By Tom Bergin
LONDON (Reuters) - In 2006, Britain's energy regulator reviewed how the gas and electricity market was functioning. Summarizing its findings, it noted the possibility that its rules on pricing had been overly generous to the network owners.
The report was one of many produced by regulator Ofgem, tasked by the government with overseeing an industry that was broken up and sold off by the state during the 1980s and 1990s. The report went little noticed at the time.
Today though, it has new relevance. Rising electricity and gas prices to homes - around nine percent in the coming year - have become a political issue, with consumer groups and some politicians saying the market is flawed.
"The fact that network businesses .... have recently changed hands at a premium to the regulatory asset value (Ofgem's own valuation of the assets) suggests considerable appetite among the investment community and indicates, in hindsight, that past price control reviews could have been somewhat tighter than they were," Ofgem said in its 2006 report 'Financing Networks'.
The trend the regulator identified continues to this day.
In the 1990s Britain divided its energy industry into owners of power and gas networks on the one hand and electricity and gas retailers on the other - like separating the railway network from the train companies.
The retailers pay the network owners to use their networks, and sell electricity and gas to homes and businesses.
After privatization, the networks were controlled by the likes of Berkshire Hathaway's MidAmerican Energy Holdings and northern England-based United Utilities. The retailers included nPower, a unit of Germany's RWE, and British Gas.
The debate over rising prices to homeowners has largely focused on the role of the retailers because they are in the public eye, sending out bills to consumers.
Critics say there is a lack of genuine competition among the six largest electricity and gas retailers leading to inflated prices. The retailers counter that increases have been driven by a combination of government taxes, wholesale energy costs and transportation fees charged by the networks.
Industry data reviewed by Reuters shows that rising energy transportation costs - which are largely determined by the regulator - have accounted for over a third of the rise in energy bills to homeowners since 2007.
The transportation costs that network owners charge electricity and gas retailers flow from a little understood calculation by regulator Ofgem - the rate of return that network owners are allowed to earn.
The fact that network owners were willing to pay inflated prices for sections of network - well above Ofgem's own valuation of the assets - suggested an overly generous rate of return, the regulator's 2006 report found.
This in turn suggested Ofgem was permitting network owners to charge excessive transportation costs to retailers, critics said, with consequences for homeowners.
A Reuters review of sales of power and gas networks shows that since Ofgem's 2006 report seven networks have been sold. On each occasion the purchaser paid a premium to the regulator's valuation of the network, an average 27 percent.
"That tells us that the regulatory framework is fundamentally flawed," said Jim Cuthbert, a consultant and former academic who has written extensively about UK utilities regulation. He argues that the rate of return set by the regulator is simply too generous.
Paul Ainsley, Group Financial Controller for Northern Powergrid, whose ultimate parent is Warren Buffett's Berkshire Hathaway, challenged this and said his company's purchase of the Yorkshire power network in 2001 reflected his firm's belief it could extract cost savings.
All of the other companies that bought energy networks in recent years declined to say why they paid above Ofgem's valuation - the so-called regulatory asset value.
The Energy Networks Association, the industry trade body, also declined comment. Ofgem said it did take account of the prices at which assets were sold when setting returns but declined to comment on the persistent sale of regulated assets at a premium to their regulatory asset value.
"Ogem has a strong record of making a positive difference for customers by bearing down on network costs" the regulator said in a statement.
Energy industry consultant Mike Madden said of the regulator: "It's a fine balancing act but, in general, Ofgem have got it right".
All of the electricity and gas networks quickly reduced operating costs after privatization. As a consequence returns allowed by Ofgem began to look increasingly generous.
The power network in the northwest of England region is illustrative of how the industry evolved and, critics say, highlights a flaw in the regulator's approach.
The first owner of the northwest of England network after privatization, Norweb Plc, halved its workforce during the 1990s. Its profits doubled.
Other network owners were also taking costs out of their businesses. Across the industry, the returns enjoyed by network owners were well ahead of those envisaged by the regulator.
The regulator responded by adjusting the way it set returns to take account of the bigger-than-expected reduction in network owners' operating costs.
Nonetheless, the network owners' profits remained buoyant, prompting the government to impose a windfall tax in 1997.
Norweb, which had merged with the regional water company in 1995 to become United Utilities, had to pay an additional 155 million pounds in tax.
By around 2002, Ofgem said it believed the ability of owners to cut costs had largely been exhausted. It adjusted the way it set returns accordingly.
Critics say low world oil and gas prices during the 1990s led to a degree of complacency at the regulator because upward pressure on retail prices was inevitably reduced.
The regulator said it remained alert and noted that in 2005 it cut the rate of return electricity networks were allowed to earn to 5.5 percent plus inflation from 6.5 percent, partly because lower interest rates meant cheaper financing.
Despite this, the returns remained attractive enough to ensure there were plenty of bidders whenever a section of the electricity or gas network came up for sale.
United Utilities decided to sell the northwestern network in 2007 because it wanted to focus on its water business. The timing was also motivated by price, said the chief executive who oversaw the sale.
"My view was if you can get a premium of 30-40 percent, and the assets are non-core, then a sale is likely to be good for shareholders because such a premium is not sustainable," said former United Utilities Chief Executive Philip Green.
United Utilities put the network on the market in 2007 and was inundated with bids from across the world, Green said.
In a tightly contested auction, funds controlled by JP Morgan and the Commonwealth Bank of Australia won, agreeing to pay 1.8 billion pounds - above Ofgem's valuation (the regulatory asset value) of 1.2 billion pounds. JP Morgan and Commonwealth Bank of Australia declined to comment.
Ofgem got tougher. In 2009, it demanded that companies such as Electricity North West - the vehicle which now owned the northwest network - accept a reduced rate of return of 4.7 percent, again citing falling interest rates.
Nonetheless, operating profits continued to rise at the northwestern network. They have risen 4 percent per year since the sale. And companies remained ready to pay big prices for such assets.
In 2010, Electricite de France (EdF) sold its three English power networks for 5.8 billion pounds - a 27 percent premium to the networks' regulatory asset value. A year later, E.On sold its English power networks for a 40 percent premium to a consortium led by Cheung Kong Infrastructure (CKI), an investment entity controlled by Hong Kong Billionaire Li Ka-Shing.
In these cases, as with the northwest England network, the purchasers were ready to accept returns which were below the levels set by Ofgem. CKI and EdF declined to comment.
(editing by Janet McBride)