The recent shambles over arrangements for the West Coast mainline franchise laid bare the incompetence of the Department for Transport (DfT) as its secretary of state, Patrick McLoughlin, was forced to scrap the award to First Group and to defer other planned franchising processes.
Indeed, the West Coast debacle has been a hugely embarrassing episode for the DfT, which has form on such issues. In 2001, Railtrack was unceremoniously shunted into the sidings and replaced by the not-for-profit Network Rail. While former rail regulator Tom Winsor did have the necessary financial tools in his box to save Railtrack – namely a monster cost-pass through award – he was precluded by politicians from using them. It caused chaos in the Civil Service, with the notorious outburst of profanities from the DfT’s then permanent secretary Sir Richard Mottram.
The latest DfT shambles has caused real concern again within the Civil Service because every department handling major financial issues is extremely worried that serious modelling errors are possible.
In utilities, regulatory mishaps are not unknown. Nevertheless, most of the criticism of utility regulatory bodies focuses on activities that are closely interconnected with government policy. An obvious example is the dominance of the big six energy companies, which was effectively created by government, partly through allowing vertical integration but also through introducing the New Electricity Trading Arrangements.
Ofgem’s predecessor, Offer, had its own West Coast mainline moment back in 1995 when the final determination of the key electricity distribution review was pulled – to general disbelief – on 7 March. In the preceding months, shares in the 12 regional electricity companies soared on the back of an expected soft regulatory review – a scenario confirmed before Christmas 1994 by the final determinations for the five-year period 1995-2000.
Following the left-field Trafalgar House bid for Northern Electric and the offer of massive special dividends to the latter’s shareholders, notwithstanding visceral criticism of Offer’s competence, the distribution review was dramatically pulled. Utility share prices plunged, Treasury civil servants panicked and company executives seethed, while some shareholders took legal advice.
The following year, the gas sector had its own meltdown when Ofgas announced planned price cuts of between 20 and 28 per cent for British Gas’s Transco business. Within moments of this unexpectedly tough announcement, British Gas’s share price plummeted.
In the event, the Ofgas ruling, which was the result of aggressive regulation rather than incompetence, did British Gas a good turn. Subsequently, it was split up into BG, Centrica and Transco. The latter now lies within National Grid. From the sub-£2 share price after Ofgas’s announcement in 1996, shareholders have benefited from massive value creation, with BG’s share price alone worth over £10 currently. Indeed, prior to its recent shock profit warning, BG was seen as one of the FTSE 100’s top growth companies.
Periodic reviews in the water sector have led to long drawn-out discussions, but to date Ofwat has avoided meltdown moments. In part, this is due to former director-general Sir Ian Byatt, who devised a durable financial regime, embracing such now familiar concepts as regulatory asset value, the regulatory asset base and the pivotal weighted average cost of capital.
Furthermore, Ofwat’s Keith Mason, who has presided seemingly for decades over Ofwat’s book of numbers, has played a key role in sustaining its financial credibility. If the DfT calls in headhunters to recruit staff to sort out the West Coast shambles, he would be an obvious target.
Although Ofwat has had relatively few major hitches, its record on competition is lousy – almost 25 years of regulatory effort has produced minimal sector competition. Nor is its desultory attitude to leakage levels, especially in the last periodic review, impressive.
Looking forward, there will be real concerns on several fronts. Ofwat is currently at loggerheads with companies over its Section 13 licence reforms. It previously said a Competition Commission referral would follow if companies rejected its plans. Many have, yet at the time of writing, no referral has followed. This breeds uncertainty and mistrust.
Along with other reforms Ofwat is making to tried and tested price determination practices, the Section 13 wrangle has unsettled investors. Impax asset management, for instance, is already talking about capital shifting into the water treatment and other infrastructure sectors, and about the narrowing in listed water companies’ premia to their regulated asset values.
It is muddy waters, too, for the energy sector, where the recent raft of policy – the Energy Bill and all associated policy, and more recently the Gas Strategy – is still being digested. On nuclear specifically, the government has welcomed Hitachi’s planned acquisition of the Horizon nuclear consortium but it will not result in output from new-build nuclear until the 2020s at the earliest – if ever. A great deal will hinge on whether the companies involved – Hitachi and EDF primarily – find the government’s guaranteed price per MWh for planned new nuclear plants acceptable.
Whether the Department of Climate Change, aided by the Treasury and Ofgem, is capable of making such financially complex decisions, which will impact for decades in volatile energy markets, is doubtful.
Perhaps energy minister John Hayes should have peppered up his energy policy interventions and argued for a Nuclear Obligation, similar to the Renewables Obligation, which would lower the Wacc and considerably simplify the revenue uncertainty issue?
Nigel Hawkins is a director of Nigel Hawkins Associates, which undertakes investment and policy research
This article first appeared in Utility Week’s print edition of 14th December 2012.
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