Gas Distribution Price Control Review

Ofgem Costs WorkshopOfgem Costs Workshop

19 April 200719 April 2007

2

Agenda

• Introduction to Scotland Gas Networks and Southern Gas Networks

• Opex forecasts and benchmarking• Capex drivers and SGN’s forecasts• Repex forecasts

3

Scotland Gas Networks

Key Features• Scottish Independent

Undertakings supplying remote communities – atypically high costs

• Large area to support with low population density

• Major centres in Glasgow and Edinburgh

• Unique stakeholders incl. Scottish Executive

Population Density

Thurso (SIU)

Wick (SIU)

Inverness

Elgin

Aberdeen

Oban (SIU) Dundee

GlasgowEdinburgh

Campbeltown (SIU)

DumfriesStranraer

Stornoway (SIU)

4

Southern Gas Networks

Key Features• Serving half of London - one third

of workload inside M25• Congestion and impact on working

practices and patterns

• High competition for utility resource and higher contractor rates

• Large number of high rise buildings• Large number of gas holders• Larger diameter pipes in London

Population Density Bournemouth

Wareham

Weymouth

Lyme Regis

Shaftesbury

Salisbury

Southampton

Portsmouth

Chichester

Brighton

Hastings

DorkingMaidstone

Dover

Canterbury

Andover

Oxford

Aylesbury

Banbury

London

Gillingham

Epsom

Horsham

Aldershot

Bromley

Eastbourne

Greenwich

Isle of Wight

Margate

Poole

Reading

5

SGN Objectives

To be the frontier company in: -

• Safety• This is a key driver, influenced by HSE, for SGN in relation to

• Policy setting• Asset maintenance• Standards of service• Employee welfare• Replacement workloads

• Customer Service• A fundamental reorganisation to a customer-focused geographical structure has

already reduced complaints by over 50%

• Efficiency• Replicate the operating model that drove SSE to efficiency frontier in 1999 and

2004

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Opex – Key assumptions

• Controllable Opex (excluding shrinkage and pensions)• 2005/6 £158m; Rising to £172m by 2012/13 (2005/06 prices)

• Cost pressures (2012/13 cf. 2005/06 levels):• Safety and standards of service improvements:

• Asset maintenance driven by legislation, condition and cycles• Improving performance on repair within 12 hours standard• Employee working practises e.g. Working Time Directive

• Real wage inflation e.g. contractor costs – real increases of 3.8% per annum• Other:

• SIU LNG storage costs (not in current price control and future cost uncertain)• Training and insurance costs

• Efficiency savings:• Productivity 2% per annum, falling to 1% by end of plan• Leakage workload 1% reduction per annum• Savings in Support Services

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Uncertain costs

• Costs not included in the BPQ submission due to uncertainty over timing and level. Need for Ofgem to address these exposures:• Cost of Emergency Service and loss of shipper/ NGM contracts

• Traffic Management Act and Transport (Scotland) Act e.g. lane rentals

• Congestion charges

• Changes to tax rules i.e. move to IFRS

• Expected Carbon Monoxide safety and monitoring obligations

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Benchmarking

•Support benchmarking in principle, however in our view it has limited use in this review:• 2005/6 data still largely reflects NG common ownership and was the year of network sales,

therefore concerns exist about full reflection of costs

•Concerns about consultants reports:• Europe Economics – Top down benchmarking can be made too complex. Single scale

variable is sufficient at total cost level e.g. total customers• PB Power / LECG:

• Cannot simply add them together, bottom-up benchmarking risks “cherry picking” benchmarks and creating a “virtual” DN that cannot exist

• Total customers is no longer appropriate once costs are disaggregated• CSV needs further work

• Insufficient allowance for regional costs. In DPCR4 LPN was allowed c. £20m (opex and capex) for additional costs of operating in London

• Erratic results i.e. differing benchmarks and outliers, potential allocation/ business model differences between direct and indirect opex. No conclusive evidence that any DN is more or less efficient than any other

•Therefore focus at this review on understanding each DNs’ forecasts to set allowances. Benchmarking should be used to establish the rules going forward and will be central to GDPCR4

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Capex – Investment assumptions

• DNs have submitted capital investment plans for the 5 year price control period totalling £2bn (2005/06 prices)• Investment is almost entirely non-discretionary driven by statutory, licence and safety obligations for meeting demand and asset life-cycle renewal• Investment plans are based on a range of workload and cost assumptions:

• Demand forecasts• Diurnal storage availability• New Connections forecasts & Market Share analysis• Asset life-cycles and new safety legislation• Historical costs and future cost projections

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Background to Capex submissions

• LTS & Storage• Investment is lumpy in nature - next period higher than last period

due to timing. Projects timed to prevent failure and to provide capacity over the planning horizon.

• Mains Reinforcement & Governors• Mains and governor reinforcement aligned to demand profile.

Investment also driven by safety requirements e.g. replacement of assets at end of useful life.

• Connections• Customer driven, based on market requirements.

• Asset integrity• Meeting specific safety requirements e.g. DSEAR, Working at

Height Regulations etc.

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Capex - Summary costs and volumes in SGN’s BPQ submission

LTS storage projects include: -

• Barton Stacey to Stoneham Lane (South)

• Farningham Phase 2 and 3 (South East)

• Central Scotland Phase 2 – Bathgate to Armadale (Scotland)

• Barton Stacey to Bramshill (South)

• Stirling Phase 3 (Scotland)

Activity Net Cost (£m)

LTS & Storage 292.2

Reinforcement & Governors

201.5

Connections 99.9

Other Operational 54.1

Non Operational 84.9

Total Net Capex 732.6

Costs are at 2005/06 base

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Capex – Key issues from the Fourth Consultation

• LTS and Storage• Application of historical benchmarks to unit costs of pipeline

projects underestimates the unique nature of each project, and future cost pressures.

• IS• IS investment is still to be reviewed. Front Office and Back Office

replacement costs are the main costs in this area, due to renewal cycles, functional enhancements and facilitating underlying operational efficiency.

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Repex - Summary costs and volumes in SGN’s BPQ submission

• Mains includes 30/30 iron policy, steel policy, other iron >30m and PVC

• Services includes relays, transfers and risers

• Other includes Solent crossings to Isle of Wight

Activity Net Cost (£m)

Volume

Mains 736.9 5,581 km

Services 530.9 655,000

Other 18.7 11km

Total Net Repex

1,286.5

Costs are at 2005/06 base

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Mains replacement workload

Ramp-up continuing to 2010/11. Decision to adopt a flat profile over the remainder of the 30yr period significantly reduces workload requirements in the next price control period, as well as reducing the cost pressures associated with high workload. Also addresses other asset risks such as unprotected steel replacement.

Scotia Decommissiong Workloads (km)

0

200

400

600

800

1,000

1,200

1,400

04

/05

05

/06

06

/07

07

/08

08

/09

09

/10

10

/11

11

/12

12

/13

13

/14

14

/15

15

/16

16

/17

17

/18

18

/19

19

/20

20

/21

21

/22

22

/23

23

/24

24

/25

25

/26

26

/27

27

/28

28

/29

29

/30

30

/31

31

/32

30/30 Policy Other Policy With Tail Off

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Innovation in design of replacement projects

• SGN has adopted a new approach to the selection and design of replacement projects using risk, condition and other mains replacement specific criteria e.g. percentage of remaining metallic pipes in a geographical area:• More effective risk reduction, with no increase in work• Target high leakage networks and help achieve opex

efficiency• “All PE” networks achieved faster, reducing capex

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Issues arising from the Fourth Consultation

• Over-complicated bottom-up analysis to derive regression lines

• Impact of regional factors, particularly in London, significantly underestimates the proportion of workload within M25

• Allowance for real price effects inconsistent with historical trend; apparently based on previous year only

• Productivity proposals are unrealistic, given the pressures on timely completion of highly complex projects.

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Steel supplies to high rise properties

• SGN has a large number of high volume of supplies to high rise properties, predominantly in South London.

• Ageing population, uneconomic to repair, with consequences of failure a major concern.

• SGN therefore has planned to take a proactive approach to their replacement• In a small proportion of cases the option to remove gas supplies and offer an

‘all-electric’ solution should be considered, based on economic assessment.

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Summary

• Facing major cost pressures and cost uncertainties in opex, the price control and frontier shift assumptions must allow for these

• Further work required on regional factors and funding of the emergency service

• Too early to rely on regression analysis at this review, but will be central to achieving Ofgem’s targeted efficiencies at the next price control review, when the new management teams have bedded in

• Issues still to be resolved around capex allowances and the costs of the repex programme

• Investment will bring safety and security of supply benefits to customers