Presentation to GDPCR Cost Workshop Alex Wiseman Regulation Director 19 th April 2007.

Presentation to GDPCR Cost Workshop

Alex Wiseman

Regulation Director

19th April 2007

Agenda

Introduction to NGN

Environment for the 5 Year Reset

Opex Forecasts

Comparative Efficiency

Summary

Introduction to NGN

Innovative Business Model

NGN has implemented a unique business model based on the principles of Strategic Asset Management, under which the roles of asset ownership/asset management and asset services are unbundled

NGN remains accountable for all asset management including licence and safety case obligations

Competitive procurement process used to select service provider. United Utilities selected on basis of market experience and success in similar utility contracts

UUOL is a special purpose vehicle working exclusively for NGN. Neither CKI nor NGN has any interests in UUOL or its parent

On 1 June 2005, NGN entered into an Asset Services Agreement (ASA) with UUOL to contract out the provision of a wide range of services including Operation and maintenance of the DN Delivery of Capex and Repex programmes

NGN Business vision

To be benchmarked by Ofgem and HSE in the top two comparable utilities in:

Customer service

Efficiency

Health and Safety

NGN supports the benchmark approach

Business environment for 5 Year Reset

Legislative changes – such as waste, environment (including landfill tax), pensions, noise at work regulations and working at height regulations

Regulatory Changes – notably offtake and interruption reforms - although decision now made, still uncertainty on incentive mechanism and precise implementation mechanism

Real increases in EPC costs – EPC rates forecast to increase by RPI+4% pa driven by predicted shortages of engineers and manpower as a result of large UK infrastructure programmes

Real increases in salary costs – Direct labour costs forecast to increase at RPI +2% pa. Shortages of experienced gas personnel due to an aging workforce resulting in investment in apprentice schemes. Also increase in staff levels and training (eg. 2 years training for network control and 3 years for safety)

Business Environment – leading to cost pressures

Real increases in Material costs – General increase in material costs of RPI+2% pa from rising commodity prices in particular oil and oil based goods

Real increase in Energy Costs – Energy costs doubled during 2005/06. Forward curves continue to show significant volatility in market prices

Security - An increasing focus on security of assets due to potential terrorist threats on gas networks

Service improvements – Improvements that NGN is planning to make in its quality of service and safety to achieve the frontier.

Cost Pressures

Changing Nature of RPI

Annual price changes in the goods and service sectors, 1993 to 2005

-10

-5

0

5

10

15

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Goods

Services

Supermarkets and suppliers of goods produced overseas are seeing inflation below RPI

Service sector firms employing a UK based workforce are seeing inflation above RPI

Opex Forecasts

NGN Performance in Current Review Period

NGN Performance vs Regulatory AllowancesControllable Opex Less Pensions & Shrinkage - 2005/6 Prices

60

65

70

75

80

85

90

2002/3 2003/4 2004/5 2005/6 2006/7

Co

ntr

olla

ble

Op

ex (

less

Pen

sio

ns

& S

hri

nka

ge)

.

Actual/Forecast

Allowance

Despite upward cost pressures NGN has delivered significant efficiencies in the current review period

GDN Controllable Opex (less Pension & Shrinkage)

90

95

100

105

110

115

120

2004/5 2005/6 2006/7

Co

ntr

oll

ab

le O

pex

(In

dexed

to

100 2

004/5

)

.

Source Data: 2004/5 Ofgem Second Consultation Document

2005/6 & 2006/7 Ofgem Third Consultation Document

NGN Performance in Current Review Period

NGN

NGN has reduced costs since sale

There is reduced scope for future efficiency savings

Contractor costs increase by RPI + 2% against a forecast of RPI + 4%

Direct Labour costs increase by RPI + 2%

Material Costs increase by RPI + 2%

All xoserve costs treated as opex in BPQ consistent with current treatment

Shrinkage gas costs based on forward prices in September 06, modest demand increases and a reduction in the shrinkage factor in line with leakage reduction

Pension costs based on latest actuarial valuation

Major Forecast Assumptions - Opex

98.5% of controlled escapes will be attended within 2 hours on a 24/7 basis across the entire NGN area

External escapes anticipated to reduce by 2% year on year throughout the period but partly offset by increase in internal escapes

Continuation of TMS and UMS metering contracts which act as “fill in” work for emergency workforce (This is now looking very doubtful)

NGN exits SOMSA NSA in 2009

Major Forecast Assumptions - Opex

Since Purchase

£1.9m spent on rationalisation and reducing workforce Business model has substantially reduced central overheads Initiatives on decommissioning expensive vehicles, procurement, recycling Partnership approach to contractors

Planned Initiatives

New IR framework Changing working practices Vehicle efficiency initiatives Improved back office processes

Efficiency Initiatives

Opex Forecast

Despite significant upward pressure on input costs NGN is forecasting to deliver efficiencies to hold costs stable in real terms over the plan period.

Capex Forecast

Major Forecast Assumptions - Capex

Contractor, direct labour and material cost increases as per opex

Investment based on existing legislation, policy and procedures

NTS storage available to NGN at zero cost throughout plan period

Network storage deficit position throughout plan period

Capacity designed to meet 1:20 demand criteria in line with 2006 LTDS

Existing numbers of network sensitive loads (ie no programme to actively reinforce the network to remove such loads)

Connections and diversion workload consistent with historic levels – no significant changes to connections market

PAS 55 principles applied

Capex Forecast

Two major LTS projects required in 2011/12 and 2012/13

IT investment required in early years to replace GTMS and to refresh IS systems

Repex Forecast

Major Forecast Assumptions - Repex

Labour, material and contractor cost increases in line with opex

Iron mains replacement workload based on existing agreement with HSE – 528km per annum abandoned

Selection of pipes for replacement driven by existing HSE risk model

Service volumes based on historic patterns

TMA costs excluded

Repex - Forecast

Major project in 2009 /10 to replace the Catton to Weatherall LTS pipeline due to its deteriorating condition

Comparative Analysis

Results of Ofgem Consultants’ bottom up Analysis

PB Power – Direct Opex:

NGN at the efficiency frontier for 4 out of 5 cost categories

LECG – Support Services Opex:

NGN not identified as being at the frontier in Support Services, but NGN ahead of the median

Allocation issues between support services and direct costs suggests that the benchmarking may not be consistent eg SGN most efficient for support service and least efficient for direct costs

Hence top down benchmarking may be appropriate

PB Power report on Capex and Repex:

NGN at the efficiency frontier for total net repex

Capex projects less suitable to comparative analysis but proposed reduction in forecasts lower than for other IDNs

EE Relative efficiency

Models should pass ‘real world’ test. For example, not clear that % non- domestic customers is a direct cost driver and it is ‘explained’ by customer numbers and volume

Objectively, main cost driver is network length (eg driving repairs and maintenance, emergency costs)

Substantive correlation between network length, customer numbers and volume

Different networks will favour different drivers but given small number of data points, a composite variable seems appropriate

One solution would be network length, customer numbers and volume in ratio 50:25:25 in line with DNO review

Summary

Summary

NGN has a clear focus on efficiency and continuous improvement led by its corporate vision and implemented via its business model.

Resulted in ongoing improvements in efficiency since purchase in June 2005 in an environment of increasing cost pressures.

NGN business plan continuing to contain costs despite exposure to significant above inflation increases

NGN incurred the lowest capital expenditure overspend in 2002-2007 period and is the only GDN to forecast 2006/7 costs below 2004/5 costs.

This achievement reflected in Ofgem Consultants’ analysis that places NGN at or close to the efficiency frontier.

Top down benchmarking using a composite variable the most appropriate approach to set regulatory allowances to maintain the strength of incentives for efficiency and hence lead to customer benefits.