Committee for Enterprise,
Trade and Investment
OFREG OPENING STATEMENT TO THE
COMMITTEE FOR ENTERPRISE, TRADE AND INVESTMENT
ON 15 JANUARY 2002
Thank you for inviting me and NIE here today to explain what is happening with the T&D price control. I welcome the fact that this matter is being examined as it should be, in a public setting, and not by a secretive and unaccountable body behind closed doors.
A price control is an economic instrument. It determines the prices which can be charged by an owner of a monopoly infrastructure business which is vital to every aspect of civilised life. It is a complex instrument designed and executed by technocrats. But it represents the expression of political purpose. It is for society as a whole, through their elected representatives, to indicate that combination of technical efficiency, cost and social justice which express society's values. It is my job to translate society's values into an effective price control.
There seems to me to be three major public interest issues involved in this price control review. The first which I believe is common ground is that we need to continue to maintain a safe and reliable network.
The second is the need to decide what is the just allocation between customers and shareholders. Customers are captive. Shareholders can of course sell their shares and get out if they don't like the way things are going and financial institutions can refuse to lend the company money or charge a premium for doing so. Over rewarding investors in comparison to the financial risks they run is to overcharge customers.
Thirdly, there is the question of how well we are doing in Northern Ireland in following the rest of the UK in reducing T&D costs and it is on this area that the spotlight seems at present to be focusing.
At the outset, just in case there is any misunderstanding about this, I should make it absolutely clear that neither I, nor any of my staff, nor anybody else that we employ has any financial interest in the outcome. None of us either receives nor should we receive, a reward of any kind for securing a reduction in electricity charges. NIE, on the other hand stands to lose money and behind NIE there is a whole Greek chorus of financial interests which have no interest in the welfare of electricity customers in Northern Ireland but who are keen to see NIE come out of this well. I mention this not to suggest that anyone is behaving improperly, but to make the point that, unfortunately, this is not a search for the truth by two disinterested parties. Only one party is disinterested. The other may feel obliged to resist what is financially painful. That is not a criticism. It is simply to note that is the way things are. But while there is an organised campaign on behalf of the shareholder lobby there is strangely no countervailing lobby on behalf of the customers. Some might argue that this is a sign that customers are not unhappy with the present situation; others might argue that the customer interest is such a diffuse and general interest that - as it is everybody's concern it is nobody's responsibility - so articulating and defending consumers' interests has gone by default.
Secondly, since comparisons are always difficult and likely to be disputed, I believe the emphasis in any test we apply to the outcome of the price control process is: "what is the trend and how does the trend compare with what has happened elsewhere?" This is not to suggest that the price control in Northern Ireland should be based on anything other than the reasonable costs of a prudent and efficient operator in Northern Ireland. But it is a useful way of testing our progress or lack of it. But it is more than just a quick "sanity" test. Failure to move in the same direction and at roughly the same pace as everyone else in a competitive world is a loss of regional competitiveness. For both these reasons we in Ofreg have raised the issue of what we have called "systemic divergence". NIE to their credit have responded to this challenge. It is through this process of challenge that we will arrive at the truth and get for Northern Ireland the best electricity system which we are capable of achieving. NIE's response to the challenge is particularly welcome because for many years they attributed the high cost of electricity in Northern Ireland exclusively to the high cost of generation and were in denial about the possibility that T&D charges could have any part to play in the high cost or the growing divergence. Indeed they shrouded everything which the MMC had either looked at or might have looked at in a degree of wonder and awe which precluded discussion by mere mortals. This all smacked of evasion, special pleading and intellectual dishonesty. The high cost of generation has certainly been the principal culprit but that was no reason for not looking dispassionately and objectively at other possible contributory factors. So I welcome this new openness to debate and discussion. My welcome is however tinged with some disappointment when I read the NIE statement which states that "an open and competitive all-Ireland electricity market is the only way sustainable, long-term price reductions can be achieved". This statement seems to me, once again, a reversion to the old tactic of finding something else - which by its nature will take years to fully address - as an excuse for not addressing the question of T&D costs or indeed the other generation cost reductions which are achievable within Northern Ireland.
Ofreg's concern is that while prices of T&D have been falling in Northern Ireland they have been falling faster in other places so that on average the further forward we go in time, the bigger the gap with GB will become compared with the gap before privatisation. Moreover, we see this problem becoming more acute in the future if NIE's allowed revenue per unit escapes the downward pressures which have been applied and accepted by electricity companies in both Great Britain and the Irish Republic. NIE has responded by showing that over the ten years of regulation they have reduced unit costs faster than the British average. It should be noted that our interests on this are asymmetrical. I would like NIE to be right. Neither of us has any interest in Ofreg's view being proved right. At this stage Ofreg's provisional view is that - however paradoxical it may seem and we have not yet applied exhaustive checks to the figures - both these conclusions are correct. The reality is that we have had growing divergence in each five year period since privatisation. NIE show that over the first ten years of regulation they have tracked the unit cost reductions in Great Britain over GB's first ten years of price controls and even outperformed them. Consequently there is no problem of divergence; customers only perceive a problem because they haven't yet mastered the art of time travel! Clearly if it is the case that there is convergence and - most importantly - if that were to continue into the future indefinitely - the problem of divergence would over time be reversed and overcome. But will it?
In looking at NIE's ten years it is important to realise that the symmetry of declining costs in GB and NI which NIE shows are the outcome of many cost drivers - in GB within and on 15 different companies - pushing and reinforcing each other and certainly not all going in the one direction or at the same speed. Many of these cost drivers have an effect on total costs for many years and their cumulative effect on total costs - and thus on price comparisons - may take many years to become apparent. Such factors include among other things, depreciation policy, the rate of build up of assets, business rates, capitalization policies, the costs from other parts of the supply change transferred into or out of the T&D businesses.
Given the high starting point and the diluting effect on fixed costs of a faster unit growth rate it is not surprising that NIE should have achieved a faster per unit reduction in costs than the GB average. I have argued that there is "systemic divergence" and I would dearly like to be proved wrong. It should be noted that NIE have not in response argued that there is convergence which is "systemic".
The key question for consumers on which we must now focus is "what will happen over the next five years?" Is the convergence over the two regulatory periods which NIE show a happy coincidence or is it "systemic" - that is something which will be maintained over the next five years and beyond. This is the heart of the matter.
All the evidence which we in Ofreg have been able to gather from the build up of costs in the present price control - and whose long-term implications for divergence have not yet manifested themselves - together with what NIE are looking for in the next period suggest to us that NIE's ten-year convergence is nothing more than a happy coincidence of the timing of costs entering and exiting the GB and NI systems and will not be maintained. Unless extreme vigilance is exercised the next period will show a continuation of real time price divergence. But I would like to be proved wrong about this.
We are not at the end of our process and I would not want to be dogmatic about our findings to date, or speculate on the final outcome. Moreover, I have always placed more emphasis on the total electricity bill than on the unit cost as the unit cost may not ultimately be the best measure of customers' welfare. In addition neither Ofreg nor NIE will want as I hinted at earlier to start with an answer and work backwards. It may be that there has to be a gap and even that it should become wider. Conversely I have never been opposed to the possibility - particularly with devolution - that Northern Ireland could outperform the rest of the United Kingdom.
Thirdly, I would like to say something about what might be described as a clash of cultural perspectives. These two perspectives are, I believe, both held with complete integrity by the protagonists - Ofreg and NIE. They do not preclude our producing - indeed they may stimulate us into producing - clever solutions from which all stakeholders benefit - a "win/win" outcome as it is sometimes referred to. But with these conflicting cultural perspectives we can only create "win/win" outcomes by - in Jean Monnet's celebrated phrase - "changing the context". Where we cannot change the context - and this price control may be such a case - we are back to a zero sum game. I believe that it is possible to go through a challenging process of this nature with goodwill and integrity on both sides and emerge with a better outcome than either protagonist could have initially envisaged.
The different cultural perspectives are these: NIE's is that so long as they comply with their licence they are entitled to take every penny legally permitted from customers in Northern Ireland; that they have a duty to their shareholders to maximise that amount and that their position, as a protected monopoly holder, does not place them under any obligations to their host community different from those of any other company located here and in particular does not oblige them to volunteer price reductions at the next price control; quite the contrary - they will resist price reductions to the utmost of their ability and their focus is London - where they seek support and if need be, protection - rather than Northern Ireland despite the fact that it is to us that they owe their existence and their income. One small example demonstrates this. For some months now NIE have been considering trying to pressurise me into levying the equivalent of 25p on all customers in Northern Ireland to pay for legal costs of the court case in which they succeeded in taking back from customers over the current five-year period £39m which I had denied them and which on the evidence since they certainly did not need to enable them to finance their activities. I think that the fact that that type of debate has to take place within NIE indicates that there is a real struggle going on for the soul of that company. Does NIE's Board really value their customers as much as their shareholders? Naturally in normal circumstances shareholders come first both in time and in obligation. Without the shareholders' money there would be no business and no customers. With NIE the position is the exact opposite. There were customers long before there were shareholders and there would be no business in the absence of customers. In this case the shareholders need the customers. Quite frankly the customers could manage without the shareholders.
The Ofreg perspective therefore is that electricity is a vital public service and is not like any other commodity. Normally if a business fails it takes its shareholders and workers with it. If the electricity supply industry fails it brings us all down with it. Consequently it is given a great deal of reassurance and protection by the host community - we need it to do well and the regulatory framework guarantees returns to shareholders commensurate with the risk that shareholders run. The quid pro quo for that security is that super profits should only be allowed in return for super performance. It is important to understand just how safe an investment NIE is. The obligation in the Electricity Order is "to secure that licence holders are able to finance the carrying on of activities which they are authorised by their licenses to carry on". This is a greater obligation than some other regulators face and consequently a greater protection for shareholders. When you consider what has happened to the value of shareholdings in other companies in recent months - not least in the energy sector - this is a remarkable degree of protection for shareholders interests. It would seem that a rational investor would expect a predictable but modest return for such an investment. However that is not what they have been encouraged to expect. Dividends have grown by 10% per annum. As the T&D business contributes 65% of Viridian's profits, it is the electricity customer in Northern Ireland who underpins this dividend growth. I can see no justification whatsoever for this state of affairs while prices remain so high relative to GB. It is in fact not sustainable in the long term without rising prices. It is crudely exploitative unless it is justified by super performance on price reductions. This is not just my view. For what it is worth the MMC stated "As to the appropriate annual rate of real dividend growth for NIE we find the DG's argument persuasive, namely that NIE's real long-term dividend growth should be consistent with that expected for the economy as a whole".
This brings me to my fourth point. In the privatised electricity industry which I have to regulate, it seems to me perfectly logical to reward super performance with larger profits since over time the benefits of super performance are shared with customers. I believe I have fully demonstrated my commitment to incentive regulation with the Supply Price Control. The Supply Price Control which emerged from the MMC was based on a profit allowance of 0.5% on turnover. This would have given the Supply business about £2.5m per annum profit. However, it cut its costs and was soon making substantially more than this. Under the normal way of proceeding I should have re-opened the Supply Price Control this year and given that extra profit back to customers in the form of lower charges. Instead, Ofreg agreed with the company to extend and change the price control so that the company retained the extra profit and provided other benefits to customers. More recently and in an even less publicised change I increased the incentive which NIE's Power Procurement Business receives from selling electricity outside its Bulk Supply Tariff. I mention these, not because they were necessarily the right thing to do but because they demonstrate Ofreg's commitment to providing an incentive structure in which shareholders can make super profits through delivering benefits to customers.
In conclusion I would want to acknowledge that we have certainly progressed in recent years, for which NIE and their staff deserve credit. But it is ludicrous to pretend that shareholders have not been amply rewarded given the low risk nature of their investment. It is the stark reality that in the year of privatisation that the T&D price gap with GB was 16% and this year is about 42%. What will it be next year and the years after that?
This exhaustive but very open process subjects this vital aspect of the economic structure of Northern Ireland to a degree of public challenge and scrutiny which is probably without parallel. It is a good process and I do not believe it should be conducted behind closed doors. I will ensure that in bringing it to a conclusion, my actions will be informed by the concerns of the wider Northern Ireland community as expressed in this Assembly as well as my statutory duty to ensure that NIE can finance its licensed activities. But the key question is for NIE.
Is NIE prepared to come clean and tell people in Northern Ireland that we must in perpetuity have a greater price differential than we had before privatisation or are they able to commit themselves to tracking GB's cost reductions.