Supplementary memorandum in reply to Kitty
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 DNie 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.