Examination of Witnesses (Questions 20-39)
MR PHILIP FLETCHER, MR CALLUM MCCARTHY AND MR DAVID EDMONDS
WEDNESDAY 8 MAY 2002
20. I am thinking of another risk, unless I am misunderstanding entirely your response, which is this: these great companies have got to manage the process of investment over the years. We are talking about very large infrastructure here, and it is possible to imagine that infrastructure being financed either by raising money on the markets through the shareholder process or by borrowing money. At the moment it is cheap to borrow money. No doubt that is a factor in the shareholders' minds. Supposing there was some kind of oil shock or some other calamitous event which none of us would want then the cost of the money which is borrowed on debt would suddenly increase substantially. If there was a problem in the money being raised from the shareholder, one would simply go back to the shareholders. On the other hand, if there was a shock as I was just proposing and the gearing of debt to equity had shifted in the way that has been described, it strikes me that you as regulator would be faced with no other alternative but to allow price rises. To that extent the financial structure of the company puts the financial risk on the consumer rather than onto the shareholder. That is the point I think I was trying to make.
(Mr Fletcher) I certainly accept in thinking about my duty to enable companies to finance functions that I need to take account of all the potential external events as well as the internal ones, but I do see it as my job to regulate across the sector on a fair and equitable basis. I expect a company that is largely or wholly financed by debt to respond to external events just as well and just as efficiently as companies that are financed largely by equity. I certainly do not see it as my job to bail out a particular company that has chosen a particularly risky structure. I have made that very clear and the bondholders and the shareholders of such companies have to bear that risk in mind as they decide whether to lend or invest.
21. Nevertheless, were there to be such a hike in interest rates, which is entirely possible given the financial structures of the world, at the end of the day the change in ratio between debt and equity must inevitably fall on the consumer? I need a yes or no answer.
(Mr Fletcher) The answer is no. The protection put in place should enable a company to perform effectively. If it does not, if it has structured itself in an unduly risky manner, in the last resort it would fail, but that would be the last resort.
22. I hear what you say. I think you detect a certain degree of scepticism on my part. Can I turn to your two colleagues and see whether or not a gradual shift—or perhaps not so gradual shift—in ratios, which we have just been discussing, is happening in your industries as well.
(Mr Edmonds) The basic industry I am looking at for the purpose of this is BT and the answer to that is no. BT has been reducing debt in the face of market pressures to a level below 40 per cent.
23. What about Mr McCarthy?
(Mr McCarthy) We have gearings in the region of 50 to 60 per cent. Unlike BT, which is a combination of a network and a supply company, we are dealing exclusively with network companies which are relatively low risk. We are comfortable, as the rating agencies are, with those degrees of gearing. We would have reservations, for very much the same reasons Philip has explained, about very high levels of gearing.
24. In other words, you are monitoring?
(Mr McCarthy) Absolutely.
Jon Trickett: That is as far as I wanted to go, Chairman.
Chairman: Mr David Rendel?
Mr Rendel
25. Can I ask you, first of all, something which I am sure all of us here on the Committee are aware of that comes through to us from our constituents and that is how you ensure efficiency gains due to multiple uses of the same hole in the ground?
(Mr Edmonds) I guess the honest answer to that is I do not. It is not, I perceive, part of my role as regulator. That is the honest and brief reply.
26. Does that go for the other two as well?
(Mr McCarthy) We do not micro manage the companies in terms of the way they discharge their duties.
(Mr Fletcher) This is the point of the RPI—X regulation that where a company sees a chance to gain efficiency then the whole concept of yardstick regulation is that they should go for it, especially if they are able to keep the benefits for their shareholders for a while. The system is developed to give them that incentive to look for the efficiency gains which we as regulators are not in a position to do because we are not managing the companies. We are challenging them to manage them properly.
27. It is very obvious to most of our constituents that there are enormous opportunities for sharing the same hole in the ground and indeed this could lead to much more efficient working for the companies as a whole, although each one individually may may not see that until the opportunity comes for a large number to join together. Do you take this into account when you are setting the X factor? It seems to me that one way in which you could be pushing the companies to become more efficient by all using the same hole in the ground is if you tell them X is larger than it might otherwise be because you expect them to start becoming more efficient in that way.
(Mr Fletcher) We expect them to start becoming more efficient almost full stop. This is again about not micro managing them, but should Parliament set rules in place then the companies must abide by them. As no doubt you know Mr Rendel, we have two potential systems at the moment about holes in the ground in the highway which are significant, one of which applies fines to companies that overstay their welcome in the highway, something which is in place now across the country, and then there is the lane rental system which at the moment is being trialed in two areas. This I must say gives me a bit of concern on behalf of water customers because if it were applied nationally it would imply a big transfer of resources from water customers to local taxpayers, but that is perhaps an issue for another day. At any rate there is room for Parliament to set incentives into legislation which then can be perfectly properly taken into account in the regulatory system.
28. If you are deciding what the level of X should be, I should have thought it is within your powers to say we think X should be a little bit higher because we can tell you are not combining operations and co-operating as effectively with each other as you could be. If you did so then you could afford to charge your customers less, so we we are going to force you to charge your customers less and that may persuade you to co-operate rather better?
(Mr Fletcher) The X is set by reference to what we think is possible for the efficiency of the companies as a whole, what they can do in the future.
29. Precisely.
(Mr Fletcher) Not X plus a little or a big lot for a particular thing coming along. We must take account of all the major impacts on them and they must then work out the detail of how they can get their best performance.
30. Of course, what I am asking you is when you are taking account of all the possible efficiency gains, are you taking account of the fact that they could be co-operating more?
(Mr Fletcher) The system provides that if there is an opportunity there they should be grabbing it, that is the virtue of it, rather than us trying to set in place something which could be seen as second-guessing the company on how best to manage itself.
31. I am not saying you should tell them that they have got to make these particular efficiency gains. What I am asking you is whether you are setting the price level on the assumption that they are going to make those efficiency gains.
(Mr Fletcher) I speak only for myself. I am setting the limit on the basis of what I think they can reasonably achieve over the next five year period taking advantage of the opportunities of new technology, better working practices and better procurement practices available to them.
32. You are taking account of the fact that you know that they could be making efficiency gains by using the same hole in the road?
(Mr Fletcher) I am very firmly not saying that Mr Rendel because I am in not in their position as engineers to be as sure as you are that putting the pipes into a single hole is going to yield a lot of gains. They are in the best position. They have got the engineers on the ground. If the opportunity is there they should be grabbing it and the regulatory system will push them into doing so.
33. Your guesswork is based on very incomplete information. You really do not know how many efficiency gains there are going to be even though my constituents are screaming at me that all these companies are wasting a huge amount of money by digging up holes after holes after holes when they could all be using the same one.
(Mr Fletcher) I do not know there is a lot I can add.
(Mr Edmonds) That is a hypothesis that you are asking us to test. It is not one I have tested to date. My view is very much that of Philip, which is we are regulating a company which is commercially stimulated to do things in the most economic and efficient way. For BT or the other telecommunications companies to make use of holes or ducts that already exist—and in some cases we have that because energy is using the electricity system—is a classic example of the regulator not insisting that a company behaves in particular way.
34. I am not suggesting that.
(Mr Edmonds)—But the private sector seeing an innovative use of infrastructure that is already there. The honest answer is to go down the route you are suggesting I suspect would open up many other suggestions where the regulator could give guidance.
35. I keep saying I am not suggesting that you give guidance on this matter. All I am suggesting is when you calculate the X you should take into account the fact that you know that there are efficiencies that can be made out of using the same hole in the ground. It seems that the reason given, at least by Mr Fletcher, for not doing so is that he does not know how great those efficiencies could be. What you now appear to be saying is there are cases in which the companies concerned have clearly found there are possible efficiencies. That has given you at least some information that the other companies could be making similar efficiencies and therefore I would have thought that gives you an excuse for raising the X above where it would be if you did not have that information.
(Mr Edmonds) I have a suspicion that in real life it would be difficult to drive us into a level of micro management that we do not presently do.
36. Right. Let me go on and ask about some other things to do with the environment, perhaps to Mr McCarthy and Mr Edmonds in particular. It is said it is hard to quantify the customers' wish for more reliability and therefore to what extent you should allow for that in the pricing mechanism. Do you make any attempt to evaluate environmental benefits such as putting wires underground or hiding away gas or possible environmental benefits in terms of wastage of gases?
(Mr McCarthy) Can I deal, first of all, with the question of reliability in terms of the distribution prices review. One of the things we did was a considerable amount of work not to ask the easy question would you like greater reliabilty, to which everybody properly answers yes, but to try and ascertain how much more people would be prepared to pay for an increase in the level of reliability, which is already very high, to an even higher level. In terms of environmental issues, in terms of the way in which we set the price controls, both for distribution companies and for energy (and also particularly, although it is not covered in this Report, for Transco as the question of wastage of methane is an important question) we specifically gave incentives to companies to discourage wastage, to encourage energy efficiency in terms of the distribution companies and to ensure that there was no artificial incentive on the companies simply to encourage more electrons to flow or more molecules to go through the pipes.
(Mr Edmonds) In the telecommunications sector obviously reliability is enormously important, particularly to the commercial customers of BT. The fact that 52 per cent of all telecommunications is now data rather than voice demonstrates how much everybody relies on totally reliable—
37. Can I move you off from the reliability. I understand that reliability is difficult. What I was really asking about is to what extent you can put a value on the environmental benefits that may arise from reducing wastage or reducing the numbers of wires that go overground and putting them underground and things of that sort.
(Mr Edmonds) The answer again to that question is we do not. The onus on the company is firstly to behave in a way that is environmentally proper because it has to conform with ordinary law and it has to conform with planning regulations. The onus is on the company to find the most efficient way of delivering its network. As far as I am concerned, I am looking for the competitive force of price to drive into the company the best way of doing things and relying on its own conformity/compliance with the law in terms of the environment.
38. Can I ask Mr Fletcher the same question. In the case of water I guess it becomes a question of how much money you can persuade the companies to put into reducing in terms of sewage disposal the potential for smells coming out from sewage farms and pumping stations and also the potential to reduce the danger of flooding, which is another thing that comes under OFWAT?
(Mr Fletcher) Environmental issues are obviously at the heart of the whole business of the water sector and the waste water sector. I work very closely with the quality regulators including the Environment Agency in the regulation of the industry. You have picked out there one of the issues that does concern me and that is the risk of flooding. Although the incidence has been reducing over time, as work has been put into it in line with the assumptions made in the periodic review, nonetheless it is something which people increasingly perceive as unacceptable, and therefore I am in the middle of a consultation at the moment which will be helpful in the next periodic review and may lead to some more work on that over the course of the current period up to 2005. Odour is a difficult issue in relation to sewage treatment. Again partly where housing developments and other developments come closer to the sewage treatment works, it has become more of an issue recently. It is primarily an issue for the environmental health officer and the Environment Agency working with the company. It is certainly something I suspect will be more of an issue at the next review than it was at the last one.
Chairman: Thank you. We will break for ten minutes for a division.
The Committee suspended from 16.57 to 17.07 for a division in the House.
Chairman: Order, order. Mr David Rendel?
Mr Rendel
39. I was really talking about the environment and things you could do to help the environment as regulators. Your answers so far have all been along the lines we can put on commercial pressure via our pricing mechanism to make sure the companies work in the best way for themselves. But the difficulty is there are certain social advantages or advantages to the country as a whole in environmental improvements which are not going to help the companies as such to improve their profits. Do you see yourselves and do you in legislative terms have any role in trying to make sure that companies spend some money on potential environmental improvements which are not necessarily good for profit?
(Mr Edmonds) My answer to that is no. There is a duty to ensure that BT provides a universal service. There is a social responsibility incorporated in the original Act to make sure that everybody has a telephone service and that there are schemes for people on low use but that does not cover environment, no.
(Mr McCarthy) There are a number of things which we do which clearly are not simply in terms of encouraging companies to make more and more profit. I gave a few examples of those in my previous reply. The difficult question is that there are, indeed, in economists' terms externalities associated with environmental costs. In terms of the policy on environmental costs the Government has set out, in a way which I think is completely correct, a system whereby it will be for the Government to make decisions when there are significant economic costs associated with environmental policies. It should not be for a group of appointed people on the Authority of OFGEM to make the really important decisions about the transfer of wealth between generations that are at the centre of the environmental decisions, but we reflect them in the way in which we go about our duties.
(Mr Fletcher) My answer is yes in the different circumstances of the water sector. £7.4 billion of the programme of £15.6 billion of capital expenditure being undertaken by the companies over the current period is for largely environmental enhancements, but the great bulk of it is under the requirements of European Directives and was allowed for therefore in the price limits. I could go on. The companies have a duty to promote water efficiency and it is part of my job to ensure that they are setting about it. It is an issue I was asked about by the Committee of Public Accounts a year or more ago.
Mr Rendel: Thank you, Chairman.
Chairman: Thank you, Mr Rendel. Thank you for getting us back to the nitty-gritty of holes in the road. We are grateful to you. Mr Brian Jenkins?
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