Select Committee on Northern Ireland Affairs Minutes of Evidence


APPENDIX 26

Further Memorandum submitted by the Director General of Electricity Supply for Northern Ireland

  In theory Capex should be finite, certainly for transmission investment. There are a specific number of pieces of work, all of which should be identifiable, to be undertaken during a regulatory period. Capex planning should be a relatively exact science with a list of evaluated projects assembled for consideration before the next price control period.

  If it worked like this, then if all the money were not spent in the first period the explanations would be:

    (a)  A lower cost solution has been found. This would mean the same quantum of projects was carried out and that the target quality of service would have been achieved. This would be a real efficiency gain. The company would benefit from the underspend for five years and customers would benefit for the next 35 years through avoiding the financing and depreciation charge as NIE's asset base would now be lower than otherwise due to the degree to which lower cost solutions were found compared to what originally was anticipated would be spent.

    (b)  The project was deferred into a later period. This means that the company benefits from the underspend in the first period but customers at some stage in the future will have to finance the project. If the project is merely deferred into the next regulatory period, the effect is to require customers to pay for it twice, once in the second period and also in the first period where they will have already paid up to 30 per cent of its financing cost if the underspend is in the first year. The company, in this case, is rewarded twice because it keeps the first period underspend and earns a return on the project from the second period once it is constructed.

  In practice, Capex is not a list of projects agreed in advance. It is a sum of money derived from an iterative bargaining process. It is therefore not possible to know by any of the usual tests if an underspend represents an efficiency gain. Some underspend may well do so, and until the last NIE price control review and subsequent MMC inquiry the convention had been to treat all underspend as efficiency gains. I believe a greater onus of proof should be placed on the company to show that underspend represents an efficiency gain as the greater probability is that it represents deferral. The MMC assumed that two-thirds of the underspend represented efficiency gain.

  The foregoing should set the answers to your questions in context. If the actual 93-97 Capex expenditure had been accurately foreseen, customers would have saved £5.13 million per annum (96-97 prices) for five years. This would have reduced the average domestic bill by £2.50 per annum. If the expenditure had proceeded up to the allowed level then the customer would have had to spend £8.68 million per annum financing that expenditure in the second period and would be incurring the financing bill on this expenditure until 2032-37. However, in that case customers would have an additional £97 million of network investment in place and logically the second period's Capex would have been correspondingly smaller.

  The ex ante imprecision or black box nature of Capex is in fact rather neatly illustrated by the way in which NIE proposes accelerating the refurbishment of the rural network. This does not involve any additional cost to customers in the present period and the money will be found by deferring work. I understand some large sub-stations upgrading or replacement will be postponed. This deferral should have no adverse effect on customer minutes lost (CMLs). It is therefore evident that the sub-stations' work did not, strictly speaking, have to occur in the present regulatory period. Strictly speaking, perhaps this work should not have been there at all.

  Ideally, Capex should be a rigorously assessed minimal list of necessary projects and all underspend should be efficiency gains. In practice it tends to be an affordable black box in which underspends are mostly deferrals, though with some element of efficiency gain which is difficult to quantify. It is this "black box" nature of Capex which probably provides the reason why the situation described in your second question of a Capex overspend has never arisen. If a company wanted to exceed its Capex it would be entitled to ask for a re-opening of its price control or at least ask that the additional assets it financed out of its own money would be included in the regulatory asset base and it would be foolish to proceed with any overspend without the assurances it needed. But for the reasons given above—the benefits to companies of underspending for whatever reason the underspend arises—I am not aware of any company overspending.

  Finally, while I hope I have answered your questions about Capex effectively, it would be remiss of me to give the impression that I believe the Boxing Day storm would have been significantly less damaging if NIE had spent all their Capex in the first price control period. I am still engaged in analysing with the company the precise relationship between investment and vulnerability to storm damage. While the reduced probability of failure in new components, wire and poles is not in dispute, it is difficult to establish how much better the network would have fared in the storms if more money had been spent in an earlier period to strengthen the rural network.

22 April 1999


 
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