Oral evidence: Network costs, HC 386 Tuesday 4 November 2014

Oral evidence, 4 November 2014.

Witnesses

Rt Hon Matthew Hancock MP, Minister for Energy, Department of Energy and Climate Change, and John Fiennes, Director, Energy Strategy Networks and Markets, Department of Energy and Climate Change, gave evidence.

Chair

Good morning. Welcome back. Sorry we have kept you after the first witness session. I wonder whether you share a general concern I have. In most industries that we talk to costs are driven down, particularly by the application of technology, sometimes quite dramatically but certainly significantly. Distribution is one of the largest elements in a consumer bill over which some control can be exercised via regulating. The biggest element is wholesale prices; nothing you can do about that. But this is quite a big chunk. Transmission distribution is largely a monopoly. It does not get so much public scrutiny, certainly media scrutiny, as generation and supply because people pay their bills to generation and supply companies but they do not pay bills directly to either National Grid or the DNOs. Thirdly, some people argue that the regulator has been a bit less than rigorous in the past in the way they have treated transmission and distribution costs. Do you share the sense that we have not managed to reduce this element in the bill more than has been the case?

Matthew Hancock

I think that it is important that this area has the focus of the regulators and gets the attention that it deserves. The need to drive down costs is very clear. However, there are different ways of driving down costs and some are helpful and some less so. What we really need to do is increase efficiency. You can drive down costs through increased competition and I think we should continue to explore all options for increasing competition in distribution in particular. However, there are areas of natural monopoly or quasi-natural monopoly that inevitably make that difficult just because of the physical infrastructure. The easiest way to drive down a cost is to stop investing and that would be a mistake. Especially since a lot of this infrastructure is between 50 and 60 years-old, we are at a point in the cycle where we do need to have that investment. The third area where we can put pressure on, as well as the increased competition where that is feasible, is on use of technology and efficiency to improve the value for money of our distribution system. I think we have to separate out cost and value for money, essentially, and drive down on value for money and make sure that the costs are appropriate and balance the need for investment and an effective service. For instance, I get as many complaints about speed of network connection as I do about costs of distribution. It is a bit like people complaining about phone masts being built and then complaining that they do not get any mobile phone signal. These two things have to be in an appropriate balance.

Chair

Given what you have just said about the opportunities for technology to promote innovation and reduce costs in a good way rather than a bad way, do you think the way that RIIO is operating at the moment is driving innovation at a pace that you think is good enough?

Matthew Hancock

I always want innovation to go faster and so do most of us. Nevertheless, RIIO is a big step forward in this area. I think it is far more dynamic as a framework than its predecessor. There are still some advantages to be unlocked. The new framework in electricity distribution that will come in in April 2015 has further advantages and is more dynamic still. We are moving in the right direction but we need to keep the pressure up.

Chair

Do you think there should be a way to let consumers get a bigger share of the benefits when companies significantly exceed the targets that have been set on RIIO?

Matthew Hancock

You need to balance the incentives. If the consumers got all of the benefit then the incentives on the companies would not be as great. Getting that balance right is always going to be a matter of judgment and I think we have it broadly right. As costs come down of course that benefits the consumers in the long run, but in order to get costs down you have to make sure that companies benefit as well in order to have the incentive structure. If there is no benefit at all to companies of bringing costs down, then there is no efficiency going to be shared. You have to get a balance. Perhaps one of the challenges here is keeping the pressure up when there is a need to balance competing priorities. It is much easier to drive something either in Government or in a regulated monopoly or close to monopoly when there is an unambiguous direction to travel. For instance, the need to balance investment in kit with the need to keep costs down makes it harder to be unambiguous about that drive, but I think the attention that you are bringing to this area is good. We are working on a voluntary agreement with energy companies to ensure that distribution costs are split out in bills, for instance. That will be a step forward. Ofgem has the capacity to regulate in that area if it needs to and I think that came up in the previous evidence session, but in the first instance a voluntary agreement will be a good step forward. I think this sort of transparency is important because you can too easily slip into feeling like everything is a trade-off and not realise that you can push the boundaries of the benefits to both sides of the trade-off as well.

Chair

Is the cycle satisfactory? In the previous session Ofgem were saying, “At the end of eight years we might find that returns have been rather high”. Well, from the consumers’ point of view, that is a bit late in the day. I appreciate there are obviously legal issues here, but do you think there is any aspect that might involve an earlier review of what has happened?

Matthew Hancock

These things are kept under review but, again, there is an important element of making sure that investment can be financed and can be financed with certainty. There is an advantage to certainty. There is a cost premium to uncertainty and that, again, has to be balanced on the speed with which benefits accrue to consumers. If we can get the cost to everybody down by having a period of certainty then ultimately, over the longer term and over the period of most people’s lives, that will benefit consumers. Of course, that can be frustrating in the short term. Again, I think the balance there is about right. To take this to its ultimate extreme, if you went to an annual cycle or a spot market, God forbid, this would be much more complicated and, ultimately, much more expensive. But if you went longer than it currently is you would essentially be removing some of the benefits accruing to consumers and that would have a downside. You have to have a balance. I think we are about right. I have not seen a strong argument either way to say that the time period should be shorter or longer.

Graham Stringer

The Government has said that it wants to turn the Big Six into the Big 60,000. You are not making a lot of progress, are you? How are you going to improve your rate of progress?

Matthew Hancock

Let me get the figures. We are making progress. In fact the proportion of the retail market taken by those outside of the Big Six has more or less doubled in the last year. Do you have the figures to hand?

John Fiennes

I have not, but there have been a very large number of new entrants in and their market share has risen to 9% at the moment and they are taking a very significant portion of new switches.

Graham Stringer

How many more local producers are being plugged into the net?

Matthew Hancock

Market share is the best way of looking at this. Of course, you can look at it across the piece in lots of different ways. I do not have that figure precisely to hand. I can certainly get back to you. The Big Six that we inherited have undoubtedly been chipped away at over the last few years and that has happened at an accelerated rate. I will find the figures and come back with the exact figures. The change over the last year in particular has been quite stark.

John Fiennes

Equally, the work of the Competition and Markets Authority will be critical in this area. As the Minister says, there has been lots of work done to make sure consumers are in the driving seat for their energy bills. We have been acting to reduce switching time and we think we are on track for halving that by the end of the year. We are working on the ability to use the consumption data, with consumers’ consent, to provide them bespoke quotes for switching and we are intervening upstream to help improve liquidity in the market in order to provide the ability for small generators and small suppliers to hedge their risk. There is an awful lot of work that is going on there. The key question is: is that going to be sufficient to ensure this market works for the benefit of consumers? We think there are real issues for the CMA to be looking at and we strongly support that process.

Graham Stringer

You are obviously relatively satisfied with the progress, so when is there going to be 60,000? When is the Big 60,000 going to be a reality?

Matthew Hancock

We have not put a target date on it.

Graham Stringer

That is not very satisfactory, is it?

Matthew Hancock

Frankly, the situation in 2010 was deeply unsatisfactory. I presume this is not on the distribution you are asking about but on retail companies. Is that right?

Graham Stringer

Also small production.

Matthew Hancock

Small production, right. The situation was deeply unsatisfactory. We have been moving in the right direction. We have made some significant progress that is accelerating and there is a long way to go. There are a couple of things that will help here. The first is having a more competitive market; for instance, making it easier for consumers to switch. It was painfully difficult for consumers to switch before and no attention had been seriously given to that. Now it is much easier to switch and suppliers are under an obligation to allow switching to be fast. Secondly, technology will help to expand this market and access to the networks will become easier just by the fact of it becoming easier to use technology to increase competition to consumers. So that will make a difference. Also, consumer awareness, especially as prices are higher, is driving attention.

John Fiennes

Let us also be clear that the actions that have been taken will greatly enhance independent generation and small-scale generation. We have the small-scale feed-in tariff, which has been going great guns. We have the renewable heat incentive, which promotes renewable heat. Through the capacity mechanism and the CfD, what you have are instruments that are designed to allow for independent generators to come into the market and we have been quite encouraged by the response for that. This is more large-scale, but what it means is you have a larger diversity of companies. They are better, bankable products as well as being cheaper for consumers. We think the picture is changing as a result of the action the Government has taken in quite a significant way. The issues that you are talking about are more on the retail end and are consumers getting the deal—

Graham Stringer

I was talking about generation—

John Fiennes

You were talking about generation?

Graham Stringer

—and community production and I was leading up to the question: do you think there are any more barriers that could be removed that would enable community production to be engaged more easily into that?

Matthew Hancock

One key thing is the connection time of production as well as the connection time of demand. I think, within electricity in April, the time to connect incentive will help to ensure that the distributors have a commercial incentive to make sure that connection is faster and, indeed, they will have a requirement to do so. The frustration of small-scale producers, and some medium-scale producers, at the speed of getting a connection has been a problem that is being addressed.

John Fiennes

It is definitely an active area of work for us. If the Committee has evidence that there are barriers that have not been addressed, I would have thought the Minister would be interested to know.

Graham Stringer

Are the charging methodologies a barrier to small producers?

Matthew Hancock

In what way?

Graham Stringer

I don’t know, I was hoping you would tell me whether there were or there were not. It was a genuine question. Are they a barrier?

Matthew Hancock

Let me answer it this way. Of course, the fact that there has to be physical change means that there is a cost to that and so, in the same way that the cost of any production is a barrier to it taking place, there is a real physical cost and somebody has to bear that. Then there has to be a balance as to which costs are borne over the network by everybody and which costs are borne by the individual who directly benefits. One of the things we are trying to do here is ensure that we get that balance better by having a second comer regime.

Graham Stringer

Sorry, I missed that; by having a—

Matthew Hancock

What is called a second comer regime. In the past the issue has been that either the network as a whole can bear the costs of putting connections in or potential connections in place. The downside of that is you can end up with some stranded investments if the demand is not there, but the benefit is you get cheaper connections where the need is. That is one option. The alternative option is that the first person in a locality that needs the connection pays for it. The problem is that puts a very high burden of cost on the first person who wants a connection in that place but then a much lower cost on everybody who subsequently comes. We are putting in place a regime to allow that cost to be spread so that the burden does not have to be across the whole network but can be across a more appropriate group of people.

John Fiennes

Could I add to that just briefly? In a way, when we are talking about the financial value of charges, obviously this is an area where Ofgem has a key role but there are two issues. There is the overall level of the charge and whether that is disadvantaging particular projects. When we are currently setting administrative support levels we take into account the costs that projects face to make sure we have done it reasonably. In the future, that will move more towards a competitive process, which will be good, and that will make sure that we find the right level. The second issue that people do talk about is: what about the volatility of these charges and does that allow people to plan their business with sufficient certainty? If you are a small undertaking, then the risk of a change there may be less easy to absorb than if you are a larger business. There is a balance there between the need for some flexibility to provide the certainty of investment on the network side, which we have been talking about earlier, but also fair treatment of the people having to pay the charges at the far end. Ofgem is working on a way of reducing the volatility and giving more forward certainty for a number of months for people rather than for the short period they have at the moment, which we think ought to improve. It certainly is not the case that we have, as far as I know, community groups saying that this is a particular issue for them. If there was, I think we would look at that again.

Graham Stringer

Just changing the focus slightly, the Energy Intensive Users Group have said there are significant indirect costs that they have to bear because of coupling up renewables into the system. Do you think those charges to the energy intensive users is justified?

Matthew Hancock

You go first, John.

John Fiennes

Obviously energy is a critical component for them and, because the Government recognises the risk of carbon leakage if people relocate and you do not improve any environment outcomes, there have been some steps taken to reduce the burden on energy intensives by way of compensation for carbon price floor and contract for difference and so forth. There is absolutely an issue there about the level of financial burden on mobile energy intensive businesses and the Government has responded to that.

Matthew Hancock

What I would say is it comes down to this balance again between, when you need a connection, is it the whole network that pays, in which case the energy intensive users who are already connected have to bear a part of that, or does the individual who is being connected pay. The more you move the dial in one direction or the other, either the person who is connecting then complains that their costs go up or existing customers bear the costs. What we have to come back to is that there are two separate questions. One is the distribution of who pays the costs and the second is whether we can reduce those costs and improve the service, have faster connection times. You have to separate out these two questions because one is a sort of batting a ball back and forwards between different groups of people and inevitably people will always make the case for their position and I understand that, but the second is how you can reduce connection costs overall, no matter who pays them, and improve connection times. I hope the incentives in the new system and the requirements in it will put more attention on them reducing those overall costs, which are the actual economic costs that somebody has to pay.

Graham Stringer

Just moving to the domestic consumer, do you think they should be told, either in their bills or separately, about the costs of renewables within the network costs?

Matthew Hancock

The costs of renewables?

Graham Stringer

Yes. Not the actual costs within the charging system but the extra charges that the distributors necessarily have to bear because of the connections. At the moment that is not transparent. Do you think it should be transparent?

Matthew Hancock

I am generally in favour of everything being transparent, broadly, unless there is good reason not to, and in this area the clearer we can be about the makeup of bills to consumers the better. Separating out which distribution costs are due to which technologies is difficult.

Graham Stringer

But not impossible.

Matthew Hancock

Well, it is not impossible to get a measure of it. If a particular connection or strengthening the grid in a certain area both helps to allow for new renewables in a geographic location but also helps to allow, for instance, for an urban expansion in the same area, logically it is not straightforward to work out who bears the burden of those two costs. It is not possible to be 100% accurate. That does not mean you could not make some kind of estimate and we are moving in this direction in terms of being more transparent about distribution costs, but it is one step at a time.

John Fiennes

There is a series of nested information here. For the real enthusiasts there will be reporting on the levy control framework, talking about what we bought, what we spent for it and so on, and we have had this conversation with this Committee before. There is masses of information about what is in the business plans for these companies and what they are being paid, but that is for people who are properly enthusiastic and want to go for it. The question of how much you put on individual’s bills, we think the evidence shows that people care about what energy is costing them and if they can get a cheaper deal. We do think there is scope for more transparency there and we are working on a voluntary agreement to do that but, the Minister is absolutely right, it is very difficult to disentangle the distribution elements. Quite apart from the issues that he has talked about, what is the counterfactual? If you were not connecting a low carbon generator in a particular place, what other sort of generation would you have and what account would you make of where that would be? If you are not careful what you get is a level of spurious accuracy on those things and we certainly would not want to burden the bills with an explanation about what that is and what it is not.

Graham Stringer

A final question from me. National Grid have raised concerns about the process in the Government’s Planning Act, which they believe inhibits connections. They have suggested a fast track for projects that are not major projects. Would the Government be supportive of that?

Matthew Hancock

I am always willing to look at everything that can speed up planning, but we also have to be consistent with the understandable local amenity and the need to take local views into account, especially when things are not counted as major projects and, therefore, of national interest and national importance. We rightly have a localised planning system. Again, we have to strike the right balance. What can be done often is the speed of planning decisions, whichever direction they go, be sped up and we have a huge amount of work on to try to improve that.

Graham Stringer

A quick decision of no as well as yes is often as useful to the company to know what is going to happen or not happen.

Matthew Hancock

Absolutely, but I would not limit the need for that to just connection and kit. That applies across the piece and there is a whole load of work in Government to try to speed that up.

Sir Robert Smith

Many of my constituents do not have access to the gas grid and, therefore, miss out on the benefit of dual fuel deals and have to go for more expensive options to heat their homes. Do you think Ofgem are ambitious enough with a target of 80,000 extra homes connected to the grid in eight years?

Matthew Hancock

The expansion of the gas grid is important and the gas grid is going to be used for a long time to come, even as we move to low carbon generation, and so continuing to connect is important. There is a real cost of expansion of the gas grid, especially in rural areas. Like you, many of my constituents are off grid, including my own constituency home, so I suppose I have to declare an interest. My interest would be very much to get more on the grid, but we have to be realistic about the very real cost that that poses and, again, it comes down to a question of who bears the cost. There would be considerable additional amenity to my constituents to get connected to the gas grid. However, there is also considerable cost in rural areas, and the question of whether that should be borne by all consumers or just by local consumers who benefit from the amenity is a balance that has to be brought. The system is designed to try to support connection where it is economically viable and to try to expand the grid at a reasonable rate.

Sir Robert Smith

Do you think Ofgem’s attempts to see what extra protection can be brought to those relying on other sources that are not on the gas grid is something that we need to support?

Matthew Hancock

Yes, I do. I think there is a lot of work to be done here and Ofgem are on it. For instance, encouraging people to buy their oil early if they are on an oil-based system, to stop bottlenecks in oil supply when suddenly the weather gets worse and when the distribution is also more difficult, is very important, and something that we as constituency MPs can all play a part in. Trying to make sure that the distribution systems for heating oil are resilient and reliable is important. Again, the rollout of technology has a big part to play here in two areas in particular in the retail market. One is in improvements in what you can call finance technology if you want to give it a posh name, but it means direct debit payment, which increasingly is being used in the off-grid heating oil market, rather than a big lump-sum bill in the middle of winter when suddenly your fuel tank is empty. The second is connections of oil tank level readers directly to the companies, which happens both with gas and heating oil. The technology is now coming on stream and I think the internet and things will make much cheaper the communication between individual gas tanks, individual oil tanks and the supply companies so that although the distribution is physical, as in human, by lorry rather than down a tube, it can be much more automated. I do not know the exact numbers, but I know that some have switched to a system where they have a piece of kit that talks to the internet on their oil or gas tank, that talks to the supplier, say Calor Gas or one of the other companies that are available, and then bills automatically. You, as the consumer, do not have to phone them up when your tank is getting low and they can pre-plan their distribution and therefore keep the costs of distribution down, because they can say, “We know that in this village there are 20 people who could do with a quarter of a tank”, and so make one visit rather than having to make 20 when they got down low and, likewise, whether it is gas or oil. Again, there is the opportunity for technology. Incentivising the rollout of that technology is important. The incentives are already there in the cost reductions that distribution companies can make, but this is an area that is ripe for improvement.

Sir Robert Smith

Do you think there may be a role for Ofgem in consumer protection and vulnerable customer policies?

Matthew Hancock

Yes.

Sir Robert Smith

On the network charging, do you share the concern of some of our witnesses that the complexity of the network charging is going to be a hindrance to people competing by trying to work out their pricing structure?

Matthew Hancock

These things are inevitably relatively complex. It always costs to understand a complex system but there are good reasons for that, too. Yes, but with reasons.

John Fiennes

The volatility is clearly an issue, which I talked about earlier, that people have logged with us. When we look at the barriers for competition, things that people mentioned was more about the credit and collateral arrangements in the market where we have done some work in talking to the industry about what that now means, but these are all things where the Competition and Markets Authority will be looking. I am sure if they felt there was an adverse effect on competition flowing from these things then they would do something about it. It will be interesting to see what they make of the relative barriers from charges and patronisation and other features of the market that may be going on there.

Sir Robert Smith

The other issue raised is this historic legacy of 14 distribution companies and 12 gas regions all charging different prices. Ofgem are doing some work on how that could be levelled or have uniform pricing. Would the Government be at least sympathetic to looking at the results of that work to see if there was a policy decision to be had there of a uniform price?

Matthew Hancock

These things are always worth looking at. Again, these differences in charges reflect differences in costs. A decision to go to a national unified cost would have winners and losers and it would involve some of those in areas of the country that are cheaper to connect paying, by cross-subsidy, for some people in areas of the country that are more expensive to connect. That would be a reality of a single national charge. Some of the locations of the winners and losers are not what you might expect. For instance, the south of Scotland has relatively cheap charges. Scotland does not have a particular problem here although, of course, the north of Scotland is the most expensive for easy-to-imagine geographic reasons. Having said that, in the move to RIIO we have not only brought down these charges but significantly flattened the charges across the country. For instance, in the north of Scotland there has been a £27 reduction in the annual average domestic charge, whereas in the south of Scotland there has only been a £4 change, but that is because it is a reduction from £170 to £143 in the north as opposed to an increase of £82 to £86 in the south. I have picked on the two Scotland sub-areas precisely because that shows that some of the winners and losers are slightly unexpected in this area.

Sir Robert Smith

But I suppose they are also just historical of where people chose to set up distribution companies.

Matthew Hancock

The areas may be historical but the charges are real because they reflect the real difference in costs in different parts of the country. It is true that which part you are in is determined historically, but anything that has subnational regional variance is always going to have boundaries in that way. What I am saying is that this policy proposition is not a free hit. It reflects a real difference in cost. There are arguments on both sides as to whether you would want to make that nationally the same. Even with the cost of stamps, it costs more to deliver letters to more remote parts but we still have a national price for stamps. It is a perfectly reasonable policy argument but, equally, there are arguments just as reasonable in the opposite direction.

Sir Robert Smith

You touched earlier on what should be in the bill and we have this constant battle between clarity and information. Do you think the actual overall network charge should be in the bill or do you share Ofgem’s view that the consumer does not want that detail?

Matthew Hancock

We are working towards a voluntary agreement to put this in the bill. Ultimately the decisions over the regulation of billing are for Ofgem, but my bias is to trust people with more information rather than less.

Chair

Some of the evidence we have had has suggested there is a difficulty trying to evaluate network costs because there are no real benchmarks that can be used. Do you think that is an area where there might be something that could be improved?

Matthew Hancock

There are benchmarks. There are international benchmarks, for example, and if you look internationally at our friends across the European Union then you will find that our network costs are below the EU average and only Cyprus and Malta pay less as a proportion of their electricity bills. Given that our costs are below average, our network reliability is seventh out of all member states for continuity of electricity supply. Of course there are benchmarks. Can benchmarks be improved? Yes. Should we improve them? Yes, we should. I do not think it is accurate to say you cannot benchmark these costs.

Chair

The change from depreciating network assets over 20 years to 45 years, is that a neat way of transferring the burden from current consumers to future consumers?

Matthew Hancock

I would not respond in the same pejorative way as you put the question. The truth is that interest rates have come down across our economy and the flipside of a lower interest rate is a longer discount period. That gives a reasonable explanation.

John Fiennes

Packed up in the question is an assumption that the future consumer is being asked to pay for something for which they are not going to benefit. For assets that last as long as this, asking today’s consumers to pay upfront for the whole thing when the benefit is going to be reaped that far into the future probably is inter-generationally unfair to start with. We think the longer depreciation period creates more fairness between the people who are receiving the benefits over time because it aligns better with the asset lives we are talking about.

Chair

It is always remarkable when fairness happens to be served by reducing immediate costs. That is a happy circumstance. Is there a danger, however, that the regulatory system we have may incentivise these sort of accounting quirks rather than actual innovations in the way in which distribution takes place?

Matthew Hancock

Well, changes to accounting systems always have to be scrutinised properly to make sure they are reasonable but if, as you say, this sort of change increases fairness also because it matches more accurately the lifetime of the assets, the lifetime over which it is paid, then it is a reasonable change. If that change is incentivised by the structures, which I think it is, that is no bad thing. Do we need to make sure that real lifetime costs are also brought down? Yes, absolutely we do.

John Fiennes

I do not think the characterisation of this as an area where there is no innovation is fair. You have the smart meter programme rolling out. You have the smart grid work, which has benefited from something like £500 billion worth of investment, which is now paying direct dividends into the RIIO distribution process. We have more about this coming on 1 April next year for the network innovation competition, so there is a lot driving there. If it was the case that we felt that what was being done was trammelling that innovation then that would obviously be a concern, but that is not a picture that we recognise. There is a lot going on.

Dr Whitehead

The rollout of smart meters has been characterised by the Public Accounts Committee as something that appears to be not particularly noticed by distribution companies in terms of what they could be doing to reduce leakages and track losses. Is there anything the department is intending to do to make that link a firmer bond as the rollout takes place?

Matthew Hancock

The rollout of smart meters is a very important part of modernising the way that electricity consumption occurs and we have talked about it at this Committee before. I am very enthusiastic about it. Making sure that we get all of the benefits from it is important. Of course, the direct relationship is with Ofgem rather than the department. Nevertheless, drawing attention to the benefits to all different parts of the grid of changes to consumer behaviour that you can get through smart meters is important. The smart grid programme, which is obviously interconnected with the smart meter programme, is something that the department, as well as Ofgem, the distributors and, of course, transmission, are heavily involved in. This is a massive change and it is a huge challenge to all parts of the system. Obviously it is inaccurate to say that any part of the system is not engaged in moving to the smart grid, but there is a huge amount of work still to do and there are big benefits to be reaped. We cannot sit back and wait for it to happen because it is happening because of the changes in consumer behaviour.

Dr Whitehead

Are you anticipating, as the smart grid system rolls out, the percentage of losses by DNOs, particularly in electricity distribution, will fall very substantially?

John Fiennes

I do not have the number for the projected loss, as it turns out, but I know that, of the £6 billion benefit projected for the programme as a whole, £1 billion of that is benefit to network, about half of which is avoided losses. So there is about £500 million worth of benefit in there. That is a material fall, but I do not have the percentage impact number in my head I am afraid.

Dr Whitehead

Is it the intention of the department that that avoided loss should be returned to the customer in terms of lower bills as a result of the lower losses that will be a component of the DNO bills?

John Fiennes

Absolutely. The RIIO process is designed to incentivise these companies to do that and, where they make improvements, those are shared with the consumer.

Dr Whitehead

Yes, but I think you would agree that the system at the moment is that DNOs are getting substantial payments to reduce losses but are not actually reducing losses. Is that going to change?

John Fiennes

I am not sure I would agree that they are being paid to reduce losses in a way that is not reducing losses. Any electricity system will have a certain amount of losses given the physics involved. There are a number of incentives designed to ensure that the companies are efficient and Ofgem is keen that there should be robust strategies in place to manage those. I do not think we would accept that there were things that were being done that were being wasted on that.

Dr Whitehead

The fact of the matter is, in terms of the period certainly between 2000 and 2010, which was the subject of a revision by the DNOs of what their losses consisted of, there was an initial review, so I understand, that awarded DNOs something like £100 million in incentives as far as their losses were concerned and then the DNOs revised their calculations on what their losses were and they got another £400 million. But over the period, if you look at what the losses were early 2000, if anything they have risen between then and to date rather than reduced. That is £50 on the bill, isn’t it, with that £400 million going to DNOs for recalculating, unilaterally, their own losses but then coming out with a performance over the period that doesn’t appear to indicate that any losses have been reduced. Furthermore, the differential in losses between DNOs is a factor of 7% or 8%, isn’t it?

John Fiennes

There is a complicated issue, which goes back a number of years, about the interface between the quality of the settlement data that suppliers generate and what that says about the losses and how that interacts with the losses incentive in place and the previous price control regime. Now, this is a matter for Ofgem as the independent regulator. I do not recognise the £400 million number. It may be I have misheard you. Ofgem arrived at a decision in March of this year seeking to strike a fair balance between the need for not reopening a regulatory settlement that was done on a particular basis before, but also the need to provide value to consumers. As a result of that, I understand £161 million was returned to consumers, which is an average reduction of £3 on the electricity bill. We welcome the fact that that money is being returned to consumers.

Dr Whitehead

With respect, that was an apparent reduction in an amount of money given out to DNOs on an original self-assessed amount, which meant that the self-assessed amount was reduced by £161 million. The idea that that was returned to customers is a little strange, isn’t it?

John Fiennes

There was an investment plan linked to the regulatory settlement in that period and Ofgem’s job was to strike the right balance between the consumers who have an interest in paying as little as they can but also the need to maintain a fair approach to settlements that had been made in the past.

Dr Whitehead

The central point, certainly in terms of going forward to what Ofgem is proposing over the next period in terms of incentives to reduce losses, is that to date it does appear that incentives, albeit perhaps to some extent clawed back, have been provided for no reduction in losses—if anything an increase in losses—and the 2015 regime appears to produce no significant increase either in incentives or indeed in penalties as far as shaping further loss reductions for the future are concerned other than the question of what happens when smart grids come in.

John Fiennes

My understanding, although you are going to reach the edge of my knowledge about the detailed RIIO settlement, is that Ofgem have adopted a different approach for the distribution settlement that comes up in the light of the complexity of trying to base this on settlement data and all the complexities that I have been talking about before. I think they would say that they have learned a lesson from that and they have changed accordingly.

Matthew Hancock

But there is an important point here, which is that, since losses are never going to be zero, the goal has to be to reduce losses from what they otherwise would have been. Therefore, there is a level of incentive payment that is appropriate for any given level of losses. You can always say, but it is an absurdity to say, that there are losses yet there are incentive payments. To argue that, because there are losses, there should be no incentive payment is to miss the point. The point is to incentivise better performance than otherwise would be in terms of losses and then to make sure that when things are improved the benefits are spread appropriately.

Dr Whitehead

Yes, but the “otherwise” benchmark surely, while accepting that losses will never be zero, is what has happened over a period of time in terms of the percentage losses that occur as a result of distribution. Certainly the figures show that there has been very little movement in those losses over a period and indeed the variation in losses between different DNOs—now possibly accounted for by different age of equipment and replacement rates and various other things—however, is in the order of 7% to 8%. That is, the best performers are about 3% but have been consistently about 3% over a period and the worst performers are about 10%, consistently 10% over a period. That seems to tell a rather different story than the simple idea that, since you can’t get losses down to zero, you need to incentivise people to do a little bit better.

Matthew Hancock

No, but there is a physical difference as well. Losses occur because of physical properties of the electricity system, of which distance is one of the biggest, but the quality of the kit, which is obviously heavily determined by how new it is, is also another one. The fact that these figures do not move very fast tells you that there is something innate in them. For instance, bigger geographical areas are going to have higher losses and there is nothing you can do about that. Even if they had the worst kit, you would still expect to have losses even if you managed it as well as you possibly could in the bigger areas. I think it is pretty unfair on the distribution companies in more sparse areas to say, “You have higher losses and you have done nothing about it compared to the low loss areas and, therefore, you are consistently and repeatedly failing”. That is not fair.

Dr Whitehead

No, but you have done nothing about it over a period of time. Admittedly they will be different losses, but if the losses remain static over a period of time, even taking into account the differences that you have mentioned, that is something to be concerned about, isn’t it?

Matthew Hancock

Obviously it is better if losses fall. However, as kit gets older you would expect losses to tend to rise and having that investment programme to replace old kit is a value-for-money judgment because you have to have big investment in order to deal with it.

Dr Whitehead

Where do we stand on international benchmarking our losses? Do you know about that?

John Fiennes

They are quite hard to compare. I would be quite cautious about them, but a recent country ranking based on IEA, OECD and UN data said that we were lower losses than most others. If the first country enlisted the highest losses, we were number 101 out of 185. So we are in the top third with a similar level to Ireland, Norway, Sweden and Italy.

Sir Robert Smith

The EU third package network codes are all about trying to harmonise network charging and capacity allocation across the member states. How does DECC assess the impact of these policies and look at the interests of the British consumer when they are being implemented?

Matthew Hancock

You go first.

John Fiennes

The aim of the network code is to make sure that, in effect, cross-border trade is able to happen on a lot more efficient basis, which ought to be welfare enhancing. There is a great deal of detailed work going on and we rely to a great degree on the expertise of National Grid and Ofgem in making our assessment of these codes. As your previous witnesses said, there is an initial process between the system operators to come up with proposals that the Commission then examine and those are considered, ultimately, in a comitology process. But, overall, we think they are sensible improvements to establish the single market that we think will provide significant benefits to consumers overall.

Sir Robert Smith

What is your view of National Grid’s performance in that process?

John Fiennes

We think they are very well connected and respected in Europe and, consequently, they are very effective defenders of a right market-based solution.

Matthew Hancock

No pun intended I am sure. The big issue for us in this is interconnection, which is obviously a matter of transmission rather than distribution. We think we have a pretty robust distribution regulation system, especially the new system rolled out for gas last year and for electricity next year. There are always improvements that can be made but, nonetheless, for our purposes, we think that is pretty good. The big opportunity here is to push for more interconnectors. We are doing that domestically and making progress with the Norwegians and with other EU counterparts. We are also pushing for that to happen between other EU states, both within and with neighbours to the Union. Even though that will not directly affect our market, it will improve energy security and it will make the system more competitive and, therefore, you would hope to have lower prices. As Ofgem were talking about, making sure we have a well regulated system of flow at the interconnectors is an important part of that. For me, interconnectors are the exciting opportunity here in terms of what happens domestically. Ofgem are well placed, along with Grid, to manage that.

Sir Robert Smith

Are you aware of the concern in the gas upstream market of the impact of the gas codes on costs?

Matthew Hancock

Yes.

Sir Robert Smith

Do you share that concern?

Matthew Hancock

There is a balance to be struck, as with all of these things, and there are strong arguments in each direction. I think most of the corporate interlocutors in this debate take the position that is dictated, understandably, by the effect it will have on them and I get that, but we have to balance the needs of different corporates. I understand the problem but I hope that we can work through it in a reasonable way.

Sir Robert Smith

Do you think there is still scope for some kind of accommodation within the European system?

John Fiennes

I personally do not think it is practical to reopen the detail of the code at a European level. The conversation earlier highlighted the fact that we are unusual in having the upstream as well as the downstream. We made attempts late on in the negotiation to see what could be done about that and, at that stage, the answer was it was not possible to secure a change. So we are where we are by way of the law. That does not mean in the future it will not change, but the task now is to look for a sensible way forward given the position that we are in. There is now a fairly intensive process going on between ourselves and the affected industries and National Grid to find a pragmatic way through that is reasonable. We now need to work with some of the people we have at a European level rather than hoping that we are going to reopen those at that point. Given, as was talked about earlier, the extent to which the Commission and other member states are working on all of the other network codes and the market codes going on at the moment, the prospect of reopening that does not seem to be very high.

Sir Robert Smith

Will those costs feed through to consumers?

Matthew Hancock

Not if they can be managed. I arrived and looked at this quite early and pushed back quite hard and the difficulty is that reopening this discussion would reopen a whole load of other things that landed much more in the UK’s favour. When you ask a question on the impact on costs you have to look at the package as a whole and, in any negotiation, some points come out better than others. You have to look at the benefits of the package as a whole. I think that the benefits of the third package will be positive for the UK and for UK consumers, but there are elements of it that I would have written differently if I had held the pen. That is what a negotiation to get something that has an overall benefit feels like.

Sir Robert Smith

With the new Commission, what do you think should be on their agenda for taking EU energy policy forward?

Matthew Hancock

Interconnectors, interconnectors and more interconnectors. Energy security of supply has gone up the agenda rapidly, even over the last six months. Given that we have landed our EU 2030 package in a way that the UK was very happy with, with an ambitious overall carbon target but then no binding national targets on how to get there, that was very positive and I commend the work of the department and the Government in getting that landed. That having been done and, of course, with the consequential work towards Paris next year, I think the new commissioner now needs to focus on ensuring that we have strong security of energy supplies and that we reduce our dominance on Russian gas in particular, but also benefit from the advantages of stronger electricity inter-linkages internationally as well, including to North Africa. Making sure that the market functions well is a matter both of a strong regulatory structure but, crucially, it is a matter of physical interconnection as well and so I think that is a very important item on the agenda in order to increase the security of our energy supplies.

Dr Whitehead

Is interconnectors a public-good investment or a merchant investment?

Matthew Hancock

Both. Clearly a more competitive electricity market and a freer flow of gas, to a lesser extent for us because we have strong supply from the North Sea— both the British but also the Norwegian North Sea—is good for consumers because it means that you get access to the market wherever it is cheapest and that impacts on prices. It is also good for security of supply. Of course, building interconnectors need to be paid for and so it needs to be a decent commercial proposition to those who are going to pay for them. We do not propose to build them directly from the Department for Energy and Climate Change, although I am sure that we could if we chose to. Therefore, it has to be a decent market proposition as well.

Chair

I very strongly welcome the outcome of the 2030 targets. As you say, exactly the right package and I am glad that we got what we were pushing for on that. I hope the logical corollary of that will be moves to strengthen the EU ETS as well, which I know we are also—

Matthew Hancock

That was part of the conclusions, absolutely.

Chair

Just on interconnectors, I should declare an interest as a director and shareholder of Eurotunnel, which is building an interconnector at the moment. I am very glad to hear again your strong endorsement of what is a whole EU-wide policy now. There are consequences, of course, for transmission in the UK once you build an interconnector. I think Nemo, which is the one National Grid want to build themselves from Belgium, has some issues about pylons going across East Kent to get to the ring round London. Is there a risk that, even though we may have investors who are now quite keen to invest in interconnectors, there may still be some planning and logistical barriers to getting this done?

Matthew Hancock

Of course there are going to be planning and logistical challenges. I think of interconnectors in the domestic context, which is the context I care about most, as a power station. They are effectively a power station that can supply power into the domestic grid. Now, they also happen to be points that can be big energy demand as well. They can be either a positive or a negative power station. That is the best way to think of them and they come with the same impacts, especially on transmission, as a new power station built offshore; very similar to offshore wind in that way. Of course, they have the consequence that the energy can flow the other way. That is an export, and so positive if we can afford to send it, but if we need it then we can have it.

Chair

By definition, an export that is going at the time to a country that is willing to pay more than is—

Matthew Hancock

Precisely, and they are very good for security of supply because it means that it increases the zone in which there is a price response to a supply shortage rather than a quantity response. Although I would rather have no supply shortages and a balanced system all of the time, given that this is an inherently uncertain world that we live in the first best response to a tightening is for a change in price rather than an absolute shortage. This is the subject of a whole other hearing, I imagine, but there is action that we are taking across the piece on that, including in order to do it in the most cost-effective way possible, but interconnectors have a positive energy security impact as well as improving, on average, the price available by making the market more liquid.

Dr Whitehead

Is there not a problem that, as interconnection increases from our present 3.5% or so to, say, more to the European norm, logically price variations between the various ends of the interconnectors reduce and, therefore, the ability of an interconnector to make money for itself through what happens at the moment, which is mainly arbitrage on differential prices, reduces? Therefore, merchant investors may think up front that that is an asset that will waste as it is installed and certainly as it is installed alongside others and, therefore, may be rather put off from the idea of investing simply on the idea they are going to make a lot of money on it.

Matthew Hancock

If you pursue the logic of that argument then there would ultimately be no trade at all because all of the gains from trade in any market would be taken advantage of and, therefore, the prices of goods and services in different markets would equalise and so there would be no need particularly to trade. I do not think that is—

Dr Whitehead

I am not suggesting that. Are you absolutely happy that the entire programme of interconnection, which I strongly support, will be able to be secured solely through people coming and investing lots of money in interconnectors because they think they are going to make a lot of money out of them or is there not the possibility that a route B may be necessary that needs an element of public-good investment in order to secure interconnectors for our energy security over the next period?

Matthew Hancock

I do not think at this stage it is necessary to publicly subsidise interconnection. There is a clear revenue stream to make them a commercial proposition. I think the impact on price differentials will be a positive one, but there are different energy systems in different countries and so there are always going to be price differentials at the margin and that is where interconnectors provide a return. In France they have a much higher proportion of nuclear, so they have a much higher base load, but that means it is harder for them to manage peaks and troughs. We had 15% renewables last year, which has an intermittency that is based on factors outside our control and that are less predictable. This will mean that at the margin there will be differentials in the two systems all the time just because of the nature and structure of the markets. Those can be mitigated by interconnectors but, until you have as much interconnection as there is within a domestic system, I can see interconnectors mitigating price differences but I think it is unlikely that they will remove them altogether.

Sir Robert Smith

Do you think the lessons have been learned from the early gas interconnection, when gas flowed the wrong way in terms of price signals because of other constraints in the market in terms of security obligations on those at the other end? While the price should have sent the gas to us, we sent gas abroad because the European companies had such a strong obligation. Is that something that could happen in the electricity market?

Matthew Hancock

I thought Ofgem gave a pretty good account of the changes that have been brought about to make sure this does not happen.

Chair

Just one final and unrelated question but topical. The Big Deal, consumer campaigners, have been in touch with us and obviously there has been a lot of coverage in the media about what they said—that consumers may lose out on the best energy deals because the comparison sites may filter out tariffs that do not pay commission. Is that an issue that concerns you at all?

Matthew Hancock

Yes, of course. We are looking at it very closely. The question of consumer regulation is an important one. If activity that has been illegal has happened then undoubtedly action will be taken. If activity that has been unreasonable has been undertaken then we will certainly look at it.

Chair

All right. Well, thank you very much for your time. Oral evidence: Network costs, HC 386 40