Examination of Witnesses (Questions 1-19)
MR PHILIP FLETCHER, MR CALLUM MCCARTHY AND MR DAVID EDMONDS
WEDNESDAY 8 MAY 2002
Chairman
1. Good afternoon, welcome to the Committee of Public Accounts. Today we are looking at the Comptroller and Auditor General's Report on Pipes and Wires—with a very up-to-date picture on the front—which examines the regulation of the utility networks. We are delighted to welcome our three witnesses: Mr Philip Fletcher, Director General of Water Services and Head of OFWAT; Mr David Edmonds, Director General of Telecommunications and Head of OFTEL; and Mr Callum McCarthy, Chairman of the Gas and Electricity Markets Authority and Chief Executive of OFGEM. If I may start with a couple of general questions just to get you into your stride, gentlemen, and perhaps you can each comment. Could I ask you please to open the Comptroller and Auditor General's Report and look at Pages 3 and 4 and particularly Paragraphs 6 and 8 which comprise a general introduction of what we will be talking about this afternoon and of the approach that you have taken over the years. You have obviously tried to deliver lower prices and you have tried to maintain and improve performance. That has been your aim. How much more can costs fall without putting the performance of the networks at risk? Starting from left to right, introduce yourselves to my colleagues and kick off.
(Mr Edmonds) I am David Edmonds, Director General of Telecommunications. I think in the telecommunications sector costs can continue to fall a good deal further. In terms of the achievement since privatisation, the price to the domestic consumer in the UK has been reduced to 50 per cent of its previous level, representing a very, very significant fall in costs. I would only claim that some of that is due to price control. A great deal of it is due to technological innovation and, of course, rises in volume. The simple answer to your question is in the telecommunications world where only last year core volumes were up by 19 per cent, where Internet traffic is growing exponentially, where new technology is being introduced at a very rapid rate, where we can see a combination of technological innovation, volume increase and price control continuing to drive down costs in the telecommunications sector, I see for the foreseeable future a continuing downward movement in costs. Those costs are of course reflected in lower prices to the consumer in the industrial, commercial and residential sectors.
(Mr McCarthy) The position in electricity and gas is rather different. They are not marked by the same rapid technological changes that occur in telecoms nor by the very rapid growth in market demand. That said, there is often the claim that RPI—X has only been successful in sweating assets and that will come to an end. In fact, we have always been very careful to strike a balance between price reductions and proper pressure on these monopoly businesses enabling them to maintain the very high levels of investment that are required. So far there is absolutely no evidence that that balance has resulted in under-investment of the network. There is every evidence it has resulted in higher standards. I continue to believe that there will be scope, though not as dramatic a scope as there is in telecoms, for further reductions in costs and therefore in prices, because there is a dynamic within each of these businesses which we control.
(Mr Fletcher) You have got us lined up along a spectrum. OFWAT water services are different again. Technological change is not so great as in gas and electricity and still less than in telecommunications. Although technological change is still very much part of the pattern, competition is not a fact of life in the way that it is in the other two sectors. I am making no predictions about what will happen to prices at the next periodic review which takes effect from April 2005, partly because it is too soon to do so, but very much because one of the factors that we are concerned about is ensuring that the very extensive network is properly maintained and continues to deliver service to customers. So we are starting work on that review in the autumn and we shall see after that where the prices need to be set whilst preserving the network properly.
2. Thank you for those brisk answers. That is very helpful. If I could refer you now to Page 39 of the Comptroller and Auditor General's Report and ask you to look at Figures 31 and 32, and we will see there, as we see coming out throughout the Report, that the price reviews are a complex and costly process for the regulator and the regulated companies. What I really want to ask you gentlemen now is as we move forward how much scope do you think there is for streamlining the process, reducing your information requirements, and reducing therefore the costs that you place on these companies?
(Mr Edmonds) In the telecommunications sector we are striving continuously to improve the process. The price control consultation that we have with the telecommunications industry, particularly with BT, starts on the methodology. We ask them about the methodology we are using and we ask them for comments on the efficiency of the methodology. We are particularly conscious of the need not to ask for more data, a criticism that was made of us by BT in the past. We can continue to refine that. The particular innovation in the current price review is that we are looking much more on the materiality. We are saying is this going to make a difference to the final price control number coming out or can we manage without this level of detail. We are consciously seeking to respond to some of the criticism that has been made of us that we ask for too much material. We can see continual emphasis on getting the process better. At the end of the day the process however, if I may say so, represents enormously good value for the UK consumer. The small number of hundreds of thousands of pounds it costs for me to do this in OFTEL and the half million it costs BT in terms of sums coming back in inter-connect charges flowing through to the rest of the industry to the domestic consumer I think—and I hope the Report suggests—represents good value for money. Yes, we will drive down costs but I think we are getting pretty good value for money already.
3. Thank you for that. Mr McCarthy?
(Mr McCarthy) Can I make one point of a general nature. We have no incentive whatsoever to ask for information which we regard as unnecessary. The other general point I would make is that one of the problems that is recognised in terms of regulating natural monopolies is what is called in the trade the information asymmetry problem, namely the information available to the companies is much less than the information available to the regulators. So I believe it is very important for us to have the right to ask for any information that we believe to be relevant. That said, we (like OFTEL) have made strenuous efforts to refine the information that we want. One of the purposes of the information and incentive project and one of the purposes of the work that we are doing on regulatory accounts is to stop the present bunching of information which tends to happen once every five years and to establish a much more coherent basis of exchange of information between the companies and the regulatory organisation which will reduce the overall requirements for information.
4. I will come back on that very point in a moment. Perhaps I should give colleagues a chance to answer the central question and I will come back to the question of bunching of information.
(Mr Fletcher) Thank you, Chairman. Like Callum McCarthy, we do not ask for what we do not think we need. We are conscious that the water companies commenting in our review of the last periodic review felt that we asked for too much. I am pleased that the NAO said we used the information. That is part of their audit work. It is a complicated business. One of the appendices to the Report brings out that you cannot have an effective control regime without a degree of complication. We do look to reduce our information where we can and that is one of the reasons we look to conduct our next review over a two year rather than a two and a half year period partly to reduce the number of iterations of information required to update information as it becomes available.
5. Thank you for that. Mr McCarthy, may I refer you back to Page 6. If you look at Paragraph 12 you will see that the lack of certainty about future treatment by the regulator of new investment may provide an inducement for companies to defer investment until after the price review. Is this a problem and how do you overcome it?
(Mr McCarthy) It is one of the problems involved in the problem of unintended effects of regulation. We are attempting to overcome it, as I mentioned to you a moment ago, by a project called the information and incentives project which was originally going to be introduced for the distribution companies in electricity, and a comparable exercise will be rolled out for the distribution companies for gas. We are also doing a number of things, notably through the system operator incentives for TransCo, designed to give people incentives that spread beyond any five-year price control period.
6. Thank you very much. Mr Fletcher, can I ask you please to go back a page to Page 5 and look at Paragraph 10. You will see there that "the regulators may make decisions on the level of investment on the basis of inadequate information." What are you doing to ensure that these companies know enough about their assets and are funded to undertake the necessary investment?
(Mr Fletcher) We are encouraging the companies which have this £200 billion worth of assets to understand those assets properly. Of course, the bulk of those assets are buried beneath the ground in the form of sewers and water mains, therefore it is not a straightforward job to understand how well those assets are performing even though many of them, including the one to which you drew attention on the outside of this Report, continue to perform well. We have launched today some consultation papers on the next steps towards better understanding of the assets by the companies. My staff in Birmingham are meeting today with the companies and others to help improve our understanding. Our focus is on the serviceability of these assets, that is how well they perform, not just how good the asset condition is but how well they are going to go on delivering service over time.
7. Thank you for that. Mr Edmonds, if I could ask you to refer to Page 35, if you look at Paragraphs 3.16 and 3.17, there is an important point there of particular interest to you about the level of return of these companies and the imprecise nature of some of the information you may be receiving. What are you doing to ensure that you can improve the way you make your estimate of the level of returns of these companies, because it can have a critical effect, can it not?
(Mr Edmonds) Indeed it does.
8. Perhaps you can explain briefly why?
(Mr Edmonds) The need in my industry, or the industry which I regulate, is to ensure that we give sufficient incentive over a period of years (a) for BT to renew its network, to keep its assets up to date, (b) to invest in renewal and (c) to be able to bring forward innovation and new technology, the innovation I referred to in my opening remarks. I am not sure I would agree the OFTEL work is imprecise. We look at a range of factors. What we seek to do in looking at that range of factors is to produce an estimate of the capital return which is needed to justify and ensure all of that happens inside BT. We discuss with BT the level we use, we discuss with the other operators—who of course benefit from the price control—both the methodology we use and the numbers we feed in. What we are doing is continuing that consultation process well in advance of the next price control. So I think my answer to your question is there is a range, we choose mid-points in the range, the evidence suggests that the incentives we have given to invest have worked, we have a good telecommunications network in the UK, the levels of investment continue to be very high, but clearly it is something we will continue to look at and will continue to talk to the company about.
9. It strikes me, reading this Report, that you have had enormous successes in the past, you have got rid of a lot of inefficiencies in these old nationalised industries through your formula of RPI—X, you have delivered price cuts, you have ensured continued investment, so I am not arguing about the past, but I want to put this seriously to you, do you think this could be your last appearance before us because, as the market becomes more competitive, is there really a need for this degree of regulation? Can we not rely on the market place? After all, we will always have the protection of the Office of Fair Trading in the future. It just strikes me, as I read this, that it is becoming more and more difficult to deliver efficiency gains as these companies become more competitive in the market place, you are having to require more and more information, you are becoming more and more intrusive, you are getting less and less out of these companies, can we not in future leave it more and more to the market place to regulate? I will start with you, Mr McCarthy, as you are middle of the table and I am staring at you, and give your colleagues a chance to answer the question in a moment.
(Mr McCarthy) To a large extent, Chairman, that is exactly what we are doing. If you take the things which were subject to detailed price control at the time of privatisation in electricity and gas, we have removed price controls from 70 per cent of those activities and the only things we now regulate in terms of price control are the natural monopoly, the basic monopolies of transport—that is the high voltage network for electricity, the low voltage network for electricity and the combined network for gas. We would be delighted if there were a way of bringing competition to those networks, nobody has yet established a means of doing so, and so long as they remain monopolies I regret to say there will be a requirement for people to do the task, which I think is a rather difficult task, of price control.
(Mr Edmonds) In many areas of telecommunications, price controls are being lifted. We now look at every individual market and analyse that as a separate market, and only if we see there is dominance or a monopoly in a particular market place do we intervene, and that may not be through price control, it could be through an interconnection directive or some other route. In most of BT's retail area, we no longer price control. The proposal I am making for revised price control later this year on the retail business significantly deregulates. In this area, my answer is the same as Callum's, we are going to be looking at the core network of BT which links the various parts of the UK, we are going to be looking at the copper which goes from the district exchange to the homes and the small businesses. BT is going to continue to be dominant in that market place, as far as I am concerned, for the foreseeable future. The evidence of the Report and my own analysis suggests, as I said to an earlier answer, that very good returns are being produced to the UK consumer through continuing to focus on this network charge control. Therefore, I think I may well be—or my successor at OFCOM—appearing before this Committee on this particular price control, but in other areas will not be.
(Mr Fletcher) The water sector and the waste water sector, which are different, are both of them very different from the sectors regulated by my colleagues. As yet, competition has made only very limited inroads in water. The Government has just announced that it is going to seek an extension through an eventual Water Bill, but only in a fairly limited way. There are good reasons why competition should be advanced slowly in the water sector—no national grid, a very costly product to move around in bulk and various others I would be happy to go into—but I suspect economic regulation in one form or another is going to be necessary in the water sector to continue to drive out the benefits for customers, which it has under my predecessor driven out over the last 12 to 13 years.
Mr Gibb
10. What are the regulators trying to achieve when setting prices for the review period? Are you seeking to simulate a market place where none exists, or are you, taking up the last words of Mr Fletcher, seeking to give benefits to the consumer? Which are you acting as?
(Mr Fletcher) Both. By replicating as far as we can, obviously in an artificial way, the way in which a competitive market would work, we are seeking to deliver benefits to customers. My primary statutory duty is to enable the companies to finance their functions which include a very large capital programme and, more than likely, a large capital programme in the future as well, but through yardstick competition, through comparative competition—perhaps a bit of a contradiction in terms—I have the advantage of having 23 companies, ten of them water and sewerage companies, to compete one with another, and my endeavour in regulation is to take the example of the best and drive the less well performing companies up to that level, thereby yielding benefits, I would say, for the shareholder but certainly for the customer.
(Mr McCarthy) I think the overall objectives are comparable in all the regulated sectors but the actual balance and particular problems which each of us has to deal with differ. If I look forward, for example, in electricity, we are likely to be faced over the next ten years with a very significant reinvestment programme to deal with, for example, renewables, which will require a different approach from the approach which was possible five and ten years ago. The way in which we react to any particular circumstances will change but the overall objectives will not.
(Mr Edmonds) I think my answer is fairly similar. Yes, I am seeking to set a price control that gives BT in effect a return that, to use your word, in a simulated world, or a world of simulation, would secure competition. That means, of course, setting a sufficiently reasonable rate which means it can invest in all the innovation it needs to invest in. I have very much, though, the interests of the consumer in mind in doing that because the network that BT operates does not just provide services to the retail bit of BT, it provides services to the mobile industry, to the other 30-or-so competitive operators, so the output charges for BT are very significant input charges to almost all parts of the telecommunications sector. So the end result flows through not just in terms of your BT phone bill but in terms of your mobile bill or the bill charged by other big corporate telecommunications companies as well. So it is a wrap-around.
11. Those three answers were very interesting because the original purpose of a regulator when they were set up on privatisation of these industries was not only to simulate competition, the competitive market, because none existed, because these were by their very nature monopolies, so you seem to have, and probably as a result of legislation as well, extended the role of the regulator to something other than that which Stephen Littlechild had originally anticipated. Can I bring you to page 7 in the Report, paragraph 14, where it says, ". . . as the regulators have to include a precise figure in their calculations, there is always a significant risk arising from the possibility that the figure they estimate [in terms of rate of return] appears to observers to be either too high or too low." Starting with Mr Fletcher and moving left, to what extent do you take account of public perceptions of the rate of return when you are setting the price review?
(Mr Fletcher) In setting the cost of capital to the companies, we take account very much of the perception of the markets at the time. Obviously we look at what we are each doing, we endeavour to set a weighted average cost of capital plus both equity and debt which will properly reflect a stable, robust company, and we then take it forward, subject always of course to the right of the company concerned, if they do not like the regulator's price limit, to refer it on to the Competition Commission.
(Mr McCarthy) We also set the weighted average cost of capital in a very comparable way. We set it by reference to the actual markets. The test that we find reassuring is that when I look at gas and electricity and the way in which the companies are trading in those industries, there is no sign at all of any of the companies being unable to raise either debt or equity capital. The transactions which have occurred, which have all been in electricity, have occurred at or above regulatory asset value. So I take some comfort from the actual performance and treatment of the capital markets of the decisions we have taken in the last three or four years.
(Mr Edmonds) A quick postscript to your last remark, the statutory duty of the telecommunications regulator is to protect the interest of the UK consumer by promoting competition. So the original legislation gave me a specific duty which had the consumer at its heart, and I think my answer was totally consistent with the legislative duty that is placed on me. The answer to your question is yes, in measuring the return needed to invest in BT we do look at the market place as a whole and we take that into account in the calculations we do.
12. Can I focus my remaining questions on the water industry and Mr Fletcher. The last but one sentence of this paragraph says, "And they point out that . . ." meaning the regulators, ". . . since the review, some companies have successfully responded to the incentives within RPI—X to achieve more efficient financing costs by becoming predominantly debt rather than equity financed." This is your defence of what many regard as an over-zealous price review in the water industry. Surely, if companies move to become wholly financed by debt, that is a sign of failed price review, is it not, rather than a sign of success?
(Mr Fletcher) We have at the moment one company in the industry wholly financed by debt, that is Glas Cymru, the owner of Welsh Water, a company limited by guarantee. That company was only allowed to proceed after very carefully considering the new dilemmas that this posed, and I certainly would have objected to it going forward if I had felt it would not continue to provide a stable company that could over time continue to deliver services to customers, carry through its capital programme and make efficiency gains. Welsh Water is not the most efficient company. The great majority of companies in the sector are a mixture of debt and equity. You may recall when they were privatised it was in the unsustainable position of being wholly equity. Nobody expected that to endure given the profile of this particular industry. We assumed at the last review that they would be financed 50 per cent by equity, 50 per cent by debt, and made our assumptions on the weighted average cost of capital accordingly. No other company is following the lead of Glas Cymru. Every company is at the moment successfully financing itself and most of them have a significant need to do so given these large capital programmes. Clearly, the relationship between their share prices and the regulatory capital value of the companies, is one of the indicators that I shall have in mind coming towards the next periodic review, but recent prices being paid indicate that market values are not very far from the regulated capital values through which they are remunerated under the price review.
13. But do you allow Welsh Water to take a full deduction for the interest as far as your price setting is concerned?
(Mr Fletcher) As you know, this is how RPI- X works. If the company beats the regulator's assumptions, then that is for the moment a benefit which is reserved to them. Where they have no shareholders, there is only one eventual destination, and that is the benefit of customers. However, there are risks in a company wholly financed by debt and therefore one of the conditions which the company accepted before it proceeded was that they should build up very significant reserves which would help to create something the equivalent of the normal cushion provided by the shareholder in equity.
14. At the moment they do not have such reserves, do they, and this company is effectively valueless and the interest will have to be paid regardless? There is no cushion over which you can exercise any control. When it was equity financed you could say stop paying the dividends or they could always stop paying the dividends. Now there is nothing. The interest will have to be paid. You will not allow this company to go bust, you will allow it to finance itself, so where is the entrepreneurial zeal, where is the risk that the company is taking in bringing about innovation and cost cutting?
(Mr Fletcher) Can I start with a fundamental point. Enabling companies to finance their functions does not mean enabling an inefficient company to bounce easily on the safety net provided by the price limit set by the regulator
15. You allow him to go bust, do you?
(Mr Fletcher) If necessary, yes. There is value; the value is the value of the regulated company for which Glas Cymru paid a price which was at a significant discount at that stage to the regulatory capital value. So at the moment they are drawing benefit both from the fact that their capital is being raised at a lower price than the assumption on the cost of raising equity and that they had leeway because the price they paid initially was rather lower than assumed by the regulator at the start of the last review. But it is very important that we look at these issues in the long term. I recognise your underlying criticism. It is something which we need to watch very carefully as this particular model moves forward.
16. Is what you have created, effectively, the renationalisation of the water industry in that part of Britain? Indeed, Yorkshire Water want to try and do the same and I suspect there are pressures in gas as well and other parts of the water industry to do this. What you have done effectively is you have driven out the entrepreneurial capital from this sector because entrepreneurs feel there is no point getting involved in this any more because there are no returns, they cannot do anything, the regulator is too zealous, there is too much acting for the consumer instead of it being (as Littlechild intended) a simulator of the competitive market. There is no point in having equity or capital in these companies any more so they have sold out, withdrawn their equity capital and replaced it with debt which is effectively risk free because the coupon has to be paid and it becomes like gilt-edged stock. In many of these companies the ultimate aim would be to have the whole value of the company owned by the community and in effect therefore we have achieved the renationalisation of the water industry. What is your view of that scenario that you have helped to create?
(Mr Fletcher) First of all, this debt is not the equivalent of gilt-edged stock. It is set according to the credit rating of the company concerned. That is an issue in which all the companies and the regulator are concerned. One of the things that I do, and I guess my colleagues would also do, is keep in close touch with the credit rating agencies who are important players in this game. It would only be gilt-edged if the regulator was going to set prices at a level which ensured that the company could not go bust and the regulator has always made clear that that is not going to happen. Is it renationalisation? I would argue it is not. This is a company that will need to prove itself against just as stiff tests as are set for every other company in the industry. If we look at the rest of the industry, although several of them are seeking to raise the proportion of debt and go for higher gearing, nonetheless there are other companies that are very strongly wedded to the conventional equity model. I have made it clear in briefings to City analysts and others that I am not looking to force companies into inappropriately risky structures. It is as much in the interest of customers as anything else that they should have robustly structured companies and that is how I intend to approach the next periodic review.
17. A final question to all three of you. Has the passage of the Utilities Act 2000 increased or decreased the regulatory risk in your relevant sectors?
(Mr Fletcher) The water sector was removed from the Utilities Bill, but there will be a Water Bill to come. Regulatory certainty is not just a matter of the official public appointee, it is usually interpreted more widely to incorporate government and all other risks bearing down on a company which is not under their direct control. I see reducing unnecessary regulatory risk as very much part of my job. I cannot remove all regulatory risk without selling the customers down the river, and I will not do that.
(Mr McCarthy) In one very significant respect the Utilities Act has been a great help in reducing regulatory uncertainty because one of the problems of utility regulation in this country since privatisation has been the personalisation of regulation. I think it is highly beneficial that the previous position when one individual had all the power and all the duties and responsibilities has been replaced by a position where there is now an Authority of 11 people. The majority are non-executives and in particular I think that will be beneficial. There was previously a remarkable degree of uncertainty every time there was a changing of the guard, when one regulator moved on and another one came in. When I relinquish this job in 18 months' time it will be one member out of eleven on the Authority changing and there will be much greater consistency and I think there is a huge benefit in that.
Mr Gibb: I think that is probably because the other one is not a utility either.
Chairman: Thank you very much for that, Mr Gibb. Mr Trickett?
Jon Trickett
18. I alighted on the same point Mr Gibb has been drawing out. Can I go straight to OFWAT and return to Glas Cymru. I think you said in response to my colleague there was no sign that the rest of the industry was following Glas Cymru's course and yet in this Footnote 54 on Page 35 it is clear that a number of companies are moving precisely in that direction. In addition to which I live in Yorkshire and I was approached by Kelda who wanted to adopt a different model, one which effectively reduced the exposure of the shareholders to no risk at all. Do you want to reflect on the words which you just indicated to the Committee when you said the industry was not following this model? It does seem to me that it is really.
(Mr Fletcher) Two models were tried out in the year 2000-01. One was the proposition from Kelda, Yorkshire Water, for a mutual in which the customers would have owned the assets. My predecessor, with my full support, because it was just at the moment of the changeover, said that he did not think that would work and I agreed with him. I did not think the proposition had been fully worked through, the customers had not been properly consulted, the proposed transfer price was the regulatory capital value which was not the then market price. There were a number of things that were not right with that particular proposition. When the Glas Cymru proposition came along there were a number of other factors in place. First of all, it was not the same model. The company was limited by guarantee with members behind it. Yes, it was wholly debt financed but with a very clearly articulated set of precautions in place to guard against the risks of brittleness and inflexibility which are possibly inherent in a wholly debt financed company. I mentioned the point that the initial price paid was lower. The other point which was very different from Kelda was that it had clear democratic support. I am accountable in relation to Welsh Water to the National Assembly which made it clear that it was of course my decision but if I was satisfied it was safe to go ahead the Assembly thought that would be a good idea.
19. Is the principle which we are tackling here not the precise nature of the corporate structure but the ratio of debt to equity capital? Is it not clear that the shareholders are going to seek a rate of return whatever happens and that, if necessary, they will use devices to secure that rate of return? In the inherent conflict between the interests of the consumer and the interests of the company, it does seem to me that by changing the ratio of debt in that particular way, effectively the risk is being transferred to the consumer and away from the shareholder, is it not?
(Mr Fletcher) I would accept that it is an issue that needs to be looked at carefully in each case but where the other companies are concerned, in each case they are not proposing that the equity should disappear. In some cases they are proposing that they should be financed rather more by bonds—by debt—than by equity. In taking forward any such proposition, I have aimed to make sure through licence amendments that concerns about customers' interests are very fully met, for example reinforcing the non-executive presence on the boards of the regulated companies; for example where the proposition involves very substantial outsourcing that I am supplied with and have a full opportunity to talk through with the company a procurement plan on just how it is going to be done; for example making sure at each stage that the company, small though it may be because a large part of its job is conducted through outsourced contractors, is nonetheless wholly in charge and wholly accountable for that company and its performance, including the quality of service it provides to customers and the safety with which it does so.
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