Matthew Lockwood, IGov Team, 27th September 2018
To coincide with its annual conference, the Labour Party has just launched a new environmental policy document, The Green Transformation. A key element of its proposals on energy is to bring ‘the UK’s energy transmission and distribution networks back into public ownership’. Much media debate has been on how that will be financed, which is obviously an important issue. Here, however, our focus is on what such a move would mean for the running of networks.
Labour’s shadow Chancellor John McDonnell was clear in his speech to the conference that this would not be about the state ownership of the 1970s, saying: ‘Be clear, nationalisation will not be a return to the past. We don’t want to swap one remote manager for another.’ Instead, he announced that the Labour Party setting out plans that would put the water industry back in the hands of councils, workers and customers.
Both the Party and the media have been focusing on the shared worker ownership of Labour’s new policies. However, for networks, the role of consumers in ownership is particularly important in this vision, for reasons to do with a problem that has dogged the current approach to energy infrastructure since privatisation in the 1980s.
As private monopolies, networks have been subject to regulation; since 2000 by the combined gas and electricity regulator Ofgem. Every few years (eight at the moment but historically every five years) Ofgem sets the total revenue that the network companies are allowed to earn (recovered from consumers through networks charges). They try to set this allowed revenue on the basis of what their best guess of real network costs (including the cost of capital – equity and debt) are. The trouble is that the companies always know more about what true costs are than Ofgem does – this is known as the ‘asymmetric information’ problem, and lies at the heart of thinking about regulation in economics.
Over the years, energy regulators have put more and more effort into trying to ascertain true costs, paying engineering consultants to go over company business plans in fine detail, consulting with the City over financing costs and bringing in ever more arcane and complex schemes – such as the Information Quality Incentive (IQI) – to try to incentivise companies to share information more accurately. However, despite all these efforts, network companies consistently seem to come away at the end of each price control period with returns that are higher than the regulator expected, to the benefit of owners and shareholders but at the expense of consumers. This issue matters more now because we will need a lot of innovation in networks, especially electricity distribution networks, over the next few years, and there will be huge struggles over what the true costs and benefits of innovation will be.
Ofgem acknowledges this problem and wants to simplify things under the next round of regulatory revenue setting. There is some quite deep thinking about the different approaches to tackling the asymmetrical information problem going on. However, there are limits to how far they will be able to mitigate the problem through clever schemes to align the interests of companies and the public interest over revealing information as long as the structure of ownership remains the same.
The only situation in which interests will be truly aligned is one in which users of infrastructure also own the infrastructure. A good example of this is district heating networks in Denmark, many of which are owned by consumer cooperatives, and set up as not-for-profit organisations. Because they are owned by consumers, they have an incentive to minimise or reduce costs and no incentive to try to conceal true costs. In a belt-and-braces arrangement, district heating companies are also regulated by the national energy regulator DERA, who provides data on all schemes across the whole country to allow comparison, so that consumers in each scheme can put pressure on managers to deliver good results). Where consumers want to, they can set prices so as to generate surplus revenue, but the non-for-profit requirement means this must be ploughed back into investment and innovation. While some might be surprised that a sector dominated by small not-for-profit companies would produce it, Danish district heating has been highly innovative from a technology and operational point of view, with major improvements in efficiency and control of systems over the years.
Consumer cooperatives are not confined to Denmark, and while some might think they could never work in Britain, there are in fact plenty of examples, from the Cooperative retailing tradition, financial mutuals, and indeed one of the UK’s leading wine retailers, the Wine Society, which is a not-for-profit member-owned mutual.
It is the direct involvement of consumers in the governance of the organisations which provide their infrastructure that is key here. The danger with conventional ‘public’ ownership, i.e. ownership by the central state, which is what the UK had in the post-war period up until the 1980s, is that the links between consumers and infrastructure providers are too distant, mediated by politicians and bureaucrats, and therefore too weak. Labour’s proposals for modernising public ownership of networks for the 21st Century are therefore grasping an opportunity.
However, the key governance issue will then be about scale. The companies currently running our energy networks are huge, with distribution parent companies often owning several networks, each of which may have millions of domestic and non-domestic consumers. This contrasts with the situation in many continental European countries, where separate network companies can be quite small. Big companies can reap economies of scale, but when they become very large, consumer involvement in their governance can lose real meaning and bite. If bringing network companies under cooperative consumer ownership were to happen, some breaking up of very large network areas into smaller companies may make sense. Having more companies may also help make comparisons of management performance work better, although it may also increase the differences between networks (urban vs rural, for example). Economies of scale can still be realised through mechanisms like joint procurement involving many smaller network companies together.
The other issue here is that not all ‘consumers’ are the same. This is not about richer and poorer households; rather it is about domestic consumers vs. much larger industrial and commercial users. About half of electricity demand in Britain is from this latter non-residential sector, and of course some of these consumers are much larger than households, have different concerns and priorities, and often connect to different, higher voltage parts of distribution networks (or even directly to transmission networks). The same is true on the generation side; while almost a million households now have roof-top solar PV, other kinds of generators connected to distribution networks include wind and solar farms, usually owned by commercial companies. Some fair way of taking these actors into the governance of network companies will have to be found, without them being allowed to dominate in practice.
Cooperative consumer ownership of infrastructure thus makes sense on several levels. It is almost self-regulating, as the incentives of the provider and the user are truly aligned. It means the end of complex schemes to overcome the asymmetric information problem. It means the end to excessive returns to network companies. It potentially means consumers being able to drive a greater pace of innovation. The current rethinking of ownership, and acknowledgement of the limits of regulatory incentives, is a good opportunity to explore new models. However, it also presents new challenges for effective governance, including scale, and heterogeneity amongst consumers.