Session 2010-11
Publications on the internet

To be published as HC 742-i

House of commons



Energy and Climate Change Committee

Electricity Market Reform

Tuesday 18 January 2011

Alistair Buchanan and Andrew Wright

Evidence heard in Public Questions 1 - 61



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Oral Evidence

Taken before the Energy and Climate Change Committee

on Tuesday 18 January 2011

Members present:

Mr Tim Yeo (Chair)

Dan Byles

Barry Gardiner

Albert Owen

Christopher Pincher

Sir Robert Smith

Dr Alan Whitehead


Examination of Witnesses

Witnesses: Alistair Buchanan, Chief Executive, Ofgem, and Andrew Wright, Senior Partner (Markets), Ofgem, gave evidence.

Q1 Chair: Apparently the requirements of the webcast mean we can’t start the session until 10.15, so we have to talk among ourselves for a few moments. Obviously I know who you are, but if you would like to introduce yourselves briefly-Alistair, do you want to kick off?

Alistair Buchanan: Yes, good morning. My name is Alistair Buchanan. I'm the Chief Executive of Ofgem, and I'm very much looking forward to this session this morning with you.

Andrew Wright: I'm Andrew Wright. I'm the Senior Partner for the Markets Division in Ofgem.

Q2 Chair: This was a session that we deliberately put back a few weeks because of the imminent publication of various documents, which we thought would inhibit our debate a bit.

Are we okay? All right, we have clearance to proceed.

Welcome to the Committee. Thank you very much. It is the first time we’ve had a chance to talk to you in this Parliament, and I’m sure we’ll have a continuing and, I hope, close and constructive dialogue. I think Ofgem is very much in the thick of what is going on in terms of policy development now, as well as its ongoing responsibilities. You yourselves are reviewing the effectiveness of the retail market. Do you want to tell us about the progress you’re making on that particular front?

Alistair Buchanan: Yes. We announced the Retail Market Review at the end of November, and I’m happy to go into the reasons behind that. The headline reasons were that we had new information; we had the accounting data that we required as one of the requirements from the Retail Market Probe. We were concerned by the very sharp increase in margins delivered by the companies. That came hot on the heels of, frankly, some substandard performance from the companies, on mis-selling in particular, and we felt, both from the information that we were looking at and from the importance of having consumer confidence in this market, that we wanted to take time out to look at the performance of the retail market in short order. That is why we will report back in March. Typically, a review like this might take longer but we’re in the very strong position of having a lot of data already available to us. We have a very good model, because of the Retail Market Probe and because of the quarterly reports that we do.

Since we made that announcement at the end of November-and you may remember that the headline figures there were a £65 margin increasing to £90-two more companies have come forward with their price increases, and that would have taken the equivalent to £97. So your margin jump would have been not a 38% increase but a 49% increase, therefore, in my view, giving us even greater concern that consumers need confidence in what is going on.

We have also looked at the submissions that the companies gave yourselves, and there is some very interesting data that came out of your session with them. Particularly, I would highlight British Gas and E.ON who gave some interesting thoughts as to maybe why they’re doing better at the doorstep-for example, they use handheld computers-than the other players, and that will feed into our review.

I think the final important piece of information that we have had is from Consumer Focus, who have delivered their Customer Complaint Survey. They do that on a starring basis. If you have seen that report you may have seen that three of the six companies got only two stars out of five in terms of performance for consumers, and I believe one of the companies was very lucky even to get into the two-star category.

All of this leads me to feel this is a very important and timely review on behalf of consumers to make sure that the companies are not abusing their position.

Q3 Chair: Is it too cynical to say there is a slight sense among consumers, and the public generally that it is a sort of periodic thing? The companies appear to abuse their position, they widen their margins and everyone says, "This is not good enough." The Secretary of State sort of coughs and splutters, you cough and splutter and have a look at it, and after investigation it appears they can show that they were justified and we carry on as before? Is that too cynical an interpretation?

Alistair Buchanan: I think it is an important interpretation. I think the consumer has now become slightly jaded and cynical, perhaps from some of the behaviours that they’ve seen from the companies. If I can step back: 18 months ago we spent the best part of a year looking at the sector in some detail, which is why we have such good information on it now. We came out with immediate improvements for the consumers, particularly those with pre-payment meters-you may remember that the companies were substantially overcharging them-the off gas grid customers, who were also being overcharged, and an uncomfortable disparity between in area and out area margins that the companies were taking. We resolved that and we clawed back half a billion pounds for the consumer.

At the time of the probe, we then said, "Look, if this market is going to work, frankly there are issues in this probe that are really disturbing. For example, 40% of people who have switched have gone to a worse deal; 48% of pre-payment meters on gas have taken a worse deal. This is not encouraging information." Therefore we set out six criteria by which we wanted the companies to improve: we put a licence condition in place for cost reflectivity and undue discrimination; we demanded better doorstep sales; we demanded annual statements and clearer bills; we demanded transparency of accounting. We also had a package for the small-medium size user.

If we look at what they have done since then-this is irrespective of the sharp increase in margin leading up to the November report-on mis-selling, we now have an investigation running on four of the six. I'm not allowed to see that information but, as you would expect, I get information presented to me, and when you hear that salesmen are saying that they are from Ofgem or salesmen are from National Grid-Grid doesn’t have a sales arm-you realise what is going on in that area. This has probably been one of the most supported and popular investigations that we’ve done with regard to the consumer, but why are we doing it? We’re doing it because there is evidence enough for us to trigger an investigation.

Consumer Focus, very helpfully, looked at the quality of the bills and the annual statements. A couple of them-npower and Scottish & Southern-got a poor rating from Consumer Focus on the annual statement. On the accounting transparency, Andrew’s team have started going into that in some detail, but the kind of high-level thing that caught my eye was: why did one of the companies have a very large chunk of their profitability in what is called a portfolio optimisation account? Why wasn’t it either in generation or in supply, or in a subsection of supply? What is that? This kind of language disturbs a consumer, and I am disturbed by the fact that we put in place a very firm package of requirements. My board considered going to a Competition Commission 18 months ago. We felt that there was enough going right in the marketplace, and with the package in place, to bring confidence into the marketplace and to see people switching.

The good news is that 93% know about switching and 75% regard switching as an easy process. My concern and one of the things that I think the Retail Market Review has to do is to regain the confidence, regain the initiative, in markets for the consumer. If we can’t do that then my board have to think very carefully about either coming to the Government and seeking new powers or going to a Competition Commission. Those are the two very significant options available to us if we think that it’s a thumbs-down moment in March when my board make that decision.

Q4 Chair: So you are possibly questioning whether the current arrangements are sufficient to promote enough competition?

Alistair Buchanan: Correct. We really need to analyse this very significantly, and I think the options open to us are, having taken a long hard look at the numbers and the behaviours of the companies, we broadly think everything is going all right and that things just take time; or we have to look at a more radical solution, which may mean looking at doorstep sales. Should all the companies have handheld meters? Should we even consider stopping doorstep sales? Automatic contract rollovers: should we just stop them, particularly for small and medium sized? Do we look at tariff simplicity? Do we get quite aggressive and take an involvement into what you might regard as a market instrument of competition, which is your tariff? Do we get involved in that? That is the radical package that we can look at. The more institutional package would be either coming to Government and seeking more powers or going to a Competition Commission.

Q5 Chair: There is a context here where it is likely that prices are going to rise anyway for other reasons than failures of competition, as we have a more secure low carbon electricity generation infrastructure in this country that, at least in the immediate future, is going to mean prices are higher rather than lower. If that is the background, would it be fair to say that makes it even more important that you should be able to insist on adequate, transparent competitive arrangements; otherwise the opportunities for the companies to exploit the market are going to become even greater?

Alistair Buchanan: Chair, I absolutely agree 100% with your comment.

Q6 Sir Robert Smith: I just want to follow up a couple of things on the switching. You said 75% find it easy. Is that 75% who have tried it or 75% of consumers? Who?

Alistair Buchanan: That’s obviously 75% who have tried it. It is worth bearing in mind that in the probe that we did, around 40% had not switched, and there is a hub-I think of around 20% from memory-that really have no interest in switching at all.

Q7 Sir Robert Smith: So 60% have switched?

Alistair Buchanan: Yes, indeed. It is a little bit lower than that, but it’s in the ballpark.

Q8 Sir Robert Smith: Yes. So is that 40% providing an inertia that allows the companies to push-

Alistair Buchanan: It is quite interesting. The companies make 75% of their profits off a customer base. I think, Andrew, it’s about 48% of their customers are their old legacy in area customers.

Andrew Wright: But those were the numbers in the probe-

Alistair Buchanan: That is in the probe, yes.

Andrew Wright: -and since the price discrimination licence condition came in place, that all changed.

Q9 Sir Robert Smith: You mentioned Consumer Focus providing various feedback.

Alistair Buchanan: Yes, indeed.

Sir Robert Smith: In the absence of Consumer Focus , how are you going to get that sort of information?

Alistair Buchanan: To just stand back, I think Consumer Focus have delivered some very useful information on the annual statements and bills, on the customer complaints and-you may have seen over the Christmas break-on switching site code of confidence. I think it’s a very good question, and we are very engaged with Citizens Advice. As you know, Citizens Advice will be taking on most of those functions. They are also looking at taking on the functions of Consumer Direct, which is currently done by the OFT, and I believe Which? are also going to get involved in assisting on the consumer direct side, which is the direct interface with the customer. It is incumbent upon those institutions that remain to make sure that we continue to get this level of service that the consumer is getting, which we rely on and which we find useful.

Q10 Christopher Pincher: You mentioned the importance of consumer confidence, but allied to consumer confidence must be information provided to the consumer. You talked about billing. Can you say what you can do to make billing more useful to the customer without making it overly regulated?

Alistair Buchanan: Yes. We are looking at the annual statement, which is giving information about what you have used and what you will use; it has to give advice on how you switch; it has to tell you what tariff you are on. A lot of these things-you could say shamefully-weren’t available to the consumer before. On the bill: clarity on the bill is very important. I notice that British Gas were suggesting that using some of the more technical terms within a bill, like kilowatt hour or whatever, doesn’t actually help many of the users, and whether that is something that can be reviewed. I know that the Consumer Focus analysis of bills welcomed the use of things like graphs to try and help the presentation. So we’ve required certain issues to be addressed, particularly on the annual statement and in the bills, on the probe remedies. It gives us a chance now to see whether that is enough.

Q11 Christopher Pincher: But is it your view that things like calorific value, which nobody understands, not even the people who provide the power understand it-

Alistair Buchanan: Yes. Indeed.

Christopher Pincher: - should be excluded and more meaningful information provided?

Alistair Buchanan: I think it is certainly an area that we should be addressing and seeing, in talking to Consumer Focus, Citizens Advice and other consumer bodies, whether this is something that is really important to the consumer. I take your view as well. My sense from you is that it is not.

Q12 Christopher Pincher: How do you decide what should go into the bill? What sort of panel do you use to advise you?

Andrew Wright: Just to give one answer on the calorific value question, there is an important process going from the meter reading to the amount of money that is charged, and information needs to be available somewhere on how that is done. Calorific value is part of that. Whether it needs to be on the bill is another matter. So as long as that information-

Q13 Christopher Pincher: The consumer is concerned about how much they’re being charged , not , "What is this thing called calorific value?" If you’re over-regulated, if you become over ly bureaucratic , then you lose the consumer.

Andrew Wright: Exactly. In terms of what information we think should be on the bill and the annual statement, we do a lot of work with consumers through, for example, our consumer panel. We ask them directly for this information. We have brought in the annual statement partly to provide all the information that a consumer needs to make an effective switch of supplier in one place. It’s something they can put by their telephone or file away, so that if they do decide to switch supplier they have all the information they need and it makes their job a lot easier. We don’t think that the way it has been implemented meets that requirement in all cases, so that’s one of the reasons why we’re looking at it.

In terms of the bill, then I think there are different criteria there. That is all about ensuring the information is clear and presented well, but it’s useful sometimes to have that information available on the bill as well, just in case consumers don’t necessarily have their annual statement to hand. But we do do a lot of work asking consumers directly about their experience with billing and what information they would want on the bill.

Alistair Buchanan: A slight side tack, but it’s quite interesting, is that as part of the range of discussions that we’ve had and we’re having-and you would imagine that we’re having a lot-with regard to the Retail Market Review, we saw the heads of the network companies a few weeks ago. One of the things that they would like on the bill is much more clearly identified what the network charge is and what the non-network charges are, because they feel that they are caught in the whole discussion of bills without, in a way, having their bit of the energy chain represented. Again, I think that is something that we can take away and have a look at.

Q14 Barry Gardiner: In 2008 you reported that the electricity sector has been increasingly vertically integrated, and you said that since 2004 the share of generation capacity held by the Big Six had consistently been between 50% and 60%-and given that they form 99% of the market that means 50% to 60% of the market. How big a problem is that vertical integration? How confident are you that you know what is going on between the generation and supply elements of those companies, and what sort of effect does it have on liquidity, and does it stop new players from coming into the market?

Alistair Buchanan: I’m grateful you asked the question. This is one of the issues that I think will in particular need to be addressed by my board, if we come out with a thumbs-down view on the performance of the companies in the Retail Market Review. A thumbs-down will either be one of or a combination of: "Management teams, you’ve been lazy and haven’t performed well enough against the new criteria"; "Management teams, you’ve been bad and you’ve misbehaved and we can go after you with our powers"; or we conclude that there are structural issues and we need to go to the CC to have a discussion with them.

You’re right to paint this picture of the Big Six. On the retail side alone, we effectively now have four small suppliers representing about 0.3% of the market; in 1999 you had 21 in electricity and 19 in gas. On the generation side, you could argue it has got tighter, from 50% to 60%, because of course dear old British Energy has gone, which represented then around just shy of 20% of the market; I think they are around 15% this year. So in fact you are actually up at four-fifths of the generation market being within the framework of the Big Six.

That then leads you on to say, "Well, are they taking an abuse here between retail and wholesale?" and one of the developments we made, on the advice of the DECC Select Committee last year, was that the QR report that we produce every quarter looks at the value chain and not just, as it originally did, at the retail end. I think that is very important because you’re having to look at how the companies are balancing their businesses going through, which then I think quite rightly leads on to the question: have they been gaming between wholesale and retail? Our conclusion was that we don’t have evidence that the companies are misbehaving here. It’s almost like the Scottish legal system of "non-proven"; we couldn’t land a punch. We looked to see if we could, and we couldn’t.

Since then, the wholesale charge has fallen quite strongly until very recently, when there has been a rapid increase. And I think one of the City analysts in a way put their finger on it in a research report that they put out towards the end of the last year when they said what is unusual this time is that, in seeing an increase in the wholesale charge, the companies appear to be going earlier rather than later in putting their prices up. So what we have to do in the Retail Market Review is analyse what is going on there. Why are they doing that? What is the underlying position? It is probably the most frequently asked question that we get and we will seek to give an answer to that in the middle of March.

Sorry, there was one final bit to your question; liquidity. Do you want to take that, Andrew?

Andrew Wright: Yes , th e impact of vertical integration on liquidity. If a number of companies , or a significant part of the market , are effectively providing electricity to themselves then it is a logical extension of that that less electricity is going to be sold on to the market, so I think we expect vertical integration to have an adverse impact on liquidity , b ut it’s probably fair to say it’s not the only factor that has an impact on liquidity . T here are other things, such as the level of interconnection with other markets, such as in Europe , s o I think we need to be careful not to put all the blame necessarily at the door of vertical integration.

The other thing is that some of the companies will argue that vertical integration is the response to a lack of liquidity -in other words, because there isn’t sufficient liquidity in the market you need to be vertically integrated. So there is a chicken and egg situation. The work that we’re doing on liquidity is attempting to break that vicious circle where more vertical integration leads to lower liquidity, which leads to more vertical integration. What we’re t ry ing to do is to attempt to break that circle and get the circle moving in the o pposite direction.

Alistair Buchanan: And it is much more an electricity issue than gas. The churn level in gas is 11 times, I believe-by some margin the strongest across the member states in Europe, whereas electricity is really poor. We’re down to about two times churn, and that is of great concern.

Q15 Barry Gardiner: You referred to the capacity for arbitrage and you said that your investigation came out with a verdict of not proven, but the wholesale energy prices were less than half their peak level that they reached in 2008, and the average retail energy bill had decreased by a much smaller amount, by about 7.5% since the start of 2009. In July 2010, Consumer Focus estimated that wholesale prices were 47p a therm for gas and £43/MWh for electricity, and that was a decline from their peak of 99p a therm. Why is it so difficult to prove this charge?

Andrew Wright: I think there are a number of factors there. First of all, wholesale costs are only a proportion of the bill. Around about half of the total energy bill is wholesale costs, so you wouldn’t expect the fall in wholesale cost to be fully reflected in the price. The second is the hedging behaviour that companies engage in so their purchase costs will be smooth through those peaks and troughs, so their own costs will not have fallen by that amount. Thirdly, at the time of the peak of prices the companies absorbed some of the increase in costs. Part of the reason they could do that-coming back to the previous question about vertical integration-is because they were making so much money at that time in power generation, partly because of the free carbon allowances, partly because of the very high cost of gas, which made the coal stations very profitable. A combination of all those factors meant that that equation doesn’t quite reflect what is going on, but we do believe, and our quarterly analysis shows this, that margins have increased quite significantly over that period, so there is certainly some truth in the Consumer Focus argument that margins have increased.

Q16 Albert Owen: You have dealt with some of the points I wanted to raise with Barry just now, but for clarity, are you saying this vertical integration does crowd out new entrants?

Alistair Buchanan: New entrants is one of the observations of a functioning market. That would be one of the issues on which I can’t give an answer here because we’re in the middle of a review, but I want to give you some assurance that my board will be looking at these issues when they’re looking at the whole issue.

Andrew Wright: One of the main reasons we’re trying to address liquidity is to ensure that small suppliers and new entrants have access to the wholesale products that they need to be able to make an effective entry into the market, and we’re not convinced that that is the case at the moment.

Q17 Albert Owen: When we had five of the Big Six in front of us a few weeks ago, they said basically-not flippantly-that as a consequence of the market in Britain we have the lowest costs of electricity and gas compared to the rest of Europe. Is there a European comparison that you can make where there is a dominance of three or four and they have higher prices? Would new entrants necessarily give the consumer a better deal?

Alistair Buchanan: Certainly on gas, the statement they made was fair and we have continually been among the lowest of the member states on gas. That is driven partly by the British gas market liberalisation and market-based approach. It is worth bearing in mind that gas contracts for most of the member states are derived off long-term oil/gas index contracts.

In electricity, that was quite a brave statement for any of the Big Six to make-that we’re among the lowest on electricity. I think you will find that the Eurostat statement shows us very much more middle field.

Q18 Albert Owen: So we could be getting ripped off on electricity because of this vertical integration?

Alistair Buchanan: I would like to send you the latest electricity charts, just in case you have a concern that you were being told that we’re the lowest in Europe on electricity.

Albert Owen: That’s fair enough.

Q19 Barry Gardiner: Peter Freeman, as Chair of the Competition Commission, has said that the longer a sector goes without a reference the less credible the threat becomes and the more the regulatory system as a whole comes under scrutiny and pressure. You’ve never made a referral. Why?

Alistair Buchanan: We made a referral some time ago on the network side, but you’re right, we-

Q20 Barry Gardiner: On licence conditions?

Alistair Buchanan: No, that was on a price control. We have also used the Competition Commission on a number of market-based rule changes. In fact we lost on both occasions in terms of our ruling on a number of very technical issues. So we have worked with the Competition Commission and we have used them, but we have not sent them on a market investigation reference on a more wholesale reference. It is not a move that my board would take lightly, nor should they, but it is a very relevant option to us. As I mentioned earlier, at the time of the Retail Market Probe the CC was a very firm proposition on the table in front of the board.

Q21 Barry Gardiner: You were heavily criticised for not making a referral instead of doing the internal probe. Why did you take that decision? Why do you see this as a last option? You said earlier in your evidence that if it got to that stage you might have to come back to Government to seek further powers or go to the OFT. Surely this whole idea that the OFT is something that you only go to as the very last option is d oing precisely what Peter Freeman has said is a problem -i t’s not using it as part of the normal mechanism, part of the normal toolbox that you have.

Alistair Buchanan: We will use them and we have no fear about using them. In fact, as I say, we’ve worked with them. If I step back, what we felt we were looking at in 2008, on the more technical side, was some quite encouraging information. On the technical side, you saw Scottish & Southern’s market share move up very sharply; you saw British Gas dual fuel market share go from 48% to 38%-you saw some very important market share moves, suggestive of competition. We saw on the gas side the HH index fall substantially-still very high. You could argue that 2,700 should have been a signal to send the gas side, but we felt that its decline from near 10,000 was very encouraging. But competition, when set against what we could see elsewhere in the world, was very encouraging-an active churn rate in the UK of just below 20% comparing to Holland, which is the nearest you can get to it, at 7% from a major country; the states in America, Massachusetts, Connecticut, and Germany, all at 3%. By contrast to other products, the only product that has a higher switching rate than us is motor insurance. Fixed line, mobile, mortgage, personal banking are all much lower.

Q22 Barry Gardiner: From 48% to a worse deal?

Alistair Buchanan: That unfortunately was one, but consumers like choice and want choice and that choice is there. The problem is that the choice being presented to them clearly needed to be redefined and the boundaries needed to be set. We felt that in the package that we could set we could deliver for consumers a better product, and therefore their confidence and their ease of switching and their ease of choice would be confirmed through that package. I am very concerned that, having put that package in place, the performance of the industry, which, had they effectively taken all the key six parameters that we required them to do, we would be in a much stronger position of confidence than we are today. I'm not happy when I see-I think it was Which? but apologies to anybody from Which? here-they did a survey towards the end of last year where the six energy companies are rated worse than the banks. That is quite an achievement in the wrong way, and therefore consumer confidence is not good at the moment.

Q23 Sir Robert Smith: Going on to the electricity market reform consultation and the work you did in Project Discovery, how do you think the proposals set out in the EMR consultation document match up to the scenarios that you explored in Project Discovery?

Alistair Buchanan: Yes, the three proposals that are broadly on the table are the low carbon support mechanism, the feed-in tariff displacing the ROC with some form of contracts for difference mechanism, and a capacity credit.

I think I’ll just step back a bit. Broadly, the findings of the EMR-and they took evidence from a whole range of inputs of which one was Discovery-would suggest that certainly we were indicating that there was a capacity problem, quite a severe one, around 2024. Their view is 2022, so it doesn’t look to me as if, within the parameters that we had in Discovery, the Government has come down with a very different outlook than we did. They had a headline price increase of 33%, ours is around 25%; there’s a capacity shortage in the early part of the next decade which is pretty worrying; there’s a concern about where you find the bulk of the £110 billion that is part of the overall £200 billion that needs to be found-so broadly quite similar.

If we take the three elements, it seems to me that what the Government has been seeking to do is to provide confidence and consistency and it looks, through what they’re trying to do on all three of those criteria, that they achieve that. They are trying to ensure that they keep the benefit of market disciplines in play, and I think they are trying to do that through their aspiration on contracts for difference to go to an auction, and potentially on capacity credits to go for an auction. If they get that right, then the question is-slightly crudely-are happy days here again on security of supply, if nothing else, and hopefully on hitting our carbon target as well? I think part of the issue there is, firstly, the devil may be in the detail and, secondly, will it still deliver the investment that we clearly need?

If I take those three elements. If we start with the low carbon support mechanism, it would appear that the Treasury is offering £20, £30 or £40 as a starting pointer. Looking at EDF’s numbers, £20 might be around about the right starting point, but if you look at some of the commentators from the City it would suggest that you need over £40. I think Citigroup’s work would strongly indicate that you would need over £40. So do they have the opening point right? We will have to wait and see. What are they going to index it to as an annual index, and are they going to provide the capital markets with some kind of parameter comfort? This is something that gets changed every year, so if you’re trying to provide long-term comfort, then every time Budget day comes around, will there be something? So broadly yes, but then a question mark about how it is going to be derived. Equally, if you’re looking at the feed-in tariff, which is run off a contract for difference mechanism, what is the cap and the collar going to be there? What is the protected price that the Government will effectively provide within the contract for difference? On the capacity credit: who is going to get it, when are they going to get it and how do they get it? The devil is all there.

If they get all of that right, then I think the next question is: do they have it right enough? Chris Huhne in Parliament on 16 December made I think a very important point, which is we’re not just here to feed the investment basis of the Big Six. He then intimated that if you look at the Big Six, you may well come to the conclusion that there are some balance sheet challenges for those companies. Indeed, if you look at those companies-taking data provided to me by Rothschild Investment Bank-the capex profile of E.ON and EDF as companies is falling, as group companies is falling quite substantially.

E.ON made a very profound comment in November that they are looking eastwards now, not to Europe, for the development of their business and they’re looking at much higher returns than they previously had and that they will be selling assets, 50% of which will be sold in order to enhance their balance sheet. RWE have also said, "There is a bit of time out going on here; we need to look at our strategic portfolio of assets". So we’re looking at an investment proposition where the Big Six have their own capital issues, the raising of equity has limitations with regard to EPS dilution, and perhaps with EDF with regard to their own structural issues because of their ownership from the French Government. You are taking that position and saying, "Well, that is what we have." We have some very big players as well, like EDF, who are running at around, what, £160 billion enterprise value, and E.ON at £100 billion; but the two British champions, SSE and Centrica are much smaller-you’re looking at £20 billion and below. So you have a big diversity of scale.

Why I think that is important is that when you take the next step forward and say, "Well, we need to attract them and we need to attract others," what are some of the key issues that we need to attract? It has to be somebody who can bring real financial firepower to the party, because the scale of what we’re looking at is that each nuclear power station is, let’s say, £5 billion to £6 billion a throw; a CCS station might be £2 billion to £3 billion, although we’re not sure yet; a large offshore wind farm might be £1 billion. You have to have substantial scale. Typically, I believe an investment bank-I spent quite a lot of my time as an investment analyst-board and chief executive will not risk more than 5% of their enterprise value on any one project, for very obvious reasons.

So you can start to see that even in mega companies like EDF and E.ON, the kind of opportunity that Britain is presenting is an opportunity but also there is a scale issue. If you can get over the financial scale you then have to say, "Do we have the managerial competence and the technical know-how?" Britain’s way forward is going to require a lot of technical know-how because we’re going into nuclear, we’re going into offshore wind, onshore wind, tidal-all exciting stuff but you’re going to need the technical issues. You are then obviously going to need a culture behind that.

These are really substantial challenges, and that is why I say when we look at the package-I'm sorry, it has been a longwinded answer-it appears that they’ve taken very seriously confidence, clarity and deliverability, all of which I think is excellent. The next stage is really tricky, which is getting the detail right; and even when they have the detail right, then there’s that moment where we say, "Well, is it enough to both get the Big Six to choose Britain and possibly to encourage others to bring their money in?" It is a mighty challenge for the Department of Energy, but they appear to have started very capably here.

Q24 Sir Robert Smith: But reading between the lines you think the challenge has quite a long way to go?

Alistair Buchanan: I don’t think anybody at the Department of Energy would suggest that they are more than at a very important point in climbing up the mountain, but they have made that first rise to sort of beyond base camp; it is probably the camp above that. They appear to have their route mapped out, and that is why I thought the Secretary of State’s comments in Parliament were very important because it clearly showed that he is mapping out all those issues as we try and get up the mountain.

Q25 Sir Robert Smith: Just one thing: as we switch profiles with nuclear and renewables and all these high capital, low running costs, how will the energy markets work in terms of the consumer?

Andrew Wright: An important part of the energy market reform package, as identified in the document, is the work not only to deal with making sure the right incentives for capacity are in the market through the capacity mechanisms, but also reform of the electricity cash-out arrangements. I think the combination of those two elements of the energy market reform package are designed to address the issues that will arise as you move from, broadly speaking, a low capital intensity, high marginal cost market that we have at the moment, relatively speaking, to a capital intensive, low marginal cost market in the future.

I think the other important element of that adaptation is developing a demand side because, clearly, if you have a lot of low marginal cost in flexible plant on the system the demand side potentially becomes more valuable and more important. You hear all sorts of things in the future about electric cars and electric renewable heat sources, for example, and all of those could contribute to that demand side capability, as well as, of course, smart meters. I think the combination of those three packages-capacity mechanisms, electricity market reform in terms of the cash out, and developing the demand side through smart meters and other changes-is the answer to that particular challenge.

Q26 Chair: Alistair, going back to what you said in answer to the previous question, it’s almost quite a potentially scary scenario, but we have these challenges about decarbonising the electricity generation process; we have the likelihood of a big increase in demand-not necessarily from economic growth but we’re probably going to rely on electricity for all sorts of things, like surface transport, heating and so on, which we haven’t done before-and you are saying that, because of the global market in which these companies now operate, the returns in the EU possibly, and certainly in the UK, may simply not be attractive enough. They see much faster growth, much less price control, much fewer planning difficulties in some of the Asian economies. Could we be in a position where we’re simply not getting the investment in this country at all to deliver the extra capacity?

Alistair Buchanan: I don’t want to send the wrong message, but let’s take E.ON AG at face value. On 17 November they put out their forward looking statement, with a new management team in place, basically saying that-as you rightly identify-they were looking towards China, the Far East, Russia, and they are looking as a minimum requirement for their cost of capital to go up by at least 1% higher than it is today. It may not surprise you, therefore, that E.ON are looking at potentially withdrawing from their network companies within the UK. Network companies have a regulated return, therefore what we’re finding is that they have their own unique investor base who like a long-term low return. Therefore, the news that you will see in the newspapers is that were E.ON to choose to sell Central Networks, there are at least four or five bidders lined up but they are typically pension funds or long-term players in that market. But, yes, E.ON have sent a signal, not just to Britain but arguably to Western Europe, that they as a company are switching signal.

Now, if the Government gets this package right, we might shrug our shoulders and say, well, plenty of others are going to come in here because this package is so well constructed and is attractive. Therefore, if other players decide to go somewhere else it doesn’t matter. This is a package that is going to attract new money and new players into Great Britain.

Andrew Wright: I think an important point here as well is that the rate of return is only part of the equation. The other part of the proposition is the risk profile, and it is important that we don’t get caught in a trap of offering higher and higher rates of return, which lead to higher and higher prices; we look at the riskiness of the proposition and whether anything can be done to ensure that risk is allocated in a more effective way. To some extent that is what the Government is proposing with the CFDs, which is transferring some of the market risk from the investor to the consumer, arguably where it is better managed. That could also be the case for other aspects of the risk as well. That remains to be seen.

Q27 Dr Whitehead: On reflection, do you think that the rather wide scope of the options set out in Project Discovery rather frameworked what subsequently happened as far as certainly the initial consultation programmes from EMR are concerned? You had five options ranging, effectively, from the market with a bit of support through to very substantial intervention. The previous Government’s response lopped off the two ends and EMR has come out roughly C, veering towards D. Would you have done it differently if you had your time again, in terms of the extent to which it could be said that you had ducked the requirement to be rather more firm about what the options might be as far as future markets and future investment and, indeed, a market that decarbonises itself are concerned?

Alistair Buchanan: You are right to highlight that there does seem to be a high level of consensus here, in terms of the Budget day proposals from the previous Government, again offering a range of five options but tighter than what Ofgem had done. Candidly, at that point, I know the Government was taking its feeds from us, from Ernst & Young, from the Wicks report, from the CCC, so they were taking a whole range of propositions. Of course, once we had done our report we closed down Project Discovery. Ours was an advisory piece of work done under sections 47 through 49 of the Utilities Act. This is high policy, which the Government has to take forward. So in fact, I think with some nervousness we offered options at the time of Project Discovery, because we wanted to give a range of what the possibilities might be, but the Government who rightly were sitting there with feeds coming in from lots of other sources could then take its view.

Yes, in many projects maybe we can do things slightly better but I feel broadly comfortable that we didn’t mislead, which would be a dangerous charge I think aimed at a regulator in something as important as this.

Andrew Wright: Discovery presented a framework of options-of escalating options, effectively. It said, "This is at a minimum what you need to get right. If that isn’t enough then you need to do this. If that isn’t enough you need to do this." I think that was a useful framework that I think has stood the test of time, but, as Alistair said, having set out that framework it was very much for Government to make those policy decisions.

Q28 Chair: Do you think that the incentives in the past have been sufficient to encourage investment in storage?

Alistair Buchanan: The answer that we’re getting at the moment from those looking at storage-and there have been a number of parties looking at storage-is that the market return is not encouraging enough. Of course, a lot of projects-Portland was a good example-were delayed or indeed killed off. Portland looks like it was delayed-because they’re looking at it again-in 2008 with the financial crisis. Looking at a number of the projects now, there is one big project that Eni of Italy are leading at the Deborah field-it’s a massive field, bigger than Rough, and we’re waiting to see whether they proceed-but there have been a number of near misses, I think, on development of gas storage recently. I think the message we’re getting back-Andrew, you’ll be closer to it than I am-is it’s just not quite commercial enough for us to do.

Andrew Wright: I think the other important aspect of this is the reforms that we’re pushing through as part of the gas market’s significant code review. We have recognised that there is an issue with the gas market. We don’t think that the value of security of supply is properly reflected in the gas mechanism. We have recognised this issue for some time, but only recently have we got the powers, through the new code governance arrangements, to be able to get a grip of this particular issue and push through the significant code review. As a part of the Energy Bill, the Government has given us additional powers, hopefully to streamline that process in this case, so we may have a fighting chance of getting these reforms in place for the next winter. The effect of that would be to sharpen the price signals and, therefore, increase the incentives on market participants to develop additional gas sources.

Q29 Dr Whitehead: You are undertaking Project Transmit at the moment. When is that going to be complete and, now that we know what the EMR consultations look like, how do you see that being co-ordinated with those consultations?

Alistair Buchanan: Just to flesh out for those of you who might not be fully alive to this, Project Transmit is based on four levels of inquiry. The first is whether you charge for the transmission and use of system correctly. That was structured 20 years ago when, frankly, a wind farm wasn’t even in anybody’s mind, and that was based on, certainly at the time, the very sensible economic theory that you wanted to basically encourage build of plant near either urban conurbations or factories, so that you reduced the cost of your transmission. Quite clearly with the Government’s policy encouraging nuclear in places like Anglesey, offshore wind, onshore wind, tidal, there has to be a question as to whether the model that we are pursuing is the right model.

Across Europe you have broadly three options: our style of model, a postage stamp model, or one that cuts in between-you might point to Nord Pool and suggest that that is a halfway house between the locational marginal charging and postage stamp. So we’re looking at that and we will be looking to give an answer in the spring.

There are three other very important things that we’re looking at, though. We’re looking at the charge that National Grid needs and the timing that it needs for that charge, we’re looking at the queuing and we’re also looking at the rules on interconnection, which have an almost profound significance now following the memorandum of understanding signing in December of the North Sea grid and what our interconnections policy will be going forward. Our work there with the European regulatory body, the new one called ACER, and also with Brussels will be very important.

That is the package and we are getting lots of advice at the moment. We’ve had a lot of interest in this review, as you’d expect, particularly in Scotland and Wales, and we will come out with our views. I am very happy to come back on a focused issue to this Committee if you’d like, when we come out with our findings.

Q30 Dr Whitehead : But how do you think that is going to run in terms of what are, to some extent, set timescales as far as EMR is concerned?

Alistair Buchanan: Yes, it seems to me that will feed in very neatly to EMR and the EMR timescales appear to be spring-late spring. This is going to be spring-late spring.

Q31 Dr Whitehead: As far as the EMR consultation is concerned, we have, obviously running in parallel but sort of integrated with the EMR consultation, the Treasury’s consultation on carbon floor price; but within EMR we also have the question of contract for difference that has a substantial impact on that. How do you see that being co-ordinated?

Andrew Wright: How do you co-ordinate the carbon floor price work with the contracts for difference work?

Dr Whitehead: Well, and EMR consultation in general, but I mean particularly the interface between, I would have thought, contract for d ifference and carbon floor price and who comes out where with what.

Andrew Wright: Yes. It is probably best answered by DECC or Treasury. My understanding is DECC and Treasury are working very closely on the whole EMR package, and , as a tax , the carbon floor price is being taken forward by Treasury as part of the Budget arrangements. You’re absolutely right : it’s important that the details of both of those don’t contradict each other and, indeed, work well with the wider European Emissions Trading Scheme, b ut as far as we are concerned we will just be working with the Government in trying to help them on both of those projects.

Alistair Buchanan: Andrew is absolutely right, but in particular we will be wearing our consumer hat here because, quite rightly, a number of commentators have highlighted that if certain decisions were to be taken and were not co-ordinated, as you rightly intimate, there is a danger of a windfall gain to particular parties. That is not good news for consumers, and we would want our voice to be heard if that was the case.

Q32 Dr Whitehead: But if you are carrying out certain consultations as part of the Budget process you are supposed to keep those to yourself, aren’t you, until the Budget turns up? How do you see that process, where one process is an open-book process of discussion and consultation and the other one, potentially, is stitching a process into a budget outcome, which necessarily has to be secret until Budget day?

Alistair Buchanan: It’s a very good question and of course they have asked, as you know, for responses to a very detailed low carbon support mechanism by early February from parties, and that then will feed into the Budget.

One of the observations I’ve had-and it takes us back to Budget day last year when it was a combined Treasury-DECC presentation, effectively on the way forward for energy and electricity market reform-is it would appear to me that there is close liaison, and even if it’s not liaison, there is now a very good understanding across Government as to what the challenges are. I don’t think they are driving blind; I think they are very alive to what the issues are. It’s a very focused question. It will be interesting to see what the Treasury have to answer to that.

Q33 Dr Whitehead: The other area of potential opacity is the question of how exactly one could properly calibrate the outcomes of contract for difference where you have insufficient information on the way that trading is taking place internally as far as, say, the Big Six are concerned. That does bring us back to the liquidity question indirectly, but also the extent to which one may necessarily have to unpack those arrangements prior to getting assurances that a contract for difference would not lead to all sorts of opaque leakages en route. Do you have a particular view on how that might proceed?

Andrew Wright: I think you are absolutely right to recognise that if you do have a contract for difference arrangement as your fix, then that relies crucially on having a reliable reference price. If you have poor liquidity in the market, then you’re not likely to have a reliable reference price and that is potentially open to manipulation, with all sorts of potential side effects, including reducing the confidence of investors in that regime and potentially scaring off non-Big Six investors, which I think, as Alistair said, is crucially important here.

The liquidity work that we’re doing is important here, but we shouldn’t forget the linkages the other way around. Introducing a contract for difference regime that covers a significant portion of the market will have an impact on liquidity itself, and some of those impacts could be positive and some could be negative. It could be positive, particularly if it brings new players into the market, which begins to undermine the vertically integrated structure of the industry. This is a complex area and one of those many areas where I think the devil is in the detail and a lot of work still needs to be done to get a coherent package together.

Q34 Dan Byles: I am interested in the RIIO model-revenue = incentives + innovation + outputs-and in particular how that is going to help shape the development of energy networks and consumer prices. It seems to me that we have a tension between the need to secure £32 billion-odd of new investment in energy networks on the one hand by 2020 and the need to maintain affordable energy prices for consumers on the other hand. You sort of sit in the middle trying to juggle that. Can you just talk me through how the new RIIO regulatory model is going to help achieve that balance?

Alistair Buchanan: It’s a very good question. We have moved from the old model of RPI minus x to RIIO, which is where your return or your reward as a company is driven off your performance, off incentives and innovations-they’re heavily sustainable development driven-and outputs. You’re right to identify the scale of the investment. We’ve analysed it at about a £60 increase on your bill between now and 2020, which is not an easy message to give consumers, but this is required. Partly it’s derived from the fact that the old super grid was created in broadly a coffin shape from Liverpool to Leeds down to London to Southampton-you were delivering the coal-based power to where people lived. Increasingly, going forward, the challenge-and it’s an expensive challenge-at the top-down level is that the power sources are going to be remote, therefore you are probably going to be bringing power down the two coastal routes, down the east and west coast and you’re going to be bringing power in from remote nuclear locations. Consequently, the challenge to the grid is substantial. It’s upgrading what we have; it’s building, frankly, completely new elements of the grid, and that is coming top down. We then have to go bottom up, because what we’re trying to do is to create a local revolution and therefore for all of us, if we have a ground heat scheme in our home, or photovoltaic, or whatever it is within your home, you’re wanting to sell back into the system. At local level, how well does the system accommodate that?

What we have with RIIO is an investment challenge. We have had laid down very clearly to us in the last Energy Act a requirement to ensure that we take sustainability seriously. That is where the two Is of RIIO really come into play, because we are incentivising the companies quite heavily: for example, a current incentive on the gas controls is to seek to connect rural areas that have not had a connection before. We’re also taking consumer money-a lot of it, £0.5 billion for each of three subsectors-for straight research and development that goes into improving the low carbon footprint of the networks.

We announced the first four winners of the electricity distribution awards under that scheme in December, and I’m very pleased with it. I’m sorry, I’m going to go into a bit of detail. It’s regional, so we have Durham, South Wales, Lincolnshire and London, but then you have a cross-section of key challenges facing the network going forward. In Durham you’re looking at smart grid, smart meter-you’re taking the city of Durham as a whole and trying to see how you can work that in a mode. In Wales you’re looking at voltage manipulation, in Lincolnshire you’re looking at linking up at the local level with wind farms, and in London you’re looking at electric vehicles. All these reflect the challenges, all of which carry a cost.

Unfortunately, the old model that we used, frankly, had run out of steam. When the industry was privatised it was deeply inefficient. Therefore, RPI minus x basically took the operating costs, and in fact some of the capital costs, and put them under enormous pressure. We dropped the price for consumers for network charges by 50% between about 1990 and 2004. Since the Price Control Review of 2004, prices have been going up for networks, because in that period-it wouldn’t be hard to see-there had been a profound underinvestment in research and development; there was no reward for the development of the system going forward. That, combined with our own sustainability duty and the need to hit low carbon targets, has led to us moving down this route of saying, "Right, we need a new way of rewarding the companies."

One of the very important things for me is that for consumers we are saying, "The network needs a wholesale refurbishment and needs to be built anew in many instances, but we want you to be involved in that because you’re going to have to pay more," and that is where the O of RIIO comes into play. Therefore we’re looking to consumer groups-we’ve had a very good meeting with the Citizens Advice on this already-for them to be involved in helping us to set some of the output measures.

Part of the problem with networks as a whole is that they’re pretty dull and they’re unexciting. The charging mechanism is quite complex, and by the time I’ve got to this point consumers and consumer groups are saying, "We’re not that interested." They need to be because £32 billion is a huge investment. The asset value of the sector at the moment is £43 billion, just to give you the scale of growth that we’re looking at in 10 years, so we are working very hard to get consumers involved. We think by regularly publishing every year what the company’s key output measures are then we can make this a much more attractive proposition for consumers to be more involved.

Q35 Dan Byles: I think I understand what it is trying to achieve. I’m still not sure I entirely understand how it achieves it. Is it effectively saying that innovative companies that are doing well earn the right to a slightly lighter touch regulation and are allowed to put their prices up by more than companies who are not being innovative and not doing a good job? Is that it in a nutshell?

Alistair Buchanan: We will still set the-in fact, we have made it more mechanistic so we’ve taken uncertainty out of the capital markets. So we’ve said how the cost of debt will be derived; the markets understand how the cost of equity is derived; therefore you have less subjectivity now coming into play when you get a new board or a new set of executives in place. The capital markets will broadly see what the return is.

The way we have structured it-and it goes right back to the purpose, I think, of the original privatisation-is to ape what markets do. What had happened latterly under RPI minus x was that everybody was sailing at the slowest pace of the convoy. Frankly, for a fund manager it really didn’t matter which one you bought, you were probably going to get much the same return. What we are trying to do is to say, "Yes, we’ll set the return and every company potentially can beat this return if they take the outputs and the incentives seriously". If they don’t, then they are going to underperform against the base, but that is their decision as a management team. Let’s say your cost of equity is around 7% to 8%. The very best might be earning low teens; the very worst might be earning much lower than the base. That has not been happening.

Talking to a number of the fund managers, as you would expect I have been, they welcome this because it gives them a chance to put management teams under pressure when they see the annual output measurements, to say, "You’re not doing very well, and therefore my return is not going to be good. You have to improve." Then if they don’t improve, they will get rid of the management team and bring a new one in. That element of capital markets discipline I think had started to not be in the network side of the business. So I think you are absolutely right to say some can beat it. All can beat it, which is a very important proposition for the fund manager, which is you’re not creating a median where 50% fail; you’re creating a median or a base and everybody potentially can beat it. But frankly, having followed the industry for some years now, I know that at any one time of the 14-plus network companies some will be badly run and they will struggle. Now, in fact, there is a much better opportunity for the fund manager to get involved and say, "This is not good enough. If you don’t improve we will get rid of you."

Q36 Dan Byles: So it makes it much more transparent, in a sense, t o see where the innovative management teams are and people who are doing well ?

Alistair Buchanan: Very much so, yes. You’ll be able to see who is getting the incentives, who is stepping forward into the low carbon network fund, and we’re going to publish the outputs. So, I think transparency is much greater.

Q37 Barry Gardiner: Forgive me if I am being very obtuse here. What precisely are the incentives? I see the stick, but how are you incentivising?

Alistair Buchanan: The companies will have a range of incentives to perform well. For example, if you’re going to cut your SF6 emissions from substations, if you’re going to cut your losses from your networks, you will get a reward for doing that, so we’re trying to incentivise.

Q38 Barry Gardiner: That is what I’m trying to get a handle on , because at one point I thought you said that they would be allowed to raise their prices.

Alistair Buchanan: No. What I’m saying is that because of the sheer spend that the industry is going to need, both in refurbishing what we’ve got but more importantly in building out a new system both at super grid and local grid level, you have a bill of £32 billion that we’re going to have to meet between now and 2020 and therefore it would be dishonest of me not to tell consumers that the network charge of their bill is going to go up.

Q39 Barry Gardiner: This is what I am trying to get a handle on. Is it part of your incentivisation of the companies that they will be allowed to raise their prices?

Alistair Buchanan: I see what you mean-a very good question. No, the overall charge is going to go up. Your ability to get a better return for your investors beyond that, or underperform against that, will depend on how well you adapt into the new RIIO mechanism.

Andrew Wright: Just to be absolutely clear on this one, unless companies are delivering real benefits to consumers, they won’t be able to earn higher returns and whether that benefit for consumers is better service, better standards of supply or lower costs, this is a sharing of benefit. It is not an ability for companies to earn higher returns for no benefit for consumers. Otherwise we wouldn’t be doing our job properly.

Alistair Buchanan: I know what you’re saying. I can almost draw it.

Q40 Barry Gardiner: We’re all consumers here. What do we care about? We want to know that when we press the switch the light goes on. We don’t care about anything else except price. Of course, you have much more to care about and so do we in Government. What I’m trying to make sure is that the incentivisation is not in terms of the price for that company because if it were, the better performing companies in terms of investment-the ones that are doing what you wanted them to do-would then find their customers drifting away from them. What I am trying to understand is how you get that investment into the company specifically without it affecting the price that their consumers are paying.

Alistair Buchanan: I totally understand what you are saying. These are monopoly companies and therefore you’re right, we owe a really substantial duty of care to the consumer. The bill goes up because the scale of the spend goes up but the company’s ability on behalf of their shareholders to outperform in a rising bill environment depends on how well they are going to pick up the challenges that we’ve put in place here.

Q41 Sir Robert Smith: It is the network companies, isn’t it?

Alistair Buchanan: Yes.

Q42 Sir Robert Smith: It was a tangential thing, because you mentioned smart grids and smart distribution. I wanted to get a reassurance that you were working with your fellow regulator in Ofcom to make sure that the communication that will be crucial to making these grids work is going to be there when we finally get our act together.

Alistair Buchanan: As you’re aware, and I encouraged this move by the Government, the Government said they’re taking control of phase 2 and phase 3 of the smart meter rollout. We’ve been working with them jointly during phase 1 but the sheer scale of this project-48 million meters across 27 million households-I support the decision made by the Government before Christmas. The reason I say that is that it’s the Government’s call because they are in charge, quite clearly, of phase 2 and phase 3, but to the best of my knowledge Ofcom will be heavily involved and I welcome that.

Q43 Albert Owen: A couple of things that you’ve raised before I move on to your future role. You have mentioned the CAB, Which? and other groups before, and you’ve mentioned CAB a couple of times, so you see them having an enhanced role as gathering data, gathering information at a grass roots level and feeding into yourselves. What is your existing relationship with them? With these extra duties and responsibilities, do you think they have the capacity to do it and the resources to do it? Will you be working with them? Will there be a man from Ofgem going into each bureau to work? How will that work? I think it is a serious issue, because it has been mentioned by both DECC and by the Treasury as a way forward.

Alistair Buchanan: We have a very good working relationship with CAB. We have a product that we jointly market with them called the Best Energy Deal where effectively we seek to train up their operatives so that they understand the energy market and can resolve issues for consumers ringing in to CAB. We have just started the third year of that.

Q44 Albert Owen: So their social policy department will be collating all this information and be working with you?

Alistair Buchanan: Correct.

Q45 Albert Owen: Do they need extra resources?

Alistair Buchanan: Honestly, I think that has to be an issue that the chief executive from CAB comes and talks to you about. I have no window on what they’re discussing.

Q46 Albert Owen: Let me ask you in a different way then. Do you think they have the expertise now to do this important enhanced role?

Alistair Buchanan: Certainly from the discussions that I’ve had with them, they know where they have expertise and they know where they haven’t, and that is almost the most important starting point, I think.

Q47 Albert Owen: All right. Their role will be changing but so will yours in the future. You have a number of major objectives outside the promotion and the competition and regulating-you have sustainable development, reduction of greenhouse gases, security of supplies. My question to you is how do you prioritise these objectives when affordability, sustainability and security of supply are in conflict?

Alistair Buchanan: Essentially we’ve lived with a range of duties from 2003, I would say, when we moved away from what a purist might call an economic regulator, when we were given social and environmental guidance. Against the tick-sheet on the guidance that you’ve seen in the NAO report to you, I felt fairly comfortable on just about every one that we can give you an answer that is satisfactory. That has really evolved through to the Energy Act of 2010, where we got three very important changes to how we go about our business. The first is that we’re responsible for future consumers as well as current consumers. The second is that previously our role had been focused on protecting and promoting consumers through competition wherever feasible-and you could always argue that that was an interesting phase-but then it has gone to say effectively that if there are circumstances where competition isn’t the right way or in the best interests of the consumer then look at that, Ofgem, as well. That is quite a big change. Then sustainable development has come right up the batting order of our duties.

Those are the three big changes. Do we feel that we have been able to manage those? I feel that we broadly have. This comes back to: are we fit for purpose? We still in a way have to see what the final purpose of the Government is in the market reform package. I think there are areas potentially of change that will enhance clarity and stability. I think this came out in both the NAO review but also the DECC report on Ofgem that they issued on 16 December. Probably the high level one is to ensure that there is absolute clarity about Government’s role over policy. One of the suggestions that we’ve made to Government there is that at the beginning of a five-year term, they very clearly set out what the high level energy policy is and then Ofgem reports every year to Parliament, or to yourselves, in line with the parameters that they set. So, in setting that five-year view on energy policy, they will then set out a number of parameters that they would expect to see during the five years. We then have to answer to that every year within the parameters set. I think that that would help.

I think there are going to be issues with regard to "fit for purpose" that you will have very strong views about I suspect-for example, heat regulation. Who does it? Why is it done? Should it be done? Those are the kind of issues that perhaps need to be addressed as well going forward.

I think we manage in our day job, as it were, to meet the duties that we have. We need to see whether the landscape is going to change in such a substantial way that it needs change to what we do. I do think the stability that we have, particularly the stability with capital markets, is very important going through to the next phase. So, whatever the changes are, let’s make them.

Q48 Albert Owen: We know where we’re going and you’ve given detailed answers of companies might want to invest in this country or not. You said about the sustainability. When capacity and decarbonisation dominate over affordability and there is that conflict, how do you see your role changing? Do you need this clearer mandate from Government alone, or do you need some sort of statutory underpinning?

Alistair Buchanan: In a way, I suppose, I’d take what we’ve been provided with and say, "Have we managed under that?" So, in the 2010 Energy Act, future consumers, while our ruling in RIIO, where we’ve now taken the depreciation charge that effectively for the electricity network companies you might say had a very severe imbalance between future consumers and current consumers, we’re looking at ensuring that there is a fairer charging for that going forward.

Sustainability? Well, we’ve created the low carbon network fund. So, for the first time in 20 years we’ve said that we are going to take consumer monies-a large amount of consumer monies: potentially £1.5 billion over a five to eight-year period-and provide that for straight, low carbon network funding.

You could also say-and some critics of Ofgem have because some people didn’t like what we did as one of the elements of the probe package on our non-discrimination clause, the cost reflectivity licence clause that we put in place after the probe, we did it on a sunset term-"Well, you’ve taken one step back towards regulation." We would say, "If that is the view that you have it’s because we’ve taken one step back to go two steps forward". But under the primary duty terms that we have now, we are empowered to look a bit wider than just markets. The current Government might say, "We don’t like that. We want to go back just to markets," in which case that’s great. We’ll do what we’re told to do.

Q49 Albert Owen: I am going to have one final stab at this. I appreciate that and we are trying to help you-in a changing EMR world we are trying to help you. Basically what I am asking is: do you envisage any potential conflict where your whole role will change significantly?

Alistair Buchanan: I’ll start and Andrew wants to have a word. I think the area that comes up most frequently is our responsibility with regard to fuel poverty and as a statutory organisation that self-evidently is not in charge of energy policy or fuel poverty policy or poverty as a wider issue. I think what I picked up from the consultation that DECC did on Ofgem is this is an area that a lot of our consultees are uncomfortable with as to what our role should be in this area.

Andrew Wright: I just wanted to emphasise that we have an important role representing the consumer interest here and that is both through making sure that when certain policies have been decided that consumers don’t pay any more than is necessary through maybe markets not working properly or us not doing our job on regulation properly. We need to do that, but it also means we have a role in making ourselves heard where we feel that the proposals that are being put forward are not necessarily in the consumers’ interest or things could be done in a way that met the objectives a bit more cheaply. We have in the past made comments regarding things like the renewable obligation scheme, for example, and that is an important role for us when it comes to looking at the EMR and our contribution towards that.

Q50 Chair: But you are almost in the position of being a hybrid now, aren’t you? You have a regulatory role. You’re giving policy advice and almost helping to make policy. You are also delivering programmes. It is quite an unusual combination, isn’t it?

Alistair Buchanan: You are absolutely right with regard to the latter. Seven years ago when I started at Ofgem, we managed £150 million-worth of energy efficiency schemes. We’re now managing, as you have seen from the NAO report, the best part of £4 billion. That is going to double in the next five to 10 years. What we have done is effectively built a very professional unit to do it. It has effectively a form of private sector management team: the finance director is from the private sector; the commercial director spent most of his life in the private sector. We’ve brought in the right skills to run the E-serve unit and the Government will have to make a decision. I presume it will make its decision on the basis of efficiency, cost saving and accountability as to where and how it wants to treat the E-serve arm of Ofgem.

You’re absolutely right, though, Chair. There are two really quite distinct functions: what we call Ofgem Orange, which is regulatory, which I think has always included a degree of advisory to Government; and then administration.

Q51 Chair: Does that compromise your independence at all?

Alistair Buchanan: It hasn’t to date, and were the Government to decide that E-serve should stay within the authority of the board of Ofgem, the authority’s remit, we have in draft a memorandum of understanding that ensures that we don’t get into those car crashes.

Q52 Chair: How does DECC monitor how well you do at delivering programmes?

Alistair Buchanan: I think we’re monitored pretty aggressively. We have had, I think, three specific and one general NAO reviews in the time that I’ve been at Ofgem. We obviously get, as does DECC, the NAO/Deloittes audit reports. They monitor each of our programmes very carefully because, of course, they’re funding them. My observation is that Phil Wynn Owen, who is the Director General at DECC, is watching the performance of these very carefully.

Q53 Albert Owen: Another one on your objectives. You’ve talked about your prominent role of helping the most vulnerable customers and those in low-paid areas. I’m very interested in the off-grid areas as well, where OFT have responsibility. In areas like that they’re paying a lot for their electricity, but on top of that they’re paying a huge amount extra for oil and off-grid gas. Would you welcome those responsibilities being under your umbrella so that you could look at the whole issue of energy and particularly linking in with the point that you made about fuel poverty?

Alistair Buchanan: If Government and you feel that is the right thing to do and you give us the parameters to do it, we’ll get on and do it. I think we have to be very careful. We have to know our place, as it were. We are a statutory body; we will do what you want us to do and we’ll do it as well as we can and if we don’t do it, you’ll call us in and give us a kicking. I hear what you are saying but I’m nervous about suggesting something, because that suggests that I am getting involved in determining high policy.

Q54 Albert Owen: Some of these groups you were talking about that are feeding in to you don’t see the barriers between OFT and Ofgem. They basically say the people that they’re representing, the people that bring those problems to them, need help. It is quite complicated as it stands now. Do you think-and I’m trying to help you with an answer here-that there would be greater simplification if one body was dealing with it?

Andrew Wright: It is perhaps incumbent on us to make sure we work closely with those other bodies to make sure that we are joined up on these issues. It is worth emphasising what we have done for off-grid gas customers as a result of the probe. We did identify they were getting a particularly raw deal because the electricity incumbents were tending to cross-subsidise their gas prices with their electricity prices and obviously if you don’t benefit from cheap gas, as these customers didn’t, then you lose out. That was one of the main items of price discrimination that we have addressed. We think if anything the situation is reversed now. Hopefully that has been a real benefit for those customers, even though we have not been able to do anything directly about fuel prices.

Q55 Albert Owen: I am going to throw this one in and I hope you will respond to it, because it has been thrown to you a number of times. Do you ever see an extension of the gas mains under the current systems?

Alistair Buchanan: We have an innovation funding mechanism in the current, gas distribution price control and I think this is going to be an area that will be opened up. Don’t quote me on this, says I on television. We haven’t made the decision yet. But the equivalent of the electricity distribution’s low carbon network fund, I think this is exactly the kind of area that may well get encouragement in the gas low carbon network fund. In what is called the innovation funding initiative within the current gas price control, which ends in 2013, we have already set aside monies and incentives for companies who do just that.

Q56 Albert Owen: You’ve set incentives, but Government needs to drive policy as well, do you feel?

Alistair Buchanan: The best example that I can point you to from last year was the 65-day rule, where the companies had up to 65 days, and another 20 on top of that, effectively to notify you that they had put up or put down-let’s say put up-their tariff. We expressed our concern about this and our desire to change it. Chris Huhne then stood up and said, "We, the Government, want this very much." Therefore we have now gone to a 30-day-ahead notification, which you’d say is absolutely right and proper. I think where you get that joint working on behalf of the consumer it can work very well.

Q57 Albert Owen: This is a very frustrating area because Ministers do stand up in the House and say, "Yes, we want to extend the thing but there are issues." Who is going to solve those issues, is what I’m asking?

Alistair Buchanan: We’ll do it with regard to the network as best we can. We have already done it within the gas distribution price control. I think basically it’s going to get a substantial step up as we have now created the low carbon network fund as a proposition. We can do it within our network regulator remit. If Government wants to have a more, I suppose, forceful and target-based policy then that is always up for Government to say, "This is what we want" and it will get delivered by the companies and ourselves.

Q58 Sir Robert Smith: Even with the network extension that could be achieved and even with the electricity fairer pricing for those without the gas grid, the bulk of people’s energy bills who aren’t on the gas main is going to remain to be provided by unregulated oil, LPG and other solid fuels.

Alistair Buchanan: Indeed.

Q59 Sir Robert Smith: As an energy regulator, how do you feel about a market operating where the consumer says, "I would like to order x units of energy," and the supplier says, "Certainly. We’ll eventually deliver it but we can’t give you a price until it turns up on your doorstep."?

Alistair Buchanan: I have read all the newspaper reports on this in the last few weeks. I think the OFT have said they are looking at this very carefully.

Q60 Dr Whitehead: Just a couple of questions briefly if I may on what you might call the quis custodiet custodes area. Most of your performance indicators are based on publication dates and the fact that something has been published. That is a bit like my son claiming he has achieved all his GCSE objectives by turning up to the exams, isn’t it?

Alistair Buchanan: Yes. I think we have three areas of indicators by which we are measured, first of all financial. We were the first regulatory body to take on the cost control mechanism that we asserted on to the companies. So, we’ve lived RPI minus 3 for five years. We’ve beaten that by £11.9 million. We have it again and we hope to beat that again to give monies back to the consumer-so we look at the financial basis upon how we run ourselves.

We then have customer service targets, which didn’t actually get a run in the NAO report, but the customer service targets are very important. We commit to deal with our licences, licence changes, new licences within 45 days. We are at 100% there. We will deal with customer letters and complaints, particularly customer letters, within 10 days. We are at 97% there. We will turn around modification rule changes within the industry within 25 days and we’re doing that at 77%. In the light of your report our audit committee have said, "Come on, we can do better than that. Let’s go to 90%". So that has been set as a new target for us.

Where I think it has been very useful from the NAO report and touched on in the DECC report on Ofgem is that we do have these performance indicators that tend to be project based and delivery based. Maybe as an organisation we are too strong about that because we are not communicating with the consumer well enough about what we might be doing for them. For example, the NAO use an approach, and they have it on the front of their report-I believe they put it on the front of every report they do-which is "We delivered £890 million of benefit to consumers last year." If I sat back and said, "Andrew’s team delivered £500 million of benefit on the PPM off-grid gas; our offshore team delivered £350 million of benefit by the way that we are doing things; we have over £20 million from National Grid on two major cases that we have had against them," we can start to add up and maybe we should do something like that.

Part of the reason that we have been a little bit concerned about that is that it doesn’t look at the qualitative issues. There is also a danger that a current management team takes benefits that another management team might want to take in a few years’ time and you start to double count. However, the audit committee at Ofgem have been very interested in this and they looked at it as part of their audit committee review the last time they met and we have an audit committee workshop on this in May. Therefore there are tricks-that’s the wrong word; I retract that. Therefore there are approaches towards performance indicators that other regulators are using-NAO in the lead in this area-that perhaps we can adopt to make communication of what we are doing better to the consumer and more relevant to what they do.

Q61 Dr Whitehead: As far as your operating costs are concerned, they’ve gone up from £42 million in 2008-09 to £51 million in 2009-10 and you’re projecting £78 million in 2010-11. That sounds like a bit of a protected zone, doesn’t it, in terms of the current atmosphere as far as cuts in costs are concerned?

Alistair Buchanan: Yes. As I clearly said, broadly half of that is Ofgem Orange; it is the regulated product that has been and will continue to be under cost control of RPI minus 3, and we will seek to beat that.

The other chunk of the business-because you’re right, if you just look at our business over the last few years it has just gone up like that-is because in the last few years we’ve had to introduce CERT, CESP and FIT. We now have to do renewable heat and social tariffs, and we have new ROC banding next year. So it’s just a huge amount of environmental alphabet, environmental mnemonics, reflecting the subsidies and the schemes that the Government has introduced in order for us to meet our low carbon targets. I’m afraid that has brought with it a price.

One of the figures that I have looked at quite carefully is the consultancy figure. When I arrived at Ofgem, the Ofgem Orange consultancy figure was £8.4 million. It was not good off a base of broadly about £35 million. We are now down to £4.4 million, so we have actively managed the consultancy out of the regulatory side of the business. You will see that the breakdown for the consultancy spend, which year on year looks like we grew from around £6.5 million to £9.1 million, that is all offshore, smart metering, environmental products, and the reason it’s there is that these are highly technical products that need consultancy advice. We don’t want to have the fixed cost of employing people longer term. We need specialist advice. It needs to be there at the beginning of a programme. But once it’s in place, it’s done and the programme gets into place. So we watch this very carefully and look at what we actively can control. We are watching the consultancy budget, as you would expect, very carefully this year, which was set at £9.2 million against last year’s £9.1 million. The run rate after nine months is we’re very comfortably below that. We are watching this carefully.

Chair: I think we have covered a lot of ground this morning and we are very grateful to you. We will reflect some of this in what we are doing on electricity markets reform and on other inquiries as well. We look forward to staying in close touch with you.

Alistair Buchanan: Thank you very much, Chair.

Chair: Thank you.