House of Commons - Trade and Industry

Select Committee on Trade and Industry First Report

Regulating Natural Monopolies

95. As United Gas confirmed "there will be a need for a permanent and evergreen regulation of the monopoly components where there can never be competition".[208] These `monopoly components' are commonly referred to as natural monopolies; aspects of industry where competition cannot deliver benefits as there are such enormous economies of scale involved. Duplication of their huge infrastructure assets would cost such vast sums that any benefit through competition would be eradicated. In the energy sector it is the pipes and wires that are seen as natural monopolies - the transportation system in gas and the transmission and distribution networks in electricity. The RECs have responsibility for the monopolistic distribution and the increasingly competitive supply of electricity. Similarly, British Gas was privatised with both monopolistic and competitive operations. The fact that natural monopolies are not subject to the disciplines of a competitive market and that they are frequently owned jointly with competitive operations gives rise to a number of regulatory issues which are not relevant in other regulated companies.

Separation of functions

96. It is widely agreed that monopolistic and competitive elements of the privatised energy utilities must be separately administered if competitive markets are to operate in the consumer's best interests. For instance, if a REC were to charge some suppliers higher prices for the use of its distribution network than it did to its own supply business, competition would be distorted and consumers would either have to purchase electricity from the REC or pay higher prices. A more subtle, and less easily detectable, approach would be for the REC to charge costs incurred elsewhere in its operations to the monopoly business, thereby inflating charges to other suppliers and subsidising its own supply business.[209]

97. There is more debate over the extent to which natural monopolies should be separate. United Gas, for instance, argued strongly that the only way to guarantee sufficient separation "is for each regulated monopoly to be held as a legally separate entity".[210] However, a large majority of witnesses felt the current regulatory framework - which provides for the artificial separation of functions within companies, with a series of `chinese walls' built to prevent, for example, cross-subsidisation and inappropriate information exchange - to be adequate. Northern Electric, Scottish Hydro-Electric, SWEB, and SWALEC, inter alia, all agreed that the current mechanisms were sufficient.[211] Yorkshire Electricity added that to go further "could result in unnecessary inefficiencies".[212]

98. It is for the regulator to instruct the companies concerned what measures to take to ensure adequate separation and to monitor the effectiveness of such measures. In the electricity industry, these measures usually include financial ring-fencing to prevent cross-subsidisation and separate financial reporting to ensure that the regulated business is transparent, both for the benefit of customers and the regulator. We remain to be convinced that the current regulatory framework provides for sufficient separation of functions in the electricity and gas industries although, as we have noted before, such separation should be continuously monitored and the possibility of further measures should not be excluded.[213] We recommend that, during the course of future reviews, the regulator should satisfy himself that there is sufficient separation of functions and impose further measures if necessary.

Cost allocation

99. There are some functions where, it is claimed, in the interests of efficiency, both the regulated monopoly and competitive elements of the company operate together. Eastern Group told us "from a business point of view, there are some things you want to share. You want to share overhead structures" such as corporate management or information systems.[214] Such sharing of functions creates the need for the allocation of costs between the regulated monopoly and other parts of the company. Typically, the costs which need allocating are a tiny proportion of total costs. For example, ScottishPower told us that less than 2% of their total costs required cost allocation and that the remainder fell obviously into one or other business area.[215] Nevertheless, incorrect cost allocation would in practice mean that one part of the business was subsidising another and, as Calortex pointed out, cross-subsidisation is a great danger to the creation of effective and fair competition. To guard against this possibility, the regulators produce strict guidelines regarding cost allocation and implementation is constantly monitored.[216] We have received little evidence revealing any discontent with current practices regarding cost allocation in the electricity industry.

100. The situation in the gas industry is different. Under its Gas Act 1986 licence, British Gas was obliged to provide regulatory accounts for its licensed activities separately from its other operations. However, it was required only to provide accounts for its UK gas supply business as a whole covering transportation, storage and supply. When the company was split into six different divisions in 1994 the DGGS required separate accounts for transportation and storage. Inevitably perhaps, initial data and financial reporting was not perfect,[217] but the DGGS told us that the situation had improved significantly.[218] However, United Gas told us that, based on the information available to them, they were still concerned that the costs charged to TransCo from other parts of British Gas were too high;[219] a concern that was echoed by the DGGS. She told us that OFGAS "have never been able to get to the bottom of the charges that British Gas Centre charges to TransCo ... and we are ... very suspicious that those figures are inflated".[220] We have not attempted to examine the figures for ourselves, nor to determine the extent to which such concerns are justified; this may form part of the MMC's review of the TransCo price control. (We should note, however, that British Gas deny that there is any basis for such suggestions.)[221]

101. The recent demerger of TransCo from British Gas will separate monopolistic transportation operations from the competitive supply side. We recommend that the regulator ensure that the natural monopoly part of TransCo is adequately ring-fenced, that strict cost allocation rules are enforced to ensure that the regulated business does not unduly inflate its prices, and that she has access to sufficient information to satisfy herself that cost allocation is appropriate. We recommend that companies give consideration to appointing non-executive directors to their Boards who would have a duty to review company policy and recommend amendments as necessary in the public interest.

102. We discuss transparency across the regulatory process as a whole later in this Report (see paras 157-164), but there are aspects that are of particular relevance to natural monopolies. Amerada Hess argued that "information relating to the natural monopoly elements of the privatised utilities should be published to the greatest extent possible".[222] Similarly, the Chairman of PowerGen told us, in the case of NGC, "I cannot see what information is confidential, because such a company is not competing against anyone".[223] Other witnesses agreed.[224] We find this to be a very convincing argument (although we do accept that some information, for instance that relating to personnel, should remain confidential). At present, if a natural monopoly claims that information is commercially confidential, the regulator must prove that it is not before it can be published. It seems that there is a great difference of approach between various companies, with some more willing than others to release information.[225] This ad hoc situation is conducive neither to consistent regulation nor to creating confidence in the regulatory process. We agree with the DGGS that the burden of proof should be changed,[226] and regret that the Government declined the opportunity to bring about this change for the gas industry during the passage of the Gas Bill in 1995.[227] We recommend that the Government introduce legislation at the earliest opportunity to create a system whereby information relating to natural monopolies is assumed to be non-confidential unless it can be shown to be otherwise and that the Government gives both energy regulators the authority to publish information relating to natural monopolies as they see fit, unless the company concerned can prove that publication would be commercially damaging.

103. We do, however, recognise that natural monopolies may have information which is market sensitive, as distinct from commercially sensitive. We do not consider that it would be appropriate for the regulator to decide on the manner or timing of market sensitive information, which may require controlled release through the Stock Exchange.[228] We recommend that any legislative proposals from the Government should take account of the needs of natural monopolies and reflect advice from the Stock Exchange regarding the release of market sensitive information.

208 Q.94. Back

209 Ev. p.246. Back

210 Ev. pp.20, 22; eg. also Q.118; See also Ev. p.83. Back

211 Mem. p.35, 44. Back

212 Mem. p.54. Back

213 Aspects of the Electricity Supply Industry, para 81. Back

214 Q.726. Back

215 Q.820. Back

216 QQ.1062-1063. Back

217 Q.900. Back

218 Ibid. Back

219 Ev. p.21; Q.103; Ev. p.28. Back