NORTHERN IRELAND
ASSEMBLY
_________________________
COMMITTEE FOR
ENTERPRISE, TRADE AND INVESTMENT
________________________
OFREG Consultation Paper on Transmission and Distribution Price Control Review for Northern Ireland Electricity
________________________
MINUTES OF EVIDENCE
(Northern Ireland Electricity)
Tuesday 15 January 2002
NORTHERN IRELAND ASSEMBLY
___________
COMMITTEE FOR
ENTERPRISE, TRADE AND INVESTMENT
___________
OFREG Consultation Paper on Transmission and Distribution Price Control Review for Northern Ireland Electricity
___________
MINUTES OF EVIDENCE
Tuesday 15 January 2002
Members present:
Mr P Doherty (Chairperson)
Mr Armstrong
Mr Clyde
Mr McClarty
Dr McDonnell
Ms Morrice
Dr O'Hagan
Mr Wells
Witnesses:
Mr H McCracken ) Northern Ireland Electricity
Mr A Boggs )
The Chairperson:
I welcome Mr Harry McCracken and Mr Ashley Boggs of Northern Ireland Electricity (NIE). The Committee has been dealing with the issue of energy for some time now. It has been receiving two differing readings of the situation from NIE and from the Office for the Regulation of Electricity and Gas (OFREG) and is trying to form an opinion. In correspondence you have answered some of the Committee's questions, some of which we wish to discuss further. You may make an introductory statement, after which the Committee members will ask questions.
Mr McCracken:
Thank you for the opportunity to put our views to you. I recognise the key difficulty of the Committee's understanding of the different views from OFREG and NIE. As recently as yesterday afternoon we had a long session with OFREG, and the matter is still a work in progress. OFREG has expressed its initial views, on which Douglas McIldoon will elaborate, and NIE has responded.
There are still one or two stages to go through, and we hope that, with continued interaction between NIE and OFREG, some of the current gaps in our views can be closed with the aim of reaching a good measure of agreement and implementing the new price controls. That is our goal.
I shall highlight the issue of price divergence and detail the current position, because our respective views on progress have converged since yesterday's meeting. I propose to speak to the note that I provided to you last week, which I tried to keep as brief as possible, and I will continue to try to do that as I go through this statement.
It is important to start from the customer's position. NIE's perspective of where customers are coming from is that fundamentally they expect NIE to provide a reliable supply of electricity in a cost-effective manner. They also expect some other things. They expect NIE to be able to deal effectively with problems that arise. They expect NIE to exhibit good environmental stewardship and a high level of social responsibility, and NIE accepts fully that that goes with the territory of the type of business that it runs.
Customers also expect at least one other thing: they want NIE to work in their interests to solve the longer-term structural problems in the industry. Those are problems that we touched on the last time we appeared before the Committee as witnesses in your inquiry into energy in Northern Ireland. Those problems can range from those large issues to other issues such as fuel poverty, emissions reduction and so forth.
I now want to move from the general perspective of what the customer expects into a price review. A price review should set out to ensure that customers' interests are protected, but in doing so the legitimate interests of other stakeholders should also be addressed. Principally, those stakeholders are the people who provide funds for the industry, that is, the investors. Therefore, it is not a sustainable position to prefer one stakeholder above another. The interests of both are legitimate and must be taken into account.
A good price review should seek to ensure that sufficient resources are provided to run the company and to look after customers' interests and at the same time ensuring that there is adequate reward for the people who are providing the funds to the company. All that NIE seeks from this review is an outcome that recognises that investments must be made on behalf of customers; NIE needs sufficient resources to be able to provide a satisfactory industry for customers. Investors need to have the confidence that those funds can be provided and that they will be adequately rewarded.
With regard to price trends, it has been well recognised that the major problem for Northern Ireland is the legacy of generator contracts. I recognise that that problem is being addressed through the work of the Committee and indeed in other arenas. There has been much discussion about how the costs and these contracts might be dealt with. The consensus that seems to be emerging concerns some way of refinancing existing contracts. That is consistent with the view that we put to the Committee the last time that we were here.
NIE would expect to see a legislative underpinning to emerge from the Northern Ireland Energy Bill. Notwithstanding that problem, NIE accepts fully that its cost for transmission and distribution must be transparent and wholly justified. It accepts that customers need to know that that is the case. By following established regulatory procedure and precedent, one will arrive at the right answer.
With regard to OFREG's view that there has been what it calls "systemic divergence" in costs between GB and Northern Ireland transmission and distribution prices, NIE has sought to show in the graph that we have given you that systemic divergence does not exist. Over comparable 10-year periods there is no divergence; in fact, there is some convergence between transmission and distribution prices in Northern Ireland and GB. That is not to say that OFREG is wrong and NIE is right, or vice versa. NIE has compared the movement in prices over a consistent period.
An analogous situation would be if the development of two schoolchildren were compared, it would be done when they are at the same age, irrespective of their dates of birth. That is all NIE is doing here. Where divergence has occurred since privatisation, it is from 2000, when GB companies went through their last price review. To the extent that there is a difference in costs between Northern Ireland and GB, the real question is: there is a difference in costs, but is there any divergence in that difference?
There has been no divergence in the first 10 years; in fact, there has been some convergence. There has been divergence in GB since the last price review. It will be impossible to say if there has been any change in the difference of costs until the current price review is finished. Convergence is unlikely to occur after the price review. That is a matter for this process to decide, and we do not have to guess at it.
In comparison with costs across UK companies, Scottish Hydro-Electric's transmission and distribution costs are significantly above the GB average and above NIE's transmission and distribution costs. That is unsurprising, because Scottish Hydro-Electric has a similar network to NIE's with similar topographical characteristics. There is a price difference between the GB average and NIE. There are obvious reasons for that price difference. It is unlikely it will go away because the amount of assets - the plant and equipment on the ground per customer - is almost 50% higher than the GB average. That is simply a topographical difference between Northern Ireland and most of GB. When consideration is given to companies that operate in regions similar to Northern Ireland with a large dispersed rural community, like Scottish Hydro-Electric, their prices are even higher than NIE's.
Historically, NIE has tried to lower prices. In real terms, costs since privatisation have fallen by 41%. That achievement is all the more remarkable because at the time NIE was investing in the network at around twice the GB rate. Some £600 million has been invested in the network since privatisation. I have given you a graph to that effect. A key aim of privatisation was to allow those companies to access private capital. Part of the funding for that new investment, while reducing customer costs at the same time, came from efficiency gains, which were passed fully to customers at the last price review when some £50 million per annum was taken out of NIE's revenue. There is a clear track record of price reduction and efficiency gains being passed back to customers and a significant track record of high levels of investment.
The Monopolies and Mergers Commission's decisions, taken at the last review, should be maintained. There was a difference of opinion at the last review - that is fine, reasonable people can disagree. The appeals process made some decisions that NIE did not like, but was prepared to live with. It is not in customers' interests to try to reopen those decisions.
Strategic energy policy was mentioned in the consultation document. NIE is quite willing to consider whatever role is appropriate for the company and the public interest, be it the promotion of renewables, efficiency improvement or whatever.
I emphasise that NIE believes that competition and an all-Ireland energy market is the way forward in addressing prices in Northern Ireland in the long term. That relates to the Committee's work. We can already see the impact of competition. The Moyle interconnector has been commissioned and has been in service for two weeks. Through the interconnector we are already receiving prices from GB that are substantially below costs in Northern Ireland. In addition, a single market in Ireland would give us the opportunity for significant economies of scale. A single market would certainly be more attractive to new entrants than two small markets. There is no reason why it should not increase mobility of business and attract inward investment.
For further competition to become a reality, to extend a much wider choice to customers and to open the market beyond its current level, the assistance of Government is needed to address the problem of generator contracts. That returns to the point that some form of underpinning the legislation will allow the refinancing of those contracts over a much longer period and allow them to be brought down to competitive levels. The Electricity Supply Board's monopoly and generation in the Republic of Ireland is in question should the same thing happen there; some of that should be surrendered to admit new entrants.
The transfer capacity on the North/South interconnector, from North to South, is approximately 170 megawatts and is therefore substantial. From South to North the transfer capacity is approximately 50 megawatts, and those transmission constraints in the Republic of Ireland lead to severe restriction on joint trading. That has already been brought to the attention of both regulators and both Departments, and its removal would help an all-Ireland market.
Ms Morrice:
I will ask the first question because I must leave to go to the Chamber. I am interested in your point that the interests of NIE shareholders and the interests of NIE customers are equal and should be treated equally. Do you have figures for the percentage increase in profits NIE has given its shareholders in the past five years, and also for the percentage decrease in prices to consumers? If their interests are treated equally, does NIE give customers the percentage decrease in prices equivalent to shareholders' increase in profits?
Mr McCracken:
I will try to answer that question with some figures that I have to hand. I am not sure I can give the precise answer, but if I cannot I will come back to you on that. The figures show that the total operating profit of the company since privatisation is some £620 million. Total investment by the company over the same period - that is, capital investment and network assets - is £570 million. The total tax paid by the company to the Treasury over that period is £180 million, and the total dividends to shareholders over that period are approximately £280 million.
For the first regulatory period from 1992-93 to 1996-97 the price controls were set by Government and not by a regulator. Leaving that period aside, at the time of the last price review, which was the first review by a regulator, some £50 million per annum was removed from NIE's allowed revenues. There was a 25% price cut in NIE's allowed revenues. If that £50 million per annum is multiplied by the five years of this price review's existence, that gives a figure of £250 million. That is one way to look at it, but I am not sure that it is wholly the right way.
Ms Morrice:
Did that £250 million compare to the £280 million dividends to shareholders?
Mr McCracken:
The reason I gave you all the figures is that the comparison needs to relate to how much of the company's profits and its borrowings went back into improving the network for customers, because the value equation for customers does not concern only the money they are given back. It also concerns the improvements and service that NIE can offer.
Ms Morrice:
I assume that many of your shareholders are also customers.
Mr McCracken:
They are indeed.
Ms Morrice:
They get that value of the security and supply, and they obviously get the value of price reductions as well. NIE should take account of the fact that they get that on top of their profits.
Mr McCracken:
You will appreciate that it would be difficult to split shareholders into those in Northern Ireland and those in Great Britain.
Ms Morrice:
On the issue of the price divergence, everyone says that prices here are not only higher than those in the rest of the United Kingdom but also in the rest of Europe, and perhaps in the world. Yet NIE argues that they are not. What about the topography of France or Greece, whose prices are much lower? How do prices compare here with those outside the United Kingdom?
Mr Boggs:
There is a difficulty in accessing comparable information on transmission and distribution costs.
The main comparisons that are published, for example, by the Electricity Association, show the total price, which includes the price of generation, and NIE is currently discussing transmission and distribution (T & D) prices with OFREG. NIE does not have a dataset of T & D prices across Europe. OFREG does not seem to have them either, so those prices may not be available. That means it is difficult to compare T & D prices consistently throughout Europe.
NIE has been able to compare T & D prices in the United Kingdom, because there is a good dataset available, and it has focused on that. Chapter 1 of our response to OFREG's paper focuses on the relative price trends in Northern Ireland versus Great Britain.
Ms Morrice:
The argument is that the prices are not much lower than in Great Britain.
Mr Boggs:
The argument is that during our first two regulatory periods, which are five years each, there has been some convergence on T & D prices between Northern Ireland and the GB average. The most recent review of distribution prices in Great Britain, which took effect on 1 April 2000, has reversed that convergence trend, but it has also changed the differential between companies in Great Britain, especially in relation to the two Scottish companies. Scottish Power's price is now 25% above the British average, whereas at the start of privatisation it was 2% below. Scottish Hydro's price is now 43% above the GB average, whereas at the start of privatisation it was 3% below.
Those prices, as well as the prices of UK companies, are the result of a series of price control reviews that followed the established building block methodology for determining the regulated revenue requirements for each of the distribution businesses. Those changing differentials are simply the outcome.
Ms Morrice:
If there were a percentage increase for shareholders and no percentage decrease for customers, I would like to know how much of a difference has been found.
Dr McDonnell:
You will appreciate that there is a perception that we are paying too much for our electricity. We are aware of the generation contracts, but we also believe that transmission and distribution is costlier than it should be. We are desperately waiting to be convinced otherwise.
The British companies adopted a strategy of depreciating their pre-privatisation assets relatively quickly, whereas here they are depreciated over 30 years. That does not make sense entirely, because if the asset base is so weak, poor or so much in need of refurbishment, it is not worth anything, so it is not worth keeping its book value for 30-odd years. It is a contradiction in terms to say that an asset is part of the company silver, and it will depreciate slowly at 3·3% per annum, yet on the other hand it is so run down that it needs almost total renewal. Have we missed the point entirely?
Mr McCracken:
No, there is a point in there, but a 30-year figure is incorrect for pre-privatisation assets. With regard to what must be done to the network to bring it up to reliable standards, it has nothing to do with the depreciation policy of existing assets. It has to do with the amount of new capital expenditure going into the network to improve it. NIE's assets in the main are depreciated over 40 years. The new capital expenditure going into the network will depreciate over 40 years. That is generally reckoned to be the economic life of the assets that NIE employs. Different depreciation policies can be adopted. If a faster depreciation policy is adopted, prices will be higher. Therefore, if pre-privatisation assets are taken for a given lump of money - for example, if there was a sum of £100 million and one wanted to depreciate it over 10 years - £10 million per annum would have to be charged to the accounts. If the depreciation period were five years, £20 million per annum would have to be charged to the accounts. Prices would be higher with a faster depreciation policy in order to meet that extra cost.
Dr McDonnell:
Dividends could be lower.
Mr McCracken:
That is depreciation. This is simply an accounting treatment that feeds through naturally into the accounts. Apart from deciding on a legitimate depreciation policy, there is no freedom of action about what is done with that. It will feed through as the legitimate cost of running the company, and that cost will have to be recovered from customers. If a cost is increased and shareholders are allowed to take the strain of that increase, that goes back to my earlier point. When one is running an industry it is not acceptable to say to one class of stakeholder that they will be inferior to another. The legitimate interests of one shareholder cannot be disregarded because they would simply say that they would not give the company any money to fund the industry because it was being run in a strange way.
Mr Boggs:
There is a distinction between the depreciation profile used for setting a price control compared to the accounting depreciation used in the company's statutory accounts. The issue is focused on the depreciation profile used for setting price controls. The depreciation in this context relates only to the depreciation of those assets that existed at privatisation. In that regard, you are quite right to say that NIE is different from GB companies. In GB the depreciation of pre-privatisation assets is occurring faster than in Northern Ireland with regard to depreciation of pre-flotation assets. The average life depreciation of assets in GB is 15 years, whereas in Northern Ireland the figure is 18½ years. That is the difference. Those are the assets that existed on the network at the time of privatisation.
From a regulatory treatment point of view, those assets had an 18½-year profile average remaining life. When the Monopolies and Mergers Commission addressed depreciation at the last price review it recognised that if pre-privatisation assets were to be depreciated on the basis of their average remaining life, NIE would find itself in the position where some of those assets would have dropped out of the regulatory asset base in 18½ years because they would have been fully depreciated. However, some of those assets would still be there serving customers. For the Monopolies and Mergers Commission it was an issue of intergenerational equity or fairness between different generations of customers. In changing the depreciation profile for regulatory purposes the Monopolies and Mergers Commission aimed to align more closely depreciation charges in prices with the remaining life of those assets on the ground.
It moved from a depreciation profile that was based on the average remaining life to a depreciation profile that was based on the actual remaining life. The bottom line is that in GB pre-privatisation assets are being depreciated faster than in Northern Ireland.
As Mr McCracken said, the effect of the difference is that GB prices under the faster profile are higher initially than they would have been had a low, slow depreciation profile been adopted. The faster profile depreciation in GB has helped the GB prices to fall faster than those in Northern Ireland. However, in one way or another, prices reflect the value of those assets as it was determined at privatisation.
Dr McDonnell:
It is hard to consider the whole business of transmission and distribution without taking into account the other companies in the Viridian Group. Powerteam, Sx3 and Zenith feed off NIE. There is a major concern that those companies probably would not exist if it were not for NIE business, and they may be doing very well out of the NIE. That in turn feeds back into the costs. The simplest example that springs to mind is that the billing system may be an extremely lucrative contract for Sx3.
Mr Cracken:
I am glad of the opportunity to answer that question, because there are erroneous perceptions about that issue.
Today Sx3 earns 80% to 85% of its revenue outside the company. Only about 20% of the revenues earned by Sx3 come from NIE, so the NIE contract represents a small proportion of the company's revenue. As a managing director of NIE, I can assure the Committee that my only requirement is that any sister company must demonstrate that its prices are competitive -otherwise it will not get the business. If the Committee wishes, I can give examples of business that NIE has taken from sister companies and given to others. NIE went into the European Journal for the whole purchasing and supply chain, which includes central stores, the purchase department, satellite stores and distribution, which is a large contract with Sx3. That contract probably amounts to about £3·5 million per annum. NIE is listed in the European Journal, and if the company gets a better price than that offered by Sx3, it will take it. Sx3 does not get preferential treatment when doing business with NIE.
There are plenty of competitive benchmarks from the work that Sx3 does in the outside world that NIE can use to compare prices. I am convinced that Sx3 can get business on a competitive basis, and NIE is not paying more. Sx3 would probably argue that NIE has been given favourable prices for some services.
I would also point out that even though Sx3 grew from humble beginnings with NIE - 400 staff from NIE created that business - the business employs 1,300 people today. Therefore, it is a real success story in Northern Ireland. In the case of Powerteam, NIE has put all its industrial staff in one organisation.
Regulation should have moved on considerably since previous reviews. The traditional review still exists, where regulators try to peer into the guts of the organisation to examine how costs are allocated and how much various activities cost. However, the companies have moved on to a point where many of the costs that used to be embedded in the companies are now outsourced. That has actually made those costs more transparent, as can be seen by examining the costs in transactions between NIE and Sx3. The billing system, other customer service activities, and things such as the supply chain have been mentioned. Open + Direct is a financial services company with whom NIE has a fleet contract for paying our vans and so forth. Those costs are completely transparent and can be lifted and compared with the competitive benchmark in the outside world. NIE has tried to provide this information as part of the review. I view the development of the companies and the outsourcing of their activities as a positive move from a regulatory point of view because they are more transparent.
Mr Boggs:
It is also positive from the customer's point of view. NIE carried out an exercise that compared the costs of some of those services before the Viridian capital companies were set up and the costs of those services now with regards to what transmission and distribution pays. NIE presented information to OFREG that shows a 28% reduction in services for accounts payable, a 26% reduction in purchasing, a 22% reduction in training costs and so forth. NIE has been able to present information to OFREG that shows that exposing the provision of those services to a more competitive environment has helped to bring about cost reductions.
Dr McDonnell:
Surely NIE is fully exposed only when the contracts start moving, or when they start switching?
Mr Boggs:
NIE accepts that some of those services are bespoke to NIE. However, many of the other services - for example, the provision of IT and transport services - are provided in a truly competitive market. NIE has provided benchmark information to compare Sx3's costs for the competitive services with others.
Mr McClarty:
It is my understanding that it costs approximately £5 per head to produce a bill for NIE. That seems somewhat excessive. Has NIE ever put that service out to tender? Will it ever put it out to tender, and if not, why not?
Mr McCracken:
The billing system costs are not a transmission and distribution cost and are not part of this price review. Those costs belong in the supply business, where price controls have been settled. The costs of the billing services are not germane, but your question is valid. It does not come under the auspices of this price review.
No service is sacrosanct to any NIE sister organisation, because of the challenging environment we live in as an organisation and the provision of services to customers and what they cost. There is no way that NIE can prefer one supplier to another. It has to decide what supplier can give the required service at the least cost. That is the only way that the business can be run.
The billing system is an old system, but that does not mean that it does not cost a lot to run. It costs a lot to run by the very fact that it is an old system that grew over the years. It is customised and specialised in the type of tariffs and so forth that the company offers to customers. It requires many people to take care of it. It is significantly prone to error for a number of reasons and NIE is looking at a replacement for the billing system. First, NIE is faced with a more competitive environment, and secondly, it needs to find a system that is less complicated and less costly. A decision will be taken in the near future. The provision of the billing system will go out to competitive tender, and Sx3 will make a bid for it. The EU Utilities Directive requires NIE to go out to tender for the letting of contracts above a certain figure. Sister companies cannot be given preferential treatment.
Mr Wells:
I am sure you read the article and the associated material in the 'Belfast Telegraph' a couple of weeks ago. I saw a slight flash of recognition when I showed it to you.
Mr McCracken:
Is that John Simpson's article?
Mr Wells:
Yes, it is.
Mr McCracken:
John will do what John will do.
Mr Wells:
We are being recorded. It is implicit in that article and in the material that the Committee has received that all regulated industries try to bury as much of the profit as possible in sister companies, all under one umbrella. It is totally legitimate, but it is also totally legitimate for the regulator to spot it and to bring it to book if it becomes excessive. Why were smaller subsidiaries formed if it was for no other reason than to bury profit? According to the regulator, about £3·4 million of profit is being earned by the subsidiaries which should, in fact, be allocated to transmission and distribution. What is the rationale for having them in the first place if it is not to bury profit?
Mr McCracken:
First, I thought the article was all right, and I did not have a problem with it. However, it was probably written after reading one document. It certainly was not written after reading the NIE document, otherwise part of the answer to your question would have been provided.
Before NIE created the holding company Viridian, it was decided that we would like to grow. Any private sector company likes to grow and grow shareholder value. That is one reason why the company exists. We looked around to see what skills and assets there were in the organisation that could be employed to enable that growth. A business outsourcing opportunity was identified through SX3, and also identified a financial services opportunity through Open + Direct.
Open + Direct was born simply out of the credit book that NIE used to have for the shops. The shops were sold off for the freehold value of about £1 million. However, the money that was made on the sale of appliances was made on the credit terms provided alongside - that is simply the way that industry works. That simple credit book was used to build a financial services organisation that has been quite profitable. Its profits have not come from NIE because it provides only fleet services, which are competitively tested. The raison d'être behind the formation of those businesses was to develop Viridian, and that has been done. Open + Direct has 250 staff, but it started with about 10. Sx3 started with 400 staff, and now it has 1,300. Those are success stories for Northern Ireland.
The profits back to NIE contained in the services provided by those companies are perfectly transparent. That £3·4 million has been dealt with in our submission document, of which I will leave a copy with you. It explicitly sets out the problem with the figures that are mentioned in John Simpson's article. Some figures in the article are wrong in relation to the assumptions that lie behind them and the calculations that have been done to arrive at them. They have taken away all the profit that those companies are earning. One could not go elsewhere and receive a service for nothing. It is a ridiculous assumption, notwithstanding the fact that the assets that were placed in those companies at the time of privatisation to sell back to us need to be remunerated. If those companies are using assets to provide a service to us, such as the billing engine, are you saying it is not legitimate for those companies to get a return on those assets?
Mr Wells:
In privatisation, has it never occurred to NIE that it may be a good idea to try to massage as much of the profits into the subsidiaries rather than allocate it to transmission costs?
Mr McCracken:
I could not say that it may not have occurred to me, but it is not the way that NIE is run because we do not believe that it is a sustainable way in which to run the company. NIE is not in business with a strategy to fleece Northern Ireland customers. It is in business to provide Northern Ireland customers with the best possible service it can provide in the most cost-effective manner. All NIE requires for investors is a fair return on the funds that they make available to do that.
Mr Wells:
I am glad the management of Viridian is so pure, because it has occurred to every other transmission company in the rest of the United Kingdom. They have all tried as hard as they can but they have not got away with it because of the regulator's involvement. So I am glad that Viridian is purer than snow.
You mentioned Scottish Hydro-Electric, which is a valid comparison. However, is the regulator in Scotland, perhaps, chasing Scottish Hydro-Electric for the same reason, in that its costs are rising faster than the GB average? It is no good to say that it is doing it as well. If its regulator is hounding it on the same basis, it is not a true comparison. What is the situation with our regulator's timeframe?
Mr McCracken:
I do not know the definitive answer to that question, but I would suggest that the same debate is not taking place in Scotland because it does not have an overall price problem. That is because Scotland does not have a generation cost problem. In fact, it has the opposite; it has a lot of fully depreciated, cheap hydropower.
Hydropower is used to subsidise distribution charges. Around £40 to £50 million is taken from the generation side of the business and used to keep the costs down on the distribution side. The context is different in Scotland. Therefore, there is not the same background driver for the debate. I do not see that occurring, but I could not honestly say that it is not because there may be quite intensive debate between the regulator in Scotland and the company.
Mr Boggs:
The outcome for Scottish Hydro-Electric's prices today is a result of the application of the building block approach to setting its price control. That is the same building block approach that applied to the other 13 or 14 companies in Great Britain. To put some dimension on Mr McCracken's point about the benefit that Scottish Hydro-Electric's transmission and distribution prices get from its cheap hydro-generation, if it were not for the £40 million cross-subsidy from cheap generation to help offset those prices, Scottish Hydro-Electric's total transmission and development price would be 22% higher than NIE's price.
Mr Wells:
What is the rate of return for the assets applied in NIE?
Mr Boggs:
The regulated rate of return that the Monopolies and Mergers Commission sets for the second price control is 7%.
Mr Wells:
How does that compare to other companies such as Southern Electric, Norweb and Manweb?
Mr Boggs:
The most recent price review for the distribution companies in Great Britain reduced that regulated rate of return to 6·5%.
Mr Wells:
If that were the result of this review, would that be an acceptable figure for NIE?
Mr Boggs:
Chapter 6 of our response outlines the submission that NIE made to OFREG, and we will leave it with the Committee. It sets out NIE's reasons for believing that the cost of capital assumption, on which the regulated rate of return is set, should be at least 7%.
Mr Wells:
This morning the rate of inflation was announced at 0·7%. Therefore, is 7% a realistic figure?
Mr Boggs:
That is a real pre-tax rate of return.
Mr Wells:
It is a very good rate of return given the present market conditions.
Mr Boggs:
The established approach for setting cost of capital is to use the so-called capital asset pricing model. We worked our way through each of its components and believe that 7% is an appropriate figure.
Mr Wells:
I have declared this many times: I am a Viridian shareholder and I notice that my dividends seem to have increased much faster than the rate of inflation. The regulator has affected the capital price, but the actual return to investors, since privatisation, has been good. The return that I am getting on my initial investment after privatisation is fantastic when compared to what I would get from a bank or building society. That leads me to believe that shareholders in Northern Ireland have benefited much more than shareholders in other equivalent companies in the rest of the United Kingdom have. That would indicate that that is where some of the money is going.
Mr McCracken:
Much of the profitability that we were able to generate was due to efficiency gains that the company has made since privatisation. In the first regulatory period NIE provided those returns to shareholders, and that is the time when most efficiency gains were being made. That was reset to zero and the slate was wiped clean as the price review progressed. All the efficiency gains that had been made, the appropriate cost of capital and so forth, were considered as the price review was conducted in 1997.
The dividend policy was maintained after 1997. One reasons that it could be maintained was that the other companies were contributing to profitability. In 2001, 25% of the earnings of the group came from companies outside NIE. Therefore, it was those growth companies that investors were examining and valuing, and that allowed us to maintain a yearly dividend increase over and above what we would have been able to do with NIE alone.
Mr Clyde:
When was the last price review in GB?
Mr McCracken:
It was applied in April 2000.
Mr Armstrong:
You have stated that you work for both the customer and the investor. You seemed to be saying to Mr Wells that the investor was making more than the customer, and the customer was being charged for his billing. It seems that NIE is setting up an area to ensure that the investor is looked after better than the customer. NIE is not giving the customer any cuts or reductions in the price of electricity.
Mr McCracken:
I do not accept that. In answer to an earlier question, I said that as NIE went through its price review - there are five-yearly price reviews, which is how the regulatory process works - a price control is set for five years ahead. That price control has incentives to encourage the company to become more efficient more quickly than what the price control would have assumed. Therefore, the difference between that increased efficiency over and above what the price controls would have assumed would be retained for shareholders. That is the method of providing shareholders with extra dividends - being able to outstrip the price controls on a five-year basis. That is an essential incentive because if there are no incentives, people will sit on their hands, do nothing and charge customers whatever they are allowed to charge them. At the end of the five-year period those efficiency gains are harvested for customers - that is the regulatory deal.
At the 1997 price review, £50 million of NIE's income was harvested for customers, which is 25% of its total income. One would be hard pushed to find another company in Northern Ireland that took a 25% reduction of its income on the basis of handing that back to customers.
I do not know what will happen at this price review. However, if the proper regulatory procedures and accepted precedents from GB reviews are applied, together with the Monopolies and Mergers Commission's decision on the company at the last review, the right outcome will be achieved.
Customers are not necessarily saying that they want price reductions per se. They want a reliable supply of electricity, because if it is unreliable, the price does not matter. It would be nice to have as cheap an electricity supply as possible, but if it is unreliable, it is too dear at any price. In the provision of this type of service - electricity, water, gas or whatever -its availability is fundamental. The price of that availability must be worked on to ensure that it is as cost-effective as possible.
As an organisation we have no other goal than to be able to provide that service as cost-effectively as possible. I am quite willing to hand back to customers whatever comes out of this review, as a view of the efficiency gains that we have made over the past five years.
Mr Armstrong:
How soon will customers know that?
Mr McCracken:
I hope that they will know as soon as possible. I still hope that we will not have the long-drawn-out process that we had last time around. I sincerely hope that we will not have to go to the Competition Commission over this. Some extremely important points must be resolved as a decision is made, but whether this price review also ends up with the Competition Commission is very much in the hands of the regulator.
Dr McDonnell:
Is divergence inevitable post-2005, when customers in England have effectively disposed of their pre-privatisation assets, or the write-off of those assets, and they will be financing only post-privatisation issues?
Mr McCracken:
I think I know what you mean. We are back to the point of pre-privatisation assets being depreciated fully at a certain date, and from that date on, because they are not in the asset base, customers will not be paying for them. Is that the point you are making?
Dr McDonnell:
Yes. Will there be price divergence then?
Mr McCracken:
The simple answer is that it will be a contributory factor. However, as we have said, there are many factors that make up a price control, and that would be one of them. So yes, that would be a factor that would tend to increase divergence at that time.
Dr McDonnell:
NIE has, I presume, included in its analysis the pre-privatisation GB liquidation or reduction of assets. If that were taken into account, would NIE's analysis of regulatory year by regulatory year still synchronise? One problem for the Committee is the synchronisation of regulatory years with a GB phase that was two years earlier. What I am really trying to get at is this: if one took into account the treatment of pre-privatisation assets in GB, would NIE's analysis still hold?
Mr McCracken:
NIE's analysis holds for any situation because all it has done is align. If one measures the development of two schoolchildren, one measures them both at 15 years of age. Whereas one child might have been born two years later, one has to wait two years before the measurement can be done.
Dr McDonnell:
That is the difficulty for the Committee.
Mr McCracken:
NIE's comparison methodology is valid, no matter what the underlying components are, because it is simply an alignment to make the comparison valid. If you are asking how it would be different in terms of the gap between the two, I do not think I could answer that without examining it.
Dr McDonnell:
You said that Sx3 accounts for only 15% of NIE revenue. How profitable is Sx3? Is it worth it?
Mr McCracken:
It is a profitable company. I hope that I am not dealing in price-sensitive information now. It is not as profitable as it was previously, in that all tech stock companies and IT companies have been through a difficult period. Everyone is experiencing difficulties at the moment. It is not only the regulator's problem - Mr Wells is driving the share price down - it is also the performance of those companies. That indicates the risky nature of those companies. They are by no means a penalty kick in terms of their profitability. They need to be worked at, they need careful management, they need good strategies. They also need a lot of investment.
The Chairperson:
Do you regard OFREG's analysis, which compares calendar years as opposed to regulatory years, as being inaccurate?
Mr McCracken:
Yes, I do. I think Douglas McIldoon would agree that for the comparison to be valid it is necessary to compare regulatory years rather than calendar years. With regard to systemic divergence, NIE has demonstrated that there is no systemic divergence by comparing the development of the two companies over similar periods of time.
On the other hand, OFREG states that if one comes right up to date, post-2000 GB price review, a marked divergence will be seen. NIE would agree that that happened only at the 2000 GB review and that there was nothing systemic about what went on in the previous 10 years. Therefore, the question is: what will happen when the review is conducted? My opinion is that as long as the review is conducted according to well-understood methodology and precedent, the answer will emerge. That answer might show that the difference is being maintained or that the difference has increased. It is unlikely that the difference will be reduced; it is more likely to increase.
The reason for that increase should be well understood. I go back to the point I made earlier: in Northern Ireland the plant and equipment used per customer is half as much again as the average in GB, and it must be paid for. Alternatively NIE could offer an inferior quality of supply, which would not be acceptable.
The Chairperson:
The Committee Members appear to be satisfied, at least up to this point. After you leave they will probably think of some more questions, and we may write to you again. Thank you for attending and dealing with our questions. We are trying to probe this issue in order to find the proper way forward.
Mr McCracken:
I hope that we have added to your understanding, and we will answer any follow-up questions that you might have.