Examination of Witnesses (Questions 60-79)|
MONDAY 8 MAY
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
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
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
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
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,
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-Americanironically
Warren Buffettat 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.