NIE Price Control Announcement

06 August 1997

The Director General of Electricity supply for Northern Ireland announces proposed modifications to Northern Ireland Electricity’s Licence

My predecessor started a review of the price controls in the licences of Northern Ireland Electricity plc (NIE) in early 1995. PRice controls which I made in July 1996 were not acceptable to NIE and the issue was therefore returned to the Monopolies and Mergers Commission (MMC). The MMC report was published in April of this year. I shall within the next six weeks be in a position to publish licence modifications (which are subject to consultation).

I am now able to announce the effect of the modifications I will shortly be publishing. I believe the modifications I am proposing are requisite to remedy or prevent the adverse public interest effects which the MMC identified would result from NIE’s current price controls continuing. In designing the modifications, I have has full regard to the recommendations of the MMC.

The modifications I am proposing for NIE’s Supply business follow the MMC’s recommendations. Those recommendations are themselves broadly consistent with my original proposals in July 1996.

The modifications for NIE’s Transmission and Distribution (T&D) business follow the MMC’s recommendations except for two adjustments to NIE’s asset base. The effect of these adjustments is to reduce the net present value (NPV) of NIE’s allowed revenues. The change arises as a result of allocating a further £4 million to the power procurement business’s asset base which will lead to an increase in the NPV of allowed revenue of that business by 31.8 million.

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On 18 September 1996, I made a reference to the MMC concerning the price controls in the licence of NIE for its T&D business and for its Supply business. In accordance with the terms of the Electricity (Northern iReland) Order 1992 (the order), I asked the MMC to investigate and report on whether the continuation without modification or disapplication of the two sets of price controls operated or might be expected to operate against the public interest; and if so whether the effects adverse to the public interest could be remedied or prevented by modification of the conditions in NIE’s licence.

On 25 April 1997, I published the MMC report. The MMC concluded “that continuation of the existing (price controls) may be expected to operate against the public interest and that the adverse effects (it) identified could be prevented by modifications to those previsions”. For T&D, the MMC proposed that the allowed charge per unit should be reduced by 25 % in 1997/98 and by a further 2 per cent per annum in each of the following four years. For Supply, the MMC proposed that the allowed charge per unit should be reduced by 42% in 1997/98 and by a further 2 per cent per annum in each of the following four years.

Under the terms of the Order, I must now make sure such modifications to the conditions of NIE’s licence as appear to me to be requisite for the purposes of remedying or preventing the adverse effects identified by the MMC. Before making modifications, I am to have regard to the modifications proposed in the MMCs report.

When I published the MMC report, I indicated that I was minded to accept the modifications for NIE’s T&D business subject to an adjustment to the asset base on which the MMC proposed that NIE be allowed to be remunerated. I also indicated that I might need to structure the price control so as to allow myself the necessary time to review information on NIE’s capital expenditure (capex) and operating expenditure (opex) programmes for its T&D business which NIE had submitted to the MMC but had not supplied to me. I opened a period of consultation on the MMC’s findings and on these issues in particular.

Over the last weeks, I have considered the proposals of the MMC and the views expressed to me by NIE and others in the course of my consultation. I have also had the benefit of a first review of NIE’s Corporate Plan (which NIE had submitted to the MMC but not to me); and of considering certain information which was not available to me at the time of the original price price review or to the MMC at the time of its inquiry. I have also received and considered NIE’s most recent accounts (for the period ended March 1997) and have monitored the movement in NIE’s share price following the publication of the MMC report and my press release.

Having taken this information and these views into account, I have now decided (subject to consultation) what modifications to NIE’s licences are needed in order to remedy the public interest detriments identified by the MMC were the existing price controls to continue. I will be publishing proposed modifications to NIE’s licence conditions in the course of the next six weeks. the Order provides for a period of consultation of no less than 28 days from the date on which I publish during which representations and objections may be made. I will allow a period of one month for this consultation, I will then need to consider the representations and objections made to me.

I am now in a position to announce (subject to issues of detailed drafting) my proposals.

Supply: I indicated on April 25th that I intended to implement the MMC’s proposals for NIE’s Supply business in full and without adjustment. Nothing submitted to me in the course of my consultation has caused me to change my view on this.

T&D: In my April statement, I stated that I was minded to accept the MMC’s proposals for NIE’s T&D business subject to a possible adjustment to the asset base on which NIE was to be remunerated. Having considered this issue further and reviewed representations made, I have concluded that an adjustment to the MMC proposals remains necessary if the adverse public interest detriments identified by the MMC are to be corrected.

The draft modifications which I will be publishing shortly will reflect the MMC’s proposals for NIE’s T&D business adjusted in two ways.

i. I will be providing modifications which are predicated on the asset base for NIE being based on the share price at close of first day trading (the MMC agreeing with me that this was the most appropriate benchmark). The MMC considered the possibility of applying an uplift to this value, I have concluded for the reasons set out below, that the uplift should be zero.
ii. I will be adopting the MMC’s proposal that pre-flotation assets should be treated as depreciated over the full length of their actual remaining lives. In my April press release, I had raised a question about the adoption of this proposal. I am now persuaded that this depreciation policy is appropriate. I intend to incorporate the proposal into the draft modifications on a going forward basis - not, for the reasons set out below, reopening the issue of the extent of depreciation over the first price control period as proposed by the MMC.

In my April statement, I mentioned that I did not then have the same information on NIE’s capex and opex programmes as NIE had made available to the MMC and that I would be asking NIE to supply the information. I suggested I might adopt the MMC’s figures for the first two years of the price control, requiring to be satisfied during those two years as to the figures of the entire five year period. I am now persuaded that the appropriate course is to implement the MMC’s recommendations on capex and opex in full; and to introduce performance measures to ensure that the capex does deliver the system benefits looked for by me and by the MMC.

I set out briefly below what has led me to diverge from the MMC and an explanation of my thing on the capex and opex.

Regulatory asset base and uplift: The MMC agreed with my view that NIE should be remunerated on an asset base calculated by ascertaining what NIE investors paid at flotation. It also agreed that the best way to calculate this figure was to have regard to the NIE share price at the close of first-day trading. the only issue now is the extent of any uplift which should be applied to the first-day closing value.

In considering this issue, the MMC noted (at paragraph 2.84) that “the arguments for an uplift above the base value based on the share price at close of first-day trading are inevitably a matter for judgement rather than precise calculation.”. It also noted that such external checks as there were uplifts applied in other price controls - varied widely, from - 3.4% in the case of Scottish Hydro-electric plc, an average of 5.07% for water and sewerage companies and 265 in the case of British Gas plc.

Against this background, I have decided whether the MMC’s proposed 7.5% uplift is an appropriate one which will deal with the public interest issues identified by the MMC - protection of consumers in respect of prices, promotion of efficiency and economy in NIE’s T&D business and promotion of efficiency in distribution.

In applying my judgment, I have had particular regard to the ability of NIE to finance its functions and am satisfied that NIE would be able to do so with an uplift of zero, I have also had regard to the MMC’s public interest finding that the current price controls do not adequately protect the interests of consumers in respect of prices charged. I have concluded that to give shareholders a return of &% real pre-tax on £29 million in excess of the actual sale price, when to do so is not in my view necessary to ensure NIE can continue to finance its functions, would fail to address the MMC’s adverse public interest findings and in particular its finding on protection of the interests of consumers. I therefore conclude that to allow an uplift is not requisite to remedy the detriments identified by the MMC.

Depreciation: I agreed with NIE, during the price control process, that it was reasonable to assume that the average remaining life of pre-flotation assets was 18.5 years at the time of flotation; and that these assets should therefore be depreciated in equal amounts over 18.5 years. The MMC suggested that this would entail a sudden fall in depreciation at the end of that period and proposed as an alternative depreciating the assets over the full length of their remaining lives. I raised questions on this proposal in my release of 25th April, but having considered the issue further, I am persuaded of the merits of this proposal.

The MMC then identified a “shortfall” - an amount which it suggested that NIE would have received during the first price control period had the new policy on depreciation been in effect - and proposed that NIE should be allowed to make up the “shortfall” in the next period. The proposals I am to publish will not make provision for “making up” the “shortfall” as the MMC proposed.

In reaching this decision, I have considered the appropriateness of reopening an earlier price control - which id the effect of identifying and making up the “shortfall”. Even if the MMC were correct in thing there is a “shortfall”, I believe it is wrong as a matter of regulatory practice to 2make up” the “shortfall” of an earlier regulatory period or indeed to recover for customers any “surplus”. The MMC, in its recent report on BG plc, seems to share this view (see, for example, paragraph 2.141 pf its report, BG plc). I have considered whether, in the absence of “making up” the “shortfall”, NIE would have difficulty financing its functions and have concluded that it would not. In the light of these factors, I have carefully considered the MMC’s “proposal” (at paragraph 2.104) as to the “right” approach to take. I have concluded that to permit the “making up” of the “shortfall” over the next five years would not be requisite to remedy the detriments identified by the MMC and summarised above.

Capex and opex: The MMC made recommendations as to the required level of capex and opex over the price control period. As I mentioned in my April 25th statement, the MMC was able to make its recommendations in the light of information which NIE had not supplied to me. I have now called for the information and have received much of it. I have instigated a review of this additional information which will take some months. It is not appropriate to delay implementing modifications to NIE’s licence.

Having had the opportunity to reflect and taking into account all that has been said to me on these matters, I am now persuaded to implement in full the MMC’s proposals for capex and opex. This will enable NIE to deliver the substantial system benefits which NIE proposed and in which the MMC saw merit. It will ensure a more stable and predictable regulatory environment - in that it will remove even the limited degree of uncertainty for the last three years of the price control which was a feature of the scheme envisaged in my press release of 25th April.

The MMC urged me (at paragraph 2.144) to set and agree targets for NIE as part of an effort to ensure that NIE’s capex is well spent. With this in mind, I will complete a review of the materials which NIE has now supplied to me so that I have the fullest possible understanding of NIE’s plans for the systems; and I will decide targets that the company must achieve to ensure a prudent and efficient use of capex.

I will review with NIE at regular intervals over the next five years of the price control the effectiveness of capex spending. Going into the next price review; I would expect to adopt the formula devised by the MMC for this price control, whereby NIE may keep two thirds of any capex underspend as efficiency gains. NIE will also have an opportunity to convince me that some or all of the remaining third is the result of efficiency. I would also expect to include in the regulatory asset base for the next period all capital expenditure that has been incurred prudently over the period and in pursuance of the targets I shall be determining.

Conclusion: The effect of the adjustments mentioned above would be to reduce the NPV of NIE’s allowed revenue for the period 1997/2002 below the level proposed by the MMC. The MMC proposed an NPV of £575 million for NIE’s T&D business. The modifications I am about to publish will reduce this figure by £36.5 million. The effect of these proposals is to reduce the allowed charge per unit in T&D by 29% in 1997/98 and by a further 2 per cent per annum thereafter.

For the reasons set out above, I do not believe that the changes affect the company’s ability to earn a return on its assets and to finance its activities. I believe that the modifications I am proposing are requisite to rectify the adverse public interest effects identified by the MMC. They should, as a result, provide the necessary balance to protect the interests of the customers and provide the company and its shareholders with a price control which should be safe from early re-opening. Any other result would increase the degree of uncertainty and call into question the sustainability of the price controls.

The process which NIE and Ofreg have gone through to produce a price control for the period 1997/2002 has been much longer and more protracted than anyone could have foreseen at the beginning. As NIE offered a voluntary price reduction in 1997 which can be corrected in 1998 customers have not suffered from the delay. Given what is at stake for the long term future of Northern Ireland’s major energy company, the competitiveness of the regional economy and the cost of living of Northern Ireland’s citizens it was highly desirable that Ofreg and NIE went through this painful but necessary learning experience.