ENERGY POLICY – KEY ISSUES (DTI)

A. Summary of Main Messages

• Diversity of supply, at competitive prices, is fundamental toachieving security of supply. The role of open market is centralto achieving this.

• Government (national and EU) has an important role to play inhelping producer countries create the right political, economic,business and legal climate to encourage long term investment inenergy supplies.

• Maximising recovery of UKCS reserves and facilitating the entryof other supplies to the UK market require industry’s confidencein the nature of the fiscal and regulatory regime; recent, adversetax changes will make delivery of PILOT’s targets even moredifficult.

• The risk to the UK’s economy of under-investment in the NationalTransmission System far outweigh the costs of some over-investment.

• Gas has been and should continue to be a significant part of thesolution to the problem of GHG emissions.

• Energy policy needs an appropriate place within Government,connected to the whole of Government.

B. General Points and Background

1. The upstream oil and gas industry has a long record of uninterruptedsupply in meeting market requirements in the UK. It can continue to meetdemand reliably, provided market conditions are conducive.

2. There need be no shortage of oil and gas worldwide, with the rightinvestment climate and sufficient lead times, so as to ensure diverse and securesupplies at competitive prices.

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3. Production from the UK Continental Shelf (UKCS) is about half waythrough its life, in terms of the amount of oil and gas that is economicallyrecoverable. However, the second half will be much more difficult to recoverthan the first, as the bigger, earlier fields decline and newer finds become eversmaller and technically more demanding.

4. Government has an important role to play in achieving maximum recoveryfrom the UKCS and, with the EU, in opening the way for new internationalsupplies. The recent report by the UK-Norway Co-operation Work Group is animportant contribution to this process. However, the 2002 Budget changes havecast doubts on achieving maximum economic recovery of UKCS reserves and onGovernment’s understanding of the long-term nature of energy investments.

5. Investment in energy transmission networks is a critical aspect of securityof supply and, therefore, energy policy overall. The upstream oil and gasindustry has a good record in delivering such investment, but the regulatoryemphasis onshore which has, in recent years, been concentrated on economicefficiency needs to be moved towards securing appropriate new investment, witha margin of spare capacity to provide both flexibility and resilience in the system.

C. Particular Points under Consultation

2.5 Security of Supply

6. Diversity of supply is fundamental to security of supply. The role of openmarkets is central to achieving this. There need be no shortage of oil and gasworldwide, with the right investment climate and sufficient lead times, so as toensure diverse and secure supplies at competitive prices. There is an importantrole for Government by helping producer countries create the right political,economic, business and legal climate to encourage long term investment inenergy supplies, with financial and technical expertise provided by business andindustry. This applies more to gas than oil, since oil is freely traded on theinternational markets with supplies coming from all over the world.

7. Import dependence should not, of itself, be a cause of concern, providedthe above conditions are met (it is sometimes forgotten that the UK was asignificant importer of gas from the late 1970s and throughout the 1980s – muchof Western Europe remains in this position). The important aspect is tounderstand the associated risks and to manage those risks appropriately (lack ofinvestment in the National Transmission System is, in UKOOA’s opinion, asignificant source of such risk both today and, on present trends, in the future –see below).

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8. Maximising recovery of UKCS reserves (see Section 2.12 below) andfacilitating the entry of other supplies to the UK market require industry’sconfidence in the nature of the fiscal and regulatory regime. The recent changesin the tax regime announced in the 2002 budget are not conducive to theachievement of either of these objectives and are likely to lead to less investmentand fewer jobs than would have been the case.

9. In recent months, new contracts for supplies of gas have beenannounced: from Norway, the Netherlands and Qatar (LNG). There are amplesupplies of gas available to make up the UK’s anticipated shortfall post 2005/6 –much of it from Norway – provided adequate infrastructure and access to it exist.There is a wide variety of possibilities for creating additional offshore links toNorway, with increasing amounts of capacity becoming available in existing UKpipelines (see also Section 2.7, International, below).

10. However, the same is not the case onshore, especially at St Fergus, thelargest entry point to the NTS and the nearest to Norwegian gas. Even ifTransco fulfils its plans at St Fergus over the next few years, this will still leave alack of flexibility in the NTS and a lack of resilience to deal with the unexpected.

11. Importantly and as we have stated several times before, the risks to theeconomy of under-investment in the NTS far outweigh the costs of some over-investment (ref. also report of Trade and Industry Committee of House ofCommons, 7th February 2002, and its conclusions and recommendations).

12. To date, the UK has not needed much storage of gas, but this will change,as the country becomes a net importer. Increased storage will provide flexibilityand temper price volatility. Government should ensure that there are no barriersto the provision of additional gas storage by, for example, easing the planningprocedures.

13. We welcome the Government’s recent initiative to accelerate the planningprocess for major infrastructure projects and look forward to its introduction, withparticular relevance to new storage, pipelines and terminal facilities for gas andLNG.

2.6 Climate Change

14. We have stated before, but is bears repetition: “Natural gas has, morethan anything else, enabled the UK to achieve big improvements in itsenvironmental performance and put the country well on its way to meeting itsKyoto commitments.”

15. Gas has been and should continue to be a significant part of the solutionto the problem of GHG emissions. It also provides the most efficient form ofpower generation, even more so if allied to CHP.

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16. However, the UK cannot act alone. If the effort is to have lasting effect, allcountries need to contribute, but there are already signs that even within the EUthis is not happening. The economy will suffer a loss of competitiveness, ifsignificant international imbalances of contribution develop, and this will hamperthe UK further in honouring its commitments.

17. Carbon sequestration, although as yet untried on a substantial scale,would appear to offer significant potential. We believe that research into anddevelopment of this technology is possible within the time-scales envisaged, sothat it will be able to make a contribution to an overall programme. This may welloffer scope for Government encouragement.

18. The PIU rightly identified energy efficiency in the domestic sector as afocus of attention. The UK has a poor record in this area which has alsocontributed to fuel poverty. The low quality of the housing stock and many publicbuildings calls for bold and imaginative action.

19. Industry and commerce should be afforded the maximum freedom ofchoice of measures to achieve desired results; flexible, market solutions are tobe preferred to regulation and taxation which are the least satisfactory ways ofreducing emissions of GHGs. Importantly, though, as we wrote in our responseto DETR’s consultation about the UK’s Climate Change Programme in 2000:“Almost all of the UK’s success in meeting its current international commitmentshas been achieved by energy suppliers and heavy industry, with natural gasplaying a crucial role. We do not believe that this can be sustained in the contextof the Government’s own aspirations for further reducing emissions. In acompetitive economy, it must be right that all sectors play a full part in meetingthe country’s overall obligations.”

2.7 International

20. In view of the UK’s move from being an exporter of oil and gas to being animporter, this section needs to be read in conjunction with 2.5 above, Security ofSupply, and, in particular, the opening paragraph of 2.5 regarding diversity ofsupply and creating the right business conditions.

21. The extent to which Europe becomes the theatre for energy policy shouldbe focused on

freeing of the markets within the EU turning the outcome of the Barcelona summit into reality using international diplomacy and, where necessary, assistance to encourage

the right investment conditions and to secure new routes into Europe fordiverse sources of oil and gas

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ensuring fiscal and regulatory stability to encourage maximum exploitation ofindigenous reserves.

22. Thus, the EU should become an enabler, removing obstacles to securinginternational supplies. It is for individual nations and companies to secure thesupplies themselves whether, in the case of gas, from Norway, Russia, theCaspian or Algeria, or through the flexibility provided by the increasing worldwidetrade in LNG.

2.8 Energy Efficiency and CHP

23. Energy efficiency in the domestic sector in the UK is poor by internationalstandards. We support the PIU’s recommendation and maybe this is an areawhere Government should consider increasing incentives (the same may also benecessary at the smaller end of the commercial sector). It will also assist theelimination of fuel poverty.

24. CHP offers considerable potential provided that the use of the heat can bematched to the demand for electricity. So far as larger CHP plants areconcerned, this favours continuous process, industrial applications, where thereis a reliable requirement for both heat and power (e.g. refineries, chemicalsmanufacture). However, the advantages of CHP are not readily realisable whereeither the thermal or electrical loads vary considerably.

25. The introduction of NETA would appear to have had disadvantageouseffects on CHP, putting Government’s targets for CHP further from coming tofruition. The House of Commons’ Environmental Audit Committee has recentlyissued some highly critical comments about NETA’s adverse consequencesgenerally. Government should consider how the interaction between the variouseconomic, technical and regulatory effects may be resolved satisfactorily. Thisshould include consideration of all forms of embedded generation, such asdomestic and smaller scale commercial CHP.

2.9 Renewables

26. Renewables clearly have a contribution to make, but in the near term eventhe 10% of electricity generated by 2010 is looking ambitious, never mind 20% by2020. However, the greater the amount of renewable generation, the greater theamount of back-up capacity required from conventional generating sources inorder to ensure continuity of supply to meet peak demand in winter.Furthermore, it is not clear where the cost of the back-up capacity is going to beborne.

27. It seems reasonable to provide some incentives for renewables in theshort term, but, if these become too pervasive, they will damage the market. The

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evidence suggests that NETA is creating unintended effects for renewables, asfor CHP.

28. Some of UKOOA’s members are already significant players in therenewables markets, through different parts of their parent organisations.

2.10 Transmission, Distribution and Trading

29. Policy measures should establish a long term and stable framework inorder to encourage development of the networks. The regulatory regime for gastransport should provide timely and efficient signals for new investment in theNTS. Regulation needs to work in the broad national interest which includesUKCS and other producers having certainty about both the availability and priceof transport capacity. The current regime is not working in this wider interest, asit provides neither the signals to Transco, nor the certainty to producers.

30. It is to be hoped that the proposed, long term auctions of NTS capacity willachieve this, but, in any event, the economic risks of under-investment in theNTS (ref. 2.5 above, Security of Supply) need to be kept under constant review,because of the damage to the country which a significant supply failure wouldcause.

31. Transco is required to provide and maintain an economic and efficientonshore system for the transmission and distribution of gas. Two recent papersby leading commentators1 have questioned whether the current or the proposedlonger term system for allocating NTS capacity can achieve this. Both papersregard some over-investment in the NTS as wise: “…likely to entail an element ofgold plating” (Helm) and “…a margin of excess infrastructure capacity as a lowcost insurance premium.” (Kemp and Stephen)

32. Kemp and Stephen conclude, “Auctions need to be backed by planningand active regulation to ensure that the appropriate investment is undertaken.”while Helm arrives at a similar result: “The PIU takes a relatively relaxed view ofthe ability of the OFGEM approach to deliver sufficient investment. Provided thateconomic growth remains low, the gas price high and winters remain mild, suchcomplacency may be vindicated by events. But it leaves little room for adversedevelopments. In energy utility networks, such risks are best avoided.”

2.11 Nuclear

1 Dieter Helm “Investment in Energy Networks: Auctions, Regulation and Planning”, April 2002;Alex Kemp and Linda Stephen “UK Gas Production, Imports and Networks: Response to PIUReport”, July 2002.

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33. We note the PIU’s recommendation with regard to nuclear power whichwould seem sensible. Clearly, the management of the legacy and the treatmentof the waste are the critical features.

34. It will be important to ensure that whatever is decided for the future doesnot itself introduce distortions and tilt the market in favour of one generatingtechnology over another.

2.12 Gas and Oil

35. One of the important conclusions from the PIU Energy Review was thatthe UK will continue to rely upon fossil fuels for the foreseeable future. Oil andincreasingly gas will continue to dominate energy supplies; the issue for policymakers is the extent to which diverse and flexible supplies can be made availableat competitive prices. The prime considerations are, therefore, the prospects forindigenous production of oil and gas and the availability of imported supplies,once the UK ceases to be self-sufficient.

(i) Indigenous Supplies

36. Work within PILOT (the Government - industry forum) completed duringthe first quarter of 2002 concluded that it was just possible for the industry tomeet PILOT’s target of sustaining production above 3 million boepd until 2010.This would require a broadly based and sustained effort from all stakeholdersacross the opportunity spectrum: from exploration to brown field redevelopment.To facilitate delivery of the target also needs, inter alia :

• No sustained collapse in the oil price• Fiscal and regulatory stability• High degrees of operability

37. Chart 1 below illustrates the shape of this prize looking forward to 2020. Itis important to recognise that, even if these targets were achieved, by 2010 theUK would be importing both oil and gas. Whilst the precise timing of the switch toimports is unclear, most expect this to be circa 2005 for gas and a year or twolater for oil. The market has already anticipated this with a number of large gasimport deals being announced in recent months, together with potential newinvestments in offshore infrastructure.

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August 2002

UK Energy policy

-

500

1,0001,500

2,000

2,500

3,000

3,5004,000

4,500

5,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Mbo

epd

ExplorationTechnical reservesPossibleProbableBrown fieldsIncrementalSanctioned

UKCS oil & gas production forecast

PlLOT Vision

Target 2005

38. When interpreting the above chart, it is important to recognise the obviousuncertainties; in particular that it is only the ‘Sanctioned’ tranche which may beregarded as firm. The remaining elements face increasing risk; the underlyingprojects necessary to deliver the production contribution are all uncommittedtoday. Furthermore, a significant amount of these tranches, referenced in thechart, remain unidentified, particularly exploration and brown field projects.

39. Recent exploration activity and success have been low and these need tobe reversed, if the aspirations are to be realised while existing infrastructureremains usable.

40. The chart below illustrates the subset of identified projects only, assupplied to UKOOA by its members. It also illustrates a significant shortfallagainst PILOT’s Vision for 2010.

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August 2002

UK Energy policyUKCS oil and gas production- identified projects

-500

1,0001,5002,0002,5003,0003,5004,0004,5005,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Mbo

epd

PossibleProbableIncrementalSanctioned

PILOT Vision

Source: DTI/UKOOA Activity survey 2001 Missing elements:•Exploration•Undeveloped discoveries•Brown fields

(ii) Gas Supplies

41. UKOOA’s current estimate of UKCS gas supply is shown in the chartbelow. This is based on the contribution from identified projects only andexcludes the additional supplies that could be expected from future explorationsuccess, more undeveloped discoveries and additional brown field projects.

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August 2002

UK Energy policyUKCS gas production-identified projects only

-

2,000

4,000

6,000

8,000

10,000

12,000

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Mill

ion

scfp

d

PossibleProbableIncrementalSanctioned

Source: UKOOA/DTI survey Oct 2001

Current UK demand

(iii) Industry-Government Cooperation

42. The charts above highlight the huge challenges remaining on the UKCS,but also a material prize. Achieving PILOT’s target not only reduces the relianceon imports, but the implied investment requirement will ensure a vibrantupstream industry and supply chain remain in the UK for decades to come.Since the formation of PILOT and its predecessor, OGITF, the close workingrelationship between Government, industry, contractors and unions hascontributed to a series of initiatives that have helped to support greater activity onthe UKCS than would otherwise have occurred.

43. In the light of this constructive and developing relationship, the industrywas dismayed that the first Government action in the field of energy policy, sincepublication of the PIU Energy Review, was to announce an increase in UKCStaxation. The complete absence of consultation has called into question formany in the industry the value of the PILOT process and whether, now, PILOT’starget can be met.

44. The details of the industry’s concerns about the Budget measures are wellknown to Government, but it is clear that such action which raises £7.6 billionfrom the industry in extra tax by 2010 can only serve to reduce investment in the

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UKCS and lead to both lower production, and greater and earlier imports. Theupstream industry is truly global with companies facing more opportunities thanfunds are available. By increasing taxes, the Government has made it moredifficult for UKCS investments to compete with worldwide alternatives.

45. Continued cooperation between industry and Government is, of course,essential if the nation is to reap the maximum benefit from the UKCS. Theadverse changes in the fiscal regime were an unexpected and unwelcomesetback. Looking forward to 2010 and beyond, further changes which reduce thetax burden will be necessary, if indigenous production is to be maximised. Theintent needs to be that all UKCS investment opportunities face the same fiscalregime and that, overall, this adapts to sustain UKCS competitivenessinternationally and reflect its increasing maturity.

46. Current expenditure on UKCS activity supports some 265,000 jobsthroughout the economy (export of goods and services to other oil and gasprovinces worldwide adds 70,000 to these). Many of the jobs are in scientific andengineering disciplines, at the leading edge of technology. It is essential that thisbody of expertise is not allowed to be dissipated through short-termconsiderations.

(iv) International Supplies

47. The UK is fortunate that it is located close to an abundance of gasresources (in Norway, FSU, Middle East and North Africa) which can bedeveloped and transported economically to European markets. Increasingly,also, LNG is enabling resources in more distant locations to be accessible, suchas Nigeria or Trinidad and Tobago. The recent announcement of an LNG gasimport deal with Qatar demonstrates the commercial reality of these supplies.The schematic below illustrates the huge volume of such proximate suppliesbased on latest estimates2. The quoted reserve data are proved reserves only(90% certain) and exclude probable and possible reserves in these countries.Addition of these categories offers the potential of growing the resource base byseveral multiples. Clearly resource ‘per se’ is not at issue; the challenge for theUK is to ensure that gas imports are sourced from a wide range of competingsupplies to ensure diversity and sufficient gas to gas competition to delivercompetitive pricing.

2 Source BP Statistical Review of World Energy June 2002

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Nigeria LNG

Trinidad LNG

Algerian LNG

Russia

Algeria

Norway

Azerbaijan &Turkmenistan

Azerbaijan &Turkmenistan

IranIraq

IranIraqEgyptEgyptLibyaLibya

Europe: “Surrounded by a Sea of Gas”Proved reserves (end 2001)TCF

Russia 1680Iran & Iraq 922Qatar 509Algeria 160 Azerbaijan & Turkmenistan 131Nigeria 124Libya & Egypt 81Norway 44Trinidad 24EU 111

EU Consumption (Year 2001) 14 TCF

Source :BP

Qatar1

48. The role for Government in encouraging investment in energyinfrastructure and new supplies is outlined above in Sections 2.5, Security ofSupply, and 2.7, International.

2.13 Coal

49. We do not have the necessary knowledge to comment on this section.

2.14 Innovation

50. The offshore oil and gas industry thrives on innovation and technology.Without the great strides which have been made in the past 20 years, it isunlikely that the UK would still be self sufficient in oil and gas. Indeed, at thestart of production from the North Sea 25-30 years ago, it was predicted thatproduction from the UKCS would last until 2000, at best. In order to ensure thatthe maximum economic recovery of oil and gas is achieved over the remaininglife of the UKCS, innovation will be a critical factor. The establishment of theNOVA Technology Fund and the Industry Technology Facilitator have added newdimensions to the substantial sums already invested in R&D by the industry.

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51. As is mentioned in Section 2.6 above, carbon sequestration would appearto offer significant potential. Some of UKOOA’s member companies are alreadyinvolved in developing this technology. The existence of a large number ofdepleted oil and gas fields in years to come ought to offer the UK everyopportunity to make sequestration a reality, subject to its cost and ensuring thatthere is no migration of CO2 from reservoirs into water supplies. CO2 injectionmay also be used to enhance the recovery of oil and gas from reservoirs.

52. We believe that a commercial approach and the private assumption of riskare essential to the future economics of new energy supply and demandtechnologies. There may be a case for public sector support for R&D in newtechnologies both for reducing the environmental impact of using existing fuelsand for developing new ones, in a way designed to introduce competition andcommercial criteria from the beginning, allowing assistance to be phased out asthe new technologies take off.

53. Improvements in existing energy technologies and in energy efficiency,and the substitution of low impact conventional fuels (such as gas), can play amajor role in improving both security of supply and environmental effectivenessin the long term. Indeed, gas has already had a transforming effect in the UK,with its lower carbon intensity and its greater efficiency.

2.15-17 Transport

54. This is not an area of UKOOA’s expertise. However, some membercompanies, through their wider organisations, are engaged in the development ofalternative fuels.

2.18 Institutional

55. The recent re-organisation of the DTI, whilst welcome in ending theuncertainty, does seem to leave energy policy in a somewhat fragmented state.The new Strategy Unit would appear to be the focal point, but important elementsare to be found in the Energy Markets and Innovation & Business Units.

56. The PIU recommended the establishment of a “cross-cutting unit” initiallybased in DTI, to oversee the future direction of energy policy.

57. The Trade and Industry Committee, although not convinced of the needfor a strategic energy authority, did urge Government “to put in place a moretransparent structure for formal co-ordination of energy policy development andimplementation across Government”.

58. Given the international requirements outlined above (Sections 2.5, 2.6, 2.7and 2.12), there is an important role for the FCO and, environmentally, DEFRA.It does seem to UKOOA, therefore, that energy policy needs an appropriate

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place in Government. Energy is fundamental to the country’s economicexistence and needs to be treated as such, across the whole of Government.

59. UKOOA remains deeply concerned about the adequacy of investment inthe National Transmission System for gas. The imbalance in the capacities ofthe National Grid (electricity) and the NTS, in relation to demand, is striking. Aswell as its market and economic objectives, Ofgem has a duty, as a result of theUtilities Act 2000, “to secure a diverse and viable long-term energy supply”. It isof paramount importance that the regulatory framework delivers this and the newinvestment in the NTS that is required to achieve it.

60. In the light of this year’s tax changes for the UKCS, the targets andaspirations within the PILOT vision may well have to be re-assessed. Theirvalidity is in considerable doubt.

D. Glossary of Terms and Abbreviations

CHP Combined Heat and PowerDEFRA Department for the Environment, Food and Rural AffairsDETR Department of the Environment, Transport and the Regions

(now defunct)DTI Department of Trade and IndustryEU European UnionFCO Foreign & Commonwealth OfficeFSU Former Soviet UnionGHG Greenhouse GasLNG Liquid Natural GasNETA New Electricity Trading ArrangementsNTS National Transmission System (for gas)OFGEM Office of Gas and Electricity MarketsOGITF Oil & Gas Industry Task Force (1999)PILOT Government – Industry Co-operation Forum for upstream oil

and gasPIU Performance and Innovation UnitUKCS UK Continental ShelfUKOOA UK Offshore Operations Association

UKOOA September 2002