House of Commons - Public Accounts

Select Committee on Public Accounts Fourth Report

1 Ofgem's approval process for the sales

1. Gas suppliers purchase gas from producers and sell it on to consumers. The gas is physically transported across Great Britain by gas distribution pipelines.[2] Until June 2005, these gas distribution pipelines were owned by one national company, National Grid plc.

2. On 1 June 2005, National Grid sold four of its eight regional networks for distributing gas for £5.8 billion (Figure 1). The new network owners now distribute gas to about 10 million customers, while National Grid continues to serve 11 million customers.[3].

Figure 1: Ownership of the gas distribution networks in Great Britain from 1 June 2005

Source: NAO

3. The gas market is regulated by the Office of Gas and Electricity Markets (Ofgem), whose primary statutory duty is to protect the interests of consumers, wherever appropriate by promoting effective competition. Its secondary duties include promoting the efficient use of gas and ensuring that gas licence holders are able to finance their activities.[4]

4. Since 2003, average domestic bills have increased by around 40% to £550 a year. This includes around £80 a year, about one sixth of the average gas bill, to cover the costs of gas distribution.[5]

Ofgem's role

5. National Grid needed the approval of Ofgem to dispose of the four regional gas networks. Ofgem originally intended to use the opportunity to maximise consumer benefits. But following legal advice on its role in respect of the transfer of assets under a licence condition, it decided to approve the sales provided there was no net detriment to consumers. The advice was specific to the unique circumstances of this deal.[6].

6. This was a challenging project for Ofgem. The sales have led to the most significant restructuring of the gas industry since British Gas split itself into two companies in the 1990s, and involved sensitive commercial negotiations between National Grid and the buyers.[7] Ofgem's tasks were to evaluate the impact for consumers; develop new commercial and operational arrangements; and address future risks. Ofgem spent £2.5 million on this work in 2004-05, making this its second largest project.[8].

Resources

7. Ofgem had plenty of advance warning about the sale. National Grid first approached Ofgem about the proposed sales in January 2003, five months before the formal announcement. Ofgem was able to complete all of its tasks in time for the sales to proceed in June 2005.[9].

8. There are, however, lessons to be learned. The project team did not have sufficient staff with the necessary skills and experience. Ofgem believes it is properly staffed for its normal business but not for one-off projects, including commercial transactions which require specialist expertise in corporate finance.[10].

9. To compensate for the lack of in-house resources, Ofgem made extensive use of consultants. PA Consulting was appointed after competitive tender on a contract worth £187,000. Costs rose to £1.3 million as Ofgem extended the contract, without re-tendering, to ensure the timely delivery of its tasks.[11] Overall, however, Ofgem has reduced its operating costs over the last three years, with consultancy expenditure falling from £8 million to £6 million.[12]

10. To meet its statutory responsibilities, Ofgem needs to recruit and retain skilled staff. It is currently running 10% below its staff complement and has faced difficulties in recruiting senior management staff. Ofgem operates within the Whitehall pay structure whereas other regulators, such as Ofcom and the Financial Services Authority, have more discretion to determine their own pay structures.[13] Ofgem's more limited discretion reflects its status as a non-ministerial government department, whereas Ofcom and the Financial Services Authority are statutory corporations.

Project management

11. Ofgem's project plan identified four key tasks that needed to be resolved before it could approve the sales, including the introduction of new commercial and operational arrangements to support the multi-ownership of the networks.[14] These tasks were successfully completed. But Ofgem made the sale process more complex than necessary. It initially regarded reform of the arrangements for allocating gas capacity on the transmission system as a pre-requisite for the sale but, in January 2005, decided to defer implementation until 2007.[15]

12. The complexity of the issues led to a heavy burden of consultation for the industry. Ofgem issued 13 consultations in a 16 month period, including four in two months in the summer of 2004. Companies acknowledged the efforts made by Ofgem to consult, but were stretched to respond in the timescales allowed.[16]

13. Nevertheless, Ofgem's work was welcomed by most participants in the industry, who felt it had a good grasp of operational issues. But its planning could have been improved in two ways. First, the project timetable could have been made clearer to the industry. Second, it did not identify all the relevant tasks at the outset. This meant that some work, such as the licence changes, could have been started earlier and the need to grant exemptions from the Gas Act was overlooked. There were also unexpected additions for the sale participants. For example, a letter of comfort was requested in the week before sale completion.[17]

Analysis of consumer benefits

14. Ofgem analysed whether the sales would benefit consumers, in order to inform its decision to approve the sales. It saw the main benefit as coming from its ability to compare the efficiency of several similar companies. It therefore estimated efficiency gains that would arise from having such comparators.

15. These estimates were based on a cost-benefit analysis which, in most respects, complied with Treasury's Green Book. Ofgem conducted sensitivity analysis to evaluate the effect of different numbers of comparators and the timing of benefits. It produced a range of results under different assumptions, including a potential loss to consumers of £63 million, but it did not consider the likelihood of each result. So it was unable to estimate whether the loss of £63 million was highly unlikely or not.[18]

16. The price paid by the purchasers represented a 14% premium on the estimated regulatory asset value at the time of the sale. Purchasers can be expected to pay a premium in acquisitions which, in this case, was in line with other disposals in the regulated utility sectors in the UK. Ofgem did not believe that the price paid for the assets or the sale premiums raised any regulatory implications. Its decision to approve the sales was based solely on its assessment of the impact of the sales on consumers, not on the purchasers of National Grid as seller.[19]



© Parliamentary copyright 2007	Prepared 11 January 2007