Select Committee on Public Accounts Minutes of Evidence

Supplementary memorandum in reply to Kitty Ussher MP

  Your note referred to Ofgem's decision to postpone the next five-yearly gas distribution price control by one year to March 2008. You raised the possibility that National Grid's costs may have come down further than we expected in the current price control period; that we would not be aware of this because of a postponement of the next review; that buyers of the distribution networks (DN), on the other hand, would be aware having seen the evidence in the data room; that they would then pay a premium for the DN in order to enjoy a further year under the existing price control; and that the benefits would be passed on to shareholders at the expense of consumers.

  I know that you have looked into this issue in detail and you have pointed out a genuine risk. I would like to take this opportunity to explain the background to the next price control, Ofgem's analysis of the risk to which you referred, and the steps we are taking to protect consumers.

  As you know, the main mechanism through which Ofgem regulates the monopoly gas distribution networks is the five-yearly price control reviews. The decision to delay the gas distribution review followed a consultation we conducted in 2003 which led us to propose a number of changes in timetable for future reviews. This arose from the merger of National Grid Holdings plc and Lattice plc (the owners of the electricity and gas transmission systems respectively) which suggested that there would potentially be significant benefits from reviewing all the transmission licensees in a single review. As a result, the full reviews for the Scottish electricity transmission companies were delayed by two years and that for National Grid by one year. At the same time, we felt there would be benefit from conducting the gas distribution review separately from gas transmission. This rescheduling of reviews also had the advantage of providing a more balanced workload for the industry and for Ofgem.

  One of the key questions arising from this change, which you picked up on in your note, is what happens in the period of the one year control. I can reassure you that the existing price control is not simply continued unchanged for a further year. A new price control will be put in place in the year 2007-08. In the interests of proportionality, the associated review will not examine the companies' costs in quite the same level of detail as if we were setting a five year control. This is because the companies need to do a lot of work to assemble the information we need to set a price control and, given that it is only for one year, in the interests of better regulation we do not want to place a disproportionate burden on the companies. However, we will still carry out a careful and thorough cost analysis. If we assess that the gas distribution companies have driven down costs further than originally expected, we can take that into account and set a lower allowance for that extension year. If there are specific issues of uncertainty that cannot realistically be resolved until the main review, we can make a provisional decision and make clear that we will apply a correction factor in the light of evidence assessed in the main review.

  Having said that, there must still be a risk that the price control for the extension year may prove, in the light of evidence arising at the main review, to be too generous. Our assessment, however, is that this risk is outweighed by other factors. First, staggering the reviews allows us to have a proper focus on distribution, separate from the transmission review. This should, in itself, provide opportunities to achieve greater benefits for consumers. Second, delaying the main review by one year will allow us to take into account data for 2006-07, the first full year in which the DNs will be in separate ownership. A five year control taking effect in April 2007 would have had to be based on financial data for 2005-06, the year in which the transaction completed. Data for that year is unlikely to provide much useful information on the approach of the new owners and might well be distorted by the sale process itself. We therefore judged that a review conducted in 2007-08, based on data for 2006-07, was in fact more likely to provide evidence that would be to the benefit of consumers than a full review conducted a year earlier.

  This raises a separate question which you rightly asked in the evidence session itself: could we have achieved the benefits of comparative regulation and avoided the above risks if the DN sales had not taken place at all? Would the separation of the DNs into regional business units, under the same owner, have been sufficient?

  The ability to make comparisons drives customer benefits in two key ways. First, it generates comparative information that the regulator can use to set more challenging price controls as a result of reduced information asymmetry than would otherwise be the case. Second, it introduces new management teams, and therefore the potential to increase efficiency savings by (a) generating greater innovation within the industry, (b) facilitating the transfer of best practice and (c) allowing economies of scope to be captured with other utility networks owned by the same corporate group.

  Separating the companies into regional units gives you some of the benefits of comparative information but not of new management. Our experience in the electricity sector, where we have 14 DNOs but only seven ownership groups, suggests that evidence derived from the actions of separate management teams (rather than just additional comparative information) is an important driver of customer benefits. Differences in performance between the licensees under common ownership may simply reflect internal cost allocation rather than any real difference in performance. However, as we could not say for certain the extent to which benefits would be the result of information or management behaviour, our analysis included a scenario where a higher proportion of additional efficiency savings was attributed to the introduction of separate price controls for each regional DN—ie a higher proportion of additional efficiency savings (and hence customer benefits) were assumed to be achievable regardless of whether sales occurred. This is the low case in the Final Impact Assessment.

Alistair Buchanan

Chief Executive

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