bRiEFiNg
summary December 2009
Every five years, Ofgem sets price controls for the 14 electricity distribution network operators (DNOs). Price controls both set the total revenues that each DNO can collect from customers and incentivise DNOs to improve their efficiency and quality of service. On 7 December 2009, Ofgem issued its final proposals for the latest distribution price control review (DPCR5), which will apply from April 2010 until 31 March
2015. This briefing summarises the main implications of the proposals.
Ofgem announced on 18 December 2009 how it intends to implement its distribution price control review
( DPCR5 ) proposals. This will be through amendments to each distribution network operator’s ( DNO ) special licence, the industry-wide standard licence conditions and two new statutory instruments. These are the
Electricity (Connection Standards of Performance)
Regulations 2010 and the Electricity (Standards of
Performance) Regulations 2010, which will replace the current Electricity (Standards of Performance)
Regulations 2005.
Initial reactions have been mixed, with some companies
– Scottish and Southern Energy ( SSE ) and Electricité de France (EdF) – publicly stating that they may well reject Ofgem’s DPCR5 proposals, which would trigger a Competition Commission price control review.
Distribution companies have until 6 January 2010 to object.
There has not to date been an electricity DPCR by the
Competition Commission (or, indeed, any recent price control reviews in the gas or water sectors). Any
Competition Commission investigation would last for six months (and could last up to 12 months in total if extended).
In addition, Ofgem has highlighted that it wishes to see more competition in connections and it intends to conduct a competition review of those distribution companies engaged in this activity by the end of
December 2013. Any arising matters of potential concern will be referred to the Competition Commission for further competition review (most likely as a market investigation).
Ofgem has taken account of the following factors when formulating its final proposals:
the economy and the ability of distribution companies to earn the revenues they need to maintain and improve network reliability;
environmental issues to support the government’s low carbon economy initiatives; and the need for service and reliability investments to the network.
The economy
In the context of the current financial crisis, Ofgem has decided to introduce a number of mechanisms to provide
DNOs with adequate protection against price and volume risk, without passing all of this risk to customers:
cost of capital and debt – Ofgem is proposing a weighted average cost of capital ( WACC ) of 4.7 per cent (4.0 per cent post tax) to allow DNOs to fund the cost of debt and equity (before taking into account any other financing risk). SSE has publicly stated that a 4 per cent shareholder return is insufficient in the context of the risk, cost and availability of finance over the last 18 months. Ofgem has sought to address this issue by stating that its capital and debt figures are based on long-term trends and recent developments in financial markets (among them
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Electricity distribution price control – overview of Ofgem’s final proposals
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the recent issuance of debt by utilities, including
EdF in November 2009). Ofgem does not consider that, on the basis of available evidence, the cost of equity has risen above its long-term average as a result of the financial crisis. Ofgem has assumed a cost of debt of 3.6 per cent (25 basis points lower than the cost of capital in the last price control for gas distribution companies). Following consultation with the DNOs , Ofgem will not protect them against the risk that the actual cost of debt exceeds permitted levels. Ofgem has preferred this fixed allowance mechanism. In its WACC calculations, it has used a 65 per cent notional figure for gearing
(its consultants PricewaterhouseCoopers (PwC) having recommended a range between 55 and 65 per cent and Ofgem having used 62.5 per cent in its gas distribution work); return on equity – Ofgem has assumed a baseline return on equity of 6.7 per cent (post tax). It considers that its assumptions on the cost of capital and equity will allow an efficient company to earn baseline returns to equity of between 7.1 per cent and 9.6 per cent, with the potential to earn up to 13 per cent through better performance; poorly performing companies may earn returns as low as 3 per cent; costs – Ofgem is intending to cut £1.3bn from the cost proposals submitted by the companies. In the context of the recession and the difficulties facing customers in paying their bills, Ofgem’s policy is to ensure that shareholders rather than customers carry the cost of inefficient practices or uncompetitive input prices; customer service – Ofgem is expanding the focus of customer service incentives from simply security of supply and interruptions to a new mechanism to reward and penalise DNOs according to their performance across the full range of services. In particular, it has introduced new standards for all stages of the connection process, targets for network reliability (including customer interruptions and customer minutes lost) and a broad measure of customer satisfaction. It will develop its measure of customer satisfaction over the next two years, which will enter into force in the last three years of the price control. The measure has been designed to be broadly similar to the way that companies in competitive sectors measure their customer services and improve their performance (including customer complaint management); and
pensions – pension deficits amounted to £2.6bn across the industry as of September 2009. The allowed revenues include £1.7bn for pension costs, including
£1bn to fund pension deficits over the next five years. The current economic and financial market conditions make the size of these deficits uncertain.
Ofgem has therefore concluded that it is prudent for customers to fund these deficits over 15 years.
Contrary to its initial proposals, companies will be able to recover the whole deficit (rather than about half). Ofgem has included additional incentives, based on those used in other sectors, to incentivise the DNOs to manage their future pension costs and liabilities effectively (taking into account restrictions imposed on DNOs on privatisation).
Environment
The review has been conducted in the context of the government’s 2020 climate change targets and policy to decarbonise energy. This has led to a number of measures to incentivise DNOs to tackle climate change, including the following:
electricity losses incentive – Ofgem intends to revise and improve the DPCR4 losses incentive to ensure
that DNOs have an incentive to reduce losses on their network; low carbon and energy saving developments –
DNOs will be obliged to improve the service and information that they give to local low carbon generation developers;
DNOs will continue to distributed generation – earn extra returns on investment used to connect distributed generation. In addition, the incentives on capital and operating expenditure will be equalised to remove the previous bias towards capital investment and charging the DNOs the costs of linking to the transmission network. Both these measures should encourage the DNOs to consider using demand-side management or distributed generation as a means of addressing capacity constraints. Distributed generation will also benefit from the introduction of cost-reflective charging and obligations to ensure that contracts and charging arrangements are clear and on non-discriminatory terms; low carbon networks fund – Ofgem will introduce a low carbon networks fund, which will allow the
DNOs to spend up to £500m to trial new low carbon
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Electricity distribution price control – overview of Ofgem’s final proposals
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technology over the five-year price control period.
The DNOs will be able to bid for a share of these funds following an annual call for proposals, provided they agree to share their learning; and reporting – DNOs will be required to report annually on their own carbon footprints.
Network investment and performance
Ofgem has introduced new measures regarding DNOs ’ investments in the quality and performance of their networks, including:
network investment requirements – Ofgem considers that DNOs need to invest significantly in the electricity networks to maintain and/or replace the majority of assets installed in the 1950s and 1960s. Ofgem has decided that £14bn should be allowed for network investment over the price control period. This should be used to provide additional capacity in certain areas as demand continues to rise, as well as to replace old assets. Ofgem has concluded in some cases that the
DNOs can carry out investments more efficiently than forecast. Following benchmarking of different costs, it has therefore reduced the amounts requested by the
DNOs for network investment (around 20 per cent less in the case of EdF). Overall network cost allowances allowed by Ofgem are 8 per cent lower than those requested by the DNOs , although slightly higher than initially set out in Ofgem’s initial proposals; and
network output measures – Ofgem states that it does not intend to apply the targets rigidly for these measures, which require DNOs to make a qualitative assessment of the condition of their network assets to predict their condition at the end of the five-year price control period following planned investment. DNOs will continue to have flexibility in their network investment decisions. However,
DNOs must demonstrate to Ofgem that any deviation from agreed outputs was justified as being efficient and in customers’ interests. In the absence of such justification, the company’s shareholders will not be able to keep any portion of investment under-spend from the price control period. five years. In terms of the maximum revenue that DNOs can recover from customers over the five-year price control period, customer prices will increase on average by 5.6 per cent. For example, the SP Manweb area will see increases of RPI -11.1 per cent, but the SP
Distribution area will see reductions of RPI -4.3 per cent. EdF’s three distribution areas will see increases of between RPI -5.5 per cent and RPI -8.8 per cent.
Ofgem has decided to set a constant percentage increase for each DNO for each of the five years, to reflect the requirement for increased investment during the price control period and to avoid a large increase either during its early or later years.
The impact on final customers’ bills will depend on variances to the allowed revenues that result from the
DNOs ’ performance against certain incentives. The impact of the structure of charges project, resulting in the introduction of a common distribution charging methodology to ensure that use of system charges reflect costs better across the 14 DNOs , will also have an effect.
(See further table 1.2 in Ofgem’s final proposals’ paper for the resulting illustrative price changes.) However,
Ofgem estimates that the impact of the price control will be an annual increase in typical household bills of £4.30.
Ofgem notes that as part of DPCR5 it has undertaken a review of the information that DNOs provide it with annually to monitor their performance against the price control. Ofgem intends to continue to publish a detailed annual report containing this data and a commentary.
However, it also intends to publish some of this information in a more accessible format. It will consult shortly on the content and format of this new annual report.
Ofgem has decided to allow revenues of around £22bn to be collected from distribution customers over the next
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Electricity distribution price control – overview of Ofgem’s final proposals
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For further information please contact David Aitman
T + 44 20 7832 7240
E david.aitman
@ freshfields.com
Nicholas Bliss
T + 44 20 7832 7170
E nicholas.bliss
@ freshfields.com
Martin Nelson-Jones
T + 44 20 7832 7307
E martin.nelson-jones @ freshfields.com
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© Freshfields Bruckhaus Deringer LLP 2009
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Electricity distribution price control – overview of Ofgem’s final proposals
Freshfields Bruckhaus Deringer LLP, December 2009