Tuesday, May 09, 2006

Danger UXB

Do you realise there is a gigantic unexploded bomb buried beneath every street in Britain? It's called the gas distribution network, and it could blow at any time.

Because it turns out the network still largely comprises ancient iron pipes laid down by Isambard's dad. And most of the rest is something called ductile pipe, dreamed up by Gas Board boffins in 1970, and now known to be even more dangerous than any old iron.

Yesterday the head of Ofgem, the gas and electricity regulator, appeared before the Public Accounts Committee and accepted that this is a "very serious" situation. But, said Alistair Buchanan, even though he's the industry regulator, it isn't his responsibility. Safety is down to the Health and Safety Executive...yes that £200m pa quango that gave us the Buncefield Oil Explosion (see this blog). Hmmm...

What is Ofgem's responsibility is money; specifically, they're meant to ensure these monopolistic gas distributors don't rip our faces off. And the main topic of yesterday's PAC was the National Audit Office report on the June 2005 sale of four regional gas distribution companies by National Grid plc. Were Ofgem right to permit the sale, from which National Grid shareholders trousered £5.8bn? Had they properly protected consumers?

It transpired that Ofgem's legal duty was not to maximise consumer benefits from the transaction, but only to ensure consumers weren't left worse off. They reckoned they'd secured that because they expect the introduction of new players will allow them to practise "comparative regulation", and thus squeeze the entire industry harder during their five-yearly price reviews. And they'd crunched an impressive mass of stats to support their contention- aided by PA Consulting who charged them £1.3m for the work...a mere ten times the original estimate.

But as with all financial modelling, it's garbage in, garbage out. And it soon became clear their were some pretty shaky assumptions and analyses underpinning Ofgem's decision:
  • Their assumed scope for future industry productivity gains- a ludicrously precise 4.13%pa- was mainly based on simple extrapolation from other regulated industries like electricity and water, from which gas distribution differs in some obvious respects...not least the risk of skimped maintenance blowing say Surbiton off the map
  • The timing of gains is extremely uncertain- Ofgem themselves admit 80% of them won't arrive until after 2013, and NAO calculations showed how further delay could easily reduce their present value to virtually nothing
  • The expected £100m costs are much more certain and arrive immediately
  • Risk had not been adequately modelled- indeed Ofgem had actually ignored standard Treasury "Green Book" guidance..."a learning point for the future" was all Buchanan could say

Taking it all together, NAO figures suggested Ofgem's projected net benefit to consumers of £225m could very easily become a net loss of £63m.

What's more, the acquirors, as is usual in take-overs, overpaid for these companies. The 14% "winners' curse" premium they paid will have to be recouped somehow by making the assets sweat. Like the sound of that down there in Surbiton?

The fact is these dodgy old pipes have now been put into the hands of companies that are smaller and less well capitalised than National Grid, and who will be financing themselves with a lot more debt. All of which will need servicing.

As we know, regulators are notoriously prone to "capture" by those they are supposed to regulate. It rarely takes the form of crude brown envelopes stuffed with fivers, but much more subtle techniques. For a start, the regulatees can and will pay for the very best operators to be on their side, and ominously Buchanan flagged up yesterday that his people are "only on civil service scales". So there is very likely an imbalance of power.

And those smart regulatees will always subject the regulators to the entire battery of negotiation nukes. Like statistical befuddlement, and veiled threats of awkward legal embroilments. And of course flattery. Mr B boasted yesterday of how his regulatees were always squawking about his harshness, and I found myself remembering one of the first rules of negotiation- always, always, ALWAYS flinch...even if you are secretly pleased with the other side's offer. Ideally, you want the other guy to think he's put one over on you.

So should we be worried? As consumers and taxpayers the answer is almost certainly yes. Even if Ofgem does manage to extract the additional efficiency gains they project- and frankly I was left unconvinced- they will do so only by pushing these new smaller players a lot harde than they've been able to push National Grid. The risks to safety are obvious, but then what?

The example of Railtrack is instructive and chilling. Once safety becomes a frontpage issue, and once casualties have reached a certain level, government is compelled to step right back in. The railways were renationalised post-Hatfield and vast amounts of taxpayers' funds are still being pumped in to put right what Railtrack failed to do.

We could all soon be paying for Ofgem's decision bigtime.

PS If you're in Surbiton and worried, I suggest you put on a quilted asbestos suit and get out as quickly as possible.


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