For reasons unknown

The utilities sector needs to restore the confidence and credibility of the regulatory regime in Northern Ireland following the recent Competition Commission report on Northern Irish gas pricing. Richard Murphy of Pinsent Masons LLP explains why and what lessons must be learnt for the conduct of price controls across all regulated sectors in future.

Regulated natural monopoly utility networks in the Northern Ireland energy sector such as Northern Ireland Electricity (NIE), Phoenix Natural Gas (Phoenix) and firmus energy are subject to price controls. The process of determining the approved costs and revenue for Northern Ireland’s gas and electricity networks is a complex and detailed exercise.

Under the current UK legal framework, networks have the right to reject their regulator’s price control proposals. In these rare circumstances, the regulator will consider referring the price control to the Competition Commission (CC) to conduct a review. This is what happened in the case of Phoenix last year. This form of adjudication is seen very much as the exception rather than the norm. To put it into perspective, the local industry has witnessed only two references to the CC in over fifteen years: NIE, a long number of years ago and, most recently, Phoenix in 2012. It is a costly and time-consuming process for all involved.

The Phoenix case that was referred to the CC in March 2012 focussed on the proposal of the Utility Regulator to write off £80 million of Phoenix’s regulated asset base (RAB).

Phoenix considered this proposal to be unexpected, unjustified and contrary to the principles of incentive regulation, since it retrospectively altered the previously agreed value of Phoenix’s asset base. The Utility Regulator argued that it was acting in line with regulatory practice and protecting the interests of consumers, by removing unspent allowances from the asset base after five years. Ultimately, the nature of the contract between the Utility Regulator and Phoenix was at stake.

The CC’s task in all of this was to consider whether the existing price control would be expected to operate against the public interest and, if so, whether it could be remedied by licence modification. Ultimately, the CC proposed only a £13.6 million reduction to the RAB in its final determination, £5 million in relation to business rates allowances (a “technical error”) and £8.6 million in relation to capex projects that had been deferred for some time and remained to be completed within future price control periods.

Importance of infrastructure

Having modern, future-proof infrastructure in Northern Ireland is a key enabler to deliver the economic growth required across the region. In order to deliver this type of infrastructure, our electricity and gas utilities rely upon equity and debt markets to fund their day-to-day operation, investment in their upkeep and funding for network expansion and development.

In the world of incentive regulation, credibility is king. These markets lend money on the basis of risk or likelihood of recovering the investment. In today’s world financial markets, capital travels quickly. If Northern Ireland is perceived as a somewhat risky investment location because of regulatory uncertainty, the cost of capital available to our utilities seeking investment will increase.

There is therefore a clear onus on all stakeholders involved in the sector to ensure that we have a stable, transparent and predictable regulatory system that can facilitate capital being readily deployed in Northern Ireland so that we can keep the “lights and boilers on” at an acceptable price for both the utilities and consumers.

A practical example of why such regulatory stability and certainty is more important than ever for Northern Ireland is presented by the Department of Enterprise, Trade and Investment’s recent bold announcement of government support to the tune of £32 million to extend the natural gas network to the west of the province. Whilst this is a potential real game-changer for our local economy, the reality is that a further sum of around £450 million will be required to build out the necessary network to homes and businesses. The delivery of this economic opportunity for Northern Ireland will be shaped somewhat by the recent Phoenix case and the satisfactory resolution of the ongoing dispute between NIE and the Utility Regulator.

The Phoenix case will have significant precedent value. Commentators ¹ have largely agreed that the conclusions that the CC reached set out some clear principles relevant to the conduct of price controls across all regulated sectors in future. These are summarised below.

Lessons learnt

1. A utility regulator, in carrying out a price control, must have regard to the importance of regulatory stability and regulatory certainty and must take into account costs (in terms of increased cost of capital) that may follow any decision that undermines stability or certainty;

2. Any revision of previous regulatory determinations should be well reasoned, properly signalled, subject to fair and effective consultation, clear and understood, and, normally, forward-looking only;

3. A utility regulator, in assessing whether a particular price control or licence modification is (or is not) in the public interest cannot narrowly focus on prices to current consumers to the exclusion of other areas of the public interest. In the Phoenix case, the CC noted that the Utility Regulator should have taken into account the interests of potential and future consumers of gas in Northern Ireland.

These principles will be important, going forward, to all UK regulators, regulated companies and the wider investor community. The CC’s final determination in the Phoenix case is timely with possible regulatory references on the horizon in relation to UK water companies and the ongoing price control dispute between NIE and the Utility Regulator.

The way ahead

An important lesson that I learnt in business a number of years ago from a valued client and mentor comes to mind: Your future will be brighter or have more promise as a result from how you learn from your mistakes, how you can learn to do things better or smarter, or even whether you desist from doing certain things. I think this lesson can be directly transferred to all stakeholders involved in future price control reviews in Northern Ireland.

We need to ensure that our regulatory environment is stable, certain and predictable if we are to attract investors to invest in the future development of our gas network and other regulated sectors in Northern Ireland.

Following the Phoenix case, one could argue that there may even be merit in carrying out an independent review to:

(i) analyse the current practice of carrying out price control reviews in Northern Ireland; (ii) canvas views and opinions from all affected stakeholders on how the review process could be improved, and qualitatively investigate the effect of regulatory risk on the attractiveness of the utility sector in Northern Ireland to investors; and (iii) consider any possible changes to the regulatory structure, policies, processes or resources, which either together or separately, may reduce regulatory risk. The key point is that lessons must be learnt to ensure that we have a stable and predictable regulatory regime.

Notes
1. Refers to bulletin by Frontier Economics Limited and report by Freshfields Bruckhaus Deringer LLP who advised Phoneix Natural Gas and its owner Terra Firma, on the Competition Commission inquiry. The reference source was unable to be included in the original published article due to limited space available.

Richard Murphy is Head of Energy & Natural Resources in Ireland for leading international law firm Pinsent Masons LLP. Richard can be contacted at richard.murphy@pinsentmasons.com or on 028 9089 4844.