Ireland’s offshore opportunity
10th February 2012
Arthur Cox – evolution or revolution
10th February 2012

Shane Lynch – regulation or competition?

PEYE-080311KB1-064 Utility Regulator Shane Lynch talks to Owen McQuade about the challenges in regulating the electricity and gas sectors and how the 20 per cent renewable electricity target can be met.

New TextThe Utility Regulator’s office has “evolved” to now regulate three utilities: electricity, gas and water.

“There are two ends of the spectrum in terms of how we regulate. One is promoting competition where appropriate and the other is monopoly regulation”, observes Shane Lynch. “There are degrees along that spectrum and where you land is a judgement call depending on circumstances.”

Lynch believes that even the parts of the energy supply chain where competition can prevail still require a significant amount of regulation on the island “simply because of market size and dominance, in both the wholesale and retail markets, and this requires a combination of regulation and promoting competition.”

The three utilities are at different stages of evolution, with electricity the most advanced and water the least. In electricity, the market has evolved to the stage where there are a number of competitors in the wholesale market and the retail market and there are now also a number of network operators.

Although there is only one network provider, NIE, there are four other price controls for the sector: SONI (the network operator), SEMO (the Single Electricity Market Operator), the Power Procurement Business and, on the supply side, the incumbent supplier Power NI. For the two parts of the supply chain that lend themselves to competition i.e. retail and wholesale, there are still four price controls. “There’s still a fair amount of regulation going on there,” adds Lynch.

In the natural gas sector there are five price controls. There are four gas network companies in Northern Ireland: Mutual Energy (which has no price control); BGE UK (which owns part of the transmission network to the north west); Firmus (which owns the distribution network in the 11 towns); and Phoenix Natural Gas Ltd (which owns the distribution network in Belfast). In the supply part of the supply chain, there is a price control for Phoenix Supply Ltd in Belfast.

Reflecting on the number of price control mechanisms for the energy utilities, Lynch asks the question: “This is where we have evolved to [but] would you have done it this way with a blank sheet of paper?

“For a place the size of Northern Ireland, why do we have three network companies? In the South we just have BGE. Even within those network companies, there are different regulatory models; the mutualisation model [is] for transmission assets but BGE has a debt-equity model for their transition assets.

When asked if he sees scope for rationalisation, he replies: “The assets, apart from Mutual Energy [MEL], are in private ownership. They have property rights to those assets. It’s hard to see how you could do it other than on a voluntary basis.

Having said that, some rationalisation has already happened. The transmission pipeline to Belfast used to be debt-equity financed and in 2006 that was transferred to MEL.

Lynch continues: “What is quite interesting, as we think about the extension of the gas network to the west, is which model should we go with? As we think about those questions with DETI, it’s important to consider the big picture: What do you think this should look like in 10-20 years’ time?

“If I was to sit down and draw this from scratch, bearing in mind gas is a relatively new market in Northern Ireland, I’m not sure I would have done it this way.” But Lynch acknowledges that “we are where we are and people have property rights and entitlements to those assets.”

Price controls

The Phoenix Natural Gas price control that is out for consultation is a draft determination and a final determination will be made shortly.

In the draft, the Utility Regulator proposed a fairly significant adjustment to the company’s regulatory asset base and it is still reviewing the consultation responses.

“The whole basis of the Phoenix model is it’s a start-up model. There’s quite a bit of capital needed for new business but the build-up of their volume lags. What you have to do is profile their recovery towards the back end, otherwise unit costs would be way too high,” he comments.

In 2006, Phoenix was not meeting the volumes it needed and was allowed to extend the recovery period over a much longer period. It continued to get 7.5 per cent pre-tax real return “which is significantly higher than gas distribution networks in Great Britain, although the gas distribution networks in GB are more mature.”

Phoenix’s actual cost of debt is a bit higher than distribution companies, but not to the same extent that they are allowed WACC (weighted average cost of capital) so the allowed return on equity here is significantly higher in Northern Ireland than in Great Britain.

These issues arise in relation to a gas pipeline to the west: “How do you remunerate an investor for a start-up business?”

When asked whether it is difficult to manage complex discussions with the industry on issues such as WACC and communicate with public stakeholders, he replies: “The regulator’s job is to protect consumers and the legislation gives the regulator quite a bit of judgement. Legislation sets about a number of things we have to have regard to as we go about protecting consumers: security of supply, sustainability, vulnerable customers.”

“I think the legislation is right as it is not entirely perspective and leaves an element of judgement based on expertise,” he emphasises.

“Protecting consumers also means protecting investors. If investors don’t get a reasonable rate of return consummate with the risk they are taking, then they won’t invest. If they don’t invest, then consumers are in trouble. It’s important that we don’t let investors get excessive rates of return that are inappropriate for the risk they are taking.”

Lynch says he comes across consumers and consumer representatives that will say to him that investors are doing too well: “I’ve heard the expression: ‘The risk is allocated too heavily towards consumers and more risk should be allocated towards investors.’

“If wholesale prices go up, it’s always the consumer that has to bear that and investors seem to be somehow protected. We can allocate more risk to investors but they will then require a higher rate of return and will argue successfully for a higher rate of return.

“The consumer either takes the risk or pays someone else to take the risk.”

An example Lynch gives is the Mutual Energy model where the consumer takes all of the risk and therefore the investors (which in this case are 100 per cent debt investors) get a very low rate of return, because they are taking next to no risk.

“We currently have the Moyle interconnector out of service. The consumer is taking the entire risk on that; the consequential cost of the outage on wholesale prices and the cost of repair. If that was a generating business, they currently would be losing market revenues,” he explains.

“The difference comes down to: what risks do consumers wish to take or should they take? Our job is to ensure that we create a stable regulatory environment that is predictable.”

The Utility Regulator has published a draft policy paper on network price controls as Lynch thought it was necessary “because we have expanded and our policies are not necessarily the same across all three utilities.”

Lynch adds: “Ultimately, the key objective is to be clear to industry and investors so they know where we stand and that delivers more transparency and predictability.”

Draft Programme for Government

The draft Programme for Government is committed to having 20 per cent of electricity from renewable energy by the end of 2015. The Strategic Energy Framework had a target of 40 per cent by 2020.

“The regulator’s role in contributing to meeting that target is quite significant and so is DETI’s,” he notes.

Lynch sees the target being met by a combination of market response to incentives and regulatory and policy action. “DETI will set certain incentives or subsidies and the market will either respond to that or not.”

What matters to a developer is the certainty of their revenue stream. One aspect is the subsidies and the other is what they can get for their energy. All investors on the SEM are realising that the sector is heading towards a regional electricity market.

In relation to wind generation, which requires network development, the regulator facilitates through their approvals for network development and connection policy.

The network development proposals are put to the Utility Regulator by NIE as part of a price control submission. The regulator asks three questions:

• Why do you want to do this investment? What do consumers get for the money?

• Is the price you are proposing value for money? How does it benchmark with other distribution companies?

• How is the risk being allocated?

The risks are performance risk (e.g. we may not be able to connect as much wind as we thought for this level of reinforcement of the network), schedule risk (will we get it done in the timeline that company is proposing?) and cost risk (will the project cost more than the company has suggested and, if so, who pays?)

“As a project developer at one point in my career, those are the questions a board would have asked me if I had put a proposal in front of them. And, like most developers, eight out of 10 of your proposals were rejected,” he reflects.

“Regulators act as a surrogate for competition in monopoly investments so we have to ask the same questions that a board would ask in a competitive market.”

Lynch adds that to get to 20 per cent renewable on wind only, NIE is proposing that that can be done with a modest level of investment, perhaps less than £100 million, and by “beefing up the existing assets.” That does not include new build on the 275 kV transmission network.

He predicts: “On the face of it, that seems achievable at a reasonable cost. It is a challenge but we would be quite optimistic that the 20 per cent target can be met. After that, there are bigger questions. To get us from 20 to 40 per cent on wind, you are talking about [almost] another billion.

“The regulator will see it as a much bigger question to sign off on because of the scale of the investment and the impact that would have on tariffs.”

The renewable scene is constantly developing and he expects that by that time offshore may have developed further. In conclusion Lynch remarks: “We would want to see the competing options: what other ways are there to skin that cat?”