New Ownership Structures in the Water Industry: a response to the Director General of Water Services consultation paper

Transcription

1 New Ownership Structures in the Water Industry: a response to the Director General of Water Services consultation paper 1. Introduction 1.1 The Director General of Water Services published a consultation paper on 6 June on the issues raised by proposed new ownership structures in the water industry. This followed a number of announcements by the Boards of water companies that they were considering a strategy which would separate asset ownership from operations. In some cases, the companies were also looking at options for the introduction of a new form of corporate structure and ownership in conjunction with the introduction of a greater proportion of debt finance into the regulated business. Suggested company structures have included mutual trusts and not-for-profit companies limited by guarantee. 1.2 Ofgem has not yet consulted on mutuals in relation to gas and electricity companies, but has considered the issues raised in Ofwat s consultation document. There are a number of special factors relating to the water and gas and electricity markets which need to be considered in relation to mutuals. In gas and electricity, the supply market is competitive, whereas activities such as distribution remain price-regulated monopolies. Ofgem will obviously wish to consider, and consult on, the detail of any specific mutual proposals made by gas and electricity companies. However, this paper sets out Ofgem s initial views on the issues raised by mutuals, including: governance; incentives for efficiency; transfer value of assets; price shocks; gearing ; and outsourcing.

2 It should be noted that both increased gearing, and outsourcing (including the separation of operational management from onset ownership) may occur quite independently of mutualisation. 1.3 Ofgem supports measures which reduce on a sustainable basis the cost of capital while preserving present and future standards. However Ofgem believes a range of difficult issues would need to be successfully addressed in relation to the mutualisation of price regulated monopolies. These issues are considered in this paper. Ofgem, in all that it now does, aims to protect the customers of the gas and electricity industries. The Utilities Bill gives Ofgem a new principal objective in carrying out its functions. That objective is to protect the interests of consumers, wherever appropriate by promoting effective competition. Outsourcing and gearing are not dependent on mutualisation and could, in Ofgem s view, bring benefits to customers. However, Ofgem s present judgement is that it would be difficult for all of the issues relating to mutuals, in the form proposed in relation to the water sector, to be sufficiently addressed for Ofgem to be able to advise customers to support mutualisation for price-regulated monopoly companies in the energy sector. 2. Background 2.1 The development of a competitive gas and electricity supply market has led to a range of restructuring proposals. As new structures have emerged, Ofgem has sought to overcome any detriment to consumers and competitors by seeking licence amendments and/or assurances and undertakings. Ofgem is keen to see new structures and ways of working which support the development of competition and bring benefits to consumers. Innovative ownership structures that allow businesses to be run more efficiently and at lower cost to consumers are therefore to be encouraged.

3 2.2 However, due to the monopoly nature of some aspects of the industry, regulation provides important safeguards for the consumer: for example, price controls, service standards, and financial ring-fencing. The existing investor-owned, equity-financed model has led to the improved efficiency of energy companies. These efficiency gains have been shared by consumers as well as shareholders through a combination of rigorous price control in areas of monopoly and the development of competition. Prices for both business and domestic consumers have been reduced, while service standards have risen. 2.3 It is important that Ofgem s ability to regulate in the interest of the consumer is not affected by any particular ownership structure; and that, once Ofgem has acted to protect consumers, external arrangements do not make Ofgem s actions ineffective. 3. Mutuals i. Governance 3.1 If there were to be a proposal to form a mutual in a price regulated monopoly energy company, Ofgem would need evidence that customers had the opportunity to give informed consent. Many of the issues concerned are complex ones. It would be a real challenge to communicate these in a way which customers would find accessible and comprehensible. Customers will need to understand clearly the implications for them, both in the short and longer term: this involves clear explanation of long term obligations as well as a description of short term effects. 3.2 Consideration also needs to be given to how customers would be consulted on the ongoing operation of any mutual. It would be for the Board of the mutual, which would clearly have to be demonstrably independent of the existing company, to ensure that it continues to represent the views of its customers. The best way of achieving this is not clear, but could be on the

4 basis of one customer one vote, or a weighting of votes by consumption. For electricity and gas distribution, customers of supply companies are no longer direct customers of the distribution businesses. Any proposals would need to demonstrate that the structure and membership of the Board of the mutual created the right pressures for efficiency and that decisions taken were in the interest of consumers. It would be important that a high calibre management team could be attracted and retained and that appropriate constitutional arrangements were in place to ensure that the Board remained commercially focused. ii. Incentives for efficiency 3.3 It is important to distinguish between the impact of mutualisation in competitive and monopoly markets. In a competitive market, managers of mutuals should have incentives to run the business efficiently in order to avoid losing significant market share, as their customers will be able to switch to an alternative provider. However, in a monopoly market (for example electricity distribution), the threat of customers switching does not exist. 3.4 Ofgem considers that mutual organisations in monopoly markets may therefore lack sufficient incentive to seek further efficiencies. The shareholder model (including the threat of take-over) creates incentives and disciplines for management that are unlikely to be replicated in a mutual model. Ofgem would need to consider, in specific cases, whether licence amendments could be adequate effectively to strengthen management independence and drive company performance. This might be difficult to achieve. 3.5 It should be recognised that Ofgem will not treat differing ownership structures differently for price controls. It will be for the owners of the company to ensure that it makes a return. At present, this is the equity

5 owners. In a mutual, it would be the bondholders, whose view on returns would inevitably be influenced by the risks they incurred. 3.6 Ofgem is committed to introducing, through the Information and Incentives Project, more incentives on electricity distributors to perform well relative to each other, rather than only in relation to regulatory targets. It would not be in the interests of any customer for companies to able to avoid this initiative through mutualisation. iii. Transfer Value of Assets 3.7 Ofgem has a number of concerns about the initial transaction, including the division of existing value between the mutual, the service provider and the previous shareholders. 3.8 Amongst the proposals discussed in relation to the water sector were those including the sale of regulated assets to a mutual, owned by customers and financed by debt, at the value placed on them by the regulator in arriving at the regulated asset base. Since this value in particular instances exceeds their implicit stock market valuation, it is argued that such a transfer would release a substantial capital sum for shareholders. However, it is by no means clear that an independent board of a mutual will be prepared to purchase the assets at regulatory asset value if this exceeds the stock market valuation. The divergence between stock market and regulatory asset base valuations results from different perceptions of business risk arising from the presence of factors affecting market value that do not affect regulatory asset value, for example having the ability to use assets outside the regulatory price control, regulatory risk, or managerial competence. 3.9 An important concern is that, if the price paid on acquisition is too high, customers will face an increased risk that the mutual will be unable to afford

6 rebates or service quality improvements, because it will have to divert a greater proportion of its revenues to debt service. Rebates and service quality enhancement are the chief benefits proposed for mutualisation. These will not be achieved if revenues are diverted to debt servicing If stock market valuations are systematically lower than regulatory asset base valuations for reasons associated with the regulatory regime, Ofgem considers that this could best be addressed by reconsidering the regulatory issues involved, irrespective of ownership structure. iv. Price and costs shocks 3.11 Proponents of mutualisation suggest that the interests of an asset owner without equity funding (or only minimal or contingent equity) would be more aligned with those of the regulator, so that the risk of regulatory shock, would be minimised, primarily at the time of price reviews. It is not clear why this should be so. Even were this to be the case, it is not obvious that this will necessarily minimise the risk of regulatory shock In setting a price control, Ofgem will consider how efficient a company is. Mutualisation, or indeed outsourcing of operations, does not necessarily give rise to efficiency. If a mutual company is less efficient than other price regulated energy companies a tighter price control will result. If the mutual is unable to reduce costs, for example because it has outsourced all operations under contract, any shortfall might have to be funded by customers. However, the price control does not permit this since price controls are intended to protect customers. To the extent that capital might be difficult to obtain from customers other than by charges, it could be argued that mutualisation would restrict the ability of the company to react to an event shock which resulted in a need for capital, for instance in the immediate aftermath of a serious storm or of a higher than expected requirement to connect embedded generation. This would raise obvious concerns about

7 service delivery and the ability to meet licence and statutory obligations. A sufficient equity buffer would seem to be necessary to protect customers from shocks resulting from regulatory price control and other unanticipated events such as severe weather The regulatory estimate of the cost of capital underlying the price control is revisited each time the price control is reviewed. If market evidence suggests that the components of the cost of capital have changed, such that the cost of capital in the following price control period will be different, the regulator will use a different estimate in setting the revised control. If the new control is based on a lower estimate, the company may have insufficient revenues to service existing interest commitments (taken out at a time when real interest rates were higher) without cutting back other expenditures. In the shareholder model, it is shareholder dividends that take this strain. In the mutual model, financed entirely with debt and after exhausting all further calls on bond holders, there would be a clear risk that customer rebates and service quality would suffer in the short term. To avoid this, a strong ringfence, with the prospect of insolvency, may be needed. 4. Gearing 4.1 It has been proposed that the mutual model could be financed entirely by debt. Ofwat questioned whether the lack of equity finance would place too great a risk on consumers in the event of poor performance. A lack of equity finance does give rise to concerns. Proponents of mutualisation have argued that the mutual will be able to service its initial debt and to meet continuing capital investment, with new investment being financed by new debt. It is not obvious that there would be sufficient guarantee for bondholders of their return to make them willing to provide new debt for this purpose. It would seem that some form of significant equity buffer would be required. But, to the extent that the mutual was not debt-dependent, the main advantage of a mutual, namely the lower cost of capital, would be eroded.

8 4.2 There is of course no need for a company to adopt a mutual structure in order to increase its level of gearing. Benefits could be derived from optimising gearing without mutualisation. Ofgem would not object to appropriate proposals on gearing. Ofgem has put in place financial ring fence arrangements designed to give customers a measure of protection against unsustainably high levels of gearing. It is difficult to see how this could be replicated in a mutual, but equally the absence of equity makes the need for ring fencing the greater. 5. Ofgem s approach to outsourcing 5.1 Ofgem has previously considered issues arising from asset ownership and operation being in separate companies. Ofgem s 23 March paper ( London Electricity/TXU Europe Joint Venture: A statement by Ofgem) set out views on the proposed London/TXU Joint Venture Company (24:seven). Ofgem recognises that a large number of utility companies out-source individual activities, much of which is on a market tested or competitive basis. In respect of such outsourcing, Ofgem sees no reason to take special regulatory action, except where operational safeguards or continued access to the underlying cost information is deemed to be necessary. However, in cases such as the 24:seven joint venture, Ofgem considered that this went beyond normal out-sourcing. The assets remained in the ownership of the licensees (London and TXU) while the management and operation became the responsibility of the new joint venture company (24:seven). Ofgem indicated that this led to the loss of a comparator and therefore regarded it to all intents and purposes as a merger. As such, Ofgem indicted its intention to apply a minimum customer rebate of 12.5 million on the fifth anniversary of the transaction. Ofgem concluded in this case that best value for customers could be achieved by letting incentives operate freely without imposing a levy on potential efficiency.

9 5.2 This is the essence of incentive based price control and, without that regulatory discipline, Ofgem doubts that distribution prices could have been cut by as much as the 40 per cent which has been achieved since privatisation. But price control reviews are not only about price. They are about value for money for customers evidenced by the balance between quality of supply and cost. Outsourcing does not necessarily lead to greater efficiency. Recent experience of price control is that some companies which had undertaken substantial outsourcing were amongst those judged to be the least efficient. Whether outsourcing leads to greater efficiency depends to a great extent on the quality of management of the asset-owner. 6. Conclusion 6.1 Ofgem believes that the market should be free to bring forward innovative proposals for structures that offer new or increased scope for efficiency gains and benefits for consumers, whilst retaining the required standards of service. Ofgem has, however, a number of serious concerns about the extent to which a mutual structure, as distinct from other initiatives which do not depend on mutualisation, would benefit the customers of price-regulated monopoly gas and electricity companies. 6.2 This paper is intended to stimulate debate about what might be in customers interests in relation to mutualisation in the gas and electricity markets. It sets out Ofgem s initial views. The range of issues identified here would need to be adequately addressed before Ofgem could advise customers to support mutualisation in price-regulated monopoly gas and electricity companies. 6.3Ofgem will consider the detail of any specific mutual proposals made by gas or electricity companies, if any are made. At that stage Ofgem will undertake public consultation to assist in finalising its views.