Structural change in the pipeline: Helen Kay on the options being considered for the future of British Gas

BY RIGHTS, next Tuesday should bring to an end a year of speculation over the future of British Gas, as the Monopolies and Mergers Commission releases the conclusions of one of the most exhaustive investigations of a publicly quoted company. But the uncertainty will not end there. If the findings are unduly adverse to British Gas, furious political lobbying is planned in an effort to persuade ministers to water down the proposals.

A flurry of buy notes from City analysts last week sent the company's share price soaring, suggesting that most analysts have allowed for all but the most radical of the solutions open to the MMC - a wholesale break- up. Most analysts argue that, with aggressive cost cuts and continuing expansion abroad, British Gas will continue to enjoy real dividend growth regardless. 'With a rate of return of 4.5 per cent and staff cuts of 10,000 in the fourth quarter of 1993, British Gas will deliver dividend growth of 6 per cent,' Rod Maclean, a gas analyst with UBS, said.

The company is actually the subject of several references, variously initiated by Ofgas, the industry regulator, and by the Department of Trade and Industry. They look at four key issues: whether Gas should be broken up; what rate of return it should get on its assets; whether its domestic monopoly should be removed; and whether its tariff formula should be revised.

Break-up. Various structural changes have been suggested to promote competition. Most radical is the proposal by Sir James McKinnon, director-general of Ofgas, that British Gas be split into at least 15 companies, including 12 regional suppliers.

An alternative model calls for full separation of the company's pipeline and storage business, which represents 85 per cent of its assets, from its marketing arm. As a result of an undertaking to the Office of Fair Trading in March 1992, British Gas has already committed itself to financial separation of the two, with transparent pricing to prevent discrimination against independent suppliers. If it is forced into full-scale divestment, it would undoubtedly prefer to retain the distribution business.

The market expects the MMC to favour accounting separation. A briefing paper produced by Coopers & Lybrand on behalf of a number of independent suppliers supports this position, stating: 'We are not necessarily in favour of the wholesale break-up of British Gas.'

Rate of return on assets. British Gas has requested 6.7 per cent on existing assets and 10.8 per cent on new investments, in contrast with Ofgas recommendations of 2.5 to 5 per cent and 5.7 to 8.4 per cent respectively.

The company argues that if it is denied a sufficient return on assets, it will be deterred from future investment. Ofgas favours greater competition through the emergence of independent suppliers. They, in turn, have an interest in seeing the rate of return pitched as low as possible. With domestic gas prices capped, they point out that high transportation costs will squeeze margins, reducing the attractiveness of the sector unless prices rise.

Most analysts expect British Gas to be granted a rate of return of 4.5 to 5 per cent. Neither the DTI nor Ofgas will want to see an increase in gas prices.

Domestic monopoly. Potentially the most explosive issue on the MMC's agenda is whether British Gas should be allowed to retain its monopoly on all customers using 2,500 therms or less. Some independent suppliers have argued for removal or further reduction of this threshold, to open up the domestic market by 1995.

So how would it work? The most likely scenario is that they would apply for licences as public gas suppliers subject to the same standards of safety and service as British Gas. They would be allowed to operate on a regional basis, with one or more suppliers competing in the area, apart from British Gas.

They would pay for use of the company's pipeline and storage facilities: hence their interest in the rate of return British Gas gets for its transportation arm.

The independents would also buy gas from British Gas until enough could be obtained from alternative suppliers (the end of the decade). British Gas would therefore be required to operate a large release programme. Finally, meters would determine the volume used by individual customers, who would be billed according to consumption and supplier.

British Gas opposes the removal or reduction of its monopoly on two main grounds. First, the independents would target profitable high-volume consumers at the expense of the low-volume and socially disadvantaged users whom they subsidise. While some 6 million consumers would get cheaper gas, 12 million would see prices go up, British Gas says. It also says the independents could not guarantee the same standards of service and security of supply. The Gas Consumers Council, which represents domestic customers, has similar fears, though in principle it approves of competition. Ian Powe, the GCC's director, said: 'We do not want to see the reduction of costs through a reduction of services.' He added: 'There is immense political risk in believing what the competitors say.'

The independents argue that the terms of their licence would make them legally obligated to supply anyone who asked for it, though they would aim to attract profitable customers. Nevertheless, as several industry experts note, with a high standing charge and lower rate per therm, they could fulfil the letter of the law and still garner only the plum accounts.

Independent experts are generally wary about opening up the domestic market. They point out, for example, that the technology does not yet exist to meter the system sufficiently, though it will by 1995. They are also dubious about how competitors will balance loading to cover peaks in demand.

Revision of the tariff. The RPI-5 formula, which controls gas prices for domestic consumers, came into effect last year. British Gas says it does not take account of the reduction of the tariff threshold from 25,000 therms last August or the separation of its transportation and marketing arms. However, with the independents claiming that 'local operational efficiencies' would enable them to charge consumers 10 per cent less than British Gas, the company is likely to have problems securing any modification of the formula.

Peter Spring, a gas analyst with Henderson Crosthwaite, believes this would have ramifications on both performance and share price.