3.2 The Reality of Changing Circumstances
If the traditional model has had significant success in achieving its mandate,
it is also the case that the environment in which it is being practiced is
changing.
The most visible sign of this is seen in the outcomes of the most recent
price control reviews that Ofgem has carried out. Three of the four most recent reviews
have resulted in significant projected rises in capital expenditure compared
with the previous price control review period. While rising capital investment is
not new, its impact in driving prices up overall is new.
The P0 adjustments indicate a rise in price in the first year of all of the
above price control periods. The RPI-X formulae give the price adjustments in
each of the subsequent four years of the five-year price control period. In electricity
distribution and transmission higher real prices have occurred because operating
efficiency savings (which continue but at a slower rate than previously) are
not sufficient to offset the effects of the extra capital expenditure on overall revenue
requirements.8 This situation reflects the fact that the ability for ‘asset sweating’
is much reduced relative to the early post-reform years. There are significant
methodological issues with the ability of efficiency analysis to detect significant
operating cost and capital cost inefficiencies when the underlying differences in
inefficiencies between the firms are small. Doubtless improvements in the size
of the datasets used for efficiency analysis, via the inclusion of international and
panel data would help, but would not necessarily address the issue of the declining
economic significance of measured efficiency differences and the unreliability of
the methods applied to them (see Pollitt, 2005).
In terms of electricity distribution and transmission a significant part of
the increase in capital expenditure is driven by low carbon investment in generation,
much of which is incentivized under the renewables support scheme (Renewables
Obligations Certificates or ROCs) and the European Emissions Trading
Scheme (EU ETS). For electricity distribution the increase in capital expenditure
to support distributed generation amounts to £500m over the price control period
(or around 25% of the increase) and for electricity transmission there has been a
separate allowance for £500m for renewable generation support in Scotland (under
the Transmission Investment for Renewable Generation (TIRG) scheme) and
scope for more if more renewable generation is connected.
If we assume that extra climate change inspired investment in GB is
£200m per annum, by 2012 the price of distribution and transmission services
might be 5% higher as a result of this extra expenditure.
More important in volume terms is the amount of investment required to
renew and upgrade the existing network. Electricity transmission and distribution
investment peaked in real terms in the late 1960s, this means rising and expensive
replacement investment in the current price control period and this trend seems set
to continue. Ensuring efficient re-investment in electricity networks is therefore
much more of a priority than it was in the early years following the initial reforms
because capital expenditure is a more significant share of total expenditure on
networks than it was in the past (see Pollitt, 2005).
Rising commodity prices for gas and coal have contributed to substantial
price rises for wholesale power since 2003 in GB. While our analysis of the
trend in network services costs suggests these are going to rise in real terms, we
have already seen substantial rises in wholesale power costs and in customer bills.
Between March 2003 and September 2006, when prices temporarily peaked, the
average household electricity and gas bill rose by £370 to £881. This contrasts
with consistent falls in electricity and gas bills from 1995 to 2003. Such a large
rise in the annual fuel bill has raised political questions and led to a significant
increase in fuel poverty, defined as households which spend more than 10% of
their income on fuel (primarily gas, but also electricity) to maintain a satisfactory
heating level (vulnerable households are those containing children, elderly,
sick or disabled). From a low of 1.2 million the number of households defined as
fuel poor rose to 1.5 million in 2005 (7% of all households) as energy prices rose
(BERR, 2007a, p.9-10).
While recent rises in electricity and gas bills are driven by supply and
demand in fossil fuel commodity markets, the impact of environmental factors on
the final price of electricity is increasing (primarily via the ROC scheme and the
EU ETS).
If the traditional model has had significant success in achieving its mandate,
it is also the case that the environment in which it is being practiced is
changing.
The most visible sign of this is seen in the outcomes of the most recent
price control reviews that Ofgem has carried out. Three of the four most recent reviews
have resulted in significant projected rises in capital expenditure compared
with the previous price control review period. While rising capital investment is
not new, its impact in driving prices up overall is new.
The P0 adjustments indicate a rise in price in the first year of all of the
above price control periods. The RPI-X formulae give the price adjustments in
each of the subsequent four years of the five-year price control period. In electricity
distribution and transmission higher real prices have occurred because operating
efficiency savings (which continue but at a slower rate than previously) are
not sufficient to offset the effects of the extra capital expenditure on overall revenue
requirements.8 This situation reflects the fact that the ability for ‘asset sweating’
is much reduced relative to the early post-reform years. There are significant
methodological issues with the ability of efficiency analysis to detect significant
operating cost and capital cost inefficiencies when the underlying differences in
inefficiencies between the firms are small. Doubtless improvements in the size
of the datasets used for efficiency analysis, via the inclusion of international and
panel data would help, but would not necessarily address the issue of the declining
economic significance of measured efficiency differences and the unreliability of
the methods applied to them (see Pollitt, 2005).
In terms of electricity distribution and transmission a significant part of
the increase in capital expenditure is driven by low carbon investment in generation,
much of which is incentivized under the renewables support scheme (Renewables
Obligations Certificates or ROCs) and the European Emissions Trading
Scheme (EU ETS). For electricity distribution the increase in capital expenditure
to support distributed generation amounts to £500m over the price control period
(or around 25% of the increase) and for electricity transmission there has been a
separate allowance for £500m for renewable generation support in Scotland (under
the Transmission Investment for Renewable Generation (TIRG) scheme) and
scope for more if more renewable generation is connected.
If we assume that extra climate change inspired investment in GB is
£200m per annum, by 2012 the price of distribution and transmission services
might be 5% higher as a result of this extra expenditure.
More important in volume terms is the amount of investment required to
renew and upgrade the existing network. Electricity transmission and distribution
investment peaked in real terms in the late 1960s, this means rising and expensive
replacement investment in the current price control period and this trend seems set
to continue. Ensuring efficient re-investment in electricity networks is therefore
much more of a priority than it was in the early years following the initial reforms
because capital expenditure is a more significant share of total expenditure on
networks than it was in the past (see Pollitt, 2005).
Rising commodity prices for gas and coal have contributed to substantial
price rises for wholesale power since 2003 in GB. While our analysis of the
trend in network services costs suggests these are going to rise in real terms, we
have already seen substantial rises in wholesale power costs and in customer bills.
Between March 2003 and September 2006, when prices temporarily peaked, the
average household electricity and gas bill rose by £370 to £881. This contrasts
with consistent falls in electricity and gas bills from 1995 to 2003. Such a large
rise in the annual fuel bill has raised political questions and led to a significant
increase in fuel poverty, defined as households which spend more than 10% of
their income on fuel (primarily gas, but also electricity) to maintain a satisfactory
heating level (vulnerable households are those containing children, elderly,
sick or disabled). From a low of 1.2 million the number of households defined as
fuel poor rose to 1.5 million in 2005 (7% of all households) as energy prices rose
(BERR, 2007a, p.9-10).
While recent rises in electricity and gas bills are driven by supply and
demand in fossil fuel commodity markets, the impact of environmental factors on
the final price of electricity is increasing (primarily via the ROC scheme and the
EU ETS).
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