LONDON Dec 2 In 2006, Britain's energy
regulator reviewed how the gas and electricity market was
functioning. Summarising its findings, it noted the possibility
that its rules on pricing had been overly generous to the
The report was one of many produced by regulator Ofgem,
tasked by the government with overseeing an industry that was
broken up and sold off by the state during the 1980s and 1990s.
The report went little noticed at the time.
Today though, it has new relevance. Rising electricity and
gas prices to homes - around nine percent in the coming year -
have become a political issue, with consumer groups and some
politicians saying the market is flawed.
"The fact that network businesses .... have recently changed
hands at a premium to the regulatory asset value (Ofgem's own
valuation of the assets) suggests considerable appetite among
the investment community and indicates, in hindsight, that past
price control reviews could have been somewhat tighter than they
were," Ofgem said in its 2006 report 'Financing Networks'.
The trend the regulator identified continues to this day.
In the 1990s Britain divided its energy industry into owners
of power and gas networks on the one hand and electricity and
gas retailers on the other - like separating the railway network
from the train companies.
The retailers pay the network owners to use their networks,
and sell electricity and gas to homes and businesses.
After privatisation, the networks were controlled by the
likes of Berkshire Hathaway's MidAmerican Energy Holdings and
northern England-based United Utilities. The retailers included
nPower, a unit of Germany's RWE, and British Gas.
The debate over rising prices to homeowners has largely
focused on the role of the retailers because they are in the
public eye, sending out bills to consumers.
Critics say there is a lack of genuine competition among the
six largest electricity and gas retailers leading to inflated
prices. The retailers counter that increases have been driven by
a combination of government taxes, wholesale energy costs and
transportation fees charged by the networks.
Industry data reviewed by Reuters shows that rising energy
transportation costs - which are largely determined by the
regulator - have accounted for over a third of the rise in
energy bills to homeowners since 2007.
The transportation costs that network owners charge
electricity and gas retailers flow from a little understood
calculation by regulator Ofgem - the rate of return that network
owners are allowed to earn.
The fact that network owners were willing to pay inflated
prices for sections of network - well above Ofgem's own
valuation of the assets - suggested an overly generous rate of
return, the regulator's 2006 report found.
This in turn suggested Ofgem was permitting network owners
to charge excessive transportation costs to retailers, critics
said, with consequences for homeowners.
A Reuters review of sales of power and gas networks shows
that since Ofgem's 2006 report seven networks have been sold. On
each occasion the purchaser paid a premium to the regulator's
valuation of the network, an average 27 percent.
"That tells us that the regulatory framework is
fundamentally flawed," said Jim Cuthbert, a consultant and
former academic who has written extensively about UK utilities
regulation. He argues that the rate of return set by the
regulator is simply too generous.
Paul Ainsley, Group Financial Controller for Northern
Powergrid, whose ultimate parent is Warren Buffett's Berkshire
Hathaway, challenged this and said his company's purchase of the
Yorkshire power network in 2001 reflected his firm's belief it
could extract cost savings.
All of the other companies that bought energy networks in
recent years declined to say why they paid above Ofgem's
valuation - the so-called regulatory asset value.
The Energy Networks Association, the industry trade body,
also declined comment. Ofgem said it did take account of the
prices at which assets were sold when setting returns but
declined to comment on the persistent sale of regulated assets
at a premium to their regulatory asset value.
"Ogem has a strong record of making a positive difference
for customers by bearing down on network costs" the regulator
said in a statement.
Energy industry consultant Mike Madden said of the
regulator: "It's a fine balancing act but, in general, Ofgem
have got it right".
All of the electricity and gas networks quickly reduced
operating costs after privatisation. As a consequence returns
allowed by Ofgem began to look increasingly generous.
The power network in the northwest of England region is
illustrative of how the industry evolved and, critics say,
highlights a flaw in the regulator's approach.
The first owner of the northwest of England network after
privatisation, Norweb Plc, halved its workforce during the
1990s. Its profits doubled.
Other network owners were also taking costs out of their
businesses. Across the industry, the returns enjoyed by network
owners were well ahead of those envisaged by the regulator.
The regulator responded by adjusting the way it set returns
to take account of the bigger-than-expected reduction in network
owners' operating costs.
Nonetheless, the network owners' profits remained buoyant,
prompting the government to impose a windfall tax in 1997.
Norweb, which had merged with the regional water company in
1995 to become United Utilities, had to pay an additional 155
million pounds in tax.
By around 2002, Ofgem said it believed the ability of owners
to cut costs had largely been exhausted. It adjusted the way it
set returns accordingly.
Critics say low world oil and gas prices during the 1990s
led to a degree of complacency at the regulator because upward
pressure on retail prices was inevitably reduced.
The regulator said it remained alert and noted that in 2005
it cut the rate of return electricity networks were allowed to
earn to 5.5 percent plus inflation from 6.5 percent, partly
because lower interest rates meant cheaper financing.
Despite this, the returns remained attractive enough to
ensure there were plenty of bidders whenever a section of the
electricity or gas network came up for sale.
United Utilities decided to sell the northwestern network in
2007 because it wanted to focus on its water business. The
timing was also motivated by price, said the chief executive who
oversaw the sale.
"My view was if you can get a premium of 30-40 percent, and
the assets are non-core, then a sale is likely to be good for
shareholders because such a premium is not sustainable," said
former United Utilities Chief Executive Philip Green.
United Utilities put the network on the market in 2007 and
was inundated with bids from across the world, Green said.
In a tightly contested auction, funds controlled by JP
Morgan and the Commonwealth Bank of Australia won, agreeing to
pay 1.8 billion pounds - above Ofgem's valuation (the regulatory
asset value) of 1.2 billion pounds. JP Morgan and Commonwealth
Bank of Australia declined to comment.
Ofgem got tougher. In 2009, it demanded that companies such
as Electricity North West - the vehicle which now owned the
northwest network - accept a reduced rate of return of 4.7
percent, again citing falling interest rates.
Nonetheless, operating profits continued to rise at the
northwestern network. They have risen 4 percent per year since
the sale. And companies remained ready to pay big prices for
In 2010, Electricite de France (EdF) sold its three English
power networks for 5.8 billion pounds - a 27 percent premium to
the networks' regulatory asset value. A year later, E.On sold
its English power networks for a 40 percent premium to a
consortium led by Cheung Kong Infrastructure (CKI), an
investment entity controlled by Hong Kong Billionaire Li
In these cases, as with the northwest England network, the
purchasers were ready to accept returns which were below the
levels set by Ofgem. CKI and EdF declined to comment.