House of Commons - Trade and Industry

Select Committee on Trade and Industry First Report

Determination of price levels

66. The price cap the regulators set must allow the regulated company to cover its forecast costs from sales revenue. The calculation of price caps is based on assessments of the company's operating costs, capital expenditure, the annual depreciation charge and the cost of capital (new and existing). This information is also used to arrive at X, the appropriate factor for productivity improvements through the review period. Several witnesses considered this to be an enormously difficult task as companies have the incentive to overstate their costs and investment requirements.[125] For example, Enron pointed out that British Gas's capital investments were substantially over-estimated from the beginning, and that "they [British Gas] were underspending their estimated capital for the purpose by an average of 30% a year".[126]

67. With regard to operating costs and capital expenditure, regulators use a variety of methods to examine the companies' projected expenditure requirements and the scope for companies to improve their efficiency. Such methods include comparisons between companies affected by the review, comparisons with other companies at home or abroad, comparisons with past expenditure and performance, advice from consultants, discussions with other companies in the industry and cross-checking of information provided with independent sources.[127]

68. The evidence from the National Grid Company and British Gas indicates that there is a great deal of contention between the industries and the regulators about the principles of calculation of the annual depreciation allowance, the asset base, and of the cost of capital. These elements are vitally important because they affect the total allowable revenue on which X is based.

69. The main criticisms centred around inconsistency from one review to another in the regulators' approach to the basis on which assets were depreciated and the cost of capital.[128] Both OFGAS and OFFER have decided during the most recent price reviews to change the basis of calculating regulated revenues. OFGAS has proposed basing depreciation and the rate of return on acquisition costs, whereas in the past the current cost accounting basis has been used; and OFFER has moved to a market-based asset valuation more closely related to acquisition cost. Both British Gas and the NGC have strongly opposed these moves because they claim that they have created an uncertain environment for future investments and increased regulatory risk which "pushes up the cost of capital, making the business higher-risk from the investor viewpoint".[129] One example of this is the TransCo formula which was announced in May 1996 and resulted in British Gas's share price falling by 30% and settling around 25% lower.[130] The NGC summarised the outcome of these changes as "the regulated transmission businesses ... face the continuing risk of seeing large parts of their asset bases written off for regulatory purposes, while being allowed to earn rates of return (on the remaining assets) which are premised on them being low risk businesses. This is not a reasonable basis for investing in vital infrastructures. In particular, it does not have the internal consistency which characterises US regulation, where relatively low rates of return co-exist with the understanding that, once assets are in a company's regulatory base ... they are in the rate base for the agreed life of the assets".[131]

70. The NGC, among other companies, called for clear and consistent rules on key factors such as the cost of capital, the regulatory asset base and treatment into future of efficiency gains above `target' from past review periods" as being essential for a more stable process and for encouraging long-term investment in national infrastructures.[132] Consistency on the cost of capital was seen as the key area, so "that in each period we do not keep on re-visiting this figure".[133]

71. We believe that there is a strong case for having clear and consistent guidelines, especially on how the regulatory asset base should be calculated and whether the principle will carry through to the next review period. We note that, partly as a result of recent MMC inquiries, greater consistency is being shown. We, therefore, recommend that the regulators develop such clear rules and communicate them, and any subsequent changes, to the regulated companies.

72. The rate of return on capital employed (i.e. profits and loan interest) should be set as low as possible to minimise the cost to customers, but high enough to allow an efficient business to attract capital necessary for investment. The regulators have recently set the real rate of return on capital at 6% to 7%.[134] The rate of return was generally arrived at after consultation, analysis of rates of returns obtained in the securities markets and assessment of the effect of taxation or, as in the case of OFGAS, the work done by the MMC in 1993.

73. Several witnesses argued that there was a lack of common methodologies for price setting among the regulators. Dr Dieter Helm believed that one result of this was a "higher cost of capital which raises the long run prices to consumers".[135] South Western Electricity plc (SWEB) suggested that "a new panel should be created to consider and establish a common methodology for sectoral regulators on the main regulatory issues such as asset valuation, depreciation and cost of capital" which should be published.[136] The Director General of OFWAT told us that "we [regulators] are also learning a lot from each other in terms of process".[137] The balance of evidence suggests that "over the years ... [the regulators] have actually arrived at very common methodologies across the price controls", particularly in terms of the asset base and the rate of return, and particularly in gas and electricity, very similar approaches are emerging.[138] The DGGS told us that the approach to the rate of return "varies slightly according to the level of risk in the particular business concerned".[139] The regulators have made good progress in this area and, providing this continues, we do not think there is a need for special panels for this specific purpose. While we accept that industries have different characteristics, and inconsistencies between industries may arise, we recommend that individual regulators should seek to improve their calculations by taking account of regulatory practices in other industries with the aim of achieving greater consistency. This is especially important for energy regulators whose different methodologies could distort the choice of energy source.