Stage set for showdown with OFGEM

Introduction

On December 2, Ofgem, the British electricity regulator, issued its “Final Proposals” on the prices to be charged by each of the regional electricity companies and the two Scottish distribution companies (together referred to in this article as the RECs) for their electricity distribution services from 2000 to 2005.

These distribution services, or ‘wires services’, make up roughly a quarter of the total charges which typical consumers pay for their electricity bills. In announcing the proposals, Callum McCarthy, the Director General of Ofgem, trumpeted that the changes would reduce those bills by an average of GBP15 per year.

From the RECs’ perspectives, the proposals would mean a loss of approximately 24% of their current distribution revenues. In the words of McCarthy, "We have been tough where there is monopoly, in distribution and transmission, to promote efficiency there, and so to drive down prices.”

Each of the RECs must now make a critical decision and they must make it by December 20. They can indicate to Ofgem that they accept the proposals in principle, in which case the new arrangements will come into force on April 1, 2000. Alternatively, they can decide to challenge the regulator and force the matter to be referred to the Competition Commission.

Referral to the Competition Commission

The right to a referral to the Competition Commission arises from the Electricity Act 1989. Implementation of many of the proposals in the distribution price control will require modifications to the RECs’ distribution licences. Pursuant to section 11 of that legislation, the Director General may modify the conditions of a REC’s licence if the REC agrees to the changes. If a REC does not agree to the proposed amendment, and the Director General wishes to proceed with the modification, the matter must be referred to the Competition Commission.

The Competition Commission is a public body established by the Competition Act 1998. It has two principal functions, namely to determine competition issues and, second, to take on the role of the former Monopolies and Mergers Commission (MMC). It is in this second role that the Competition Commission would consider a licence modification reference from Callum McCarthy.

Given the specialised nature of the task under electricity licence modification references the Secretary of State has already appointed to the Competition Commission a number of experts in the electricity industry. The Competition Commission would set up a reporting panel to conduct the enquiry and a number of these electricity experts can be expected to be appointed to the panel.

Process before the Competition Commission

The Competition Commission, subject to any general directions by the Secretary of State, determines its own investigative procedures. In particular, it may determine whether any persons interested or claiming to be interested in the licence modification reference may take part in the investigation. However, it is obliged to take into consideration any representations made to it by persons appearing to have a substantial interest in the subject matter of the reference (such as the RECs). The Commission must also consider submissions by bodies appearing to represent substantial numbers of interested persons (for example, the Consumer Councils).

The Competition Commission has the power to require any person to give evidence or produce such documents, estimates, returns or other information it specifies. It also decides the extent (if at all) to which the sittings of the reporting panel of the Competition Commission would be held in public. As part of its recent investigation into the motor car market, the Competition Commission held its first public hearings, a trend which is likely to continue.

The reporting panel of the Competition Commission may not have all the skills required to consider effectively all the various and often complex issues which arise out of the modification reference. It may (as Ofgem has done) contract out certain aspects of the data analysis to consultancy firms providing services such as accountancy, economic and market research, and technical, management and surveying skills.

Report by the Competition Commission

The issue which will be referred to the Competition Commission is, broadly, whether the current state of affairs, in the absence of any licence modification, may be expected to operate against the public interest.

At the end of its enquiry, the Competition Commission would submit a report to Callum McCarthy, answering the questions put to it in the licence modification reference. On receipt of the report, the Director General must send a copy of it to the REC to which the report relates and to the Secretary of State. Thereafter, McCarthy must publish the report.

The report would set out the background to the enquiry, provide a detailed analysis of the electricity distribution industry, and give fully reasoned conclusions and recommendations. In the unlikely event that the Competition Commission decided that there was no need to make any changes to the current licence provisions, then that decision would normally be final. More probably, if the Commission found that the current arrangements do, in fact, operate (or may be expected to operate) against the public interest, it would report on whether the adverse effects could be remedied or prevented by modifications to the REC’s licence and specify such modifications. The modifications may or may not be the same as those proposed by Ofgem.

The Competition Commission is normally given six months to complete a licence modification reference (which deadline would fall after the April 1, 2000 implementation date for the proposals), and one extension of up to six months may be granted.

Modifications recommended by the Competition Commission

As indicated, it is likely that the Competition Commission would conclude (and RECs would not contest) that the current licence conditions and, particularly, the pricing provisions in those licences, do require modification. The main issue would be to determine the nature of the modifications to be made and, therefore, the new price controls to be applied.

The Competition Commission’s conclusions could, conceivably, be harsher than those of the Director General. However, the RECs may well consider this unlikely, given the hard line that Ofgem has taken in its Final Proposals. Perhaps more importantly, the Competition Commission and its panel of independent experts are required to take an independent view of the issues. This would mean that RECs would have the opportunity to persuade the Competition Commission to a take an approach quite different than that of Ofgem.

In particular, if the Competition Commission adopts a clearer methodology for reaching its conclusions that is more acceptable to the industry, electricity companies would be in a stronger position to insist on such clarity behind all future decisions taken by Ofgem.

Before making any modifications pursuant to the Competition Commission’s findings, McCarthy must issue a notice identifying the modifications and setting out his reasons for them. The notice must also specify the period within which interested parties may make representations or objections with respect to the proposed modifications.

Recommendations made by the Competition Commission are not binding on Callum McCarthy. The Director General must, however, make any changes to the licence which “he considers” requisite to remedy or prevent the adverse effects against public policy. He must “have regard to”, but is not bound by, the modifications specified in the Competition Commission’s report. This may not be wholly satisfactory to the RECs, who may find that having invested time and money in the licence modification reference and obtained a favourable report, McCarthy need not follow the Competition Commission’s recommendations.

However, they should note Northern Ireland Electricity plc’s (NIE) protracted dispute and ultimate action in judicial review against its regulator, Ofreg, following the regulator’s selective acceptance of recommendations made by the MMC in its April 1997 report. The Northern Irish Court of Appeal’s decision in that case found that the regulator could not reject the MMC’s conclusion that NIE required a revenue of £575m because this was an integral part of its findings (and not merely a matter to be had regard to). Thus, a reference to the Competition Commission can become more akin to an “appeal” from the regulator’s decision than a source of advice to the regulator on the public interest issues at stake.

The Government has also acknowledged that the Director General’s ability to depart from Competition Commission recommendations almost with impunity defeats much of the usefulness of a licence modification reference. The issue is currently being considered in consultations over the new Utility Bill proposed in the Queen’s Speech and which is due to be debated from January 2000. Resulting legislation may give the Competition Commission a veto against any modifications proposed by the Director General which in the Commission’s opinion do not remedy or prevent the adverse public interest effects it has reported.

Should RECs Challenge Ofgem before the Competition Commission?

RECs could regard a referral to the Competition Commission as an opportunity to demand coherent, transparent and logically sound regulatory processes and policy.

Such a referral has significant advantages over the other option that is potentially available to the RECs (either upon accepting Ofgem’s proposals, or after modifications are proposed by the Director General subsequent to a report by the Competition Commission), namely an application to the Courts for a judicial review of Ofgem’s proposals. The Competition Commission will consider the merits of Ofgem’s proposals, which would include assessing the robustness of the economic basis for Ofgem’s conclusions. Judicial review, however, is less useful in that it is likely to be limited only to a consideration of whether Ofgem’s proposals are illegal or irrational, or the procedures used by Ofgem lacking in propriety or fairness.

Some commentators have been quick to suggest that RECs might not wish to take matters to the Competition Commission for fear of antagonising the regulator and jeopardising future good relations. This would not appear, however, to be a sound basis for accepting questionable Ofgem proposals. Clearly, the mechanism of review by the Competition Commission was incorporated in the legislation for the specific purpose of dealing with situations where the industry found Ofgem’s proposals and methodology to be unacceptable.

RECs should look to the Competition Commission not simply for a short-term challenge to the distribution price control review process and a fresh reassessment of these particular Ofgem proposals. Instead, it should be seen as an opportunity to have the Commission make an independent assessment of the overall economic methodology of Ofgem, and the transparency of the agency, which could well have significant ramifications beyond this specific matter.

Given that there are eight distinct (if heavily inter-related) reviews of public electricity supply businesses underway, and the distribution review alone directly affects fourteen companies, it is highly likely that there will be some Ofgem proposals which will be unacceptable to the industry, prompting a reference to the Competition Commission at some stage. Ofgem has been bullish throughout over the idea of a challenge, declaring its readiness to be scrutinised. “I am perfectly reconciled that one of the fourteen will take us to the Competition Commission and I’m unfazed by that prospect” declared Callum McCarthy.

The quality and quantity of the economic and commercial arguments which have been raised against Ofgem’s proposals would seem, however, to imply that it is unlikely that the Commission will simply agree with the regulator. This, in itself, may seem to give sufficient cause for reconsideration of the matter before the Competition Commission.

Also, the RECs should note that it may be dangerous for any of them to sit back and let another of their number initiate the referral to the Competition Commission. For example, Scottish Power found in 1995 (after Scottish Hydro-Electric’s successful challenge before the MMC against the regulator’s proposed supply and distribution price control) that it had to take the regulator to the Court of Appeal before the regulator backed down and allowed it to take the benefit of the MMC’s findings. One REC may not be able to rely automatically upon favourable conclusions reached by the Competition Commission where the proposals are challenged by another REC. Further, a challenge by a number of RECs together would add weight to the argument that Ofgem’s proposals are unacceptably flawed in relation to all RECs.

Many of the other price controls operating in the electricity industry will cease to apply once competitive pressures are deemed to be sufficient to make them unnecessary. However, the natural monopoly of electricity distribution is unlikely to become a contestable market and the current distribution price control proposals will, therefore, have very long-term consequences for RECs. Future distribution price controls from 2005 onwards are likely to follow the precedent which Ofgem is now trying to set.

Finally, it should be borne in mind that, under the proposed new Utility Bill there will be a new primary duty on utility regulators to protect consumer interests. Accordingly, the anti-profits stance taken by Ofgem may well be exacerbated. A challenge to the Competition Commission now may well provide a more acceptable economic basis for setting a number of future price controls.

For further information please contact Munir Hassan at [email protected] or on 0171 367 2046, or Mark Moseley at [email protected] or on 0171 367 3240.