On reflection, Ofgas' case is still strong

The Independent found itself virtually alone yesterday among broadsheet newspaper business sections in supporting Clare Spottiswoode, the gas regulator, against the cries of foul emanating from British Gas/TransCo. With the dust beginning to settle on Ofgas's explosive proposals, it is worth asking the question again: are they unfair on shareholders? One difficulty with answering the question is that it is actually quite hard to find any genuinely independent expert to provide an assessment. We phoned National Economic Research Associates, acknowledged experts in the economic regulation of utilities. Er ... hard for us to comment, they said, since we are advising TransCo. What about Professor Michael Beesley of the London Business School? He was part of the last Monopolies and Mergers Commission team to examine these issues so he ought at least to know which side is right to claim MMC support for its view. Sorry old boy, no can do. I'm advising Ofgas, you see.

Oh well, we'll just have to try ourselves, with a little help from Peter Vass, research director of the Centre for the Study of Regulated Industries (who presumably is independent). So, dear reader, sit up and concentrate for we are about to enter territory which although guaranteed to make the eyes glaze over is of great import to the future of the utilities and how they are regulated.

There are two ways in which the proposals might be unfair on shareholders. If it could be shown that they add up to an expropriation of shareholders' assets, then that would certainly be unfair and possibly even illegal. Secondly, if it could be shown that the regulator's assumptions about the scope for improved efficiency are impossibly demanding, then that would also be unfair because it would mean TransCo would not be able to achieve the allowed rate of return. It is virtually impossible for a journalist to make a realistic assessment of the second of these possibilities for it requires detailed analysis of the integrity of the forecasts. The targets seem harsh to the point of being virtually impossible but then all cost-reduction programmes are thought impossible by those who have to carry them out until they are actually tried. An adjudication will have to await the MMC.

The possibility of expropriation is easier to address. The regulator's proposals on depreciation, whatever she may claim, are certainly at variance with the more liberal approach authorised by the MMC in 1993. The MMC said British Gas should be allowed to depreciate its assets on the basis of their replacement cost or book value. What Ofgas is proposing is that they be depreciated on the basis of what investors actually paid for those assets at the time of privatisation, which is clearly a much smaller figure. The difference may seem an obscure and arcane one, but the numbers involved are considerable. Ms Spottiswoode's approach is a lot less generous to British Gas than the MMC's but in itself it doesn't amount to expropriation. There may well be something in the detail which does, but on the face of it, Ofgas is allowing TransCo to recoup shareholders' original capital through depreciation.

It might have been a lot worse, for there is a third approach which a few wild voices were urging on the regulator. This is the one that assumes that the gas industry has no long-term future and that there is therefore no need to replace the company's network of pipes, pumping stations and storage facilities. In these circumstances the industry would become regulated on a cash-flow basis, taking no account at all of the need to replace the company's stock of capital. Now this really would be expropriation for depreciation has another role besides being a source of funds for future expenditure - that of recovering the cost of past investment. On what might be called "the depreciation-free" approach, the industry would be progressively run down until there was nothing left. If Clare Spottiswoode had opted for this method, then shareholders really would have a case.

On the approach she does adopt, the effect is to allow lower prices now at the expense of consumers in the future. For if gas does have a long- term future, someone is one day going to have to pay the replacement cost of the industry's assets. What Ms Spottiswoode is allowing by way of depreciation won't cover the bill. But that is all a long way in the future and, in any case, not of direct concern to shareholders. There is a lot of detail in the proposals, and quite a bit of unexplained fudge too, so it is possible that expropriation is involved. But on methodology alone, the MMC is going to find it hard to support TransCo against Ms Spottiswoode.

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