Background

With the current price control period for electricity Distribution Network Operators having recently ended, Ofgem has launched a consultation on the future funding of deficits attributable to regulated activities.  The last round of full actuarial valuations for Network Operators' (NWO) pension schemes (as at 31 March 2013) showed a total deficit of approximately £7.5 billion, with £5.9 billion being attributable to members employed in regulated activities.  The current figure is likely to be much higher.

Ofgem's current approach

As a reminder, Ofgem's current approach to dealing with regulated activity pension deficits, set in 2010, is as follows:

  • Deficits relating to pensionable service before a cut-off date are passed through to customers.  The cut-off date is 31 March 2010 for Distribution Network Operators, 31 March 2012 for Transmission Operators and System Operators and 31 March 2013 for Gas Distribution Networks.
  • The deficits are to be paid down over a 15-year period from the cut-off date.
  • Ofgem monitors funding through triennial reasonableness reviews with NWOs being benchmarked against each other and fines being imposed on outliers.
  • Deficits attributable to service after the relevant cut-off date are dealt with as part of the benchmarking of total costs.

Problems with the current approach

Ofgem considers its current approach to protecting consumers and ensuring normal market incentives for schemes is not operating as effectively as it would like.  It is concerned that uncertainty about the size of deficits and how deficits remaining after the end of the current 15-year funding period will be met might encourage NWOs and scheme trustees to adopt overly prudent valuation assumptions, resulting in an unfair spreading of pension costs between current and future customers and, potentially, the overfunding of schemes.

Ofgem's proposals

Ofgem is consulting on the following key changes to its current policy:

  • NWOs will have the ability to agree a different period over which pre cut-off date deficits should be eliminated, if the amount of deficit has changed.  Funding over a longer recovery period than the current 15-year period will be passed through to customers.
  • Reasonableness reviews will focus on matters within the control of NWOs (rather than scheme trustees) and the specific circumstances of the NWO.  These will include issues such as liability management and the control of administration expenses.
  • NWOs will be required to report to stakeholders on how they are promoting good governance for their scheme and good end results for their customers.  This will include demonstrating the steps they are taking to avoid the risk of a trapped funding surplus.  NWOs will be subject to a requirement to address these issues as part of a new Statement of Regulatory Corporate Governance to be included in RIIO accounts.

Comment

Ofgem's proposals look sensible, particularly given current market conditions.  The move to look at each NWO's pension position more on its own merits and on the basis of what is within its control is to be welcomed.

The flexibility to agree revised recovery plans should help to spread funding costs more fairly across current and future customers and avoid the risk of overfunding leading to trapped surpluses.  The commitment that deficit repair costs arising after the end of the current 15-year recovery period can continue to be passed through to customers will also remove the effect of funding uncertainty on NWO capital costs.  Where deficits have increased since the last full scheme valuation, Ofgem is setting a benchmark recovery period of a further 15 years.

The proposals will bring the approach to the funding and governance of NWOs' schemes closer to that applying to unregulated sector schemes.  Ofgem is clearly wanting to encourage more focus by NWOs on scheme funding and investment strategies and increased engagement with trustees to ensure an approach which is aligned with long-term customer interests.  Ofgem continues to be supportive of NWOs agreeing risk reduction strategies with trustees which they can demonstrate are in customers' best interests.

Ofgem is expecting NWOs to be more rigorous in benchmarking total employee reward costs against those of other NWOs and the wider market.  Where the cost of future DB pension accrual results in costs being out of line with the benchmark, NWOs should be looking at whether the value of benefits can be reduced.  NWOs will need to consider their options carefully given the protections in place for members.  Ofgem also expects NWOs to be looking at other liability management techniques such as offering pensions increase exchange (PIE).  In the area of scheme administration expenses, Ofgem has said it will be collecting more data and NWOs should be looking closely at whether there is scope for efficiencies.  This could include outsourcing administration services or, where this has already been done, looking at whether it is possible to reduce charges.

The consultation closes on 16 July and a copy of it is available here