KPMG LLP (UK) Power & Utilities

Reforms in the utilities sector

why we cant afford to get it wrong

The UK is facing a fundamental challenge to ensure long-term, sustainable access to and the provision of electricity and water. This might sound striking when put so bluntly, but the challenge for the wide range of proposed reforms in the utilities space (EMR, RMR, RIIO, WPP , FPL, etc) is in reality no less than that as even the most successful demand management programme is dwarfed by the overall needs. The reforms should therefore focus on this fundamental goal.

Addressing the sustainable supply challenge in both electricity and water requires appropriate generation capacity and ability in order to tap the necessary resources in a balanced and managed way bearing in mind long-term optimisation needs and limited resources; it also requires signicant investments in the networks and infrastructure in addition to a well functioning supply regime.There is a risk of being distracted by other issues from this fundamental goal. Even without nancial constraints this would be a formidable challenge given the scale of the problem (an estimated combined investment of approximately 200 billion is needed over the next decade), the essential nature of uninterrupted access to these services, limited (and diminishing) resources and the ever-growing urgency (due to continuing decrease in generation capacity margin and expected droughts). But the problem comes also combined with a considerable nancial challenge and major externalities including the impact on climate change.

The nancial challenge is signicant given constraints on public nances and the continuing crisis in nancial markets. Ultimately, all the solutions will need to be delivered by the private sector using private capital under a signicant affordability constraint. The proposed reforms must also recognise that the future challenges cannot be met without maintaining the condence of existing investors. So the reforms will need to be able to successfully attract private capital whilst also ensuring the best value to consumers to minimise the overall cost. There is no guarantee that this will be successful and alternatives with even higher prices and/or supply interruptions might be socially unacceptable. Striking that balance between enabling private capital to deliver the necessary solutions and ensuring that these solutions are sustainable and affordable is at the heart of the challenge to be tackled by the reforms. And this relationship is complexif the new market regime results in inefcient delivery the costs and bills will rise, but if the private sector faces too much risk the same will happen pushing up prices at the detriment to the nal consumer.

Reforms in the Utilities Sector / January 2013

2012 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member rm of the KPMG network of independent member rms afliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

So how can this capital be attracted and employed in an efcient way? And given that this investment would put signicant upward pressure on customer bills, what can be done to keep customer bills affordable? Tackling these dual challenges government (HMT, DECC, DEFRA) and the economic regulators (Ofgem, Ofwat) have embarked on signicant reforms to the market and regulatory arrangements applied across the energy and water value chains.

The reforms ultimately face the fundamental challenge of ensuring sustainable supply, subject to multiple constraints. With that challenge in mind, the reforms reect some common themes, but the policy makers and regulators should resist the temptation of trying to address all the perceived issues in the sectors as part of these reforms. Three identiable themes include attracting new capital and entry, giving more power to consumers and encouraging innovation.

Water White Paper, Future Price Limits (PR14)

Resources

Network

Retail

Generation

Network

Retail

Electricity Market Reform

RIIO, OFTOs

Retail Market Review

Reforms in the Utilities Sector / January 2013

2012 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member rm of the KPMG network of independent member rms afliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

Attracting new capital and enabling new entry to broaden the investor base and tap into different types of capital

Attracting capital from a more diverse range of sources will increase the total amount of capital available to the power & utilities industry and increase the resilience of funding if having access to a wider pool of capital increases the likelihood of capital being available during difcult nancial market conditions. Increasing the supply of capital might also help to constrain increases in the cost of capital as projects and companies compete for increasingly scarce capital. Measures in this vein include: Enabling investments in new generation including nuclear and renewables. Encouraging more liquidity in the wholesale markets aimed at enabling smaller and non-vertically integrated, generators/retailers to enter. Establishing the OFTO regime which provides opportunities for investors to participate in the sector through investments with limited cheque size. The White Water Paper allows for upstream only entry, which might allow investors to finance individual water resource projects Interconnectors might also provide opportunities for new investors (e.g. under the Flood and Water Management Act provisions).

A greater emphasis on letting customers choose the best value for money

The reforms generally propose a wider and stronger role for customers, both in the price setting process and through enabling choices between providers. Customers will need to be engaged more effectively and on a wider range of issues (e.g. target outcomes). The legitimacy of retailers might also be increased by enabling more and stronger competition. Proposed reforms include: Retail market review aimed at encouraging more competitors to the Big 6. Measures are aimed at removing barriers to entry for new entrants and at making the benets of existing competition clearer to customers. RIIO and PR14 look set to be more focused on outcomes than outputs and give greater roles to customers in agreeing the targeted outcomes. More retail competition in the water sector and the establishment of an Anglo Scottish market, albeit just for non domestic customers at this stage.

Encouraging exibility and innovation rather than just efciency

The challenges posed by climate change are uncertain: what will need to be done and when it will need to be done are hard to predict. Enabling companies to be more exible and innovative in their approach, rather than prescribing particular approaches, can help companies adapt to changes in circumstances: RIIO and PR14 look likely to give regulated networks more flexibility to adapt to uncertain and changing circumstances by choosing different outputs to achieve the outcomes. There will also be larger upsides and downsides under the regulatory incentive mechanisms i.e. the potential range of returns to shareholders will be wider, providing stronger incentives for companies to outperform the regulators assumptions. EMR ultimately aims to employ market mechanisms, combined with various incentive arrangements, to deliver the required new generation investment.

Is this enough to ensure that the sustainable supply challenge is successfully addressed by the private sector in an affordable way? Most likely a lot more will be needed as some fundamental issues such as ultimate allocation of risks, returns to innovation, or ways to determine what is sustainable in the long-term and at what price, etc are still outstanding. The reforms pose some critical challenges as well as opportunities for market participants:

a) How to continue to secure the supply of capital needed from the existing major players and minimise any increase in the cost of those funds; and b) How to transform operations to optimise performance under the new regimes to ensure the most efcient delivery. KPMG is working with companies, investors, and the authorities alike to address these issues, which are explored in more detail in our two accompanying brieng notes.

2012 KPMG LLP , a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member rm of the KPMG network of independent member rms afliated with KPMG International Cooperative, a Swiss entity. All rights reserved.

January 2013 / Reforms in the Utilities Sector

Contact us
Dr Matt Firla-Cuchra Partner KPMG in the UK T: +44(0) 20 7694 5308 E: matt.cuchra@kpmg.co.uk David Gascoigne Partner UK Head of Power & Utilities KPMG in the UK T: +44(0) 20 7311 4314 E: david.gascoigne@kpmg.co.uk

www.kpmg.co.uk

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