Author: Mintel Group Ltd.
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Gas Supply and Distribution - UK - March 2016
Executive Summary
 
“Ofgem has adopted a new regulatory framework for the current price control period for gas distribution and transmission networks, known as the RIIO model. A key element of the RIIO approach is to give greater focus to incentives and innovation than the previous regulatory regime. This means new technologies and innovation play a more pivotal role in the efficient operation of the infrastructure network and in achieving operational cost savings. To stimulate investment Ofgem has introduced the Gas Network Innovation Competition, which allows gas network companies to compete annually for funding for the development and demonstration of new technologies.”
-Claudia Preedy - B2B Analyst

The market
UK gas demand in long-term decline
Total UK natural gas demand fell by a cumulative 29% between 2010 and 2014. In the first three quarters of 2015, gas demand was up 6% compared with the same period in the previous year. Despite this increase, gas demand remains below levels seen prior to 2014. The overall decline in recent years has largely been driven by reduced demand in the residential and electricity generation sectors, which represent the key end users of natural gas.

The use of gas to generate electricity has fallen by 29% between 2010 and 2014. This was partly due to a shift in electricity generation from coal to gas-fired stations between 2009 and 2012, reflecting falling carbon prices and emissions allowance costs during that period. However, output from coal-fired power stations fell in 2013 and 2014 as a number of coal-fired plants were closed. Strong growth in electricity generation from renewable sources has also restricted demand for electricity generated from gas-fired plants.

Demand for gas from the domestic sector strongly influenced by changing weather patterns
Gas supplied to the domestic sector has fluctuated strongly in recent years, largely due to changing yearly weather patterns. Following cold weather in 2010, a much warmer climate in 2011 resulted in a 25% reduction in domestic gas demand. Gas supplied to the domestic sector increased by 18% in 2012, but fell marginally in 2013. Domestic gas consumption fell by a strong 19% in 2014, again reflecting milder weather conditions, with 2014 the warmest year in the UK since records began. Partial year data for 2015 indicates a 13% increase. High energy prices in recent years and improving levels of energy efficiency in the residential sector have also exerted a downward pressure on gas demand.

FIGURE 1: Gas consumption by key end use sectors, 2010-14
  
Source: DECC data

Total capital expenditure across the gas transmission and distribution network picks up in 2014/15
Total capital expenditure in the gas industry on transmission and distribution has fluctuated during the five-year review period. Spending fell by a considerable 26% in 2013/14, as most network operators reported lower capital spending during the first year of the new price controls RIIO-GD1 and RIIO-T1. Investment levels started to pick up in 2014/15, with total capital expenditure increasing by 8% to £992 million.

FIGURE 2: Total gas transmission and distribution capital expenditure, 2010/11-2014/15
  
Source: MBD analysis of individual company data

Gas network operators report lower capital spending than the allowances set by Ofgem in the first two years of RIIO-GD1
Despite GDNs reporting increased capital spending in 2014/15, overall network expenditure has remained below the allowances set by Ofgem. This is partly due to the increased focus on efficiency savings, which have been achieved through an ongoing drive to use innovative techniques by operators. Other factors that have contributed to the GDNs’ outperformance at the start of RIIO-GD1 include milder winters, lower than expected economic growth, and planning delays.

During the current price control period, total capital expenditure by GDNs is projected to peak at £383 million in 2017/18, before declining in the following three years. Southern Gas Networks is set to report the highest level of capital expenditure during most years reviewed.

Replacement expenditure by GDNs is expected to be strongest in the middle part of the current eight-year control period, with annual spending forecast to oscillate around £763 million between 2016 and 2019, before falling in the final two years of the period. HSE-driven mains replacement activity will continue to dominate replacement spending. Southern Gas Networks is expected to have the highest annual spending throughout the control period.

Market factors
UK increasingly dependent on natural gas imports
UK natural gas production has been in decline since the turn of the century. In 2014, UK output was almost 40% less than in 2009, reflecting the maturity of existing natural gas fields. This means that the UK has become increasingly reliant on gas imports, with the country becoming a net importer in 2004. In 2015, UK gross gas production was up by nearly 9%, the strongest increase since 2000. This was partly due to higher volumes of gas following the start up of the relatively large Jasmine and Breagh fields at the end of 2013. However, the long-term downward trend in gas production will not be reversed, with production in 2015 still less than 60% of the volumes recorded at the turn of the millennium.

While UK natural gas production has been on a downward trajectory over the last decade, imports have increased, reaching a peak in 2010. Since 2011, imports have demonstrated a moderate decline, but have remained higher than total UK gross gas production. 

FIGURE 3: UK Gas Supply, 2011-15
  
Source: DECC data and MBD estimates

Iron Mains Replacement Programme (IMRP) drives replacement expenditure by gas distribution network operators
The programme, which is enforced by the HSE, was introduced in 2002 to address “societal concern” about the potential for failure of cast iron gas mains and the consequent risk of injuries, fatalities, and damage to buildings. The objective of the IMRP is to decommission all cast iron mains within 30 metres of property in 30 years. According to the HSE’s 10-year review of the programme, an estimated £4.8 billion at 2009/10 prices was spent on the IMRP (both mains, services and overheads) between 2002/03 and 2009/10. The IMRP remains a key part of total gas distribution network expenditure during the current price control period. 

Plummeting wholesale gas prices prompt major energy suppliers to cut prices 
Wholesale gas prices rose sharply between 2009 and 2013, with average prices more than doubling during the four-year period. This growth was reversed in 2014, when average prices fell by 27%, reflecting strong supply across Europe and lower demand due to warmer weather conditions. This prompted a number of energy suppliers to announce price cuts in early 2015. Prices continued to fall as 2015 progressed, driven by the plunge in oil prices, increased global supplies of LNG, and mild winters in Europe. In response major suppliers announced further price cuts in early 2016. Despite the reductions, prices have still been criticised for not sufficiently reflecting falling wholesale gas prices.

New regulatory framework introduced for current control period
Ofgem has introduced a new regulatory framework, known as the RIIO model, for the current eight-year price controls for the gas transmission and distribution networks, which run from April 2013 to March 2021. Under the new framework, the revenue earned by network operators is strongly linked to incentives, innovation and outputs. The changes mean that companies need to adopt a more long-term approach to infrastructure investment decisions, with increased focus on active asset management over traditional network investment. There is also an increased focus on innovation and new technologies that facilitate the efficient operation of the infrastructure network and provide operational cost savings.

Companies
Transmission and distribution industry structure
There are two types of gas network: transmission and distribution. The transmission systems generally include pipes, compressor stations and storage facilities, including LNG storage. They connect production through terminals to distribution systems. Gas enters the transmission system through importation and reception terminals and interconnectors. National Grid Gas is the sole owner and operator of gas transmission infrastructure in Great Britain. Gas leaves the transmission system and enters the distribution networks at high pressure. It is then transported through a number of reducing pressure tiers until it is finally delivered to consumers.

There are eight regional distribution networks, four of which are currently owned by National Grid. In November 2015, however, National Grid put a majority stake of its four remaining gas distribution networks up for sale. The assets are said to be worth around £10 billion, with the process expected to start in spring 2016 and complete early next year.

Gas supply industry continues to be dominated by ‘big six’ energy firms...
Gas suppliers buy energy in the wholesale market and sell it on to customers. Suppliers work in a competitive market and customers can choose any supplier to provide them with gas and electricity. The UK gas supply market continues to be dominated by the ‘big six’ energy suppliers, which claim a market share of around 88%. The ‘big six’ are British Gas, EDF Energy, E.on Energy, npower, Scottish Power and SSE. The suppliers provide gas and electricity, either under single-fuel or dual-fuel contracts.

... But independent energy suppliers are rapidly gaining market share
Recent years have seen a number of new entrants in the energy retail market, mainly small, independent firms. The new entrants have been able to take advantage of the high energy prices charged by the ‘big six’, which have encouraged many consumers to switch to a cheaper tariff, with independent suppliers often offering the most competitive rates.

By the end of 2015, the number of independent energy suppliers had risen to 33, with most active in both gas and electricity. Overall, smaller suppliers have managed to increase their market share significantly in recent years - from just 1% in 2012 to 12% by the end of 2015. Some industry analysts predict that the ‘big six’ could lose a quarter of their customers by 2020, with their market share falling to 70% by 2020. 

What we think
Ofgem has introduced a new regulatory framework, known as the RIIO model, for the current eight-year price controls for the gas transmission and distribution networks, running from April 2013 to March 2021. Under the new framework, the revenue earned by network operators is strongly linked to incentives, innovation and outputs. The changes to the regulatory framework have pushed companies to take a more long-term approach to infrastructure investment decisions, with an increased focus on active asset management over traditional network investment. There is also an increased focus on innovation and new technologies that facilitate the efficient operation of the infrastructure network and provide operational cost savings.

During the first two years of the current price control period, gas distribution network operators have outperformed their network investment targets set by Ofgem. This has been attributed to the increased focus on efficiency savings, supported by an ongoing drive to use innovative techniques by all operators. Other factors that have contributed to GDNs’ outperformance at the start of RIIO-GD1 include milder winters, which were kind to gas pipes; lower than expected economic growth; and planning delays.

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