Gas Distribution Transportation Charging What are the Risks to Pricing predictability? Stephen Marland Pricing Manager

Context- Obligations  Changes to Prices take effect from the 1 st Oct this year and then from the 1 st April from 2009  DNs required to provide 150 days indicative notice and 2 months notice of the actual charges [1 st February 2009 for April Price year]  The transportation charging methodology is required to achieve three objectives : (a)cost reflective! (b)account of developments in the business (c) facilitate competition

Context- Obligations continued  DNs have incentives to recover their Allowed Revenue within the Formula Year (April – March).  The value of K brought forward is penalised if the DN materially over or under recovers. Furthermore, DNs have Licence Obligations that prevent them for setting charges to deliberately over-recover.

Maximum Allowed Revenue – 2008/13 MRt = Zt + Ft + EXt + MSRAt + Sht – Kt + EEt + DRSt + IFISDt + LMt Maximum Allowed Revenue Core Allowed Revenue Cost Pass thru’ items Exit Incentive Adjustment Mains & Services Replacement adjustment Over / Under Recovery b’f Shrinkage Incentive mechanism Environmental Emissions Incentive Discretionary Reward Scheme Loss of Meter work Revenue Driver Innovation Funding Incentive for Sustainable development Scheme New Incentives / Adjustments  In order to set prices DNs must first estimate their Allowed Revenue and the associated risk has increased following the 2008/13 PCR and price setting timescales  The majority of the value is known in advance (i.e. core revenue)

Incentive / adjustment forecasts  But!  MSRA (formally DNMRA) materiality Increased, forecast accuracy within DNs control  Shrinkage also significantly increased but beyond DNs control  New incentives and re-openers could be material  Loss of Meter Work (uncertainty around timing)  Innovation Funding (materiality is low)  Environmental Emissions (materiality is low)  Discretionary Reward (probably known in advance)  ® Tax (this change alone could increase prices by ~ 10%)  ® TMA (when does it come in and how much?)  ® Exit Reform (value and how its passed onto Shippers)

Demand forecasts  Commodity charges reflect the costs associated with flow of gas through the network. We need to predict future demand which largely depends on Weather.  Reconciliation charges reflect the commodity charge difference between allocated and reconciled volumes. This is unpredictable and depends on the materiality of the commodity charges.

Capacity forecasting  Capacity charges reflect the network capacity costs associated with the supply points peak demand requirements. Charges are fixed from day to day but a forecast of aggregate booked / deemed capacity for each day is required.  AQ review impact is the major uncertainty to forecasting.  Likely to be more challenging with an April price year.

Move to an April price change  The October price change means that for the first six months of a Formula Year the DN is recovering it’s Allowed Revenue on charges set to target the previous Formula Year’s Allowed Revenue.  As prices are published in August, the DNs have collected revenue from April to June and forecasts are required from July to March. When we move to an April Price change, forecasts are for the full year as well as the previous Formula Period (forecast of K brought forward required). This implies more risk!  However, this becomes less of an issue with Capacity based charges (providing SOQ remains relatively constant after AQ Review).

Move to an April price change  However, an October price change effectively gives DNs six month to collect the difference that would be collected if there were no price change and the Allowed Revenue in that Formula Year.  Depending on the Capacity / Commodity ratio in October a price change scaling factor (1.7 to 2) is required.  The move to an April Price year removes the scaling factor and therefore should reduce the magnitude of price changes relative to an October change.  Even though this may increase the risk on Allowed Revenue forecasting and require a forecast of K Brought Forward the benefits of removing the half year scaling factor is expected to reduce price volatility

Pre – 2007 charge structure & risks The major risk was associated with demand forecasting due to the large proportion of revenue collected on Commodity Charges. Reconciliation also material risk due to level of Commodity. October Price change and low level impact on Capacity from AQ Review. Allowed Revenue included cost pass through, DNMRA, Shrinkage, Exit and K brought forward – Core, cost pass through and Exit were relatively certain, Shrinkage and DNMRA less material than present day. Although a risk, this was less of an issue than demand forecasting.

February 2006 Ofgem recommendations  Capacity / Commodity split – Customer charge  Capacity / Commodity split – System charge  Customer / System split  System charge unit rates  Customer charge unit rate Apr 2007 Oct 2008 Apr 2009 Apr 2009/10 Not Started

Post October 2008 charge structure Commodity and reconciliation becomes less material and lower risk April price change reduce magnitude of price changes but brings forecasts forward by six months. Allowed Revenue uncertainty increased due to new / amended incentives and adjustments and forecast requirements following the April price change timescales. Capacity becomes a significant forecast risk due to the impact of AQ review.

Going forward what are the options?  Allowed Revenue forecast is more material – DNs need accurate forecasts of elements under their control i.e. MSRA, cost pass through, Exit, re-openers, new incentives / adjustments  Capacity (SOQ) change is now highly significant, impacts on six months of the forecast and beyond DN control due to the AQ review  Options to reduce capacity risks?  Early forecasts of SOQ changes from market  Use SOQs as at 1 st January for Price purposes  Move AQ Review so that it is implemented on 1 st January  Possible introduction of fixed supply point charges Proposals welcome!