Utility Week

Utility Week 25th October

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Comment Utility Week expert view Nigel Hawkins "Under the quasi Marxist-based regulatory system, the financial interests of water company shareholders are diametrically opposed to those of their customers" U tility prices, with the exception of the telecoms sector where competition abounds, have risen sharply in recent years. Electricity prices are up by 20 per cent since 2007. Meanwhile, domestic water prices have increased by around 50 per cent in real terms since privatisation in 1989. But are customers being ripped off by utilities operating either clear monopolies or participating in markets where monopoly power is endemic? In the electricity sector, there was a period of falling prices, most notably in the 1990s. These have been reversed with a vengeance. The key factor has been rapidly rising gas prices, in complete contrast to the US, where the shale gas boom has depressed prices. Since privatisation in the early 1990s, virtually all new baseload plants have been gas turbines, thereby stoking heavy demand for gas. For the first few years, this scenario was fine because North Sea gas supplies were plentiful. But as indigenous production declined, more expensive gas was imported, thereby pushing up prices. Gas can account for up to 75 per cent of the operating costs of a combined cycle gas-fired plant. Add to that the various costly green subsidy programmes introduced by successive governments, such as the Renewables Obligation, and it is no surprise that unit costs per kilowatt-hour have soared. The investment issue is relevant as well, because the big six companies will be expected to undertake the bulk of the £110 billion capital expenditure programme required over the next decade. To finance such investment, they need to generate sufficient cashflow. They recognise, too, that interest rates are now set to rise rather than fall, thereby making investment more expensive. It is against this background that the big six have raised their prices over the past decade. For domestic gas customers, Centrica's annual price adjustment is particularly crucial. Certainly, its price increases have outnumbered cuts in recent years. Centrica, though, is having to buy more expensive gas because its Morecambe Bay gas fields are no longer booming. It recently concluded an initial 20-year deal to import 89 billion cubic feet annually of Liquefied Natural Gas (LNG) from the US. In its 2012 results, Centrica reported an operating profit for its UK British Gas business of almost £1.1 billion. Wholesale energy costs accounted for about half of the annual £1,188 average combined gas and electricity bill. Profit were just £49 per customer. After Miliband's price freeze pledge, Centrica's chief executive, Sam Laidlaw, observed that "if prices were to be controlled against a background of rising costs, it would simply not be economically viable for Centrica… to continue to meet the sizeable investment challenge that the industry is facing". Strong words indeed. Yet, with a domestic gas market share of close to 50 per cent, Centrica undoubtedly calls the shots, with its competitors already following suit on tariff increases. Irrespective of Miliband's radical initiative, it would be no surprise if some form of domestic energy price controls were reintroduced. Water customers, like their energy counterparts, have experienced large rises in water bills. The 1999/2000 periodic review, which brought about substantial price cuts, now seems to be an anomaly when set against its successors. The past two reviews have been based on large annual capital expenditure, of around £4 billion a year, and minimal price cuts. Ofwat has consistently overestimated the weighted average cost of capital (Wacc) – and especially the cost of debt. The last periodic review assumed a cost of debt (the main Wacc component) of 3.6 per cent. Earlier this summer, Ofwat chairman Jonson Cox suggested the current figure was just 1.25 per cent. If the next periodic review were to incorporate a Wacc well below 4 per cent, sizeable cuts in water charges should be expected. But can Ofwat deliver such price cuts or is it all talk and no action? We shall see. Severn Trent's flotation price in 1989 of 240p has soared to £18 – a £22 per share offer was recently rejected as inadequate. Given this near eightfold increase, it could be argued that its customers have missed out. Under the quasi Marxist-based regulatory system, the financial interests of Severn Trent's shareholders are diametrically opposed to those of its customers. Every positive percentage of K equates to a 1 per cent increase in water charges and vice versa. A simple analysis of the Severn Trent scenario would suggest that its shareholders have done rather better than its customers. However, in the case of Welsh Water, whose parent company Hyder failed in the late 1990s, the reverse would have been true. The conclusion has to be that utility customers have undoubtedly profited from far higher investment and much better customer service but, unlike their telecoms counterparts, have had to pay considerably more than previously for these tangible benefits. Nigel Hawkins is a director of Nigel Hawkins Associates UTILITY WEEK | 25th - 31st october 2013 | 7

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