House of Commons - Trade and Industry

Select Committee on Trade and Industry First Report

8 Capital expenditure

80. One of our main conclusions following our inquiry into national network resilience was that "a faster rate of replacement of capital assets is called for" and that "there needs to be a significant rise in investment to achieve this".[107] We had been interested to explore how the regulator decided the rate of capital investment necessary to maintain the performance of the network. Ofgem explained to us that it was dependent on the information supplied by the companies themselves to assess the condition and investment needs of the electricity network, but, because there were 14 distribution companies, Ofgem was able to make comparisons between them and determine a benchmark for their performance.[108] Ofgem told us that it also employed external consultants to assess the information supplied by companies and to advise on a range of specialist issues.[109] For this price control review, Ofgem has employed the consultants PB Power to assess each company's capital expenditure needs, and Ernst & Young to comment on aspects of the DNOs' operating practices.[110] Both the companies themselves and the consultants were asked to base their calculations on the assumption that current network performance was to be maintained.

81. The assumptions and models used by PB Power are described in Ofgem's June proposals.[111] For our purposes, it is enough to say that PB Power's initial findings differed significantly from the companies' forecasts.[112] PB Power subsequently held meetings with each company in August 2004 to discuss its findings, and made some changes to its conclusions as a result. Ofgem also undertook some complex work on a more flexible approach to capital expenditure that would not, however, disadvantage companies that had provided "more reasonable forecasts."[113] Ofgem described this more flexible approach as "sliding scale incentives on capex" to bridge the gap between PB Power's and the companies' views of what was required. Ofgem told us that the sliding scale mechanism was designed to allow companies some scope for increasing capital expenditure while not providing incentives to them to over-invest, and therefore increase the value of their assets unnecessarily and at the expense of customers. Equally importantly, from our point of view, Ofgem said that the mechanism was also designed to discourage under-investment.[114] In its September document, Ofgem reported: "Most companies supported the sliding scale mechanism in concept but have continued to argue for higher base capital expenditure allowances plus the sliding scale capex allowance on top."[115]

82. The net result of these adjustments was that Ofgem's September proposals for capital expenditure allowances were higher than its initial ones, but it still proposed to allow significantly less capital expenditure than the industry had forecasted that it would need. Moreover, although some individual companies would be allowed more than their forecast, others would be allowed significantly less. The details are given in the table below.

TABLE 1: Ofgem's proposed capital expenditure allowances for each of the DNOs[116]

DNO Actual/ forecast capital expenditure for 2000-05 Adjusted Company forecast expenditure for 2005-10 Percentage increase/ (decrease) over 2000-05 expenditure Ofgem's proposed allowance for 2005-10 (excluding Quality of Service) Difference between company and Ofgem
Ofgem's allowance as percent of company forecast Total allowance (including Quality of Service)

£m £m £m £m £m

CN-Midlands 336 485 44% 477 -8 98% 501

CN-East Midlands 301 480 60% 476 -4 99% 485

United Utilities 347 457 32% 466 9 102% 466

CE-NEDL 228 268 18% 277 9 103% 277

CE-YEDL 242 358 48% 367 8 102% 371

WPD South West 221 269 22% 283 13 105% 283

WPD South Wales 191 171 -11% 179 8 105% 186

EDF-LPN 260 536* 106% 452* -84 84% 452

EDF-SPN 283 479* 69% 466* -13 95% 487

EDF-EPN 438 745* 70% 674* -71 91% 697

Scottish Power 253 375* 48% 361* -14 96% 361

SP Manweb 240 455* 90% 404* -51 89% 404

SSE-Hydro 165 208 26% 204 -5 98% 204

SSE-Southern 375 511 36% 536 25 105% 561

Total 3,882 5,798 49% 5,623 -175 97% 5734

Increase on 2000-05 49% 45% 48%

* These figures have changed significantly from those published in Ofgem's September proposals. As far as company forecasts are concerned, in September EDF-LPN's figure was £543 million, EDF-SPN's was £489 million, EDF-EPN's was £856 million, Scottish Power's £395 million and SP Manweb's £465 million. Ofgem's proposed allowance, excluding Quality of Service allowances, was then: for EDF-LPN £454 million, for EDF-SPN £468 million, for EDF-EPN £701 million, for Scottish Power £367 million, and for SP Manweb £406 million. As a result, the percentage figures and the calculation of the difference between the company's and Ofgem's figures have also changed for these companies, as have the overall totals. The most significant of these alterations are discussed in paragraph 84 below.

83. Ofgem emphasised that, for many companies, capital expenditure allowances were equal to or above what the companies had sought. The exceptions were the three EDF companies and the two Scottish Power companies.[117]For the EDF companies, not only were the proposed capital allowances overall much lower than they had requested, but also, under the September calculations, they were the only companies that would suffer a penalty for extra expenditure under Ofgem's sliding scale mechanism.[118]

84. A comparison with Ofgem's September document shows significant changes to company forecasts between September and the final proposals in November, with smaller adjustments to Ofgem's proposed capex allowance excluding Quality of Service. The companies which have made adjustments are the three EDF companies and the two Scottish Power companies. Ofgem noted that, following discussions on the capital allowances and the operation of the sliding scale mechanism, "some DNOs have suggested that the inclusion of certain items of expenditure in their base case forecasts was inappropriate and have requested that these items should be removed from their forecasts."[119] Ofgem agreed to these requests, which have had the overall effect of decreasing the total allowance proposed by Ofgem from £5661 million (September proposals) to £5623 million (November proposals), and the increase on 2000-05 actual/forecast out-turn from 46 percent to 45 percent. They have also had the effect for the EDF companies of eliminating the penalty for extra expenditure under Ofgem's sliding scale mechanism. The November proposals would give the EDF companies a very small incentive for such expenditure.[120]

85. Ofgem was understandably reluctant to comment on the situation of individual companies before the publication of its final determination on 29 November, but we felt that we had to explore the reasons why the EDF companies appeared to be so much out of line with the other DNOs. In oral evidence, Ofgem said that it was quite difficult to pin down exactly why its and the companies' estimates differed so widely; but in its September proposals Ofgem commented: "In part, this may reflect the timing of EDF's investment—having been relatively low in the [2000-05 period] to date for EDF-LPN and EDF-EPN in particular".[121] Ofgem believed that the company should not be rewarded for this earlier low rate of investment and "consumers should not pay twice for investment".[122] Ofgem explained this statement as follows: EDF (and its predecessor companies) had been allowed by the regulator a certain level of revenue from consumers on the basis that, among other things, they would incur a certain amount of capital expenditure. In practice, however, these companies underspent their capital allowance between 2005-10, with shareholders benefiting accordingly. If Ofgem now allowed the companies higher revenue to catch up with the investment that ought to have been made in 2000-05 as well as dealing with the investment for 2005-10, to some extent consumers would have paid twice for the same pieces of equipment—once before 2005, when it was not installed, and once after 2005, when presumably it would be. Ofgem told us that it was for the shareholders, not the customers, of EDF to pay for any extra investment needed to make up for earlier under-investment.[123] Furthermore, Ofgem argued, even these companies would be able to incur significantly higher capital expenditure in the 2005-10 price control period than they had in practice made in the current one: "For EDF, the proposed allowances are 67 percent higher than they will have spent (on a comparable basis) in 2000-05. For SP, the proposed allowances are 55 percent higher than they will have spent in 2000-05."[124] Ofgem commented: "These are very substantial increases."[125]

86. Although we agree with the principle that shareholders should not benefit from previous low levels of investment at the expense of customers, we would be very uneasy if applying this principle meant that the company would be hindered from making the capital investment necessary to provide its customers with as reliable an electricity supply as comparable customers elsewhere expect and receive. At the worst, there would be potential for a vicious circle of under-investment followed by penalties for failing Quality of Service targets, which would leave even less money for necessary capital investment. However, we have received no evidence that the customers of the companies concerned on this occasion would suffer as a result of Ofgem's proposals; and we note that the proposed allowances would enable these companies to invest more than they have done in the recent past. We take even more comfort from the inference that Ofgem intends in future to deter any similar under-investment by companies by means of the sliding scale mechanism. Both for the sake of the customers and for the promotion of efficiency of the electricity industry, we would much prefer that under-investment be prevented rather than punished.

87. The Energy Networks Association was not as sanguine as Ofgem about future investment in the infrastructure by DNOs. It agreed that Ofgem had largely accepted the companies' bids for capital expenditure to maintain current network performance; but said that Ofgem had rejected the companies' proposals for investment to improve network performance — whether to increase resilience against severe weather conditions, or to improve quality of service, or for improving the environment by, for example, putting powerlines underground in National Parks and other sensitive areas.[126] The ENA also commented that companies had different approaches to the task of maintaining the resilience of the network: some preferred to increase maintenance levels for ageing equipment, while others sought to replace it, and in the latter case they did not want simply to replace like for like but preferred to install more modern, efficient and, in many cases, reliable equipment. The ENA argued that it was this sort of upgrading, which was particularly designed to increase resilience against severe weather conditions, that would be discouraged by the capital allowances proposed by Ofgem in its September document.[127]

88. Ofgem dismissed the proposals for extra capital expenditure to upgrade the network rather cursorily. A short section of the September document dealt with suggestions by DNOs that they should be allowed additional expenditure to improve network resilience or performance for the worst-served customers. Ofgem responded:

"For many of the projects or programmes of work proposed [to this end], expenditures of over £1,000 per affected customer (incurring financing costs of hundreds of pounds per year per affected customer) would be necessary to deliver significant benefits. This would raise issues of the extent of cross-subsidy. The schemes that are cheapest per customer tend to deliver relatively little benefit or, in some cases, the benefits have not been quantified by the companies concerned."[128]

Ofgem argued that the most important single action to improve network resilience was vegetation management, and, as we have noted above,[129] that it had made additional allowances for this in the proposals for 2005-10. The regulator concluded:

130

89. We asked Ofgem, first, what assumption it was making of the cost of capital that led it to the conclusion that expenditure of over £1,000 per affected customer would incur financing costs of several hundred pounds a year per customer; and, secondly, whether the regulator had in mind any cut-off point for cost per customer in assessing whether extra expenditure would be cost-effective. Ofgem's response to the first question was that its calculation of financing costs included not only interest and other charges but also tax, and depreciation.[131] In response to the second question, Mr Martin Crouch[132] said that the determination of cost effectiveness was for the DNOs themselves to make: Ofgem had no view on this.[133]

90. These responses are a little disingenuous. While we acknowledge that companies will be able to choose which particular projects will give the greatest benefits—and that it is always open to them to finance projects at the expense of the shareholders rather than the customers—the regulator does, and must, make a judgement on what companies need to do in order to decide how much money they need to do it.[134] By refusing to make specific allowance for improvements to the network, Ofgem is, in effect, deciding that such improvements are not necessary from the customers' point of view: they are something which can be left to the discretion of individual DNOs.

91. Also, although we recognise that the regulator has to take into account depreciation when calculating capital costs, from the point of view of the customer this is simply an accounting mechanism. The charges that would be passed on to customers in their bills would amount to significantly less than several hundred pounds per year per affected customer. Moreover, as these costs would be spread over the whole customer base of the DNOs concerned, as such capital costs would be a relatively small proportion of DNO charges to customers as a whole, and as the cost of electricity distribution forms about 25 percent of domestic electricity bills, the actual increase in individual customers' bills would probably amount to at most a few pounds per year.

92. One area where Ofgem has significantly shifted its position is the question of investment in infrastructure for environmental reasons. In March, Ofgem announced that it was reviewing information provided by the DNOs on the cost of putting powerlines underground in National Parks and Areas of Outstanding Natural Beauty. It was also seeking consumer views via the survey described above.

93. Although this issue was not considered to be a very high priority, the respondents to both Ofgem's consultation and the consumer survey were generally in favour of providing companies with incentives to put cables underground for amenity reasons, and the consumer survey indicated a willingness to pay a little extra for this: for each percent of the network 'undergrounded' per year, customers were willing to pay about £2.50 per year or 0.7 percent of the total bill.[135] Despite this, in its June proposals, Ofgem refused to make an allowance for the cost of such undergrounding because: "Ofgem does not consider that it is the appropriate body to make such decisions". The reasons why Ofgem reached this rather startling conclusion may be summarised as:

— improving visual amenity would benefit everyone who visited the area, so the local DNO's customers would be paying for work that would mainly benefit other people;

— in practice, the amount of undergrounding that Ofgem could allow for would be relatively small, given that the total cost of undergrounding all lines in National Parks and Areas of Outstanding Natural Beauty has been estimated as about £6.9 billion; and

— the Social and Environmental Guidance issued to Ofgem by the Government explicitly stated that any environmental measure which would have a significant financial implication would be primarily implemented by Ministers rather than Ofgem.[136]

94. We are pleased to note that Ofgem has changed its views on whether it is appropriate for the regulator to make an allowance for investment to improve visual amenity.[137] It now proposes a modest, but reasonable, extra allowance with expenditure capped at a level sufficient to allow undergrounding of 1.5 percent of the network in National Parks and Areas of Outstanding Natural Beauty at an average cost of £100,000 per km. The allowance would be subject to DNOs' demonstrating that the expenditure was made within these areas, was additional to normal expenditure on infrastructure replacement, and that they had consulted local environmental groups and/or planning authorities on how best to prioritise this investment.[138]

95. In March we stated our belief that customers would be prepared to spend a modest amount extra to obtain a better network and more reliable electricity supplies, and we are confirmed in that view by the research subsequently undertaken into consumer preferences, which we discussed earlier. However, while we are sympathetic to the companies' arguments for being allowed to undertake capital investment to increase the resilience of the network, we understand that — not least in view of previous under-investment by some companies — Ofgem is inclined to proceed cautiously and wishes to see a robust case for such extra investment.[139] We cannot say that Ofgem is wrong in its approach, but we emphasise that Ofgem should keep an open mind about the need for further investment in the infrastructure if it wishes to increase Quality of Service standards.

96. Overall, we welcome the fact that, in its proposals for capital allowances, Ofgem has clearly acknowledged that extra investment to replace infrastructure is needed. The regulator may not have gone as far as we wished, but a gradual approach is justifiable. We simply reiterate our view that, just to enable ageing equipment to be replaced, investment in the electricity infrastructure will have to be significantly higher than in recent years and over an extended period, probably about 20 years. We urge Ofgem to view this five-year review as the opening of a long-term project to ensure the resilience of the UK electricity network.

107 Third Report, paragraph 80 Back

108 We note that Ofgem itself recognises that benchmarking is becoming increasingly difficult as mergers within the industry are reducing the number of comparators: September proposals, para 4.48 Back

109 Third Report, Paragraph 36, Qq 2 and 9 (Part 2) Back

110 September proposals, para 1.2 Back

111 Paras 6.71-6.77 Back

112 June proposals, Table 6.7 Back

113 September proposals, para 4.63 Back

114 Q 7 (Part 2). The ENA admitted that there has been under-investment in the past: Q 26 (Part 2) Back

115 September proposals, para 4.64; see also Q 25 (Part 2) (ENA) Back

116 This Table is based on 'Table 7.5: Comparison of capex allowance to forecast total 2005-10 (£m, 2002/03 prices the percentage increase)' in the November proposals, with the addition of our calculation of the percentage increase over 2000-05 expenditure, and the percentage increase over the revised company forecasts. Back

117 September proposals, para 4.66 Back

118 Ibid., para 4.70 Back