the security of the system. In both cases, the prices on offer seem prohibitively low.
In certain instances, plant operators have faced paying for the privilege of spilling power on to the grid. ‘Some CHP operators we’ve talked to are unable to put power on to the system,’ Nicholson says. ‘That is nonsensical.’
‘The National Grid price is ludicrous,’ Gillett adds.
Ofgem acknowledges Neta’s structure discriminates against small, less predictable generation. But it blames the government, and advises that it may need to ‘review whether its environmental targets can be met within the levels of subsidy now proposed’.
Certainly, the 10,000MW of CHP envisaged by 2010 – which would make probably the biggest contribution to the planned reduction in greenhouse gas emissions – looks to be vanishing into the mist at present.
‘There must be at least 1,000MW of CHP that’s been forced off the system,’ says Jackson. ‘It will also ruin the prospect of new investment.’ Ofgem’s figures suggest output from small generators has fallen by 44% on last year.
The difficulties that renewables and CHP face under Neta – and Ofgem’s reluctance to tamper too heavily with a system that has taken two years and a reported £1bn to implement – present the government with a dilemma.
Energy minister Brian Wilson reiterated recently that small, environmentally green generators had a ‘crucial role to play in the UK’s green revolution’ and that failure to address the barriers to small generation could compromise the 2010 targets. At the end of July, he set up an Embedded Generation Co-ordinating Group to link such plants into more local distribution networks.
But direct subsidies to green generation, as advocated by Ofgem, will not go down well with the Treasury, and may fall foul of European law, while amending Neta in its favour will risk undoing the price reductions the new system has yielded. ‘We should be careful not to lose the principal benefits Neta is delivering,’ Nicholson says.
The underlying problem both for small generators and potential demand-side managers is the investment required to trade in the new electricity market. It is not just a question of installing the IT systems required to provide real-time access to the vast volumes of information, but also of engaging the necessary expertise in futures and derivatives trading. One large firm puts the total cost at £25m. While this is open to dispute, the figure would certainly run into millions.
‘The cost and complexity are disproportionate to the benefits of being in it,’ says Jackson at Slough Estates. ‘Our biggest complaint is that they’ve created an exclusive club.’
The answer in both cases would be for consolidators or aggregators to put together portfolios of small generators or demand-side managers, which would have the critical mass to justify the investment and to provide the flexibility to meet variable demand.
However, consolidators have failed to materialise. While eight companies told Ofgem ahead of Neta’s introduction that they would become consolidators, the cost and complexity of setting up such an operation have proved prohibitive. So the only set-up to date – the Concert Energy subsidiary of the big generator and supplier Innogy – has become no more than a purchasing arm of the company’s supply business, striking bilateral agreements with individual small generators.
Steve Smith, Ofgem’s director of trading arrangements, concedes that the lack of consolidators is a problem with the new system: ‘There are concerns about the speed with which they have become available.’
Graham Meek, deputy director of the Combined Heat and Power Association, blames Ofgem rules for consolidators, which he describes as ‘incredibly complicated and unworkable’.
Jackson says would-be consolidators would not be prepared to offer small generators better prices than they could get elsewhere. ‘You’re still being offered prices that are 40% less.’
There is obviously a structural problem if the only companies equipped to become consolidators are the big generators and suppliers. For the likes of Innogy, Powergen, Scottish Power, TXU and Scottish & Southern, to meet a supply contract from a consolidated portfolio of small generators, demand-side managers or a combination of the two would be far more complex and less profitable than assigning output from a large power station.
When generating capacity exceeds demand, expecting these companies to use a portfolio of small generation is akin to asking them to cut their own throats. This may explain why the prices on offer have been so low.
‘The conditions to favour the development of consolidators are just not there,’ says Gillett. With a big surplus of generating capacity available over the summer months this was unlikely to change. But the position could change with the weather: ‘The real test of this will come in the depths of winter,’ warns Gillett.
With the construction of new nuclear plants in the UK now back on the agenda, there is also the question of how Neta can accommodate the long-term power purchase contracts needed to underwrite such investment. British Nuclear Fuels highlighted this dilemma in its submission to the government’s energy review earlier this month.
Chief executive Norman Askew said a short-term trading system like Neta simply did not provide a basis for investing in large baseload generation.
While few would dispute that Neta has produced lower electricity prices than its predecessor, the benefits do not seem as clear cut or universal as Ofgem would like to think.
Callum McCarthy, Ofgem’s chief executive, has ruled out fundamental changes to the system, but it is difficult to see how in its present form it can stimulate green generation in the form of renewables and CHP. This leaves the government, and in particular energy minister Brian Wilson, with a number of potentially embarrassing options.
It can accept that it has introduced a flawed system under which it will fail to meet targets for encouraging renewables and CHP, and which threatens to undermine its ability to meet climate change targets. Or it can keep the system but introduce greater subsidies for green generators, not likely to be popular at the Treasury. Or it can overrule Ofgem.
With UK industry still paying more for its electricity than its main European rivals, it looks as if further adjustments will be necessary for it to gain the maximum potential benefits of on-site generation and demand management.
SIDEBAR: Out of the pool, into the beer fund
The old pool system gave most market power to generators, amid claims that prices were kept artificially high. Neta was meant to change all that.
The New Electricity Trading Arrangements replaced the Electricity Pool as the means of wholesale electricity trading in England and Wales on 27 March. They were designed to address weaknesses of the pool system, which had prevailed since the privatisation of the UK electricity industry in 1990.
Under the pool, generators bid prices for their plants on half-hourly intervals for the day ahead, and the National Grid called up the plant it required to meet demand for each 30-minute period in ascending order of the bid prices. In any given half-hour, all the generators used would then be paid at the same rate as the last (and most expensive) plant called on to the system.
While most large consumers – including the regional electricity companies – hedged their exposure to pool price through direct contracts with generators, these inevitably reflected pool prices. The system gave most market power to generators, and prices did not fall in line with reductions in their input costs. There were accusations of market rigging.
Neta was designed to be a more market-orientated system, based on bilateral contracts between generators, suppliers, traders and customers. As far as possible it is based on trading systems in other commodities, with forward, future and spot markets evolving. However, given the need to maintain system security (to prevent blackouts) the grid operator manages a balancing mechanism. Under this, it accepts bids for the electricity needed to match supply to demand three-and-a-half hours in advance.
The accompanying settlement system – known as the beer fund – charges market participants whose metered electricity fails to match their contracted positions, to meet the costs of balancing the system. The system consequently puts sharp incentives on the contracted parties to match their contracted and actual volumes closely, with high penalties for being ‘short’.
SIDEBAR 2: Burden piles on industry
The apparent failure of Neta to deliver the cost reductions to industry that it has delivered elsewhere will be particularly disappointing for a sector that has experienced two body blows on its energy bills over the past 12 months.
The most serious has been the doubling of industrial gas prices, which is estimated to have added £500m a year to the cost of the energy-intensive manufacturers alone. It also looks as if the current price levels will remain the norm for the foreseeable future.
Wood Mackenzie, the Edinburgh-based oil and gas consultancy, warned in a report at the beginning of September that high gas prices were here to stay as UK approached the end of self-sufficiency in the fuel by 2005/6 and would have to import up to 56% of its demand by 2010.
Robert Plummer, Woodmac’s principal consultant, said gas prices would remain linked to those in Continental Europe, but ‘a bit higher’.
From 1 April, industry has also had to absorb the cost of the government’s climate change levy, which has added a charge to each unit of electricity, gas and coal consumed.
While the most energy-intensive sectors have secured 80% discounts on their CCL bills through negotiated agreements, the cost is still considerable – the chemicals sector alone faces an additional £20m a year.
For others it is even worse. The Engineering Employers’ Federation estimates that the 3,000 manufacturers with bills over £100,000 who do not qualify for the agreements will have to pay an extra £95m a year.