UK Electricity Distribution Price Controls
Ofgem decided to apply a single X factor of 3 per cent to all the companies.
The arguments for allocating the revenue reduction between P0 and X are finely
balanced (Ofgem, 1999c, pp. 48–9). Customers were assumed to prefer larger
immediate price cuts and companies to prefer financial profiles that did not
deteriorate over time. High levels of X might be unsustainable, but low levels of
X could underestimate the scope for efficiency gains. The inefficiency of the
typical company relative to the OPEX frontier companies is to be eliminated
over the next control period. The range of inefficiencies is from zero to 40 per
cent, with an average of about 20 per cent (Ofgem, 1999a, p. 33; Ofgem, 1999b,
p. 24). Over the seven years from the date of the Ofgem (1999a) study (1997–98)
to the end of the next control period (2004–05), the companies, with some
allowed adjustments, should be able to eliminate the average level of
inefficiency (Ofgem, 1999a, pp. 35–6). This produces an X factor of
approximately 3 per cent per year for the next control period, used in the Ofgem
(1999c) analysis. This is illustrated in Figure 3 by the link between n and nX; the
diagram crystallises the glidepath issue. However, the inefficiency ratings for
each company are also used to reduce its projected controllable operating costs
for the next control period. For the frontier companies, this means that they must
continue to reduce prices each year of the next control by the average annual rate
of cost reduction needed to reduce the average level of inefficiency in the 1997–
98 operating costs to zero (approximately X = 3 per cent per year). For the
inefficient companies above the frontier in 1997–98, their individual levels of
allowed operating cost are also to be reduced by all of the measured inefficiency
in the 1997–98 costs. Adding in the projected non-controllable costs gives a
profile of allowed operating cost (OPEX) for each company over the next control
period. The rate of cost reduction each year is referred to as the cost ‘glidepath’.5
In negotiation with the companies, Ofgem has made adjustments to the projected
costs but increased the gradient of the glidepath from its initial smooth profile
over seven years by requiring that three-quarters of the cost inefficiency of a
company is eliminated in the first two years of the next control (Ofgem, 1999b,
p. 25; Ofgem, 1999c).
It is these projections, together with Ofgem’s adjustments to the companies’
capital expenditure projections, that make up the components of the discounted
present value of costs. The third critical issue in the Ofgem model was therefore
the nature of the allowed CAPEX provisions. Ofgem (1999c, pp. 30–1)
demonstrates huge cyclical swings over the period 1950–90, with annual
industry distribution CAPEX totals varying from less than £0.5 billion to more
than £2 billion in constant 1997–98 prices. Initial input into the process was the
company forecasts for their CAPEX over the review period, and this was bench-
marked by Ofgem in two categories — load-related (LRE), driven by new
5This is a curious misnomer, since the inefficient companies have a steep gradient of efficiency improvements
to climb.
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