Examination of Witnesses (Questions 40-59)|
MONDAY 8 MAY
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 thisand you always learn
things from these reviews, that is what they are here for, to
help usis 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
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
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
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
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
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
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
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.