Select Committee on Public Accounts Minutes of Evidence


Examination of Witnesses (Questions 1-19)

OFFICE OF GAS AND ELECTRICITY MARKETS

MONDAY 8 MAY 2006

  Q1 Chairman: Good afternoon and welcome to the Committee of Public Accounts where today we are looking at the Comptroller and Auditor General's Report Sale of gas networks by National Grid. We welcome Mr Alistair Buchanan, who is the Chief Executive of Ofgem, and Mr David Gray, who is the Managing Director of Networks you are both very welcome. If you look at the summary of this Report, particularly paragraph 12, page six, I was intrigued by what it says here "Ofgem clarified its role during the sales. In March 2004, Ofgem decided that it would recommend the approval of sales if they did not result in a net detriment to customers. This stance was consistent with legal advice obtained by Ofgem on the scope of its statutory objective to protect the consumer interest, but differed from an earlier commitment to maximise consumer benefits". Why did you embark on this project apparently without knowing whether you needed to maximise benefits for consumers?

  Mr Buchanan: I should like to address two issues here. The first is our responsibility under Section 3 of the Utilities Act which is to seek to protect and promote the interests of consumers. That is something that we always do and in the regulated business our opportunity primarily to do that is at the five-year price review situations, whereas clearly in markets we have a monitoring of markets role. With that comment about the importance of the consumer to us, may I move on to this deal? This deal was fairly unique and it is covered extremely well on page 37 in paragraphs two and three. It is outlined in those paragraphs that this is a commercial transaction, a transaction that had a unique transfer of assets under licence condition 29 and it was because of that uniqueness that we took legal advice from a leading QC and that advice was to use a no-net-detriment test. It was on the basis of that that we proceeded on this deal.

  Q2  Chairman: So did this legal advice force you or encourage you to take a narrow view of your responsibilities on other projects as well? How important was this legal advice, which is mentioned in this paragraph and which you have just mentioned as well?

  Mr Buchanan: It is a very good question and we wanted to know that as well. The legal advice is narrow to this deal because it was such a unique situation. As I said, it related to the transfer of assets under a licence condition and that is therefore how we shall treat it going forward.

  Q3  Chairman: If I ask you how you prove yourselves, if you look at paragraph 14 it says there "... in November 2003, Ofgem delayed the sales timetable to ensure sufficient time for full analysis and consultation on the impact of sales on consumers' interests. The industry faced a large burden of consultation and many gas companies were concerned that Ofgem added complexity and costs by unnecessarily including a separate project". Why did you do this? Why did you add delays, complexity and cost to the industry?

  Mr Buchanan: One of the lessons learned that we shall take away from this excellent Report from the NAO is that possibly within the process, and it is in paragraph 2.17, we may have made the process more complex than it should have been. That is a lesson learned and a useful part of the process. However, the delay was important in November 2003 because we had received such strong representations from various parties to the sale to take more time, to analyse the cost-benefit analysis, that we actually effectively put a block on the sale we put in a three/four-month review and the board then looked at that analysis in April. I think that was the right thing to do and indeed whilst I am very keen to pick up some of the criticisms of us in this Report—as mentioned, paragraph 2.17 about perhaps over-engineering it—on the other hand in paragraph 2.11 the NAO very kindly say that we consulted very well. I should not want there in any way to be a suggestion that we did not sound out all the parties through this process. We sought to do that. In fact, David told me last week, when we went back to have a look, we actually did 13 consultations in this process, which is a lot.

  Q4  Chairman: The Report tells us that Ofgem concluded that the potential benefits to customers from the sales were most likely to be £325 million. Does that indicate to the Committee therefore that there was a huge level of inefficiency in this industry?

  Mr Buchanan: The benefit that the electricity industry had had since 1990 was that it was broken up. Basically in England and Wales you had 12 companies and through the price reviews of 1995 and 1999 the regulator effectively took 50% of the income away from the companies they put in cuts of what are called "P-noughts"—one-off price cuts of 50% combined over 1995 and 1999. You did not have that in the gas industry and in fact the gas industry was treated as a job lot. The regional companies and the national transmission company, Transco, were effectively given one price control in 2002. A year later that was broken down into the constituent eight regional companies. Effectively, in gas you got the eight regional companies in 2003, whereas in electricity you had the 12 England and Wales regional companies in 1990. Therefore from 1990 onwards in electricity you had the benefits of comparative regulation. You can clearly see that in figure 12 on page 22 because the electricity industry delivered 7.7% annual cost saving 1992 to 2003 was the timescale used in that analysis.

  Q5  Chairman: So the reason you did not identify this £325 million before was because, in your words, it was viewed as a job lot. Is that right?

  Mr Buchanan: We believe comparative analysis is a substantial benefit to getting more for the consumer and we estimated in this Report that 95% of the benefits will come from comparative analysis.

  Q6  Chairman: It tells us in the Report "The predicted benefits are subject to uncertainty". I am sure that is right and it may be an understatement. "The benefits are forecast over a long time frame, whereas the costs of restructuring are already being incurred by the industry. It is possible, therefore, that the disposals could lead to higher costs before the predicted efficiency savings are passed on to customers. The difficulties faced by Ofgem in securing customer benefits include: the inherent uncertainty of achieving benefits over a period as long as 15 years". So the obvious question to you is: before we get any of this benefit to the public, are we just paying for restructuring?

  Mr Buchanan: The good news is that we have a track record and comparative analysis works over a track record. If I hark back to the answer to your previous question, we have basically seen that track record work from 1993 to 2005 for the electricity companies and what we are saying for the gas companies is that the gun is effectively going to go in 2008 and going to run forward.

  Q7  Chairman: So in that sense this Report is wrong and the customer will not have to wait 15 years for any benefit.

  Mr Buchanan: What the Report has clearly identified is that that 2013 price review is the real crunch price review, because it is at that point that we have captured five years of data, five years of benchmarking and yardstick and comparison between the companies and that is why we estimate that 80% of the benefit comes after 2013, which is exactly what happened in 1995, five years after the electricity companies had been running under comparative analysis. I am going to hand over to David for the detail.

  Mr Gray: There is an important point which is that the costs concerned are those that were being imposed on the other participants in the industry. We took a very firm view early on that, to the extent that there were costs of restructuring that would be felt by National Grid and by the buyers, they should pay those costs and those costs should not in any way be passed through to customers. That was very clear. Our assessment of the costs was based on the question of what sort of systems users of the transportation system would have to invest in, in order to work with the new set-up. It was about £25 million in up front costs and then about £7 million per annum and that gives you, in present value terms, the £100 million we talked about. We took the view that that impact, the £25 million up front, was small enough that it should not put us off allowing the sale, given the substantial nature of the benefits that we saw coming later.

  Q8  Chairman: How can you be sure that these gas companies will pass on the benefits of cost savings to the consumer?

  Mr Buchanan: This is how the five-year price regulatory cycle works. Effectively, the companies compete aggressively amongst each other, we collate that information, we see what we can capture for the consumer and it is at the price review that we shall capture that benefit for the consumer. We are committed to doing that. Sir John Bourn clearly said in his comment about us that it is well done so far, but we have to get everything now, and we fully understand that.

  Q9  Chairman: What if I said to you in summary that, after reading this Report, it is clear that there are so many uncertainties in all this that it is by no means certain that you will be able to pass on any benefits to the hard-pressed gas consumer, in other words us, as opposed to the people running these companies?

  Mr Buchanan: One of the certainties of the energy regulatory regime has been that a track record has now been delivered since 1990 of stable, consistent, tough regulation and I would hope that that would give confidence to those looking at this.

  Q10  Chairman: You would hope?

  Mr Buchanan: I would hope.

  Q11  Chairman: How much has all this restructuring cost?

  Mr Buchanan: I cannot give you an absolute certainty, but what I can say is that the track record we have and the commitment we have to do the best for the consumer and why everybody comes to work at Ofgem is for our fundamental section three responsibility that we shall seek to get the best for consumers.

  Q12  Chairman: Why can you not say "we guarantee"? Why do you use the words "we hope"?

  Mr Buchanan: Largely because, looking forward over a period of 15 years, there may be situations that we could not foresee at the moment. Laws may be passed, changes may occur in the way businesses operate and we would have to take that into consideration.

  Q13  Chairman: How much has this restructuring cost?

  Mr Buchanan: In terms of...?

  Q14  Chairman: How much has it cost to the companies for instance?

  Mr Gray: I do not have an estimate of what the cost was for the companies concerned because we made it entirely clear that they had to pay that, so it comes from their own shareholders' pockets essentially. The costs for other companies in the industry were that £100 million I referred to, and our own costs were the £2.5 million figure that the NAO reported in the Report.

  Q15  Helen Goodman: I wonder whether I could ask you to turn to page 22 and figure 13. This is the one that shows the scope for cost reductions in the gas distribution sector. I was rather concerned to read that you were assuming a £325 million cost saving. Is my understanding correct that you have captured that already in the existing regulatory structure?

  Mr Buchanan: No, that is not right. This is what we believe can be captured.

  Q16  Helen Goodman: Right. But the NAO are saying that in fact another £830 million could be captured.

  Mr Buchanan: Correct.

  Q17  Helen Goodman: Do you dispute the NAO figure, or do you accept it?

  Mr Buchanan: When we look at the NAO figure, the best words for us to use are that it "appears to be a reasonable assumption for the NAO to make". In the light of figure 12 just above it perhaps you can see where the NAO was drawing its information from, but the figure that we focused on in our consultants' review and in our review was the £325 million. I am not disputing the NAO's figure it looks reasonable but we are not committing to that figure.

  Q18  Helen Goodman: It is just that normally the numbers in the NAO Report have been agreed with the department or whoever it is, so I would have expected you to have agreed it.

  Mr Buchanan: It may be my use of the word "reasonable". I am sorry if I am causing trouble there.

  Q19  Helen Goodman: My concern is of course that if, when you come to the next price review, you work on the assumption that the savings achievable are £325 million and you ignore this £830 million, gas consumers are going to be paying over the odds. Do you think there is that risk?

  Mr Buchanan: I would hope very much that the evidence from what we have seen in the electricity sector, as evidenced in figure 12, will be the kind of performance that we shall see unleashed in the gas sector. I fundamentally believe that comparative analysis will ensure that the companies look for their cost saving of 77%, which is the amount that they can go for of their cost base and which is controllable by them. I would hope to see cost savings coming from how they address their working practices, how they address their IT, the transport fleet et cetera. I would be hoping and confident that we could see that.


 
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