This article covers the review that reset Great Britain’s electricity distribution price controls from 1 April 2005, known as DPCR4. It follows the third article in this series, on the review that reset charges from 2000, and is followed by the fifth article, on the 2009 review. It draws primarily on Ofgem’s November 2004 final proposals, together with the September 2004 update paper, the March 2004 background paper on the cost of capital and the February 2005 statutory consultation that implemented the settlement in the licences.
Table 1: How the review unfolded, July 2003 to April 2005
Sources: Ofgem consultation and decision documents, 2003 to 2005.
DPCR4 was the review that set the revenues of Great Britain’s regional electricity distribution monopolies for 2005 to 2010. It was the first review conducted after the Utilities Act 2000 completed the separation of distribution from supply, so the companies under review were, for the first time, distribution network operators in the modern sense. There were fourteen regulated wires businesses, twelve covering England and Wales and two covering Scotland.
The ownership map had also changed. A wave of takeovers and mergers had grouped the fourteen licensees under nine ownership groups, so the review had to compare licensees while accounting for group structures. While another merger happened during the price review process, reducing the number of ownership groups to eight, Ofgem used the previous sector structure to make its decision, to retain consistency within the development. Ofgem provided additional operating cost allowances for the DNOs that had not merged at the start of the 2002/03 base year, and treated comparisons on a per ownership group basis as a valid check on the licensee-level benchmarking.
The review’s framing differed from every one before it. The second consultation of December 2003 and the March 2004 policy document identified three themes: incentives for investment and efficiency, quality of service, and the challenge of connecting renewable generation. Rising retail prices, security of supply and the Government’s renewable energy targets were the backdrop, so the question was no longer only how much to cut, but how to fund a growing network efficiently.
Charges rose because the networks were entering an asset replacement cycle. Much of the distribution system had been built in the post-war decades, and both the companies and Ofgem’s engineering consultants concluded that replacement and reinforcement expenditure had to increase materially. In total, companies requested an increase of around 50% from existing levels of expenditure to maintain service levels.
The final proposals allowed a one-off price change in April 2005, known as the P0, that averaged an increase of 1.3% across the fourteen companies, with charges then permitted to rise in line with inflation, an X factor of zero, for the rest of the period. The single exception was EDF Energy’s South Eastern network, which received an actual P0 of 3.1% with an X factor of RPI plus 2 to target revenue in the years it was most needed, alongside additional revenue to protect its financial position. Because distribution accounted for around 25% of a consumer’s final bill, the effect on final prices was considerably smaller than the headline figures.
Figure 1: One-off price changes in April 2005 by company, from the November 2004 final proposals. Positive figures are increases.
The numbers applied at each individual company had a large variation around the average. Companies with large investment programmes relative to their asset base, such as SP Distribution and SSE Southern, received significant increases, while companies whose earlier spending had run ahead of need, such as CE YEDL and SP Manweb, faced further one-off cuts. The spread is the building-block method at work, as at the 1995 and 2000 reviews covered earlier in this series: each company's efficient costs, asset base and cost of capital translated into its own price path.
The final proposals allowed capital expenditure of £5.7 billion over 2005 to 2010, an increase of 48% over the roughly £3.9 billion spent in the previous five years. Where company forecasts were well justified they were largely accepted; where they were not, Ofgem’s engineering consultants proposed adjustments. Consumers pay for capital expenditure over long periods, generally around twenty years, and Ofgem noted that the operating cost savings achieved in the previous period would feed through to consumers and help offset the impact of higher investment on bills.
Figure 2: Capital expenditure allowances for 2005 to 2010 against actual and forecast spending in 2000 to 2005, by company. Figures include investment to improve quality and exclude capitalised faults and pension deficit costs.
DPCR4 introduced the sliding scale, a menu of choices that made honest forecasting the profitable strategy. A regulator can never know a company’s efficient capital expenditure as well as the company does, and at previous reviews the companies’ incentive was simply to bid high. Under the sliding scale, a company whose forecast sat close to the consultants’ view received a higher baseline allowance, a small additional income and a stronger share of any underspend. A company that bid far above the benchmark received a lower marginal allowance and a weaker incentive rate, so overbidding carried a price.
Ofgem described the design as providing flexibility for companies that genuinely needed to spend more than the central analysis supported, while reducing the profits available from underspending inflated allowances. Companies broadly supported the concept, and the mechanism was implemented with the matrix consulted on in September 2004. The idea outlived the review: the information quality incentive at the 2009 review, and the totex menus of the RIIO framework after that, are direct descendants. DPCR4 is where British network regulation started taking asymmetric information seriously in the design of allowances, not just their level.
DPCR4 changed how the allowed return was expressed as well as its level. At earlier reviews the tax burden was buried inside a pre-tax cost of capital. From March 2004, Ofgem adopted a post-tax approach, calculating company-specific tax allowances separately, for three stated reasons: changes in the tax treatment of network capital expenditure, consistency with the rest of the framework, and reducing the incentive to increase gearing purely to capture the tax shield.
The March 2004 cost of capital appendix set out the full build-up and consulted on a vanilla weighted average cost of capital of 5.1% to 5.9%, equivalent to 4.2% to 5.0% post tax. The June initial proposals and September update used the midpoint of 4.6% post tax as a modelling assumption. Most respondents argued it was too low, pointing in particular to Ofwat’s draft determination of 5.1% post tax for the water sector published in August 2004, and to competition for capital across the regulated sectors. In the final proposals, Ofgem settled at the top half of its range.
Table 2: The DPCR4 cost of capital decision
Source: Ofgem, Electricity Distribution Price Control Review Final Proposals, November 2004.
The pre-tax equivalent of 6.9% compares with 6.5% at the previous distribution review. Companies matching their allowances and targets could expect returns of up to 5.0% post tax once sliding scale income is included.
Two supporting decisions went with it. Notional gearing was set at 57.5%, up from 50% at the previous review, reflecting the higher debt levels companies had actually adopted. However, Ofgem was explicit that this was not an endorsement of any particular capital structure. Second, a claw-back was attached to the tax allowance: if a company geared above 57.5% and its interest costs exceeded those in the financial model, the associated tax benefit would be recovered for customers at the next review. The post-tax framework and the gearing claw-back are both still recognisable in the price controls MCC Economics works on today.
Operating costs were benchmarked. Ofgem used a five-stage approach: normalising each company’s 2002/03 operating costs plus fault costs for definitional differences and regional factors, regressing normalised costs against a composite scale variable, testing alternative specifications, and then setting allowances by reference to the upper quartile of the resulting efficiency scores. In general, companies were given allowances based on reaching that upper quartile by 2004/05, with no glidepath for higher-cost companies, and a continuing efficiency improvement of 1.5% a year was built into allowances for 2005/06 to 2009/10, supported by a total factor productivity study from Cambridge Economic Policy Associates. On the November 2004 factsheet’s summary, the proposals sought an operating cost reduction of about 3% on average against existing levels.
The review also ran into a data problem that recurs throughout this series: allowances depend on the reported costs beneath them. A substantial normalisation exercise was needed to make companies comparable, and Ofgem committed to institute a more effective cost reporting mechanism for the future, the origin of the regulatory reporting packs that underpin later reviews.
Consumer research commissioned for the review showed that customers were willing to pay more for better service, but only up to a point. The final proposals therefore set tougher interruption targets with stronger rewards for beating them, and widened the total revenue at risk.
Table 3: Revenue exposure to quality of service incentives
Source: Ofgem, Electricity Distribution Price Control Review Final Proposals, November 2004.
The review also introduced the first price control instruments for the energy transition. An Innovation Funding Incentive allowed each company to recover a share of research and development spending. Registered Power Zones offered enhanced rewards for innovative connections of distributed generation, and a new incentive paid companies per kilowatt of distributed generation connected, alongside revised connection charging arrangements designed to remove regulatory obstacles to the Government’s renewables targets. These schemes were small in revenue terms, but this is where decarbonisation entered the distribution price control, and it stays there in every later review in this series.
DPCR4 changed the direction of British distribution regulation. The reviews of 1995 and 2000, covered earlier in this series, were exercises in returning excess profits to customers; DPCR4 was an exercise in funding investment while protecting customers from paying for exaggerated plans. Three of its decisions lasted: the post-tax treatment of the cost of capital, the menu-based sliding scale, and the widening of the control to cover innovation and distributed generation.
All fourteen companies accepted the proposals, so no reference to the Competition Commission was needed, and the licence modifications were consulted on in February 2005 with only minor corrections to the calculations. The next article in this series covers the 2009 review, which inherited DPCR4’s architecture, tested it against a financial crisis, and closed the era of five-year RPI-X controls.
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