Committee for Enterprise,
Trade and Investment
15 January 2002
MINUTES OF EVIDENCE
OFREG Consultation Paper on Transmission and Distribution
Price Control Review for Northern Ireland Electricity
(Office for the Regulation of Electricity and Gas)
Mr P Doherty (Chairperson)
Mr D McEldoon
Mr W McIlhatton Office for the Regulation of Electricity and Gas (OFREG)
Mr S O'Hare
I welcome Mr McIldoon to the Committee once again. I will not introduce the members, because you have met them several times. The Committee is examining the issue of energy, and is trying to probe the apparent contradictions between OFREG's position and that of NIE. There has been correspondence on the subject and the Committee has received all your reports. Could you elaborate on those, before members ask their questions?
My two colleagues are William McIlhatton, who joined OFREG from Kilroot and brings a private sector perspective to OFREG's deliberations on the matter, and Seamus O'Hare, who does much of the analytical work on the structure of NIE's costs. My opening statement would last 15 minutes, and it would be unreasonable to tax you with it, so could it be included in the proceedings?
The statement is repetitive. In three places it contains the phrase,
"I would very much like NIE to be right about this matter"
As the discussion progresses, you might understand why that is so.
I will summarise the introductory statement. There are three public interest issues in price control. First, we want to maintain a safe and reliable network. That is common ground, which Mr McCracken mentioned earlier; there is nothing more to be said about that. Secondly, we need to discuss a just allocation between customers and shareholders - I will return to that point. Thirdly, we are interested in how Northern Ireland is doing by comparison to other regions.
I have five fundamental points. First, there is a degree of asymmetry in disinterestedness. That is a contextual point, but it is worth recording so that there is no misunderstanding. OFREG is staffed entirely by civil servants. Nobody in OFREG has any interest, financial or otherwise, in the outcome of the price control. We get paid exactly the same salaries, regardless of whether we reduce or increase NIE's prices.
Asymmetry results from the fact that NIE, its shareholders and its management have an interest in avoiding price reductions. There is nothing improper about that - that is how privatised industries work. Nobody there is doing anything improper, but, although OFREG has no financial axe to grind, its opponents do. NIE wants to resist price increases in order to augment the reward that its shareholders gain.
There is a difference in trends. We do not argue that prices in Northern Ireland should be the same as in Great Britain, or in any particular region. We want to know whether prices are moving in the same direction and at roughly the same pace, and, if they are not, why not?
NIE has responded admirably to OFREG's challenge. We put it to NIE that when the industry was privatised, prices were 16% higher than the British average, whereas today the gap is 44%. We call that trend "systemic divergence" because the situation is worsening over time. NIE has responded admirably by saying that, according to its figures, which are based on 10-year blocks of time, there has been no divergence, but that there has been convergence. NIE's figures do show such a trend, but it has not argued that there has been systemic convergence. Mr McCracken went out of his way to avoid having to make that claim. It is our assertion that any convergence in the first 10 years of regulation, here and in GB, is due to happy coincidence. It is not systemic; it will not continue.
The question for customers is: what is going to happen? Will convergence continue, or will it worsen over the next five years? I would dearly like NIE to respond that it could continue that trend, in which case we could quickly reach an arrangement. However, I do not think that it is saying that. Divergence is caused partly by the present price control - some effects take time to materialise. Depreciation policies last for 40 years, therefore it takes time before their impact can be seen. Divergence will also happen as a result of the things that NIE has been asking us for. Our graph demonstrates that, whether charted in regulatory or calendar years, there will be significant price divergence.
It must be recognised that there is a clash of cultural perspective between NIE's view of what it is entitled to do and OFREG's view. We try to reflect the view of society, if you told us that we have not done so, we would change our position. NIE has a licence that puts it in a privileged position and which protects it. I have a statutory obligation to ensure that NIE can finance its activities, although other companies do not have that protection. Anyone who owns shares - particularly those who invested in dot.com companies, or in companies such as ENRON - knows what can happen to shareholdings. That could only happen in NIE's case if the management were to go off the rails and act irresponsibility. That is unlikely to happen.
In return for such substantial protection, shareholders should reason that the company will give them a better return on their investment than a building society, and that it will be safe. However, their profit should not be growing at 10% per annum, as it has been for the last 10 years. Sixty-five per cent of the profit is created by the transmission and distribution business therefore NIE customers are sustaining that high rate of dividend growth - that is exploitative. There is a major cultural clash of perspectives. It is for the Committee to decide whether OFREG or NIE is right.
My final point relates to incentive regulation. I have no argument that NIE is not entitled to its safe, predictable return. However, in line with incentive regulation, it is also entitled to make "super" profits if it does exceptional things. I could give several examples of how we have incentivised the company to make exceptional profits. Our reasoning is that if NIE does exceptional things, customers will benefit as well. There is nothing wrong with NIE's making exceptional profits, but it must perform exceptionally.
Price control is an economic instrument, which can confuse those who are not directly involved in the process. It determines the prices that the owner of a monopoly infrastructure can charge for a very vital commodity. It is a complex instrument, designed and executed by technocrats in OFREG and NIE, but it represents the expression of a political purpose. It is for society, through its elected representatives, to indicate the combination of technical efficiencies to be employed, the costs that it is prepared to face, and the social justice that expresses its values.
My job is simply to translate those values into a price control that everyone will regard as being just. We have not had that yet, and I want to ensure that it is brought about.
Five years ago OFREG referred NIE to the Monopolies and Mergers Commission in respect of the same issue. Is that an option this time?
The law has not changed. The procedure is that we publish initial proposals, upon which the company, or anyone else, can comment. We then publish final proposals, after which we could still change our position. Although we did not do so last time, negotiation with the company could take place. If the company refuses to accept our proposals we have two options. One is to back down, and the other is to refer the case to the former Monopolies and Mergers Commission, which is the Competition Commission.
If we go to the Competition Commission, any proposals that we make will allow the company to finance its activities and will give shareholders a decent return on their investment. If the company rejects our proposals, it is telling customers in Northern Ireland that they are not paying enough and that its shareholders need more money. Technically, I would be making that reference, but the company would be triggering it by arguing that prices must be higher.
The price gap of 16% that was revealed at the time of privatisation is now much bigger, and it is growing. However, the gaps that are revealed at privatisation are not necessarily always accurate, as was the case in Scotland. NIE argues that the gap of 16% understated the true gap between Northern Ireland and the rest of the United Kingdom. It has not yet said what it believes the true gap should be, but at least its position has become more honest and transparent than in the past. It used to argue that the gap was entirely the fault of the generators, but now it acknowledges that transmission and distribution prices in Northern Ireland should always be at a higher level than those in Great Britain and that the gap should be greater than it was at privatisation. The process, from our perspective, is aimed at reducing that gap as much as possible.
You talked about the crux of the matter - the clash of cultural perspectives between customers and shareholders. You also talked about the growth of share profits. Should NIE make greater profits than other companies? Are its profits the result of genuine efficiency gains that will eventually benefit the customer, or are they the result of a manipulation of the regulatory framework?
So far, they have resulted from a manipulation of the regulatory framework. Companies throughout the United Kingdom have done that, not just NIE. When industries such as NIE were privatised it was expected that their shareholders would make safe investments that give modest returns. The financial industry behaved in such a way as to encourage people to make enormous gains. The Labour Government introduced the windfall tax, because it felt that the system was being abused, and NIE paid its share of that tax.
The question is what is a "reasonable return"? A problem with privatising such a utility is that the main high-cost driver is the necessary financing of private sector companies. A good example is a water company in Wales that was translated into a not-for-profit organisation. British Rail might undergo such a change. The 7% return that NIE currently gets and the 6·5% that English companies get is significantly higher than the cost of financing a not-for-profit organisation. Such a structure would acquire capital at around 4·5% to 5%. It is not for me, but for policy makers or politicians, to decide whether our current privatised structure is the most appropriate way to finance this type of infrastructure investment. Ten years ago, the fashion favoured that, but the trend seems to be changing.
Earlier, we put to Mr McCracken a point in respect of the subsidiary companies of Sx3, Power Team and Open + Direct. He said that it is wrong that OFREG should allocate all £3·4 million profit to finance transmission and distribution, because that wipes out the entire profit. Mr McCracken said that some return capital must be invested in the subsidiary companies; that would have an impact on your calculations. OFREG suggested that profits are being buried elsewhere to keep them out of its control. Frankly, if I worked for NIE I would try to ensure that everything that I earned was kept out of OFREG's control so that that profit would not be regulated. That is human nature; we all do that. In another world, we refer to that practice as "putting it under the mattress". In the light of Mr McCracken's comments, how do you justify that figure of £3·4 million?
OFREG's aim is to strip out the excess profit and to allow NIE the equivalent of 7% on the assets. We will need to work our way through the make-up of that £3·4 million with NIE. Our intention is not to strip the profits completely so that NIE would be cut back down to its basic cost - the company is allowed to have a rate of return, but we want to take out any excess profit.
You are implying that contracts are being awarded to the subsidiary companies at prices that are not a true indication of the open market rate and that they are making excess profits.
In some cases, when we work through the information relating to the management accounts of some of those service providers, the profits are higher than we expected.
But if those contracts are being made the subject of open tender, and if there is competition -
Mr McCracken explained that future contracts would be advertised through the European Journal. However, the initial contracts were secured on an arms-length basis between NIE and its subsidiary companies based on benchmarking. However, as efficiencies start to flow through as a result of the operation of those contracts, the profit level rises. Our consultants identified that problem. We want to examine those cases and to return any excess profits resulting from those contracts, but will still allow them to retain some profits.
Surely it is unfair to compare Northern Ireland's transmission and distribution (T&D) costs with those in Great Britain? T&D costs per unit in London must be a fraction of those in rural areas. Would it not be better to compare NIE's T&D costs with those of Scottish Hydro or Yorkshire Electricity, which operate in large, sprawling rural areas where the cost of provision is much higher? How does NIE perform by comparison with those companies, on a like-for-like basis?
OFREG is not comparing Northern Ireland with any specific region. If NIE was at 100 in 1992 and companies in Great Britain were at 100, and if those companies have since fallen down to 70, NIE should have fallen to the same level. If we were 200 and they were 100, and they had then fallen to 70, we should have fallen to 140. OFREG is interested in those trends, and whether we are driving our prices down at the same rate - not at a faster rate. NIE has said that so far it has been doing that. Our problem is that according to NIE it will not be able to continue to do that in the future.
If one stripped down large urban conurbations and compared a basketful of rural areas with Northern Ireland, you might discover that there are different forces at play and that there is convergence between this Province's figures and those for the rural areas.
The factors that result in higher prices in some regions do not change over five years. Factors such as rural dispersal, or the presence of lakes and mountains, do not change from one ice age to the next - they are constants. If, in 1992, one area's electricity system costs 16% more than another area's, why would it cost 44% more in 2002?
Perhaps demand is rising significantly in Northern Ireland, and the added cost of meeting that demand would prevent convergence.
Demand has grown faster in Northern Ireland, and greater demand means that more units are used to pay for the same fixed costs. Faster demand growth should dilute the fixed costs and therefore reduce the cost per unit.
If the source of that demand is thousands of new bungalows located in the back end of nowhere, all of which have to be supplied with electricity, the capital expenditure that that requires will result in a low return.
The network has not changed its configuration since privatisation. NIE has added bits to it and spent £600 million. However, nothing has happened that would change the trend. NIE claims not to have changed the trend, but to have reduced electricity costs pro rata with those in Great Britain. That is the good news. The bad news is that it says that it will be unable to do that in the future. OFREG's graph forecasts the impact of NIE's failure to do that in the future.
Do you simply want an undertaking from Viridian that there will be a steady convergence in profit levels over the next five years so that the trend will be reversed?
Yes. That would be one way of managing it. Neither of us wants to get into the position of starting with the answer and working back. As Mr Boggs said, we must continue with the building block approach and produce a safe and reliable network. The test of effectiveness is whether we are moving in the same general direction. An acceptable approach, which would satisfy people in Northern Ireland, would be if NIE were to seek an incentive to move in that direction, agree to base a price control on the rates of other British regions, and guarantee a safe and reliable network without diluting its service quality.
Even if price divergence happens for legitimate reasons, that imposes a burden on the entire economy of Northern Ireland. It reduces our regional competitiveness. It is difficult to see why our competitiveness in electricity, for example, should be worse than that of the Irish Republic, which has a much more dispersed population. Line length in the Irish Republic is four times greater than in Northern Ireland, but ESB has only two-and-a-half times the customers and two-and-a-half times the demand. Its costs should be dramatically higher than ours, but they are not. Despite having a price control on its distribution network, which involves an enormous capital investment programme - far bigger than anything that we have done - its distribution prices are still falling.
On what statutory basis are you empowered to claw back what you believe to be excess profits from the previous five years? I would have thought that, once you reached an agreement with NIE, it was signed and sealed, and that it was up to you, as a regulator, to police it. I believed that if that did not happen, it was not NIE's fault; it was the regulator's fault. I cannot see how you can then justify taking from NIE its profits from the previous five years.
There is no law one way or another. The price control is set according to custom and practice. OFREG did not reach an agreement with NIE; a socially unjust arrangement was imposed, whereby NIE got more money than it needed - all the evidence shows that. The amount of money that it has given you in your dividends is also evidence of that. Therefore, there is no agreement that I must honour. It was imposed on customers in Northern Ireland against OFREG's will. There is no question that it would be bad regulatory practice to take a company's legitimate earnings, regardless of whether that would be moral.
On the other hand, it is unacceptable that a company should receive the same reward twice over. For example, we must be sure that NIE's customers are not still paying a 7% return on an asset that the company has sold. We want to investigate such issues. We would not expropriate profits that NIE had legitimately earned in the past.
You want to reign in NIE's expenditure; will that not reduce NIE's ability to provide customer service and to react during storms, for example?
The critical question is what does it cost to maintain a safe and reliable network? Responses to storms and emergencies are part of that. We all agree that we do not want a reduction in NIE's standards, or in its ability to respond to such events. The general view is that NIE has been getting better at responding in such circumstances.
Can you explain why the cost of regulation per customer in Northern Ireland is twice that in GB?
If there are no criminals, you do not need a large police force. Perhaps that is too glib an answer. Regulation here has had to be much more intensive than in England. I have to fight far more battles, and I deal with the company at a much more detailed level. My opposite number in England would certainly not see the officials of electricity companies as often as I do. Regulation in England works much more by diktat from the top. We are in a goldfish bowl here, and we operate a different style of regulation, which is inevitably more personal.
The system has good and bad aspects. In some ways it makes life difficult for everyone. However, it also enables us to be pioneering, and to achieve things that have, in some ways, put us ahead of the rest United Kingdom. I would like to accentuate that positive aspect of the system.
I would like to reduce the cost of regulation in Northern Ireland. However, each year, in unpublicised ways, we succeed in securing the odd few million pounds for customers which they would not have secured if we were not here, and if we were not well resourced. We certainly give value to customers.
Did you say that the figure of 65% corresponded to Viridian?
Yes. 65% of Viridan's profits come from transmission and distribution.
Can that be compared to a figure for the Republic?
That is not possible. ESB has been split up into separate businesses, but it does not have all the non-regulated businesses that Viridan has. It does not have subsidiary companies such as Open + Direct and Sx3, although it may do in the future.
Can you make an estimate? Is there a means of comparing the figure?
We could find out ESB's profits on each of its electricity businesses. One of those businesses is generation, which NIE does not yet have. Viridian will have a generation business in the Republic from later this year.
Profitability is the main issue. I would also like NIE to get a return on its investment. I would even like it to get "super" profits if its activity is "super". However, the difficulty is that there is an inbuilt public guarantee - you provide security to underwrite certain investments. What percentage return do you think is reasonable? In other words, what percentage return does your intervention ensure?
That must be decided when fixing the price control, and I could not estimate a figure yet. Suffice it to say that rates of return have been coming down across the regulated sector. That brings us back to my earlier point about disinterestedness. NIE got a return of 7% last time, which was the going rate for the electricity sector across the United Kingdom. That rate has gone down in the rest of the United Kingdom. There is now an interest in taking out equity and using more debt to finance infrastructure businesses, which should drive down the cost of capital. However, NIE now says that it should get more than last time. It produces all sorts of well-written papers showing why it should get more, which is fascinating.
NIE has an interest in driving divergence because that will result in more money for its shareholders. However, we will have to state clearly what we think that the cost of capital should be when we publish our final paper. Once we have done that, the markets will respond to the whole paper and people may buy and sell NIE shares. That will then become a price sensitive issue. There are rules on how we should release information onto the stock exchange. It would be improper of me today to say precisely what I think NIE's cost of capital should be.
As amateurs in this field, the Committee needs to get a bearing on such matters, because the situation is, for the large part, a moveable feast. As with a piece of string, the question is: how long is it? If a public guarantee is to be given, there must be a commitment on the other side to maintain a moderate return. The state might guarantee that the business will stay above zero level, but if it guarantees a return of 4% or 5% the top side should be much closer to that.
The Committee will be observing what is happening elsewhere in related sectors. No doubt you will come to your own conclusions as to where it should be.
It is estimated that NIE made some £3 million from back-ending on its allowed revenue. Could NIE be encouraged to redirect that money to assist, for example, the estimated 170,000 households that are affected by fuel poverty?
In terms of regulatory practice, what NIE did was quite normal, but their actions did not reflect the intention of the regulations. It is a perverse outcome, but all companies have tended to act in that way. Such activity results in greater profits, which although legitimate are not regarded as being good practice. I cannot dictate how the company should spend its profits. If it is making excess returns, which the Committee feels should be used by the company for the common good, it is a matter for the company and the Committee. It is not for me to comment on.
Mr McCracken commented on the different capacities of the interconnector North/South as opposed to South/North. Is that matter within your remit, and do you deal with the regulator in the South? What effect does that have on NIE?
That matter is beyond the area of transmission and distribution. NIE has addressed the transmission and distribution issue this time, and has not hidden behind the smokescreen as it did before now by claiming that high generation costs are wholly to blame. However, I was saddened by NIE's comments that the only way to achieve reductions is to create an all-Ireland electricity market. We have an all-Ireland market at present. Someone in Cork can buy their electricity in the North and vice versa, but the market is subject to physical constraints and other factors such as different tax regimes and the exchange rate. That market does not function very effectively, therefore to claim that everything must depend on the development of that market is to divert attention once again from the problems at our doorstep such as transmission and distribution costs and local generation costs, which should be addressed.
However, the development of better trade between the two parts of Ireland is a major issue, and requires a great deal of investment, mainly in the Republic, because our section is quite good. At present, we can transfer 600 megawatts South of the border, but then it gets blocked. Therefore, the available transfer capacity that we auctioned this year for transmitting electricity from the North to the South was only 170 megawatts. There is greater capacity, but its availability is not always certain. The Republic is to auction capacity availability for transmitting electricity from the South to the North on 31 January, but only 70 megawatts will be on offer.
Theoretically, the interconnector could move 600 megawatts of power in either direction. The reason for those restrictions is that the transmission network in the Republic, especially around Dublin, is constrained, and much investment in the system is needed. That investment will take place over the next four to five years, and we are told that many of the problems will then disappear. Electricity will flow more easily between and within the two jurisdictions. However, that is no reason for doing nothing to reduce transmission and distribution costs.
You stated that NIE's analysis does not include any evidence of systematic convergence, and that its figures are recorded according to regulatory years. Are its figures for the last ten years reasonable or fair?
Mr O'Hare is the expert on those numbers. We have not crawled all over them for verification, but let us assume that the figures are all right: NIE acknowledges that its prices have moved from a 16% differential in 1992 to the current gap of 44%. However, if customers in Northern Ireland could travel through time, they would not see that price divergence, because two years later the differential would have returned to the 9% that NIE has observed.
I could take comfort from the NIE analysis if it could then extrapolate and say that over the next five or ten years, on a basis of matching regulatory years, the real divergence is 9%, 10% or 11%, or whatever the figure is, and make specific predictions for the coming years. If that were the case, I would be quite happy to pack my tents and tell NIE that it is doing a grand job. However, NIE is saying that in 11,12 or 13 years it will move back up from the 9% or 12% figure that was observed this year. Mr O'Hare has figures that predict where we think that figure might move according to what NIE has told us.
You have already seen the figures in the table. According to regulatory years, in year 10 there will be a divergence of 14%. We are currently examining NIE's proposals for the next price control period, and they show a divergence of approximately 55% continuing over the next five years - an increase from 14% to 55%.
The Committee will take some time to deliberate, and will not be able to respond for at least two weeks, although we will correspond with OFREG. We are trying to conclude our report on the energy inquiry, but as the Committee moves towards its conclusion such difficult issues as these have emerged. Initially, the Committee thought that it would have been able to conclude on the matter within six weeks, but nine months later we are still working on the subject. This is a huge issue therefore we want to ensure that we have proper facts and figures. The Committee is torn between two different analyses of what, for us, is the same picture.
Thank you for the analysis and information that you have given us. It has made us probe and analyse much deeper than we had planned.
OFREG is grateful that this hearing has taken place in an open forum and not secretively behind closed doors. I pay tribute to NIE for being a much more open organisation than it was a few years ago and for being prepared to debate the issues and publicly defend its position in public. I welcome that.