Examination of Witnesses (Questions 1-19)
OFGEM
16 NOVEMBER 2004
Q1 Chairman: Good morning, Mr Buchanan.
Perhaps you could introduce your colleagues and then we will put
our questions.
Mr Buchanan: I
would be delighted to do that and perhaps give you a couple of
opening comments and then we will very much welcome your questions.
As you would expect me to say, Ofgem is fully occupied at the
moment looking after consumer interests. The big three projects
that you will be alive to at the moment are the high gas prices
where we continue to take forward our probe, we are working hard
to deliver the merger of Scottish wires in with those of England
and Wales, and, thirdly, we are about to publish a much awaited
and anticipated document on wires investment that is needed to
carry the renewables broadly from Scotland down to the demand
load in England. On top of that we have the very important price
review which primarily we are here to discuss today and, as I
mentioned, we welcome your questions on that. In brief, it is
a review where investment is up, quality will have to go up, efficiency
of the companies is demanded to go up and we believe that it is
a renewables friendly package as well. I am joined by the brains
behind the network review: David Gray who is our Managing Director
of Networks, and Martin Crouch who is our Director of Networks.
They will deal with a lot of the details of the questions that
you would like us to cover today. There is an element of safe
harbour required in today's meeting insofar as we will announce
our final proposals for each of the individual companies on 29
November and short of wanting to go to see my predecessor, Callum
McCarthy, at the FSA, we clearly have to be quite careful. Nevertheless,
we feel that since the September document is such a detailed document
with regard to the broader parameters of the price review we certainly
can meet your aspirations for information today and if we cannot
we will be only too happy to come back to you either orally or
in writing. Those are all my opening comments, Chairman.
Q2 Chairman: Thank you. We seem to have
you and your predecessors in at fairly regular intervals. We would
like to look this morning at some of the matters relating
to the capital expenditure arrangements. You have proposed a capex
increase of something of the order of 46% over five years. We
were told in the course of our inquiry earlier this year into
network resilience that capex over the next 20 years would have
to be double what it has been over the last few years just to
maintain the existing network. We are conscious of the fact that
there was a fantastic amount of investment in the Sixties and
Seventies into that. When you made the calculations about capital
allowances, did you base your assessment on how much investment
the network needed, what you thought companies could realistically
absorb in the period, or was it based on how much you thought
the customers could be asked to pay? There are different sets
of players here. We could have the best wires in the world but
the poorest consumers unable to benefit from it. How did you strike
the balance?
Mr Buchanan: You are absolutely
right to say that there is a balance. Perhaps I could put a little
bit of context into your question. You are right to say that there
was major investment in the Fifties and Sixties. The Fifties was
when the 275kV network went in and the Sixties was the Supergrid
network with a lifespan of between 40 and 60 years and that is
one of the reasons why we are looking at the need for reinvestment
in the network. One of the things that I am quite keen to knock
on the head is that this price review stands out from the previous
three in being one where we are alive to capital expenditure requirements.
I think it is worth pointing out that £16 billion has been
invested since the companies were privatised in 1990 into the
networks. Over that period we have seen both an improvement in
the blackout level, at the distribution network level, by about
11% and the duration of power outages has been down by 30%. This
is not to be seen just solely as the first time since 1990 that
we have sought to meet those investment requirements. Let me move
on to your question about the balance. We are very minded that
our statutory duty under section 3 is to ensure that consumers
are protected and therefore we do look very carefully on behalf
of the consumers at the balance between value for money and the
need to ensure that the network is developed in an efficient and
economic way, and indeed "efficient" and "economic"
you will find within the statutory requirements of a distribution
company as well. We do seek to create that balance. In terms of
the detailed reasons why we are looking at that plus 46% or, we
might even argue, plus 59% if you include the renewables capital
expenditure that we are including within this review, which is
a new departure, I think I will hand over to David to pick the
specifics up from this review.
Mr Gray: In terms of how we do
it, we start with your first point, which is how much is needed,
and we ask the companies to give us their forecasts of their requirements
over the next five years. We then subject that to challenge by
ourselves and consultants that we have employed to help us in
the process and one of the things that we would check is the credibility
of the forecasts in terms of how much the companies can handle.
I do not think we did see that as a constraint this time round,
although there must be a limit as to how far you can step up the
level of capital expenditure and this is quite a big step that
we are talking about in the next five years, and we also think
about how much the customer can pay when we look at the balance
of the overall package. In this case there has not been any requirement
as a starting point that we set ourselves to get prices down or
anything like that. We set rather a different objective which
was that prices should not be any higher than they needed to be,
having taken account of the capex requirements of the industry.
Q3 Chairman: Could you give us a rough
indication of what the impact of this will be on the industrial
and the domestic consumer in ballpark terms?
Mr Buchanan: If you take the headline
figures from either the June document or the September document—and
I have to caveat this by saying we may yet change it between now
and 29 November—broadly speaking you are looking at an annual
price position of RPI-0, it might be a little bit more or less
than that, and a P0 cut virtually at nought. Those parameters
may change a little bit between now and November 29 but you are
effectively looking at a flat situation. Distribution typically
accounts for about 25% of your bill, to put that in some kind
of context. How does that tie in to what we have done in the past?
Distribution one and two price reviews in 1993-94 saw a cut on
the P0, that was a one-off cut of around 24% and we saw a similar
cut in 1999. There has been a pretty dramatic cut in the pricing
parameters for the companies since 1990 and now we have reached
the stage where we believe that effectively a flat pricing position
is the one that will meet those requirements that I made earlier,
investment up and efficiency from the companies up.
Q4 Chairman: So we are talking about,
as you say, between nought and about 0.6% of the average bill?
Mr Buchanan: Indeed.
Q5 Chairman: Early on in your answer
you made a reference to a 10% blackout and I just was not clear
what that was.
Mr Buchanan: It was an 11% reduction
in power outages at the distribution level rather than at the
National Grid Transco level and those outages have had a dramatic
reduction in duration time as well since 1990.
Q6 Chairman: Let us assume capital allowances
were to prove inadequate and that people were saying you are demanding
too much from us, would you be prepared to look afresh at them
and to increase the allowances during the price control period?
Mr Buchanan: Perhaps I can give
you a broad philosophical answer and then I will ask David to
deal with the details of the question. We spent a lot of time
in this price review process looking at whether we wished to stay
with what I regard as the core philosophy or principles of the
electricity pricing regime since 1990, which is effectively to
say once every five years we will set the parameters on the basis
of engineering and accounting advice, external advice as well
as our own highly proficient internal advice and then it is up
to you, the management, to work through that, but should something
completely untoward occur in that five-year period then you can
approach us. That is slightly different from Ofwat. Ofwat have
a mechanism horribly called an IDOK which effectively sets out
criteria by which you can come back and see the regulator within
the five-year period. We really are saying, in terms of the capital
expenditure and our operating expenditure efficiency requirements,
this is the package for the five-year period, but if something
went very untoward in that period then they would have to come
back and I think we would listen very carefully.
Mr Gray: First of all, challenging
your assumption, I do not think the allowances should turn out
to be inadequate.
Q7 Chairman: You would say that, wouldn't
you?
Mr Gray: To be specific, we went
through our normal process of having consultants look at the numbers
and they came up with a set of figures which were some way below
what the companies had asked for and, rather than do what has
been done in previous reviews and simply impose those figures,
we introduced a new mechanism to bridge the gap between ourselves
and the companies which we call the sliding scale allowance. In
essence it allows the companies to spend more than we originally
thought was necessary if they feel it is necessary and, as a protection
for us and for customers, it reduces the benefit they would get
from under-spending that amount. We have already moved quite some
distance towards accommodating the companies' spending requirements
in those allowances. The second point I would make is that there
are two ways in which you could argue allowances would become
too low. One is simply that companies spend too much, in which
case if they find they have to spend more for in effect the same
outputs the mechanism captures that and there are penalties for
the overspend in costs and money. If something new comes along,
we would look at it and see if it required some adjustment to
the price control. I think a good very large scale example of
that is the process we are currently going through on transmission
investment for renewables, where we are making proposals to allow
investment in infrastructure in Scotland that simply was not considered
when that price control was set for electricity transmission.
If there was something dramatic that came along in electricity
distribution, we would have the option to do the same thing and
take action during the five-year period if necessary.
Q8 Chairman: You are proposing tougher
targets for minimising customer interruptions and customer minutes
lost, but it would appear that for some of the DNOs you are not
making much scope available for capital expenditure. Do you think
that capital expenditure really has a little role to play in improving
quality of service and that it is up to the companies just to
work that bit harder? What is the view there?
Mr Buchanan: There is the broad
philosophical view that we do set the parameters and that the
companies then have to achieve that within the five years. It
is worth mentioning the point because we are so near the conclusion
of our formal part of the review. When the companies receive our
statement on 29 November they have the opportunity to reject it
and to go to the Competition Commission and clearly they will
look at the whole of this package to see whether it is a reasonable
package, whether they think they can work within this package.
They have a duty to their own customers and if it is a clearly
unreasonable thing that we have set down, or they think it is,
they have that opportunity to challenge. In terms of do we think
we have set aside enough, we have set aside around £112 million
specifically for quality of service on capex, £114 million
on opex and, as you rightly point out, we are expecting an improvement
both in customer interruptions and customer minutes lost, about
5% and 12% respectively in both categories. This is something
that we are keen to see an improvement on and we believe that
companies can deliver it. To put it in context, since we introduced
this scheme, which I think was a very good idea that our predecessors
introduced in 2000, those quality of service indicators have already
gone up by 7% and we think the companies can do more. I would
take us back to the point that David made about the interplay
between value for money and realistic improvements that we look
at in the deliberations.
Mr Crouch: The quality targets
are very much based on what some companies are already delivering.
It is about bringing all of the companies up to the standards
that are already being delivered by the best.
Q9 Linda Perham: In the September document
you note that for most companies the proposed capital expenditure
either equals or exceeds what the companies themselves forecast
they will need. The two main exemptions are the two Scottish Power
companies and the EDF companies. As a Londoner, I know EDF London,
Southern and Eastern cover a very large population. Why does your
estimate of what these companies need differ so widely from what
they think they need?
Mr Buchanan: Perhaps I can set
the framework and then hand over to David and Martin. In terms
of the framework, we work very closely with our engineering advisers
as to what the right figure should be and there has been a huge
amount of interface with the advisers, with the companies and
with their advisers as we have worked through what we think the
right capex figure is. As David mentioned earlier, to a large
extent, concerns about high capex are captured and/or caught by
the introduction this year of a sliding scale. In other words,
it cannot be a "gamed" figure, which is always the worry.
If you set a high figure, you might game it by underspending against
that high figure. In terms of the companies involved, you have
picked out two that from the September document might stand out.
I want to be quite careful at the moment given where we are in
our negotiations not to talk specifics about those two companies
other than to say that it has been in previous documents that
as far as London is concerned there has typically been a London
weighting for the unusual costs of London and that would be something
that we would not be changing in this review. David, I do not
know if you feel you can go any further?
Mr Gray: The way we did this was
that we used our consultants and our own people to do a comparative
assessment of what is required. They did two things: one was they
looked at the submissions put in by the companies and at the major
items in that and made an assessment of what was necessary and
what it should cost; the other was that the consultants developed
an industry model from which they predicted what they thought
the necessary requirements would be based on the scale of assets
or the asset lives and so on of various companies and then they
compared the output of these things and came to some judgments.
We found that in the case of quite a number of the DNOs those
processes, our own assessment and the checking of their forecasts,
were producing numbers that were quite similar to their forecasts
and in the case of EDF and, to a lesser extent, Scottish Power,
there were big differences. It is quite difficult for me to pin
down exactly why. We just felt that those companies were overestimating
what was required in the next five years. To be clear about the
output, the three EDF companies will be allowed three of the four
highest increases in percentage terms compared with the previous
price control and it is typically 65 to 70% for the EDF companies
by which capital investment will be increasing if they spend their
allowance. It is not as though we held them back down to an obviously
low level relative to the industry, quite the opposite in fact.
The companies that said they needed to spend more are getting
the higher allowances.
Q10 Linda Perham: I do not know how specific
you can be on my next question, but the company most seriously
affected is EDF-Eastern. In the evidence we took last year on
the October 2002 storms, we got the impression that there had
been underinvestment by the previous owner of the network before
EDF took over and you confirm that in your September proposals.
To what extent are you willing to let EDF try to make up for its
predecessor's failures to invest sufficiently in the network?
Mr Gray: On the point about the
storms, in their case it was primarily to do with their activities
on tree cutting, which is a necessary regular activity as most
of the damage in the storm is caused by trees or branches affecting
the lines. There did seem to be some suggestions that that had
not been carried on at a suitable pace in the period before the
storms. What we have done generally this time is we have done
a very careful assessment of the necessary expenditure on tree
cutting. We have set the allowances to allow the companies to
move from a five-year cycle of tree cutting to a three-year cycle,
because that was one of the recommendations that came out of the
Network Resilience Group and your own discussions on the storms.
Yes, we are doing everything we need to allow the companies to
step up the level of expenditure on tree cutting to make sure,
hopefully, that if there are similar storms in the future we do
not get anything like the same level of damage. Martin?
Mr Crouch: Where there is a backlog
due to underinvestment by a previous owner or whatever, whether
on tree cutting or on investment, we have not necessarily been
convinced that the customers should pay rather than shareholders
paying to fund the investment necessary to catch up for previous
underspend. We are not precluding the companies from spending
more to catch up, but some of that expenditure the shareholders
should pay for rather than customers.
Q11 Linda Perham: There is a balance
between the customers being prepared to pay more and not getting
power cuts and the other way round. The DNOs are suggesting that
they should be allowed additional expenditure to improve network
performance for the worst served customers, but you reject this
idea on the grounds that "expenditures of over £1,000
per affected customer . . . would be necessary to deliver significant
benefits" and that such expenditure would incur "financing
costs of hundreds of pounds per year per affected customer".
How does this assessment of the cost of borrowing square with
your allowance of only 4.6% after tax for the DNOs' cost of capital
for the next five years, 2005-10?
Mr Buchanan: I understand the
linkage of the questions, but there are almost two questions there,
which are the degree to which we are looking out for the worst
served and the degree to which 4.6 is certainly the right message
for investment and I understand the linkage, but if you will bear
with me I will split the two. I would like Martin to answer the
first aspect, which is how we deal with the worst served and David
to deal with the cost of capital which I know he is only going
to be able to take you so far on because it is one of the big
announcements that the industry is waiting for in 10 days' time.
Mr Crouch: In terms of worst served
customers, we looked at the companies' plans that they put forward.
As you say, they are in many cases quite expensive per customer
affected. Some of the schemes involve the sorts of investment
that the industry looked at after the October 2002 storms, things
like undergrounding and I think in your own report you said that
was not generally cost effective, but there were other things
to do, such as improving tree cutting and so on, that better improve
performance. We have tried to set targets for customers as a whole
by requiring and incentivising companies to improve performance
on an ongoing basis. The specific numbers you mentioned include
depreciation as well as the cost of capital, so that is why the
financing costs are not just 4.6% of the total. We have set allowances
for large increases in investment and it is a matter for the companies
to prioritise that investment. We are not precluding them from
spending on any particular area, but we are seeking improvements
that benefit the generality of customers.
Mr Gray: As Martin said, the reason
it appears to cost more than 4.6 is you have to allow for the
pre-tax cost of capital which is 6.5/6.6, those are the numbers
we have been using so far, plus the depreciation of the investment.
Compared with the upfront cost of making improvements, the ongoing
cost that the customer feels is a bit more than 10% of that. Whether
4.6 post-tax is enough is an underlying question. It is no good
making these allowances for capital expenditure if the return
on the investment is not high enough to encourage the companies
to do it. All we can say, really, is that assessing the required
cost of capital is as much an art as a science. There is a lot
of economic theory behind it, but what that points you to is a
fairly broad, plausible range within which the cost of capital
should be set. In our initial comments on this earlier in the
year we excluded the lower half of that range based on market
evidence because we thought it was reflecting short-term factors
in the market and we thought that would not be enough to encourage
investment. We left the final decision on what will be needed
until our final proposals in two weeks' time. The authority is
very much aware of the point that in a review where we are trying
to allow and encourage a significant increase in investment the
cost of capital needs to be sufficient to do exactly that.
Q12 Linda Perham: Is there a cut-off
point in the costs per customer when you are assessing whether
the extra expenditure will be cost-effective or is that not an
exact science either?
Mr Gray: I do not think there
is a specific cut-off point and, equally, we do not specifically
say, "No, the companies can't do that". What we do is
set an overall allowance and then it is up to them to prioritise
what they spend it on and to the extent that they have lower cost
schemes they might well decide to do those anyway. We do not have
a pound-per-customer cut-off. That comment in the document was
based on the specific schemes that had been put to us which generally
seem to us to involve quite a substantial cost for improvements
in relatively small groups of customers where we thought we could
achieve a lot of beneficial effect through the other arrangements
that we have described: the improvements in tree cutting, allowances
for exceptional events, increased incentives on the companies
to restore supplies quickly and so on. We just thought that was
a better way to spend money on behalf of customers in general.
Q13 Sir Robert Smith: The Energy Networks
Association has put it to us that Ofgem's current proposals do
not do enough to facilitate the widespread connection of either
onshore or offshore renewable generation. How would you answer
that challenge?
Mr Buchanan: Perhaps I can deal
with offshore first of all because that has really come into sharp
focus since the passing of the Energy Bill in the summer. The
DTI has lead policy on this and we are currently working with
the DTI to work through how the regulatory structure might work.
I am not passing the buck here; we really are in the process of
working through with the DTI where we are going to go on this
because it is so very fresh. The Networks Association can make
that comment and obviously it has done. All I would say is we
are right at the beginning of the process and we are on top of
that. As far as onshore is concerned, I think we most certainly
are on top of that. In August we went out with a consultation
paper and we will be producing what I think is a much sought after
document in about three weeks' time outlining how we are facilitating
the development of the high voltage network in the middle of a
price period, which is a most unusual thing to do, but we effectively
are reacting as a facilitator to the Government's requirements
on renewables and within this document what we will do is basically
outline the baseline projects, projects which we believe clearly
show a consumer benefit on a cost-benefit analysis that were these
networks to be upgraded or developed you would not have stranded
assets as a consequence. The companies have provided us and our
external consultants with the details and we will grade the projects
between those that effectively get the green light, those that
get the flashing green light and those that are in amber and they
will be reviewed as time proceeds. I think we are actually working
quite hard on both onshore and offshore and I think we are up
with the pace of development and with the requirements of us.
David, I do not know if you would like to add anything?
Mr Gray: Could I add something
on the specific scheme we have for distributed generation onshore
and relating to generators connecting to the distribution networks
because we have developed that during the course of the price
control. As with any investment of this type the balance we have
to strike is between encouraging investment to happen and avoiding
having it happen and finding there is no use for it. We would
not be congratulating ourselves if we allowed wires to be built
in vast areas of the country where there might be renewable generation
and then nothing was built. There has to be a balance between
how much evidence you need of it being required and how quickly
you allow the expenditure. In the case of distribution what we
have done is said that really the people best able to assess that
balance are the distribution companies. They are talking to the
generators who have projects in their areas. They should be capable
of making a reasoned assessment of how much is going to be required
and we have provided a mechanism which allows them to spend on
reinforcement of their networks to accommodate that generation
demand and it provides them with a premium rate of return if they
get it right. In other words, if they come up with a reasonable
assessment of what is required and then deliver the network capacity
on time and on budget it is designed to give them a premium rate
of return compared with the normal regulated rate of return and
I think that is a very positive step from our side to try to ensure
that the investment is done by asking the people who are in the
best position to judge to make that assessment.
Q14 Chairman: Some people have questioned
the settlement that was implied within BETTA in respect of Scotland
where there is a lot of wind and there is a need for investment,
but the charges will be of an order that might well be prohibitive
in terms of the ultimate price of electricity. I know things have
moved on from the initial stand-off on this issue. I appreciate
that November 29 still beckons, but can you give us an idea of
where we are on that issue?
Mr Buchanan: In terms of the distribution
implications, you are right, that is caught by the twenty-ninth.
In terms of the transmission implications, which has been the
much more controversial focus and high level focus, we are at
a stage now where we have received National Grid's recommendations
on how the charging structure should work in Scotland. The authority
will meet shortly to determine whether we feel that the options
being offered to us by National Grid are workable, and again I
would like to go further but I would be pre-empting where the
authority's decision will lie on that. We have been very careful
up until this point not to take a view. We have been doing a lot
of work on it. It is incredibly important for us given the interest
from the parties, from the Scottish generators, down to the southern
England generators and all have a very strong interest in our
decision. We have been very boring in not giving any view on this
at all until we received that document from National Grid. We
are now at the point of making that decision and we will make
it within the next couple of weeks and then again, rather like
the comment I made earlier, we would be only too happy to give
you a written or oral submission.
Chairman: That would be helpful. Some
of us in Scotland have constituents who would be very happy to
forgo any possible capital expenditure, particularly in relation
to the Beauly-Denny line. It is not a view to which I subscribe
myself. I have disagreements with some of my constituents on that
issue.
Q15 Sir Robert Smith: Some constituents
might prefer not to pay more depending on the location. Returning
to the distribution network, you are suggesting that you have
built in an incentive or reward to get it right in terms of anticipating
where distributed generation would be best connected to the distribution
network, but the ENA are saying to us that "at its best it
seems that the incentives for network companies to encourage the
siting of new generating facilities on their network are neutral."
Are they commenting on the same thing? It is clear that for some
companies they are clearly insufficient in relation to the likely
risks involved.
Mr Gray: I find it very difficult
to follow that comment. We started with the companies' own estimates
of the capital expenditure they anticipated needing to make in
response to connection requests from renewable generators. We
set the allowances on the basis of those estimates. We have assumed
certain volumes of generation in setting up the scheme and, as
I said, it is designed to produce for the companies a premium
rate of return if they have made a correct assessment of what
is required and delivered the necessary network capacity on time.
I am not sure I can add much to that.
Mr Crouch: What the ENA says to
you does not necessarily reflect the flavour of the comments we
are getting back from the individual companies. It is not just
about the companies; we are also having comments from renewable
generators on this and, generally, they are now concerned that
we are being too generous to the distribution companies and not
that we are not giving them enough encouragement to invest in
the wires which the renewable generators themselves need.
Q16 Sir Robert Smith: On the operational
expenditure, it looks like you are going to allow less money per
annum from 2005-10 than the actual costs incurred in 2002-03 and
2003-04. Is that a fair summary of the way your proposals are
looking?
Mr Gray: It is fair in one particular
respect, which is that we assess a base level of operating costs
which we do by comparative assessment between the companies. The
proposals we set require the relatively inefficient companies
to catch up to the upper quartile performance and then we expect
that performance to improve at a rate of 1.5% per annum. So, yes,
in that base opex figure we are anticipating continuing efficiency
improvement. What we have done separately is made specific allowance
for other costs we know are rising and are outside the companies'
control; for instance, pensions, rates, tax are all outside of
that base opex allowance where we are requiring efficiency, so
we are careful to make sure that the efficiency targets are concentrated
on the areas where the companies can actually deliver by responding
in their performance.
Q17 Sir Robert Smith: Finally, on customer
views, you did a survey of customers to work out where they put
their balance. Did they want to see a more reliable, constant
supply of electricity or did they want to see a cheaper bill through
paying less for the distribution? I am just a bit concerned because
the survey shows this time that the customers were actually quite
keen to put the emphasis on reliability and consistency of supply
even if it meant paying some more on their bills, yet you have
put some doubts on this survey in your own response. Is that because
it does not fit with your desire to always keep prices coming
down or have you got more robust reasons to disagree with the
survey?
Mr Buchanan: I think, in macro,
there was a concern that we were basing the whole of our perception
on the wording of the survey. I think you have to be quite careful
when you are using surveys as the primary reasons for setting
out what you are going to do. If I can use an example of something
else (on which, in fact, we went to see the PAC recently), in
relation to energy efficiency, surveys of customers there are
often extremely depressing because consumers, it would appear,
would rather spend their money on, let us say, double-glazing
than energy efficiency. So you have to be quite careful, I think,
about the quality of the question that is asked and the quality
of the survey, and then how much weight you are going to put by
it, in terms of the specifics.
Mr Crouch: We have been discussing,
actually, with other regulators, including the Italian energy
regulator who did a very similar survey but got slightly different,
lower, answers, so we were conscious that the survey we conducted
seemed to get higher answers in terms of willingness to pay than
other comparable surveys. That does not mean it is wrong but there
is a weight you can place on it.
Q18 Sir Robert Smith: Presumably what
the Italians want for Italy and what the British want for Britain—
Mr Crouch: May well be different.
Q19 Sir Robert Smith: Was that before
or after their major—
Mr Crouch: After. We have set
targets for improvements in quality, partly in response to the
survey.
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