Select Committee on Public Accounts Minutes of Evidence


Examination of Witnesses (Questions 40-59)

OFFICE OF GAS AND ELECTRICITY MARKETS

MONDAY 8 MAY 2006

  Q40  Greg Clark: But you did not take a view. So you relied on shippers presenting their views.

  Mr Buchanan: No, we looked at their consultants' Reports. Quite clearly they hired leading consultants and we took that into consideration at the authority when coming to our conclusion as to whether there was no net detriment to consumers on this deal.

  Q41  Greg Clark: Can you turn to page 23 of the Report and look at paragraph 3.16? It says "To take account of the risk posed by uncertain outcomes, the Treasury Green Book recommends calculating the `expected value' of risks. This is a technique which can reflect all known risks by multiplying the likelihood of a risk occurring by the size of the outcome in monetary terms". Ofgem could have used this technique. Why did you not follow the Treasury Green Book?

  Mr Buchanan: By and large we did. If you look at paragraph 3.5, it says that—

  Q42  Greg Clark: On my specific point. Why on this point did you not follow the Green Book?

  Mr Buchanan: If I could take you to the Green Book, reference 3.5, in many respects Ofgem's cost-benefit analysis followed the Treasury's Green Book.

  Q43  Greg Clark: In many respects, but in this respect it did not.

  Mr Buchanan: One of the learning points that we have taken from this—and you always learn things from these reviews, that is what they are here for, to help us—is that we can take that away and be alive to the fact that we did not use this particular sensitivity analysis. If I refer you on to page—

  Q44  Greg Clark: Do I infer from that that you should have used the Green Book? Is that what you are accepting?

  Mr Buchanan: We felt that we used a wide range of sensitivity analyses which the NAO have reviewed on page 38—

  Q45  Greg Clark: Sorry, you just said that there was some learning to be taken from this. I just want to clarify this. Are you saying that the NAO brought to your attention that there was some advice in the Green Book that you should attach probability to different scenarios and weigh them up? You did not do that. Should you have done it?

  Mr Buchanan: We did use a degree of probability analysis in the other sensitivity work which we did, which was thoroughly audited and is outlined on page 38. Are we as an institution big enough to take a recommendation? Yes, we are. Paragraph 3.16 is clearly a recommendation to us for something that we should have a look at and we have taken that on board.

  Q46  Greg Clark: Are you not required to follow the Green Book?

  Mr Buchanan: By and large. As I said, paragraph 3.5 suggested that we were following the Green Book.

  Q47  Greg Clark: It is odd that the Treasury Green Book can be followed "by and large". Either you follow it or you do not.

  Ms Diggle: The Green Book is meant to be guidance on best practice. In any particular scenario it is for the people using it to make a judgment on how best to use it. There are lots of choices in it and if the accounting officer feels that some way of handling it is actually best in those circumstances, it is for him or her to make that judgment.

  Q48  Greg Clark: Very helpful. So it was a considered judgment that you thought it best not to attach probabilities to these scenarios.

  Mr Buchanan: Indeed.

  Mr Gray: We need to distinguish between two types of risk. We did look at this question of risks and what could go wrong. The risk of when the savings are delivered is one that is to some extent in our control because it is delivered through price control reviews, which is what we do. There were other risks which went outside our control and, for instance, one of those was the number of companies that would be sold and therefore the number of comparators we had. In that case we looked very specifically at what the impact would be of having four comparators or fewer.

  Q49  Greg Clark: We are digressing from the subject. There is clearly a scenario in which the consumer is going to lose money.

  Mr Gray: No, I am saying that in the areas where we could identify a specific risk, such as "What if they sell only three companies rather than four" or "only one company rather than four", we looked at those specific risks quite accurately.

  Q50  Greg Clark: We are talking at cross-purposes. The NAO have identified the risk that the consumer is going to lose money and you made no assessment of what probability that is. Can we move on to a different subject? You did consider the possibility of a constant rate of improvement between 2008 and 2023, but, following discussions with the industry, you decided that savings would not be linear and they would come later on. In other words, the industry persuaded you that the savings would come between 2008 and 2013, but the costs of course are immediate, are they not, or forward looking? Is it not the case that the industry has suckered you into a soft settlement with that first period and the much more valuable period is later and of course time value of money means that that is much less valuable to the industry?

  Mr Buchanan: If the industry thinks there is a settlement and thinks it has suckered us, then more fool it. I have the distinction or otherwise of having followed this industry since 1988 and therefore when I look at what happened in the electricity industry through the 1990s, by obtaining the data and by providing that five-year period of active competition amongst the companies, 1990 to 1995, the regulator was able to insert a one-off cut of basically 25% in 1995. The companies then were thoroughly competitive. I can give you individual examples.

  Q51  Greg Clark: How many companies were there in the electricity industry?

  Mr Buchanan: There were 12 in the electricity industry in England and Wales.

  Q52  Greg Clark: How many are there going to be in this industry?

  Mr Buchanan: There are eight DNs.

  Q53  Greg Clark: What happens if they are not operated as separate businesses, as is entirely possible?

  Mr Buchanan: What is interesting is that at the last electricity price review we basically had seven/eight management groups owning the electricity companies, but we did the price review of the individual units.

  Q54  Greg Clark: The consultants that the NAO brought in looked at this and were concerned at the small number of comparators even through this. So you are basing your assessment on what happened in these other industries but the NAO point out on page 45 that there are only eight DNs compared with 14 DNOs and 22 water companies. This number could be reduced further to only four, so there is a risk there, is there not, that the 95% of the gains that you expect to come from comparative competition have nowhere near the number of comparators that these other industries have? Is that a risk which you have modelled?

  Mr Gray: We start from a position in this particular sector where we have no comparators; at least we only have one. Therefore what we have been having in the past is a one-to-one dialogue with somebody where we could not prove our case.

  Q55  Greg Clark: Clearly if you are basing your estimates, your projections, on what happened in other industries when you have many fewer comparators than those other industries, that is a risk.

  Mr Gray: Yes indeed.

  Q56  Greg Clark: I am wondering whether you modelled the likelihood of that compromising your ability to deliver.

  Mr Gray: That is one of the reasons why we were quite cautious in extrapolating directly from the other sectors to this one in looking at the test of whether we can be confident that there will not be a detriment to the consumer.

  Q57  Kitty Ussher: You said that the reason why you thought these sales were in the interests of consumers was that 95% of the benefit for the consumer mainly came from having comparators, as we have just heard. Yet you also said that you had already effectively been looking at the regional business units for the purpose of your regulatory activities in the last price review in 2004, so in effect you already had comparators. Is that not true?

  Mr Buchanan: In the electricity industry, that is right that was the price review in 2004. However, for the gas industry this will be the first time that we are effectively doing a clean review of the regional gas companies. The last gas review was in 2002, which was done as a job lot with the national Transco gas transmission business.

  Mr Gray: We have since then, and had anyway, taken steps to separate the price control into individual price controls for the eight regions, so you are right in the sense that we could have looked at a comparative assessment between the eight DNs all still owned by Transco. The important learning point that we have from the last 15 years frankly is that it is different management rather than simply a different licence that gives you the information. You could achieve a certain amount by comparing DNs when they are all owned by National Grid, but frankly they are all going to adopt the same policy they are going to adopt national approaches to how they do certain types of job. The value comes from having new management who will do things differently, will demonstrate to us what can be done so that we can then impose that best practice on the other companies and four comparators is a lot better than one in that sense.

  Q58  Kitty Ussher: They may all have the same top management, but it is standard practice within organisations to break it down into business units precisely to have, internally for their own purposes, those types of comparators. So I am sure the fact that it is all the same company means that each regional organisation would have been identically efficient in fact, quite the opposite.

  Mr Gray: No, but equally there is no incentive on one of those regions to demonstrate to us best practice. If they are better than the other components of the same group, the pressure is going to be on them not to make that obvious to us, whereas an independently-managed and independently-owned distribution business can get some financial benefit out of demonstrating to us that things can be done better, because we allow them to keep the savings until the next price control review, at which point we then reset everybody's allowance on the basis of that new evidence and pass the benefits through to customers. It is having different management groups which can see some commercial advantage in outperforming each other. What we are trying to do in a regulated sector is get the advantages of competition in a sector which is intrinsically not competitive. You find that you can make them compete really quite effectively with these incentives for cost savings.

  Q59  Kitty Ussher: I am sure it would be easier for you if they were separate companies, which is indeed why you have supported the sale, but the point that I am trying to probe is that you may get quite a lot of that advantage by regulating in a different way a larger group broken down into business units. Indeed, if you turn to page seven, paragraph 16 "Ofgem believes that the separation of National Grid's gas distribution price control into eight regional controls in 2004 was an essential first step in the process of setting future price controls which will deliver larger savings for the consumers". That makes it quite clear that by regulating the business units, as opposed to the entire company, you believe that you could get substantial benefits for consumers.

  Mr Gray: We believe that could improve what we could do by having separate price controls within the same ownership. We think we can improve it a lot further by the evidence that will come from separate ownership, as well as separate price controls in the same ownership.


 
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