Further Memorandum submitted by Northern
Ireland Electricity plc
As a result of our written and oral evidence
given to the Northern Ireland Affairs Committee, a number of requests
for additional information arose as recorded within the transcript
document. In addition, we are grateful to have had a copy of Ofreg's
submissions dated 3 and 5 February 1999 to the Committee.
We enclose a Supplementary Memorandum which
I hope the Committee will find addresses satisfactorily the requests
for additional information. We have also addressed within the
memorandum important issues which we believe arise from the Ofreg
submissions to the Committee.
If there is any clarification required on the
attached or if there are any further questions arising, we would
wish to respond to the Committee as required.
1. INTRODUCTION
NIE valued the opportunity to give evidence
to the Northern Ireland Affairs Committee on our handling of events
following the major storm on Boxing Day and the subsequent disruption
to electricity supplies. There were a number of points raised
during the hearing on which we were asked to provide further information,
and this submission seeks to address those points.
Question 58 of the evidence dated 8 February
1999, brings together a summary of the main requests for information.
These are as follows:
— An analysis of the relationship between
the age of the network and its vulnerability to storm damage;
— Further explanation of the implications
of the accelerated and supplementary programmes of refurbishment
referred to in paragraph 8.3.2 (page 34) of NIE's Report.
— Clarification of the difference between
Figure 2, page 9 and Table 2, page 10 of NIE's Report which refer
to customer minutes lost on the NIE system and a comparison with
other utilities.
Section 2 of this Memorandum addresses these
issues.
Section 3 provides commentary on some additional
issues which were referred to in the evidence and/or in Ofreg
correspondence to the Committee and on which we believe the Committee
may find it helpful to have additional comment.
There have been and are continuing significant
differences between NIE and Ofreg on some of the major issues
affecting customers in the area of capital investment, network
refurbishment rates and models of effective regulation. These
differences are highlighted particularly in Section 2.1, Section
2.3 and most of Section 3, but particularly Section 3.1, Section
3.4 and Section 3.7. On many of the issues, NIE would be quite
willing to accept the MMC's determination. We believe that the
differences between Ofreg and the MMC need to be understood and
that a public consideration of the issues involved is a very important
part of finding a resolution on which all of the parties may move
forward in the best interests of the customer.
2. FURTHER INFORMATION
REQUESTED BY
THE COMMITTEE
2.1 Network age and vulnerability
The Committee requested further information
on NIE's analysis of the relationship between the age of the network
and its vulnerability to storm damage.
The overhead distribution network comprises
approximately 3,000 km of 33kV lines, 20,000 km of 11kV lines
and 6,000 km of low voltage lines—a total of some 29,000
km of overhead network. A substantial proportion of this network
was constructed in the period from the late 1950s to the mid-1970s,
as rural customers were brought onto the system through new rural
electrification schemes.
The analysis which follows focuses on the 11kV
network since it is the most extensive, but the principles of
age and condition monitoring extend to all network voltage levels.
The 11kV network comprises main lines which
form the arteries of a very extensive rural distribution system.
These arteries service over 240,000 customers who live in mixed
rural/urban environments outside of the main cities and over 210,000
dispersed rural customers who also require for their supply what
might be described as a complex subsystem of veins, also constructed
at 11kV and fed by the main arteries. As new rural customers come
onto the system, the 11kV network must be extended at a local
level, year by year, across the breadth of Northern Ireland. The
main arterial 11kV network also requires periodic extension and
reinforcement in order to meet the new load demand as it builds
up over a period of years. As a result, poles and system components
of widely varying ages are widely distributed throughout the system
and the age of poles and components does not adhere to any particular
pattern of geography. Thus, for assessing the potential maintenance
needs of the system, the age of poles, whose maintenance assessment
triggers assessment of the other principal components subject
to deterioration, is recorded and monitored at an individual level.
While age is the principal surrogate for likely
condition, actual condition can vary with such factors as the
quality of the original preservative treatment of poles as supplied,
the foundation conditions, and the degree of weathering and other
exposure as determined by the terrain or location. Thus, in practice,
the refurbishment needs of a local supply system will vary along
the entire length of the specific 11kV circuit, depending on the
date of construction of the original main arterial line, the dates
of local extensions and reinforcement, and the lifetime conditions
and rates of deterioration of individual components. In general,
a best-practice approach to maintenance, which ensures a cost-effective
result for the customer, necessitates that overhead lines should
not be subject to wholesale replacement at a point in time, but
should enjoy substantial maintenance and ongoing replacement guided
by condition monitoring and assessment of the individual line
components—conductors, poles, insulators, steelwork, etc.
This is the practice adopted by the industry in general and by
NIE. It involves tracking the age of the system but, as indicated
in Section 3.2 of our Report on the storm, it also involves an
ongoing assessment of the fault history of individual circuits
as a further guide to maintenance and refurbishment needs. Once
a circuit has been selected for maintenance, a thorough assessment
of all the line components is carried out to determine the extent
of replacement necessary and the precise schedule of work.
Industry norms, based on long run statistics,
assume a distribution of probability of failure of wood poles
centred on an asset life of 35-40 years. The expectation of failure
is higher in the higher age range but failure can occur earlier
in a significant percentage of cases due to the more rapid deterioration
of individual poles or particularly onerous wind-loading conditions
in a storm, and also due to the nature of the local terrain and
the wind direction relative to the particular orientation of the
line. For example, if wind direction is at right angles to the
line conductors, maximum force is exerted on the pole. Conversely,
there are poles on the network of more than 50-years-old which
have been assessed as to condition and have been found to be sound
and perfectly serviceable and have withstood the force of the
recent storm.
Thus, in practice, age is used as an important
factor in guiding maintenance need but it is not the single determining
factor. In addition, in order to effectively manage the process
of maintenance and, in particular, in order to minimise the number
and duration of interruptions of supply to customers, it is necessary
to plan and focus resources circuit by circuit in a maintenance
cycle which extends over a period of years. It is not acceptable
or effective to progress the refurbishment of circuits on a strictly
age-of-pole basis.
When focusing on age-of-pole as a guide to maintenance
need, likely failure rates may be modelled based on the industry
model for pole decay/failure rates. The number of poles likely
to fail in a given age category may be predicted as the total
number of poles in that age category multiplied by the probability
of failure corresponding to the age point on the failure distribution
curve.
The graph below compares predicted pole failures
calculated on this basis for the HV distribution network and the
actual pole failures which occurred during the Boxing Day storm,
against their age profiles. There is reasonable correlation between
the two sets of data. Any mismatch may be ascribed to the fact
that age is not an absolute proxy for actual condition of all
line components and, as explained, local wind conditions, terrain,
etc., can be significant contributory factors.
Overall, the graph clearly shows that network
refurbishment must take particular account of poles in the 30-45
year age category. On the 11kV network, some 57 per cent of the
pole population of 240,000 lies between 20 and 40 years old. It
is this knowledge, combined with the above type of analysis, and
allied to condition monitoring of individual circuits, which led
us to focus a particular effort on 11kV network refurbishment
during the first regulatory period and to propose a continued
programme of refurbishment at a high level in our submissions
to the Ofreg price review and to the MMC. It has been clearly
shown that the network of refurbishment programmes carried out
to date have been very effective in improving network performance.
Table 2 in the storm Report confirms the underlying reliability
improvement since the refurbishment programme began and Figure
3 in that Report shows, on the basis of the circuits in the sample,
that refurbishment can improve performance by a factor of 3.5.
Despite the evidence, the case for higher levels of expenditure
to enhance reliability was contested vigorously by Ofreg at our
MMC review. It is clear from paragraphs 2.126-2.131 of the MMC
report that, in considering our plans for the refurbishment of
11kV overhead lines to improve network performance, the MMC felt
it necessary to restrict that programme in the light of Ofreg's
arguments against it. It is in the light of the demonstrated experience
of the recent storm that we intend to engage again with Ofreg
on their approach to this issue. We are concerned that any inability
to see a resolution to the issue of high generation costs, which
have by far the greatest impact on prices to the customer, should
not lead to an inappropriate focus on the relatively weak impact
on price of this type of refurbishment programme.
2.2 Implications for Subsequent Work
The second question referred to in question
58 of the evidence is specific to the implications of the accelerated
work programme proposed, i.e., "What the implications
would be for subsequent work once you have brought it up to that
state".
The full overhead line refurbishment programme
is based on a 15-year cycle. The asset replacement work performed
on each circuit once during a cycle ensures acceptable component
reliability until the next time the circuit is due for refurbishment.
When all the circuits have been fully refurbished in line with
the investment plan, it will be time to recommence the cycle.
In the storm Report, apart from accelerating
our programme of full refurbishment, we proposed to supplement
full refurbishment work with a programme of partial refurbishment
work, to target the replacement of poles nearing the end of their
useful life on those circuits which are not immediately scheduled
for full refurbishment. With the replacement of some 10,000 additional
poles, partial refurbishment will help to minimise the potential
effects of future storms on these circuits. When all these circuits
have been partially refurbished in line with the investment plan,
they will enter the normal maintenance cycle and will be fully
refurbished in accordance with the normal 15-year cycle, requiring
attention to other line components without the need for the pole
replacement element of the work.
The cost of any refurbishment programme will
always be minimised to the extent possible. In the particular
case of lines which have benefitted from early pole replacement
due to prior partial refurbishment, this element of cost will
not arise in the normal refurbishment programme. However, programme
costs vary over time for other reasons. For example, currently,
the full refurbishment of overhead lines requires about 10 per
cent of the conductors to be replaced, the remaining conductors
being in an acceptable condition. As the age profile increases
for conductors, future refurbishment cycles will need to increase
the amount of conductor replacement. This work is very cost-intensive
and tends to increase the average cost per km for full overhead
line refurbishment. Conversely, NIE attempts to use best practice
international procurement and strategic sourcing partnerships
with suppliers to minimise materials costs where possible.
2.3 Customer Minutes Lost
The third question referred to the analysis
of customer minutes lost figures quoted in the Report, i.e., "It
would be quite useful to know if there is either an update of
Figure 2 by which we can compare NIE by Figure 2 calculations
or, alternatively, whether there is an update for other utilities
which compares with the figures which appear in Table 2 . . .
it would be helpful so that we get away from comparing apples
with pears".
The figure and the table appear under two separate
sub-headings and each attempts to explain a separate issue.
Figure 2 simply demonstrates that the overall
performance of the NIE network at privatisation was at the bottom
end of all of the regional electricity companies and required
higher levels of investment. This indicated that pre-privatisation
investment in the system was inadequate. The consequent new investment
need was a major area of discussion at MMC. Paragraphs 6.20-6.22
of the MMC Report summarise the evidence we submitted to MMC as
to the need for targeted improvements in Customer Minutes Lost
(CML) to keep pace with the projected improvements of the broadly
comparable regional electricity companies (South Western, SWALEC
and Hydro-Electric) which, like NIE, have much higher levels of
overhead network per customer than the GB average. Table 6.6 of
the MMC Report shows how CML may be improved by specific rates
of 11kV line refurbishment. Figure 6.4 of their Report illustrates
that the large improvement envisaged by NIE depended primarily
on improving CML in the rural districts. Paragraph 2.127 of their
Report indicates Ofreg's evidence against higher levels of capital
investment and Appendix 6.2 summarises the main findings of an
Ofreg survey which purported to demonstrate that the Northern
Ireland electricity customer was largely satisfied with the current
level of service and did not think that the quality of electricity
supply needed to be improved.
Figure 2 simply attempts to establish a sense
of understanding as to the need for higher levels of capital investment
in network refurbishment in order to improve quality of supply.
Against the background of what we believe to be an inadequate
recognition on the part of Ofreg of the specific capital
investment needs of the rural network, we would be concerned that
there should not be an inappropriate focus on this as a pricing
issue in the context of an inability to see a solution to the
over-burdening issue of high generation costs.
Table 2 shows the improving underlying trend
in CML arising only as a result of 11kV network performance. It
is through 11kV network refurbishment on rural circuits that NIE
aimed to obtain significant CML improvement. The Table shows a
reduction by 50 in CML due to normal 11kV faults in the period
from 1993-94 to 1997-97 and a reduction by 52 to 1997-98. Total
CML fell from 268 to 209, a reduction of 59, in the period to
1996-97. The 1997-98 figure was 319 but this was heavily distorted
by the 1997-98 storm. The higher figure in the year of a storm
is not just a measure of network vulnerability, it is heavily
distorted by the sheer scale of the number of customers off-supply
due to the loss of arterial lines even for a limited duration,
combined with long delays in reconnection times for some customers
due to the sheer scale and complexity of network faults. These
lead to an exceptional impact on customer minutes lost and could
distort the view of the underlying investment need leading to
inappropriate levels of investment.
3. ADDITIONAL COMMENT
It may be helpful to the Committee to have the
following additional comment on other issues referred to in the
transcript and/or in Ofreg correspondence. As suggested during
the evidence hearing, where possible, we have made cross-reference
to the MMC Report of March 1997 which has very fully documented
the entire range of issues affecting investment and performance.
We hope this may provide the Committee with a useful independent
reference.
3.1 Investment levels
Reference is made in question 56, of the evidence,
to investment levels: " . . . many people would regard
the level of investment that you made as utterly insufficient
given the age of the system that you are trying to operate".
The investment in network expenditure post-privatisation
has been at a level approximately double that pre-privatisation.
The present level of expenditure amounts to around £90 per
customer compared to an average of £60 per customer in the
other electricity utilities in the UK. Extensive analysis of the
type indicated earlier has determined that it is primarily 11kV
refurbishment which impacts on network performance and NIE has
focused on a major programme of refurbishment since 1994. This
is the largest programme of its kind in the UK and addressed the
legacy of a poorly performing network inherited from pre-privatisation.
The challenge at MMC was to be able to maintain
programmes at their current level in the light of the way in which
capital investment was contested by Ofreg, with what purported
to be supporting evidence from customer surveys as indicated in
Section 2.3 above. Ofreg appear also to challenge the suggestion
that there has been under-investment prior to privatisation by
referring to the levels of capital investment pre-privatisation
and lay a particular emphasis on the impact of high nominal levels
of network investment on the quantity of assets which the customer
in NI has to finance (Ofreg letter of 3 February to the Committee).[2]
We underlined to MMC the importance of ensuring
that customer surveys are properly constructed to obtain information
which supports reliable conclusions. We believe that the customer
survey format included as Appendix 6.2 of the MMC Report and referenced
at paragraph 2.127 of the Report in the discussion of distribution
asset replacement does not deal with the complexities of the issues
as dealt with by the MMC. For example, the survey indicates no
distinction between urban and rural customers who are exposed
to starkly different experiences of customer minutes lost. As
the MMC Report indicates at paragraph 2.126 "Customers in
the more rural parts of Northern Ireland, who tend to be served
from long stretches of 11kV overhead wire, experience a much higher
level of CML than customers in urban areas. By concentrating its
efforts on refurbishing the worst-performing circuits. NIE can
achieve a significant improvement in overall average CML as well
as delivering a better service to customers who at present experience
a relatively high level of interruptions."
The full range of capital investment issues
is largely covered in the MMC Report in Chapter 2: Conclusions
(paragraphs 2.106-2.144) and in Chapter 7: The Capital Investment
Programme of NIE. The issues are complex and were determined by
MMC only after a careful investigation which occupied a substantial
portion of the six month review process and took account of very
detailed submissions made by Ofreg and NIE, supported by the work
of engineering consultants Rust Kennedy & Donkin (RKD) for
Ofreg and Merz & McLellan for NIE, and the MMC's own consultants
Electrowatt. We believe that the process of arriving at conclusions
on what was an appropriate investment programme for the Northern
Ireland system was severely inhibited by a poor understanding
and presentation of the issues by Ofreg and their consultants.
Very surprisingly, RKD prepared their report for Ofreg without
visiting Northern Ireland and without discussing their findings
with NIE. Indeed, as paragraph 2.120 of the MMC Report makes clear,
we had not been aware of RKD's involvement before the MMC inquiry
took place, and, as clearly stated in paragraph 2.121 of the MMC
Report, the MMC itself felt the need to take a newly independent
view of the issues. "Given the circumstances in which RKD's
report was produced and our own findings from studying it, . .
. we consider that conclusions drawn directly from the report
are not sufficiently robust in themselves to form a basis on which
we can reach appropriate price control decisions".
The MMC went on to undertake a detailed assessment
of the capital expenditure needs of the system in the light of
a full knowledge of the issues and consideration of the public
interest issues, including the impact of capital expenditures
on price.
In their evaluation of operating expenditures,
which include cost allowances for repairs and maintenance on networks,
the MMC encountered a similar problem. Paragraph 2.149 of the
MMC Report, which deals with operating expenditures, states. "Although
the DG [the Director General of Electricity Supply] had described
the findings of PKF's report [PKF was the DG's consultant in this
area] in putting his proposals to NIE, he had not made the report
itself available to the company. When we did so, NIE submitted
evidence on what it regarded as errors, inconsistencies and unreasonable
assumptions in the report. Having studied the report ourselves
(with the help of Electrowatt in respect of R&M), and having
taken account of comments by NIE, the DG and PKF, we believe the
conclusions are not sufficiently robust in themselves to form
the basis for the future price control. We have accordingly sought
to reach our own assessment . . . "
We believe that the process of effective utility
regulation is a complex one and that the interests of the customer
will be best served by the fullest possible understanding of the
issues by the regulator's office. It is essential that the regulatory
authority has available to it the best possible expertise. It
is essential also that the work of external consultants is not
accepted uncritically. We believe that the interests of the customer
in Northern Ireland may be very badly served in the future if
the expertise available to Ofreg for their evaluation of these
issues and their own interpretation of the work of their consultants
were to continue to follow the pattern of that evidenced at MMC.
3.2 Refurbishment rates on the 11kV network
Reference was made in question 57 to the possibility
of supportive material being made available for the case for an
annual rate of 11kV refurbishment programme of 1,750 km.
In our submission to the MMC we indicated that
our target was for an improvement in customer minutes lost to
107 CML by 2002-03 based on a proposed refurbishment of 1,750
km per year. The background to this target is set out in the MMC
Report in Paragraphs 2.126 and 6.20-27 along with supporting graphs
of comparator companies and Table 6.6 which sets out our estimate
of the projected availability improvement as a result of various
levels of 11kV line refurbishment. Paragraphs 2.126 and 6.21 state
clearly the importance of this refurbishment on rural networks.
Paragraph 2.122 and Appendix 6.2 indicate the evidence submitted
by Ofreg for a lower level of refurbishment.
The figure of 1,750 km is deleted at Paragraph
2.128 of the published version of the MMC Report and we do not
believe that Ofreg would dispute it but we can provide evidence
of the figure if required. Ofreg's recommendation was for a figure
just below 1,200 km a year and again we believe that they would
accept that.
The MMC determined that a less ambitious target
of 120-140 CML by the end of the price control period, consistent
with refurbishment at the rate of 1,500 km/year, would be better
justified in the particular circumstances of Northern Ireland
(Paragraph 2.129 of the MMC Report). Following the damage sustained
during the recent storm, NIE has taken the view that the better
performance of the refurbished circuits was such as to justify
an accelerated programme of refurbishment.
3.3 Capital expenditure programmes and past underspend
Reference was made in question 58 to capital
expenditure in the last price control period of £243 million,
that being less than the capital expenditure proposed by Ofreg
for the present five year price control period.
In addition, in his letters of 3 and 5 February,
the Director General raises concerns in this area relating to
the level of capital expenditure, the underspend in the first
regulatory period, the setting of priorities and the lack of accountability.
The level of expenditure
It is important that customers can be confident
that the right level and type of investment is being put into
the electricity network. Our storm report explains that we are
investing almost twice as much in the network as we did before
privatisation and at a much higher rate per customer than electricity
companies in GB.
In defining the level of total capital expenditure
to be adopted for the purpose of setting the new price control,
the MMC weighed carefully the public interest issues associated
with each category of investment.
The Director General's proposals to the MMC
were based on cutting NIE's proposed investment in the network
by 20 per cent. However, the MMC rejected the work of Ofreg's
consultants, regarding it as "not sufficiently robust"
to form a basis on which price control decisions can be reached.
After conducting their own extensive investigation into NIE's
investment proposals, with the assistance of their own engineering
consultants, the MMC based the new price control on an overall
capex figure which was 10 per cent lower than what NIE had proposed
and which they considered balanced the various public interest
issues.
The underspend
The salient facts pertaining to the underspend
are as follows:
— The reasons for the underspend were
very fully explained at the MMC and are largely documented at
Appendix 7.1 of the MMC Report.
— The extent of underspend was by far
the greatest in the transmission network which was relatively
unaffected by the storm. Within the transmission capital underspend
detailed in Appendix 7.1, some 32 per cent is explained by the
delay of a single project viz Belfast transmission project,
and some 60 per cent was attributable to demand management measures
which are widely regarded as necessary performance management
on the system.
— Over 80 per cent of the distribution
capital budget was fully spent.
— In our evidence to the MMC, we explained
how we had responded to the incentives within our price control
to increase the efficiency of our investments. We quoted, as examples,
the introduction of better procurement practices to enable us
to purchase equipment at cheaper prices and the modification of
our tariffs to introduce price signals designed to slow the rate
of growth in customer demand in order to defer the need for certain
types of investment.
— Any investment impacts on prices,
since prices must be set at a level which covers the financing
costs of the investment including the cost of capital and the
depreciation charges over the life of the assets. Customers benefit
from efficient investment, since prices will be lower than they
would otherwise be if investments were inefficient, unnecessary
or premature. It is crucially important in proper regulation that
the incentive not to invest the allowed capital if it is
not to customers' benefit is maintained. This was clearly recognised
by the MMC.
— The effect of the underspend which
arose by investing efficiently in the first price control period
is that prices are now 2 per cent lower than they would have been
if the full capex which was forecast at privatisation had been
spent. The Director General's comments that . . . the underspend
was " . . . more than enough to have paid for the Scottish
Interconnector at no extra cost to customers" is quite
incorrect. If the full forecast capex had been spent, then customers
would be paying for it for the next 40 years. Since the money
has not been spent, and customers are not paying for it, the interconnector
could not be said to be capable of funding at no extra cost.
— The MMC recognised the force in our
arguments about maintaining incentives to invest efficiently.
The MMC resolved the issue of the underspend by allocating the
benefits between the company and customers.
— The MMC set guidelines as to how
to judge future capex savings by focusing on whether the outputs
have been met (e.g., targets for customer minutes lost), rather
than focusing on whether the envisaged inputs in terms
of forecast capital expenditure have been spent. The MMC regarded
the absence of output measures as a deficiency in Ofreg's price
review.
In returning to the underspend theme in his
letter of 5 February, the Director General suggests there has
been a £12 million underspend in the first year of the new
price control, and he says that this shows NIE did not even spend
the amount he would have allowed under his proposals:
— The concept of calculating an underspend
on a year by year basis is not meaningful since certain network
investments are by their nature "lumpy". No underspend
can be said to have occurred until the full 5-year term of the
price control has elapsed. Annex C of the DG's own submission
to the Committee shows the phasing programme of expenditure.
— The capex levels inherent in the
Director General's proposals are not a suitable benchmark. The
MMC rejected the work of Ofreg's consultants upon which the DG's
proposals were based, describing their conclusions as being "not
sufficiently robust".
Priorities
Our report explains how, shortly after privatisation,
we made the refurbishment of the 11kV circuits an investment priority
in order to improve the performance of our network which in 1992-93
was, by comparison with the GB companies, at the bottom end of
the performance scale. We engaged in an investment programme which
the MMC considered was adequate to balance the public interest
issues of quality of supply and price. The priorities that we
are now re-emphasising are the ones we have maintained throughout
the first price review period and throughout the discussions at
MMC.
Accountability
In defining the level of total capital expenditure
to be adopted for the purposes of setting the new price control,
the MMC weighed carefully the public interest issues associated
with each category of investment. At the same time they were not
prescribing an investment programme. They recognised that there
would be competing demands on NIE's capital budget and it would
be for NIE to determine its priorities among those demands.
In recommending the reallocation of £24
million to the network performance improvement category, we wish
to discus with Ofreg their approach to higher levels of investment
in this category given:
(i) the MMC's careful consideration of the
public interest issues surrounding this; and
(ii) the fact that Ofreg had argued for significantly
lower levels of expenditure in this category.
In returning to the issue of lack of accountability
for capital expenditure in his letter of 5 February, the Director-General
indicates that he has appointed consultants to examine NIE's capex
programme and he intends to consult with customers as to their
involvement in determining the size of the capex programme and
the priorities within it. He also indicates that he now intends
after a very short time to change his previously stated policy
of allowing management to organise priorities on the basis of
their own judgment and in the light of network performance. It
is precisely this type of inconsistency in regulatory approach
in Northern Ireland which led us to argue at MMC for a detailed
understanding of the basis upon which our original capital investment
programmes were constructed. This was in the context of what we
understood from MMC was a preference on the part of Ofreg not
to deal with capital expenditure in an itemised way—what
was discussed within the hearing as the "bucket" approach.
The MMC investigation included a very detailed
assessment of the public interest issues relating to the capital
investment requirements over the current price control period
to March 2002. It is for that reason that NIE wishes to discuss
with Ofreg its approach to slightly increased levels of investment
in measures to improve network performance.
At the time of the MMC referral there were significant
differences between NIE's view and the Ofreg view. Although, in
the context of setting the new price control the Director-General
has agreed to adopt the MMC's level of capex, when it comes to
discussing an actual investment programme, particularly areas
relating to performance improvement, NIE will be mindful of the
difference in views which were presented to the MMC, for example:
— The proposals which Ofreg put to
the MMC were based on cutting the amount which NIE proposed to
invest in the network over the current five years by 20 per cent.
— As regards the specific investment
in refurbishment of the 11kV overhead lines, Ofreg's proposals
would have cut NIE's proposed expenditure by 50 per cent. In terms
of the numbers of km to be refurbished each year, he considered
that the rate which NIE proposed should be cut by over one third.
If the Director-General's arguments had been fully accepted on
this specific point, the network would have been deprived of an
investment essential to its performance improvement. NIE's report
into the Boxing Day storm now proposes that the rate of refurbishment
for the remaining three years of this price control period should
be increased to an annual average of 1,750 km/yr which would bring
us back to the figure we proposed to the MMC.
— There were other areas of performance
improvement expenditure where Ofreg disagreed with NIE, for example
Ofreg proposed:
— to cut NIE's bid for expenditure
on system development and performance-related work by 41 per cent;
— to disallow all of the proposed
£12.7 million for system development work;
— to cut 24 per cent of the proposed
undergrounding programme; and
— to disallow all of the proposed
expenditure to replace undereave wiring.
We believe there is a much wider issue of accountability
at play in this discussion. The Director-General is seeking to
cut NIE's revenues below the level which the MMC considered was
the minimum necessary to enable the company to finance
its activities including the level of capital expenditure which
the MMC considered justified to improve continuity of supply to
customers. We are concerned that further price cuts would call
into question our ability to fund the revised plans to improve
the resilience of the network to future storms.
We believe that this wider issue of regulatory
accountability has been satisfactorily addressed in the recent
DTI White Paper on Regulation referred to in Section 3.7 below.
Reallocation of capex
The Director General thinks it is disingenuous
of NIE to give the impression that the problem is being solved
by the company at its expense.
In recommending the accelerated refurbishment
programme, our report makes it clear that the extra cost will
be financed through a reallocation of expenditure. Page 34 explicitly
states that the necessary £24 million will be funded by a
reallocation from other categories of expenditure reviewed
by the MMC.
3.4 Prices
Reference is made in question 65 to the issue
of electricity price increases as a result of the capital expenditure
programme.
The reallocation of capital expenditure to improve
the resilience of the network during storm conditions will not
impact on electricity prices in this present price control period
and overall we believe that the capital investment requirements
of network performance improvement are entirely justified and
in the long-term interests of the customer.
The Director General also addresses prices in
his letter of 3 February.
It is widely recognised that the costs per customer
of providing a transmission and distribution (T&D) network
are influenced to a very significant extent by the size and nature
of the customer base served by the network. In this regard, NIE's
service territory is characterised by having one of the smallest
customer bases, connected to a widely dispersed rural network.
Therefore the assets employed per customer, and hence the costs
per customer, will be correspondingly higher. This relates to
the well recognised problem of economies of scale. Comparisons
of NIE's T&D charges should therefore not be made on the basis
of the average of all the GB companies but rather on the basis
of those companies whose customer bases are most similar to NIE's.
There are similar price differences within GB, between our comparator
companies and the GB average.
Our charges today (1998-99) for the network,
at £120 per domestic customer per annum, are very similar
in real terms to what they were in 1992-93, the year the industry
was vested. In the intervening period we have invested £257
million in the network. What this means is that NIE's efficiency
gains in this period have funded a considerably more reliable
network at no additional cost to the customer.
A further check on the efficiency of NIE's network
activities is the fact that the charge of £120 per domestic
customer is almost identical to our comparator GB companies, i.e.,
ones with similar large rural networks—Manweb, SWEB and
Swalec. It is in fact quite surprising that we are able to deliver
this comparative figure on a customer base which is much smaller
than our comparator companies. The fact is that NIE has more assets
employed per customer by virtue of its smaller customer base,
yet is able to hold its costs per customer at a similar level.
As a large proportion of the costs in these businesses are fixed
costs, the only conclusion is that NIE is a more efficient company
than its comparators.
To the extent that costs per customer may have
moved out of step with comparator RECs since privatisation, a
reason can be found in the different investment profiles. Since
1992-93, the RECs' investment per customer has fallen from £66
per annum to £58 per annum. Over the same period, NIE's investment
per customer has risen from £52 per annum to £90 per
annum because of the specific needs of the network.
This level of investment is entirely consistent
with the needs of a network which had severe under-investment
while in the public sector, giving rise to some of the poorest
reliability figures in the industry. This was the situation we
faced in 1993 when we decided to embark upon our major refurbishment
programme. This inherited situation is now being turned round.
The figures we have for capital expenditure today and going forward
have been fully validated by the MMC.
NIE's current charges have been set in accordance
with the outcome of the MMC's investigation into NIE's price controls
which resulted in price cuts to domestic customers of 13 per cent
real since 1 April 1997. The Director-General notes that the current
price regime is of the MMC's devising and he is seeking leave
to challenge it in the House of Lords.
The difference in impact between the Director-General's
price proposals and those of the MMC is, we believe, about 2 percentage
points on domestic prices. Paragraph 2.211 of the MMC Report and
Table 2.14 show the MMC's estimates of their proposals as producing
a 28 per cent reduction in the Transmission, Distribution and
Supply component of the domestic bill, resulting in a 14 per cent
real reduction in the domestic prices between 1996-97 and 1997-98.
Paragraph 2.211 goes on to state that the effect of the DG's proposals,
calculated on the same basis, would have been to reduce domestic
electricity prices by 16 per cent in real terms between 1996-97
and 1996-98, a difference of two percentage points.
Domestic prices have reduced by less than the
MMC's estimated reduction because of a number of cost increases,
the level of which could not be anticipated at MMC—the most
easily identifiable example was an increase in the cost of rates
on NIE facilities and on the generating stations.
The difference of two percentage points on domestic
prices between the MMC's and DG's pricing formulae is dwarfed
by the potential impact of lower generation costs. These are estimated
by Ofreg to be over 40 per cent above an open-market price. Their
reduction to an open-market rate would impact domestic electricity
prices by some 20-24 per cent.
3.5 Customer/Shareholder balance
The balance between customers and NIE's shareholders
was very fully considered by the MMC. The MMC price control reduced
NIE's allowed revenues by some 28 per cent per unit. As a result
NIE's allowed revenues were reduced by some £57 million with
effect from April 1997. In making this reduction, the MMC took
full account of cost reductions achieved by NIE to-date and the
level of profitability which should be allowed for the very high
installed asset base required to service the Northern Ireland
customer. The MMC made it clear in paragraph 2.215 of their Report
that they regarded the targets within the price control as "challenging
but achievable".
The Director General acknowledges that since
privatisation customers have benefited from improved levels of
customer service.
Given the difficulty in making any real impact
on generation costs, which are not subject to regulation and which
Ofreg have suggested are some 43 per cent above an open-market
price, we find it strange that the Director General should suggest
that the generating companies in the electricity sector in NI
have demonstrated a greater willingness to remedy the customer
pricing imbalance which clearly arises predominantly from excessive
generation costs.
3.6 Attribution of blame
The Director General in his letter of 5 February
suggests that we have attempted, by highlighting the relatively
low level of network expenditure pre-privatisation, to attribute
blame to parties other than NIE's management for expenditure decisions.
We would wish to reject this suggestion.
As we listened to the concerns expressed by
our customers and their representatives following the storm, we
met the suggestion that the level of network investment had fallen
since privatisation, this could have been a contributory factor
to the extent of the damage sustained during the storm. Our report
simply draws attention to the fact that we are investing almost
twice as much in the network as was invested before privatisation.
The intention behind this comparison was simply to make the public
aware of the facts. There was no attempt to attribute blame.
The data on Customer Minutes Lost demonstrates
that we inherited a network whose performance was at the low end
of the performance scale. It was our decision, shortly after privatisation,
to refocus our investment programme on performance improvement
measures, in the form of the 11kV refurbishment programme. On
the basis of the evidence available, we embarked on the largest
network refurbishment programme of any UK electricity company.
If we had not made this decision, we are convinced that the effects
of the storm would have been considerably worse. We remain fully
convinced that this was the right decision and best served the
public interest and this was confirmed at the MMC. We are equally
convinced that an increase in that programme will make the network
more resilient to future storms.
The crucial point to note is that if investment
prior to privatisation had been adequate, then the network would
not have been so poorly performing in 1992-93. As we have previously
indicated, this situation is now being turned around. The low
levels of expenditure in the early 80's is not irrelevant, as
the DG suggests in his letter.
3.7 Protecting the customer interest through effective
regulation
In their very detailed consultation Green Paper
entitled A Fair Deal for Consumers, March 1998, the DTI set out
to examine how to modernise the framework for utility regulation.
Section 7 of the document dealt with "Better Regulation"
and the constituent requirements of an effective and legitimate
regime of regulation.
In the context of the powers of the regulators,
Paragraph 7.6 of the Green Paper goes as follows: "But there
are risks in concentrating too much discretion on an individual.
There are few formal checks and balances on the regulators. In
practice, the regulators have made ad hoc use of advisers to assist
them, but there is no statutory obligation on them to do so, and
no disciplines on the regulators to follow the advice given. They
are not accountable to a board of directors or equivalent. There
is a risk, therefore, of unpredictable and unaccountable decision
making. There is also a risk of discontinuity in decision making
when new appointments are made".
The Green Paper put forward alternatives to
the present structure, for consultation. The subsequent White
Paper publication of the response to consultation states at Paragraph
69: "The response to the Green Paper suggests there is strong
support for reforming the top-level structure of the regulators'
offices, in order to ensure the right checks and balances exist
on individual regulators". The Paper goes on to state at
Paragraph 70: "The Government has concluded, in light of
detailed consideration of the responses, that small executive
boards of three full time members should provide the most effective
regulatory model for all the sectors covered in the Green Paper.
This model offers the advantages of collective but streamlined
decision-making by a small cadre of high calibre, professional
regulators; greater accountability; scope for greater continuity
and consistency when regulators are appointed, and an ability
to spread the regulatory burden—this is particularly important
in energy and telecommunications, given the increasing complexity
of these sectors".
NIE believes that regulation of the NI electricity
industry, particularly because of the so far intractable issue
of high generation costs, is a very complex and onerous task.
We would be anxious to see the NI regulatory model continuously
evolve to meet the best practice models defined for the UK. We
believe that this evolution will best ensure that the interests
of Northern Ireland customers are fully protected for the future.
6 March 1999
2 Ev. p. 39. Back
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