All Gas and Profits?

There has been a great deal of publicity in recent months about gas prices. Britain is running out of gas, there are going to be shortages, power cuts, rising prices, consumers being ripped off as gas companies make massive profits and all manner of scare stories that have made the front pages of the newspapers.

Gas production, processing and supply has undergone major changes in the last 20 years - has it resulted in a more efficient industry or are there still problems to sort out? Copyright: Daniel West, stock.xchng.

What is the reality of the situation behind these headlines? This Mind your Business departs from its usual format and offers an explanation and analysis of the gas market. It will look at how the industry operates, what the market structure is and what the implications are for consumers of this market structure.

What is the Gas Market?

Gas has become an increasingly important part of our energy needs - not just in the home but also in the industrial and commercial sector. Has privatisation, 20 years on, produced the sort of benefits to consumers that supporters of privatisation claimed or has the market become dominated by firms wielding monopoly power? Copyright: Hagit Berkovich, stock.xchng.

The discovery of oil and gas in the North Sea meant an unexpected financial bonus to the UK, which led to it becoming a net exporter of oil and gas and also prompted moves towards the greater use of gas for energy and for generating electricity. This image is Shell's Neptune 1 exploration rig in the North Sea in 1966 after the discovery of a major gas find. Copyright: Getty Images, from Education Image Gallery.

The gas market consists of more than just the supply of gas to domestic users. The way the UK sources its gas supplies, stores it and uses it has changed significantly since the gas industry was privatised in 1986.

Prior to that time, the gas industry had been a part of the public sector when it was nationalised in 1949. Privatisation was meant to instil market discipline into the industry, open up the market to competition, increase efficiency, reduce costs and provide a better service and value for money to customers.

Since privatisation, the gas market has continued to evolve. The change in the way the gas market has been operating has altered the market structure and the behaviour of firms in the industry.

Gas is a natural resource - a fossil fuel - that is non-renewable. Gas occurs as a result of millions of years of geological change. Dead creatures settled on the ocean beds and became subject to vast pressures, which in time - a long time - created pockets of natural gas. Natural gas can be distinguished from coal gas, in that the latter requires coal to be burned and the gas is given off from this process. Natural gas is a much more efficient and clean process than gas produced from burning coal.

Up until the privatisation of gas in 1986, gas supplies had, since the end of the Second World War, been in the hands of a state monopoly. The British Gas Board had a number of regional boards each responsible for gas supplies in its area. Nationalisation meant that gas prices and supply could be largely controlled by the state. From the initial discovery of gas in the North Sea in the late 1950s to the start of supplies being piped ashore in the UK, gas usage gradually increased.

The improvements in technology meant that it was becoming more accessible to households and to business users. Gas fires, ovens and cookers, central heating and so on all became more common and led to the increase in demand for gas. In addition, the move from coal fired to gas fired power stations further boosted the demand for gas. In recent years the supply of gas from the North Sea has started to decline - we have not run out yet but the stocks are diminishing and does mean that the UK has to look to secure supplies of gas from elsewhere.

The Market Structure

British Gas plc was the entity born out of the privatisation of the industry. £9 billion worth of shares were sold in the new gas company when it was floated on the stock market in 1986. To regulate this newly privatised monopoly, Ofgas was set up. Its responsibility was to monitor the behaviour of British Gas and to ensure that the public interest was not being compromised as a result of its monopoly position.

In the 1990s, British Gas began to change as the industry evolved. The company split up into a number of different businesses in 1997. The chart below clarifies how the company was divided.

After some further restructuring, BG plc itself divested and two separate companies emerged - BG Group plc and Lattice Group plc. BG Group is responsible for searching out new gas fields and bringing gas to different markets. The Lattice Group then merged with National Grid and Transco to form the company National Grid Transco in 2000. In 2005, this was renamed National Grid plc. National Grid is responsible for over half of the infrastructure of the gas network and is also involved in networks covering electricity and telecommunications.

The gas network comprises over 82,000 miles of pipes and connections. National Grid is responsible for the maintenance and renewal of its network system as well as making sure that gas is delivered to its customers. The gas network consists of collection points, storage depots, pipelines and the offshore drilling rigs.

In addition to the companies that have evolved out of British Gas, privatisation has opened up the opportunity for a large number of other businesses to become involved in the gas market. For customers there is now a wide choice about who to buy their gas from. Some companies not only supply gas but also electricity and telecommunications. There are a number of Web sites that exist to provide customers with information about comparative prices for their gas and energy supplies. Examples of such companies are uSwitch, (http://www.uswitch.com/) The Energy Shop(http://www.theenergyshop.com/) and EnergyLinx.(http://www.energylinx.co.uk/)

The number of suppliers in the market should create a greater degree of competition in the market, but for some customers, getting accurate information about what the differences are between these suppliers and understanding the bewildering array of choice might be almost too much to be able to make informed choices. Remember, one of the key elements of perfect competition is perfect knowledge!

Who actually supplies the gas that enters your house and whom you pay for this service is only the tip of the iceberg. The choice in the market for gas suppliers is now much greater but does this mean there is more competition? Did you know that Richard Branson's Virgin group supply gas? Copyright: Ante C, stock.xchng.

The Supply of Gas

Gas is extracted from two main sources. One is the North Sea. Once the gas has been extracted it is piped to a gas terminal - one in the north of Scotland and one in Teesside. From this point the gas is then fed through the National Grid network to various storage facilities from where it is piped to homes and businesses.

The other main source of gas supply is through the so-called interconnectors. These are gas pipes that connect the UK with other sources of gas supply. The first one was opened in the late 1990s and runs from Bacton in Norfolk to Zeebrugge in Belgium The 150 mile long, 40-inch pipe is capable of pumping gas both from Europe to the UK and from the UK to Europe. As the image above shows, other interconnectors are currently planned or are under construction as the gas industry gears itself up to meet the expected market needs and cope with the supply changes of the coming decades.

The diagram to the left further summarises the gas supply process. There are currently 70 'shippers'. These are companies who buy gas when it comes to the terminals and then pays the National Grid to distribute the gas along the pipeline network. They own the gas in the pipeline until it gets to customers premises at which point the gas supplier sells the gas to the customer.

Examples of the sort of companies who act as shippers are AGIP, British Gas Trading, Calortex, Shell Gas Direct, Yorkshire Electricity, Mobil, National Power and Crown Energy. The gas supplier (for example Manweb, Scottish Power, Amerada, TXU Energi, Virgin HomeEnergy and nPower) will enter into a contract with one of the shippers to buy gas in the wholesale markets and ensure that it is transported through the pipeline system to customers' premises. The customer in this case is not only the domestic user but hospitals, gas-fired power stations, industrial premises such as chemical works, and any other number of industrial commercial users. The business sector accounts for about two-thirds of gas consumption.

As a domestic customer, therefore, you enter into a contract with a gas supplier to supply you with gas. You will pay a sum of money for each unit of gas that you use to your supplier. Given the current state of the gas market, the domestic household is now in a position to enter into an agreement with any number of suppliers, so there should be effective competition in the market. If you believe that your current supplier is charging you too much, then you are able to switch supplier relatively easily to one that is cheaper. Centrica, for example, lost 764,000 customers to other suppliers as a result of it increasing its prices during 2004.

The Business of Gas Supply

Gas shippers have a statutory duty to ensure that the supply of gas they are offering matches the demand from their customers in any one day. If the shippers are unable to manage their gas portfolio and meet customer demand they face possibly severe penalties from Ofgem, the regulator of the energy industry. As the supply of gas from the main producers varies, the shippers are in the business of buying gas at one price and selling it to the suppliers at another.

If they face a shortage of gas for their needs, they can look to buy gas from the various storage facilities around the country or from the European interconnector. If they have a surplus of gas they can sell it back to the storage facilities or back through the interconnector. The interconnector has the capacity to be able to pump gas both ways. The timespan to change the direction is around 24 hours! For most business users, the price they pay for their gas varies each day as a result of the activities of these shippers.

The business of getting gas from the field to the customer is complex and involves a large number of businesses. Matching demand and supply is a vital part of their activities - failure to do so can result in serious penalties for the businesses concerned. Monitoring the activities of these businesses is one of the roles of the energy regulator Ofgem. Copyright: Chris Chidsey, stock.xchng.

Gas shippers, therefore, have to source gas from different routes. Normally, it will be from the terminals where the gas has come - from the production fields. This is called 'buying at the beach'. If, however, the demand has increased - during periods of cold weather, for example - shippers will have to source supplies from the interconnector or from storage. The firms who own the storage facilities store up gas for use in periods of expected peak demand, normally January and February. To release gas from storage, therefore, they are going to charge prices either equal to or in excess of what they would expect to receive at these peak times and this causes prices to rise further.

A chemical company buying gas to use in its production process will have to estimate the amount of gas that it is going to need and agree with suppliers each day what the price will be. Some days the price might be lower than previously, on other days it might be more, but the trend in gas prices might be what concerns the chemical company. If gas prices are rising over a period of time, it might put heavy pressure on its costs, especially if it is producing a product that has a fixed price contract.

One Teesside chemical company produced a summary of the effect on its cost of the increase in gas prices. In 2003, the gas bill for the plant stood at £890,000. In 2004 this rose to £1.1 million and then to over £1.5 million in 2005. The company expects that the increase in gas prices over the last six months will take its gas bill to well over £2 million in 2006. The rise in its gas costs therefore will be well over 125% by the end of 2006 compared to 2003. The recent cold weather in the UK has led to a further tightening of the market and gas prices quadrupled on one day earlier in the week in which this article was being written. Such volatile price changes make it very difficult for the planners at the company to be able to feed reliable cost information through to the rest of the business. This in turn makes it very difficult when negotiating with clients on the sale of its final products.

The contract to supply gas for domestic users is not based on day-to-day fluctuations in the gas market. The gas supplier will tend to supply gas at prices set over a longer term than is the case to industrial users but have to manage their business in buying gas to meet that supply during that time period. The increases in the price of gas by major suppliers such as Centrica, Powergen and British Gas has caused much concern, especially given the large profits that these same firms seem to be making.

Big industrial users like this chemical plant on Teesside are major users of gas. Prices change on a daily basis and can cause major problems for such firms causing their costs to rise and margins to be squeezed.

The firms claim that the price increase to domestic users is nothing like the full amount that the supplier has to pay and that domestic users are not where they make their profits. British Gas, for example, has pointed out that it is paying 70% more for wholesale gas but has only increased prices by 22%. By taking the major burden of the rise in gas prices, British Gas are pointing to the fact that their profits were lower than a year before - down in fact by 63%.

A breakdown of the average gas bill - are consumers being ripped off or does the price we pay for our energy represent value for money? Source: Crown Copyright, reproduced by kind permission of Ofgem.

Centrica has pointed out that its profits come from other parts of its business, notably gas production and storage. The lurid headlines, therefore, do bear some further analysis to see what is really going on. Our analysis of the market has shown that domestic users do account for a relatively small proportion of total sales, so again it is not surprising that these users are not where the profit is being made.

Has Privatisation Worked?

We earlier outlined the main aims of privatisation of public utilities like the gas industry. To what extent has the aims of privatisation been matched by the reality? The headlines might seem to suggest that there are a number of greedy businesses out there who are using their market power in supplying what is a fairly important product to leverage up prices and make abnormal profit.

The regulator of the energy industry, Ofgem, maintains a watching brief over the industry and is charged with asking questions about price rises and ensuring that the industry does not operate contrary to the public interest. Ofgem produce regular reports on the performance of the industry and analyse price changes and output variations. The charts below provide some indication of what has happened to gas prices since privatisation.

This first chart shows a comparison of the average gas price in Europe for industrial users in pence per kilowatt hour (p/kWH). The general trend is essentially upwards but this might be expected, given the increase in the demand for gas over the period. Ofgem point out that the average price to UK users has been favourable over the period compared to our European neighbours. They further outline that in this period British industry paid significantly less than many of our European partners for their gas: £7.9 billion less than Germany, £5.8 billion less than Italy, £4.3 billion less than France, £3.6 billion less than Span and £2.6 billion less than the Netherlands.

For domestic users, the picture is much the same. Gas prices in real terms started to fall after privatisation and after the break up of British Gas plc and the increase in competition in the supply of gas, prices were lower than the British Gas price.

As with industrial customers, domestic users have paid far less for their gas compared to those in Europe. £75 billion less than Italy, £67 billion less than Spain, £35 billion less than France and £28 billion less than Germany, for example, over the period 1990 - 2004.

Does this mean the market is as effective and competitive as it could be? Not necessarily. Ofgem still have concerns about the problems faced by UK suppliers in securing supplies of gas from abroad. As North Sea supplies dwindle gas supplies will have to be sourced from abroad - Russia for example. There are plans, as we have seen, for new interconnectors to be built to facilitate this but there have been concerns about the state of the gas market in parts of Europe.

Russia recently turned off gas supplies to the Ukraine after a dispute over the decision by the Russian gas firm Gazprom to quadruple prices to its former satellite. There has also been an investigation into the behaviour of firms in Europe by the EU's competition authorities. In February 2006 it announced that there was evidence of collusive behaviour by a number of un-named gas companies in Europe who were holding back supplies and forcing up prices.

The future for the gas industry rests on some fairly simple business and economic factors. What will happen to the demand for gas and what will happen to the supply? For businesses the price they have to pay for their gas will affect their input costs and influence the prices they charge to their customers and for government major decisions about the future energy needs of the country loom large. Privatisation has certainly changed the industry but as students of business and economics we have to get behind the headline news about such industries and be a little more discerning in our analysis before arriving at conclusions.

Questions

The questions below are divided into one set for students following economics courses and one for students following business studies courses.

For Economics:

Use supply and demand analysis to explain why gas prices have risen in the last year.
To what extent is the gas market a competitive market?
Assess the role of Ofgem in regulating the gas industry.

For Business Studies:

Rising gas prices place a burden on business users.

Comment on the impact on the cash flow of a business that use gas as a result of the way the market works.
Centrica and British Gas have both pointed out that they have not passed on all the costs of increased wholesale prices to its domestic customers. This implies that it is making some losses on gas supply to these customers. How can they manage their business if this is the case?
Assess the strategies facing business users of gas in coping with the increase in prices of gas.

Mind your Business - 20 March 2006