Examination of Witnesses (Questions 24-39)
ENERGY NETWORKS
ASSOCIATION
16 NOVEMBER 2004
Q24 Chairman: Good morning, gentlemen.
As I said, I do not wish to diminish the significance of your
evidence in any way but this is somewhat arcane stuff; however,
it is important to a lot of people, at the end of the day. It
is the kind of thing that if it did not happen they would let
us know about it. They did when it did happen—or did not
happen—in East Anglia. We are grateful to you for coming.
Perhaps, Mr Smith, you could introduce your colleagues, and we
will move on from there.
Mr Smith: Good morning, Chairman.
Thank you. On my right-hand side is Andy Phelps, who is the Head
of Regulation for the Energy Networks Association and on my left
is Frank Duffy, who is the Engineering Director for the Energy
Networks Association. I am the Director of Policy and I am sitting
here for the Chief Executive, Nick Goodall (unfortunately, he
is ill) so most of the questions today I will pass to the experts
by my side. I would like to start by saying that we are obviously
here representing the GB industry DNOs across the whole of the
UK so we will keep our comments very much across the whole of
the UK rather than commenting on individual companies. If you
want an individual response perhaps we can write to you with individual
responses as we may need to.
Q25 Chairman: Thank you. In some respects,
actually, it would appear that on capex matters most companies
are getting, by and large, what they wanted, which immediately
makes you wonder whether or not the regulator is doing their job.
Perhaps you could give us some kind of background. Did they bid
(if that is the right way of putting it) on the basis of what
they really needed or what they thought Ofgem would accept? Is
that a rather loaded question?
Mr Phelps: The amounts that the
companies have been allowed are, as David pointed out, pretty
close to the original bids that the companies put in. What has
to be remembered, however, is that these were for what was called
the "base case scenario", so these were the bids that
were put in by each company so that the network over the next
five years would perform at its current level—not to improve
its performance but to, in a sense, stand still. So we were looking
at 40 to 50% increases in investment just for the network to maintain
its current level of performance. I think that needs to be understood.
Along with those submissions, of course, the companies also put
in submissions for their preferred cases. When I say "preferred
cases" this tended—as I say, as David pointed out and
this is talking globally now—to include extra capex money
to improve the resilience of the networks to extreme weather conditions,
some money for undergrounding and visual amenity and increased
money for quality-of-supply improvements as well. So whilst we
acknowledge that Ofgem have themselves acknowledged the investment
problem, there are one or two other areas where we feel, perhaps,
that they have not followed the steer from your own Report in
March of building extra resilience into the network, improving
quality of supply in a way that we believe that customers—and
their own survey suggests—would be willing to pay for.
Q26 Chairman: Do you think the sliding
scale that Ofgem has introduced is going to enable companies,
as it were, mid-term to find more investment if the infrastructure
requires it?
Mr Phelps: The impression that
I have is that the sliding scale mechanism was introduced very
much to concentrate company minds on getting a most efficient
capex forecast; Ofgem were clearly worried about companies underspending
their capex allowances, and this historically has been the case.
I do not think we can avoid stating the fact that companies have,
in the past, underspent their capex allowances. However, going
forward, at a time when there clearly is a need for a large increase
in investment, Ofgem clearly were concerned that we would just
throw everything into the pot, I guess, and this is a way of,
perhaps, concentrating companies' minds to go for what they believe
is needed to keep the network, and network integrity, strong for
the longer term, and I think it is the longer term that, perhaps,
we are talking about every time we look at this. So an increase
of 40% over the next five years, we believe, will need to be followed
successively by further high levels of investment in order that
the network is then replenished and kept in good condition.
Q27 Chairman: Within the figure of, I
think it was, 46 plus 13 for renewables, some companies are going
to be a wee bit disappointed in Ofgem's response to their assessment
of capital expenditure requirements. Yet there seems to be quite
a differentiation between companies. How do you account for that?
Why is it that different companies seem to have different requirements
at this stage?
Mr Phelps: I will answer initially,
and maybe Frank would pick up some of the other issues. Each network,
clearly, is very different and then, of course, each management
within each company deals with operating their network differently.
Also, the customers are very different. So we have, in EDF, certain
strategic companies, certain strategic bodies that require, perhaps,
a higher level of security than elsewhere. It is very much down
to the individual networks. I guess it is almost a theme running
through the whole regulatory framework. Something we have always
recognised (and I think Ofgem, to an extent, recognises) is that
the networks are different; of different vintage, with different
density of population, and they need to be considered differently.
This has manifested itself in the different bids for capex which
have been submitted to Ofgem for this five-year period.
Mr Duffy: I think I would add
to that that our companies have, broadly, two different ways of
looking at how you keep the network up to scratch. One way is,
essentially, founded on replacement and another way is to continually
spend money on maintenance—a lot of money on maintenance
and refurbishment. That is very simplistic but there are two different
sorts of schools of thought as to how you tackle keeping a network
renewed, and different companies occupy those two positions. We
have to give you a kind of an average response on things like
level of capex, because some companies ask for capex and some
companies ask for operational expenditure. However, what we would
say, broadly, if we look at capex requests, for example, is that
when you replace a part of the network that may have been built
in the 50s or 60s then, preferably, from an engineering perspective,
you do not want to replace it with what was there in the 50s and
60s, because things have moved on, designs have moved on—especially
in the area of automatic control, for example, where control techniques
have moved on—and you would prefer to install something
that is modern and more resilient, so to speak. Most of our company
submissions have been based on the fact that where we would like
to replace then we would like to replace with a modern equivalent,
which is possibly more robust and certainly more able to withstand
network perturbations. That is factored into what the DNO companies
ask for when they asked for increased capex.
Q28 Chairman: What about those companies
that are going to get a lower allocation than they had requested?
How do you think they are going to accommodate the fact that,
in terms of their expectations, their requirements are deemed
to be less great by the regulator? How will they fund it or will
they just have to settle for second-best?
Mr Phelps: It is a difficult one
to call because we are now into the individual company discussions,
and I am very well aware that individual companies talk bilaterally
to Ofgem, and they themselves have to sort out how they deal with
any shortfall that is then forthcoming. So I really find that
difficult to answer in a general sense, certainly, from the ENA
perspective.
Q29 Chairman: What is your reaction to
Ofgem's rejection of the idea that DNOs should be allowed additional
expenditure to improve network performance for the worst-served
customers?
Mr Phelps: This, I think, is part
of the overall concern we have about capex money not being allocated
for improving resilience during storm conditions. A number of
companies submitted schemes to refurbish their overhead line network,
and maybe for some undergrounding as well, to improve performance
and resilience during extreme weather conditions. Essentially,
I think, Ofgem have said "You can improve your resilience
simply by an operating expenditure allowance". Partly, I
believe, that is because there is a fear that you cannot measure
the output of resilience. How do you measure if a network has
become more resilient? We believe that Ofgem are taking risks
by not allowing capex to improve resilience just because there
is no obvious measure of output of resilience. We believe they
should have accepted the companies' bids to improve resilience
and use capex to do that. Then we are planning—and obviously
we have agreed—to work with Ofgem to sort out a way of measuring
the output of resilience, so that money is not going to be just
sunk into the network without a clear return. I think that is
something we could do, and are planning to do, over the next few
months. I believe Ofgem, perhaps, have said "We are not willing
to risk that", and I think that is actually risking the performance
of the network during extreme weather conditions.
Q30 Chairman: Mr Duffy, did you want
to add anything?
Mr Duffy: I would simply say that
the companies would like to increase the resilience of the network.
The companies do not like to lose customers for any reason whatsoever.
So if there is an opportunity, as we see it or as the companies
see it, to increase the resilience of the network perhaps by replacement
of one overhead line with a more robust modern equivalent, then
we would like to do so and we think that—if I characterise
it—the Ofgem approach has been a little unambitious in this
area; we would like to see a bit more movement in this area in
contribution towards resilience specifically.
Q31 Sir Robert Smith: In your submission
you talk about the lack of incentives for allowing embedded renewable
generation. Ofgem feel they have built into their model a reward
for anticipating the most likely and effective places to reinforce
the distribution network. Where is your point of dispute?
Mr Duffy: Yes, there is a reward
but it is a double-edged sword reward in that to reinforce the
network in advance of connections is in itself taking a risk because
it is predicting where you expect connections will be made to
the network, but you might not be right and you might not be specifically
right. Especially in Scotland, for example, there will be a great
many connections of a huge range of ratings of wind farm, for
example, and it is a best guess as to how you increase or expand
the network to take account of what you believe to be future connections.
The risk is, so to speak, that the reward mechanism rewards you
if you build the part of the network and then the generators come
along, connect and generate. That is all very well but if they
do not—or not in the numbers that you had previously estimated—then
you are penalised. So there is a kind of a good if they come along,
bad if they do not, and you have to make that guess.
Q32 Sir Robert Smith: Is that not about
being good at business?
Mr Duffy: It is not so much good
at business because we, as a network company, are reliant on the
generators who finally decide, at the end of the day, that they
will connect in that area.
Q33 Sir Robert Smith: What alternative
would you see?
Mr Duffy: Can I just add to that
that there is another facet to the equation, which is that we
understand the potential for the network operator to have to pay
the generator if, for example, the network is unavailable to the
generator, and is constrained off. What the DNO companies—again,
I would say, averagely—regard as a broadly neutral incentive
is made less attractive by this potential of having to pay the
generator if the network is lost for any reason.
Q34 Sir Robert Smith: When you say "lost"—because
of?
Mr Duffy: For network reasons.
Q35 Sir Robert Smith: Damage or whatever?
Mr Duffy: Yes.
Q36 Sir Robert Smith: So you do not like
the penalty for not being able to provide the connection as a
result of storm damage or—
Mr Duffy: That is correct. We
think it detracts from an otherwise neutral incentive.
Q37 Sir Robert Smith: What, in an ideal
world, would you want to see, then, as an incentive?
Mr Duffy: I think more acceptance
of the fact that you may not be right in your engineering estimate,
at the end of the day, and that it may be that if you spend money
on a part of the network that is not fully taken up by connected
generators then you should not be penalised for the fact that
you have made what, in your opinion, is an engineering best guess.
The important bit about this is that you cannot decide "Well,
it looks like three weeks from now a generator is going to connect",
because that timescale is no good for you in reinforcing a network.
The further back that you go into the network the longer timescale
you need to actually make those reinforcements. So you are actually
guessing, albeit a best engineering estimate, quite some way in
advance of the actual connection which, at the end of the day,
may not materialise.
Q38 Sir Robert Smith: Moving on to operating
expenditure, in the past the companies have complained about what
has been demanded of them, yet the outturns in 2002 and 2003 show
that they actually could deliver the efficiency savings in the
end. So would you agree that in the past they have said they cannot
do it, and—
Mr Phelps: Cry wolf. Yes, you
cannot argue with that situation. Going forward, looking at the
next five years, I think we have reached, perhaps, a watershed
and I think that is, again, where the issue lies. In expecting
some companies to improve their operating efficiencies, which
is improve their productivity by over 6% per annum over the next
two years—these are the non-upper quartile companies—and,
overall, all the companies by over 4% per annum over the next
two years in order to catch up to this so-called upper quartile
group of companies, and then to continue on at 1.5% more efficiency
and have higher productivity growth than the rest of the economy
(this is not just equalling the rest of the economy this is out-performing
the rest of the economy) I think too much credence has been given
to what has happened since privatisation. Yes, there have been
huge improvements but I think the expectation is that these improvements
can continue, and I think in an era where we are talking about
46% increases in investment, continuing to squeeze opex in that
way is not justified. We have argued quite strongly, as the ENA
and as a group of companies, that even the 1.5% per annum performance
is too high relative to the rest of the economy, and also the
requirement for catching up the upper quartile performers in two
years is too severe; it smacks of the further and further tightening
of operating expenditure in an era where we should be looking
further ahead and saying "We need this industry to expand,
to build and to operate efficiently." Of course, what it
does do is it does enable, if you are squeezing opex, to be able
to absorb such a large capex increase within almost a stable price
framework. Alistair talked about a P to zero and an X minus zero;
in fact, if you look at it like-for-like there are actually price
reductions compared with the last price review, if we take the
September update paper as the final set of figures.
Q39 Sir Robert Smith: One specific part
of that comparison between companies, obviously—without
getting too technical—is to compare one part of the country
where there is a lot of overhead lines with another part where
there is a lot of underground lines, therefore less disruption
but more expensive. Do you feel they have managed to, at least,
do that?
Mr Phelps: It has been a long-running
debate we have had with Ofgem about whether benchmarking is the
appropriate way to conduct such analysis. The risk is that benchmarking
produces a one-size-fits-all approach when we know for sure, as
you have pointed out, that it is not one size; each network is
very, very different. Ofgem have tried to normalise the costs
in order to try and take away that situation but in making companies
catch up to a so-called, specific upper quartile performance level
it is suggesting that they have now got it right, that that is
that upper quartile performance level that everybody should be
attaining. I think, although it is likely to upset the colleagues
behind me, if you look at what water are doing, they acknowledge
much more that this is a fairly inexact science and so they are
saying you only have to catch up a certain amount and if you can
out-perform it, fine, because customers will get their money back
in five years' time. What Ofgem are doing is almost implying they
have got this right; therefore you have got to achieve this level
of performance and then improve faster than the rest of the economy.
I believe that whilst it is a difficult approach to take, they
have, perhaps, given far too much weight to the numbers that have
come out of the econometric model.
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