Select Committee on Public Accounts Fourth Report

2  Setting the price for the gas networks

17. Ofgem sets price controls for the gas distribution sector. Ofgem sets a price cap for a period of five years, based on targets for efficiency savings that gas distributors should achieve. This limits the price that companies may charge their customers. Setting challenging, but realistic, price controls lies at the heart of Ofgem's duties and is their primary opportunity for delivering customer benefits.[20]

18. Companies that exceed their efficiency targets are able to retain the savings, and thus earn higher profits, until the next price control. Companies are thus incentivised to outperform each other, thereby creating the advantages of competition.[21] At the next price control, the regulator can use this performance information to re-adjust efficiency targets, and pass the benefits through to consumers in lower prices.

How the sales offer the potential for consumer benefits

19. Ofgem believes that consumers will benefit from its ability to compare the costs and operational performance of four independent network owners. Before June 2005 Ofgem could make only internal comparisons of National Grid's costs and business plans.[22] The ability to make comparisons enables the regulator to generate better information to set more challenging targets at the price control. And the introduction of new management teams also increases the potential for efficiency savings through greater industry innovation and the transfer of best practice.[23]

Ofgem's assessment of potential consumer benefits

20. Ofgem calculated that the existence of four independently-owned operators offered the potential to achieve a 1.13% per annum reduction in the operating expenditure between 2008 and 2023.[24] This represented cumulative benefits for consumers totalling £325 million over the whole 15 year period.

21. The benefits of comparative regulation have been evident in the electricity sector. Following the break up of the electricity industry, Ofgem was able to compare the performance of the 12 electricity companies to secure 7.7% annual cost reductions between 1992 and 2003.[25] Ofgem expects to see the benefits materialise in the gas distribution sector but was cautious in its extrapolation of potential savings as there are fewer gas network owners.[26]

22. Before the sales, Ofgem regulated National Grid as the monopoly owner and operator of the gas networks, but with no independent source of information to benchmark efficiency. Ofgem sought to address these difficulties at the 2002 price control when it required National Grid to provide performance information on its regional networks.[27]

23. Even without the sales, Ofgem could have set stretching efficiency targets. It concluded that the existence of regional comparators would have enabled a 3% annual reduction in operating expenditure between 2008 and 2023.[28] Over 15 years, this represents a cumulative potential efficiency saving of £830 million.

Figure 2: Ofgem's estimate of additional benefits from the sales and NAO analysis of additional benefits available
Potential value SourceWhen deliverable? Information
Ofgem's estimate of additional benefits from the sales 1.13% improvement per year, totalling

£325 million

Separate ownership of the gas distribution networks following the sales 80% of benefits from 2013 Ofgem is collecting new information from the network owners to analyse performance
NAO analysis of additional benefits available 3% improvement per year, totalling

£830 million

Potential efficiency savings regardless of sales Deliverable from next price control review in 2008 Information should already be available

Source: NAO

When consumer benefits are expected

24. Ofgem does not expect gas companies to achieve cost savings evenly between 2008 and 2023. 80% of savings are expected to come after 2013, with the highest level of savings in the second price control period between 2013 and 2018.[29] Ofgem considers 2013 to be the crucial price review as it will then have five years of information from the companies, thus enabling more detailed comparisons and analysis of time-series data. The timing of potential savings has a significant impact on the consumer benefits calculation; the sooner gains occur, the higher the present value of consumer benefits.[30]

25. Ofgem's last gas distribution price review took place in 2002 and was due to run until 2007. In response to the sales, it decided to extend this until 2008 and then start rolling five year reviews. A one year deferral will enable Ofgem to take into account the first full year of data from the new network owners. It also allows Ofgem to prioritise its workload by staggering price control reviews in different parts of the energy market.[31]

26. Deferring the price control has a potential benefit for National Grid and the new owners if they outperform the efficiency targets set at the last price control, and thus achieve higher profits for a year. As a result, consumer benefits may be delayed, or lost. But, conversely, deferring the price control has risks for the owners. In particular, there is continued uncertainty over Ofgem's treatment of issues such as capital overspend and the leakage of gas.[32] Ofgem did not, however, evaluate the costs and benefits of deferring the price control review for the network owners, nor did it quantify the impact for the consumer.

27. Ofgem will put in place an interim price control for the year 2007-08. This will not be a full scale review but will involve a thorough cost analysis. If companies have driven costs down further than originally expected, Ofgem will take this into account and set lower prices for 2007-08. The full review will consider whether targets have been too generous and, as necessary, adjustments to targets will be made at the full review in 2008.[33]

The uncertainty of consumer benefits

28. The benefits of the sales come from reduced costs for gas distribution. These reductions should be reflected in lower prices to companies that retail gas. The retailers in turn may pass on the reductions to households and companies, as end consumers. Making sure that benefits are realised through this complex chain depends on several factors:[34]

  • the practicality of achieving the cost reductions. At present, Ofgem's estimates are based on high-level assumptions, as opposed to a detailed understanding of the operational areas where potential efficiencies may lie; and
  • competitive conditions in the energy market. In a competitive market, any reduction in the cost of gas distribution should be passed quickly from gas retailers to gas consumers. In future, however, a highly concentrated retail gas market, with economic barriers to entry, may mean that lower gas distribution costs are simply reflected in higher margins for incumbent gas retailers, and not passed on to consumers.

Ofgem's role in delivering consumer benefits

29. Ofgem cannot, itself, deliver the consumer benefits but must create a robust regulatory framework that provides incentives to encourage innovative and efficient behaviour. Ofgem has begun to collect data on the performance of the network owners. The availability of existing data should also help Ofgem to set challenging targets at the next price review in 2008 and deliver customer benefits as early as possible.[35]

20   Q 1 Back

21   Qq 8, 58 Back

22   Q 5; C&AG's Report, para 3.6 Back

23   Ev 18-19 Back

24   C&AG's Report, para 3.8 Back

25   Qq 4, 19 Back

26   Qq 54-55 Back

27   Qq 57, 90 Back

28   C&AG's Report, para 3.17; Qq 60-63 Back

29   Q 7 Back

30   C&AG's Report, paras 3.14-3.15 Back

31   Q65; Ev 18-19 Back

32   Qq 69-71 Back

33   Q 21; Ev 18-19 Back

34   C&AG's Report, para 4.2 Back

35   C&AG's Report, para 11 Back

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Prepared 11 January 2007