Select Committee on Public Accounts Minutes of Evidence


Examination of Witnesses (Questions 60-79)

OFFICE OF GAS AND ELECTRICITY MARKETS

MONDAY 8 MAY 2006

  Q60  Kitty Ussher: Were the savings of £325 million that you quantified additional savings compared with the situation of being able to regulate regionally anyway, which you had just begun to do?

  Mr Gray: Yes, on our best estimate.

  Q61  Kitty Ussher: I do not quite understand why you cannot get the information that you would require out of National Grid if the regional parts were not sold off. Surely you could require those accounts.

  Mr Gray: We could get the information, we can get as much detail as we like off them separately, though there is a question over the regulatory burden you impose by asking for more and more detail. What gives us the incremental benefits and the confidence that we will get incremental benefits, is having different thought processes, different management thought processes applied to the same business, where there has only been one before, so that we can do what a market normally does, which is favour the people with the best approach and the lowest costs and encourage them to carry on pressing for lowest costs.

  Q62  Kitty Ussher: If the £325 million is the additional benefit, even after taking account of the fact that you were going to regulate by regional unit anyway, what is the same sum for the calculation you made a couple of years earlier when deciding to regulate by regional unit, ignoring the possibility that there might have been a sale? I am trying to work out to what extent the benefits that are already happening have been accelerated by a sale. Am I making myself clear?

  Mr Gray: We did not make a specific calculation at that stage because we simply had no evidence to base it on. We have not regulated separate companies all owned by the same group in that sense previously and therefore to make a quantified assessment of how much we thought we could get out of it is difficult. When I said "our best estimate", that is what it is. You have to take a view on how much you think you can achieve with separate companies, same ownership, and then there is much more evidence as to what you can achieve with separate companies, different ownership, because we have the electricity industry and the water industry to look at and the track record is very positive in that.

  Q63  Kitty Ussher: I understand that, but it is still theoretically possible that you could have achieved quite a lot of those savings by not having sales because it is an untested model. You were going down that road, then National Grid came to you and said "sales" and you said "Oh, that must be better" but in fact, it is quite theoretically possible that the approach you had already tried to take would have led to significant savings.

  Mr Gray: In theory it is possible and in practice I am sure we would have got some benefit, but if you look at our experience with electricity distribution, with the companies which own more than one distribution company, we actually learn much less from comparing those two companies with each other than we do from comparing them with ones under separate ownership. We can see real track record advantages of separate ownership to the extent that you can track efficiency movements in some of the companies over the last 15 years and see how the pace changed with different ownership with new ideas, which came in when there had been corporate transactions in the sector and so on. We have a high degree of confidence in the incremental benefit of different management teams.

  Q64  Kitty Ussher: But compared with the "no change" scenario, the £325 million may actually be less if the previous approach had actually worked quite well.

  Mr Gray: If we had been very successful in regulating separate companies in the same ownership, yes, it would be less. We had to take a view on what we thought we could achieve by one method and what the added benefit was of the other.

  Q65  Kitty Ussher: I understand. Thank you for explaining. I want to turn to the fact that you have postponed the price review, which seems to me, to be totally honest, a rather odd thing to do. You said a few minutes ago that there were three reasons for this. Can you say exactly when you made that decision to postpone the gas distribution price review by one year?

  Mr Gray: We actually made the decision before this deal was announced by National Grid. We were doing it anyway and the reason for that was, following the merger of National Grid and Transco which brought together electricity and gas transmission, that we wanted to be able to look at the transmission as a business separately without the clutter of doing a job-lot on gas transmission and gas distribution. We actually separated out the distribution price control and delayed it by a year in order to allow us to do a proper job on transmission.

  Q66  Kitty Ussher: That contradicts what has just been said. You said you wanted proper data from the break-up, from the sale.

  Mr Gray: As it happens, we reviewed this decision once we knew about DN sales and in fact the timetable works quite well, because it gives us a review for commencing in 2008, gives us the chance to have effectively two years of data as to how these companies look in separate ownership. We only had ten months of the first year, which was last year. This financial year we shall have 12 months and then we shall be able to use that in setting a price control for the next five.

  Q67  Kitty Ussher: National Grid presumably knew that the price review was being postponed while they were considering a sale.

  Mr Gray: Yes.

  Q68  Kitty Ussher: Can you explain the precise timetable there?

  Mr Gray: Yes, they did.

  Q69  Kitty Ussher: You announced it at the same time that they were considering a sale. Presumably this increased the value of the sale to National Grid quite substantially, because every single distribution price review in gas and electricity has led to a tightening of profit margin, an incentive towards innovation, so in a sense it is a windfall gain by the company and increases the value of the sale they should have.

  Mr Gray: Sorry, I may have misled you. It is not the case that there will be no price control review for that single year: it is just that for the extension year, as we call it, we have to do a rather simpler process because it would be disproportionate to put the same amount of effort into that. For that year we have to set a price control and to the extent that there are benefits we can see that we can capture in that year, we shall do it. It is not a windfall gain, or it only is to the extent that we do not spot things that we should spot.

  Q70  Kitty Ussher: That is precisely why. They could do all the efficiency savings that you were expecting them to do in the previous price control and more and not tell you, knowing that you are not going to do a rigorous piece of work, and then take away that excess profit for that year, knowing that you are not going to look at it properly for another year. It is a gain for them, is that not correct?

  Mr Buchanan: I shall give the crude answer which is that any company which seeks to gain the system and basically hood-wink the regulator will come seriously unstuck when they come up to the formal price review. The point of getting clear data, the point of being over these businesses like a bad rash, is so that we can see what they have done and if they do that, then we shall take the benefit and cull it for the consumer. That is what firm and fair regulation every five years is about.

  Q71  Kitty Ussher: Well that is fine if it is all the same company, but if in the meantime they have sold companies with a higher value than they otherwise would have had because you have postponed your in-detail price review and have pocketed those gains and given them to their shareholders, you cannot then regulate the sold companies more harshly because of what National Grid centrally has done.

  Mr Buchanan: We are only at the early stages of this one year of rollover price review, but the really interesting thing I guess is that the companies are really quite anxious about this one-year rollover because of the issue of shrinkage. What is shrinkage? Shrinkage is gas which leaks from the system. As you are aware, the price of gas has sadly gone through the roof in the last two years and therefore the companies will be approaching this one-year rollover in a very nervous state of mind indeed as to how we are going to handle things like that. Funnily enough, rather than from your angle, which is thoroughly reasonable, to say "Gosh, these companies are going to get a one year free ride" in fact, they are going into this price review pretty worried that we are not going to make any change or resolution on this issue of shrinkage.

  Q72  Kitty Ussher: If, when you do the proper price review, you find out that in fact that was all a facade and they have huge regulatory teams to make you think that they are worried and that in fact there was a direct transfer from the consumer to the shareholder of National Grid, how can you, once the sale of that has actually taken place, make sure that the consumer is reimbursed? You cannot force National Grid shareholders to pay money back to the customers of a business which has already been sold.

  Mr Buchanan: I think your question is driving at whether we have a view on special dividends or buybacks or certain levels of dividend derived from a corporate deal. Is that it?

  Q73  Kitty Ussher: No. It seems to me a fairly crucial point. If by postponing the price review gas consumers have had a worse deal, National Grid has sold a company that is worth more because it has not been harshly regulated, thereby benefiting their shareholders—

  Mr Buchanan: There is no evidence to suggest that it has been a holiday for them. What is interesting is that after the 2002 price review, the Lattice Company, which was the parent company owner, traded at a discount of its regulated value. The company very nearly went to the Competition Commission in anger at the regulatory regime at the time I was not here at the time, but I knew from where I was that that was very close. There is no sense that there has been a soft deal and there is no sense that there is going to be a soft deal on the rollover. As I said, I think the companies will actually be going to this rollover extremely agitated about what we are going to do.

  Q74  Mr Mitchell: Coming from your background and with your ideological pre-suppositions, what was your starting position when this proposal came up? To flog or not to flog?

  Mr Gray: It goes back to where we started, which is our duty to customers. Our primary duty is to protect the interest of customers and our predisposition was not to get in the way of a commercial transaction unless we could show that it would have detriment to customers, in which case we should definitely have wanted to get in the way of it. I suppose there is a predisposition not to interfere in this market for ownership of utilities—

  Q75  Mr Mitchell: And give it a fair wind.

  Mr Gray: —other than wearing our "customer protection" hat.

  Q76  Mr Mitchell: You have both been doing a very dapper job in explaining to us that a mess was in fact a thoughtfully considered and carefully worked out mess, but it was really a mess, was it not? Initially you decided that you had to look at maximising benefits to consumers. Then you say that you had to consider there were no disbenefits, which is a change in the whole basis of the thing. Then you find that you cannot prove the figures and you do not have the knowledge and the experience to have any effective control or say, so you hire in £1.3 million worth of consultants to do a job that you should know about in the first place. It does give the appearance that you are being pushed along walking backwards by the National Grid which wants to flog it.

  Mr Buchanan: I shall try to answer a whole range of issues there. On maximisation of benefit and no net detriment I shall go back to what I said earlier. Because, under section three, we seek to get the best deal for consumers, we always will do that at price review periods. Under this specific deal, which boringly is called licence condition 29 on the transfer of assets, the clear legal advice to us was no net detriment applied. On timetable, I do not believe that there was a mess on timetable.

  Q77  Mr Mitchell: Except a lot of your research papers came out too late to affect the decision. You were providing a lot of information suddenly at the last minute which is too late frankly.

  Mr Buchanan: We had 13 consultations through the process, but what in a way I was most pleased that we did was that at two points in the process, one was in November 2003 and the other was in January 2005, we actually reflected that we were listening to consumers and we were listening to various parties who were concerned about aspects of the deal and in November 2003 we put a time delay in so that we could make sure what we were doing was right and that we could stress test the numbers to a level of comfort. Then, in January 2005, we dropped an element of this deal, which was called "exit reform", because we felt we were basically trying to overcook the cake and trying to make it too complex. That is a lesson that we have learned from this process. I feel that we managed, because this is a commercial timetable, and the NAO on page 37 paragraph three very clearly say this is a commercial deal, and we get involved through that licence condition approval that we have to give. In terms of knowledge and experience, I should actually challenge what you say quite strongly in terms of the leadership. We were uniquely lucky to have a lead investment banker looking at what is a very complex corporate deal. Did we have enough of that kind of background? No, we did not. Did we therefore have to go to hire specialists? Yes, we did. At the same time was Ofgem running its business extremely well in terms of financial management? I am pretty pleased about our record over the last two to three years. I should say yes, we were.

  Q78  Mr Mitchell: But you keep changing your mind. At the end of the day, with all these consultants, you still got the price 14% wrong because 14% more was paid for it than you expected and the National Grid expected.

  Mr Buchanan: In terms of the premia, as Oxera clearly show in appendix 3, the companies paid around 14% but actually it was more like 10%. It is very difficult to draw too much out of premia. If you look at some of the premia in the utility industry, you will see that the German company RWE paid a premium of nearly 30% for a company, Thames Water, and you will see that non-regulated companies typically pay a lot more and there is a table in the Report. I put a circle around a quote this morning on premia that companies pay and this is from Warren Buffett at the weekend. This is where too much is paid for deals. A strategic buyer, if you argue that you are a strategic buyer, is just someone who pays too much. What you cannot ever do is stop somebody paying too much for a deal. If they get their numbers wrong, they get them wrong, but what we know is that at the time of the 14% stress test there were other utility deals. Yorkshire Electricity had been bought by Mid-American—ironically Warren Buffett—at a 14% premium.

  Q79  Mr Mitchell: I know some speculators get it wrong. The fact that they were prepared to pay more than you thought, and you indicate they might have got it wrong by overbidding, indicates that they thought that your regulation was going to be too soft and there was a chance of making more profit from it than you were calculating.

  Mr Buchanan: I actually think it feeds quite heavily into our argument about there being benefits, because if there were no opex savings and capex savings, but particularly operational expenditure savings, the companies would not be putting that kind of premium down, although, as you see from the Oxera Report, they think it is more like 10%. You would not be putting that premium down. You have to Report to shareholders about your premium and you would not be putting it down unless you felt that there were substantial opex savings to be gained going forward between now and 2023.


 
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