Memorandum by Northern Electric
Northern Electric welcomes this opportunity
to contribute to the Committee's Inquiry.
Following the acquisition of the distribution
business of Yorkshire Electricity, Northern Electric is one of
the largest electricity distribution businesses in the country,
covering the area East of the Pennines from South of the Humber
to North Northumberland and serving a total of 3.5 million customers.
The specific questions raised by the Committee
in its Press Release announcing this Inquiry deal largely with
the supply of energy. But it is important not to neglect the issue
of the distribution networks, without which power cannot reach
the consumer. It is worth remembering that a major factor in the
California crisis was the inability of the transmission and distribution
systems to wheel enough power from outside the State.
Any long term energy review must have at its
heart capital investment and the means of ensuring that that investment
takes place. The total investment in the electricity network is
twice that in generation, and twice as much is spent each year
on the network as on generation. If the move towards embedded
generation, such as renewables and CHP, continues, the proportion
could be even higher because of the need to reconfigure the network.
It is clearly vital to ensure that this investment takes place.
But increasing numbers of commentators are saying
that the current regulatory regime, based on RPI-X and five-yearly
reviews, actively dissuades long-term investment. Two of those
making these points are the Better Regulation Task Force in its
recent report on Utility Regulation and the PIU itself in its
scoping papers for the Energy Policy Review. In Northern Electric's
view, we need to move to a longer-term regime that provides the
right signals for cost-effective investment for the long term
while keeping up pressures for efficiency.
Northern Electric's submission to the Energy
Policy Review argues these points at greater length and suggests
a way forward. A copy is attached for ease of reference.
SUBMISSION TO ENERGY POLICY REVIEW
1. Northern Electric welcomes this opportunity
to contribute to the PIU Energy Policy Review. We would be happy
to expand on the issues in this submission further in writing
or in a meeting.
2. In this submission we argue that:
Securing the right level of investment
in infrastructure for energy delivery is an essential part of
any long-term energy policy.
The current RPI-X regulatory regime
has generated significant cost savings to date, but there is general
agreement among commentators that, in its present form, it is
not providing adequate incentives for infrastructure investment.
There is a need to develop the regulatory
regime in a way to make it "bankable" in relation to
future investment in energy infrastructure.
A suggested outline is put forward,
involving long-term quality targets, a move from five-year regulatory
cycles towards a longer-term arrangement with an adequate allocation
of benefits to the investor to encourage investment and incentivise
3. Northern Electric is currently a major
supplier of electricity and gas to domestic, industrial and commercial
customers throughout Great Britain and the electricity distribution
company for the North East of England. On 6 August 2001, Northern
Electric and Innogy announced an innovative swap under which Northern
Electric will acquire the distribution business of Yorkshire Electricity,
currently owned by Innogy, and in return Innogy will acquire Northern
Electric's supply and metering businesses. After completion, Northern
Electric will be one of the largest electricity distribution businesses
in the country, covering the area East of the Pennines from South
of the Humber to North Northumberland and serving a total of 3.5
4. Any long-term energy policy, particularly
if it is concerned about security of supply, needs to have at
its core ensuring the provision of investment in the energy industry.
If this investment, whether into capital assets, the maintenance
of those assets, innovation, acquisition and retention of skills
and knowledge, safety or education and training, is inadequate,
there is the danger that security of supply can be put at risk,
perhaps catastrophically. An inadequate level of investment could
arise from short-term cost reduction pressures or the lack of
a stable regime in which investors feel confident they can make
an adequate return. The energy crisis in California is one of
the reasons for the current Energy Policy Review. The reasons
for the crisis included under-investment in both electricity generation
and transmission. Closer to home, we must learn the lessons from
the Hatfield rail crash and avoid the circumstances which led
to it arising anywhere in the energy industry.
5. Prior to privatisation, the Government
could itself decide on what investment was needed in the electricity
and gas industries and provide the cash to bring it about. Since
privatisation, the provision of cash for investment is in the
hands of shareholders and banks who have other uses for their
money. If, within a market structure, the Government wishes to
influence the level or direction of investment within the context
of an energy policy, it needs to ensure that adequate incentives
are provided to investors.
6. To the consumer, security of supply means
the secure and dependable delivery of energy to the point of use.
This depends as much on the reliability of the delivery systems
as on the availability of the primary sources. In the electricity
industry, current levels of investment in delivery (transmission
and distribution) are double that in generation (£21 billion
compared with £10 billion) and turn over at twice the rate
(£1.6 billion a year compared with £0.8 billion; figures
from the Electricity Association website). Over the next 50 years,
simply to replace existing assets will require twice as much investment
in delivery as in generation.
7. Environmental concerns may well lead
to changing patterns in generation. Requirements for more non-fossil
generation could lead to more embedded and intermittent generation
and possibly micro-CHP plants. This would require investment in
network systems, which have traditionally served to deliver power
from a small number of large power stations to customers. Other
environmental concerns, from reducing system losses to further
undergrounding of cables, would also increase investment needs.
All of this will need to be funded.
8. Traditionally, energy policy has focused
on generation. While this remains an important element, it would
be foolhardy to ignore the role of investment in delivery infrastructure
9. Unlike generation, electricity delivery
is a monopoly and its prices are therefore regulated by Ofgem.
The ability of the industry to provide continuing high quality
delivery of electricity therefore depends on the nature of the
regulatory regime. Over the last 10 years or so since privatisation,
prices to customers have reduced by 30 per cent, while standards
have generally improved. In 1999/2000, twelve of the fourteen
distribution companies had a lower number of interruptions than
their ten year average, while all companies reported a higher
level of availability than their ten year average (Ofgem Report
on distribution and Transmission Performance 1999/2000).
10. However, it is clear that, as currently
structured, the regulatory regime does not meet the requirements
of a basis against which companies can raise cash for investment.
Price controls have had at most five years' duration, with no
guarantee that they will not be reopened by the regulator sooner
(cfDPRs 1 and 2). The methodology lacks clarity (at least, in
terms of predicting its outcome) and has changed from review to
review. The standards and targets against which companies are
judged are also set for no more than five years forward. Although
so far electricity companies have been able to raise adequate
funds for investment, recent experience in the water industry,
which has a very similar regime, speaks for itself.
11. This has been recognised by a number
of observers. To quote the PIU's own scoping note on gas, "there
has been an increasing recognition that, whilst [RPI-X] was a
successful mechanism for exerting a downward pressure on cost
and prices, it may not always have been the most appropriate incentive
for encouraging long-term investment." This is supported
by a wide range of commentators. Anthony Hilton, in the Evening
Standard on 9 February, pointed out: "If there is going
to be enough water, gas, electricity or rail transport for the
country in 20 years, planning and investment decisions need to
be taken now. But they will only be taken if the regulatory regime
has a similar long-term view and will deliver the certainty and
security of return that makes long-term investment possible. This
is not what is happening." Mark Bentley, a managing director
of J P Morgan, is quoted in a European Policy Forum pamphlet,
"The Politics of Regulation", last year as saying: "It
is now extremely difficult to make money in the electricity supply
business. Many of the inefficiencies have been identified and
eliminated. In the longer term, many RECs will need to find substantial
capital sums for investment. There is a real danger that the regulator
will not allow shareholders to earn an appropriate rate for return
on their investment. The last regulatory review of prices in the
electricity sector was swingeing." Lord Haskins, in launching
the Better Regulation Task Force's report on Economic Regulators
makes the same point, as does Dieter Helm in a recent series of
A WAY FORWARD
12. But with what should the current regime
be replaced? Dieter Helm argues that we should move away from
five year periodic price reviews and replace them with a system
that minimises regulatory risk and restores certainty to the regulatory
process. As he points out, "Five year, fixed price contractsthe
conventional approach under RPI-X regulationare often ill-suited
to industries where investments can take years to plan, obtain
the necessary planning permission, and execute, and where assets
lives are typically measured in decades". He adds, "The
private sector has developed all sorts of innovative ways to address
these problems, and fixed-price, five year contracts are not common".
13. The introduction of competition into
electricity and gas supply has led to the concentration of conventional
price control regulation onto the monopolistic wires businesses.
This has helped clarify the nature of the regulatory relationship.
It is now much more akin to a contract between regulator (as proxy
for the customer) and company under which the company delivers
a product (measured by a set of quality indicators) in return
for which the company is paid a stream of income. As such, as
Helm says, there are useful private sector analogues.
14. A longer-term regulatory regime implies
the need for Ofgem to set long-term quality of supply targets.
In the absence of such targets, it is difficult to see the basis
on which companies are expected to invest. At present, quality
targets are set only for the period of the regulatory review.
Achievement of these targets is not simply a question of the level
of capital investment in the period. Ofgem has shown a marked
reluctance to determine the appropriate long-term quality targets,
preferring instead to search for comparator-derived solutions
to quality. Individual customer choice might be appropriate (and
indeed feasible) for some larger users. But it is difficult to
see how the interests of domestic consumers can be fairly met
without the regulator determining on their behalf the level of
service that the network company should provide, given that the
trade off between cost and quality will have a different outcome
in different parts of the country.
15. In looking at what form such a regime
might take, it is worth considering what investors and consumers
require from it. Investors need:
Reasonable certainty of a basic rate
of return with opportunities for upside
Encouragement of a business-driven
culture that promotes cost-effectiveness
Customers (and therefore their proxy, the regulator)
16. This suggests a possible regime based
Long-term quality targets
Monitoring and control related to
reaching milestones towards achieving these targets, ie a move
away from intrusive management of inputs towards a genuine customer's
interest in outputs.
Long-term indicative income levels
based on achievement of these milestones. Base income levels to
be determined for (say) a rolling 20 year period to allow for
appropriate investment decisions.
Ensuring the company benefits from
cost reductions achieved in excess of the implied cost levels.
The formula must be set to allow the company an adequate return
on improvements, whilst providing that over time customers benefit
17. At present, the regulatory process does
not identify genuine "best practice". High cost companies
are assumed to be "bad" and low cost companies are considered
to be a model to be copied, regardless of whether their activities
are genuinely cost-effective or jeopardising their long-term impact
on quality of supply. This simply encourages companies to compete
to minimise costs in the short term and penalises any attempt
at longer-term maintenance of quality and security of supply.
An approach grounded in the circumstances and needs of each licensee
would rectify this and could even encourage sharing of best practice.
18. Ensuring cost-effective investment for
the long term is not easy under a regulated monopoly regime. Nevertheless,
it is a vital part of any long-term energy policy. This paper
has suggested a possible way forward.