Shareholders wll foot 20% of above-forecast pension costs

Ofgem is introducing incentives for distribution network operators to better manage their pension schemes in light of a £2.6 billion deficit, as Ian Smyth and Colin Haines explain.

One of the biggest challenges facing utilities today has nothing to do with supplying a service. It is running a pension scheme. Companies in the sector, like many other UK companies, are finding there is a deficit in their pension scheme and that they need more money to resolve it. These deficits have generally arisen from lower than expected investment returns and people living longer. According to Ofgem, the electricity distribution network operators had a combined pension scheme funding deficit of £2.6 billion by the end of September 2009.

At present, Ofgem allows electricity and gas distribution companies to recover all efficient pension costs from customers. However, given the large increase in deficits and changes in pensions legislation, Ofgem has unveiled a new set of rules for electricity distribution network operators for the five-year period to March 2015. The regulator has indicated that other network operators (gas distribution and transmission network operators) will be subject to the same new rules in the future. The changes are likely to have a profound effect on businesses.

Penalty for shareholders

In contrast to current arrangements - where all efficient pension costs are simply passed on to customers - Ofgem is going to give the network companies an incentive to better manage their continuing pension costs. If pension costs are lower than forecast by the companies over the five-year period, the underspend will be shared equally by shareholders and customers. However, if costs are higher, customers will foot 80 per cent of the bill and shareholders 20 per cent.

One way to change costs is to change benefits, and Ofgem's pensions proposals will no doubt encourage companies to take a closer interest in their pension arrangements.
Around 21,500 staff are employed by the electricity distribution network operators. Just under half joined the industry in the period before privatisation in 1991 and receive defined benefit pensions that are linked to pay and service at retirement. These benefits are "protected" under the 1991 privatisation legislation, which means there is limited scope for the companies to change them unless two-thirds of employees consent.

Defined contribution schemes

For other existing and future employees, there may be easier opportunities to control costs. However, as many network operators have already made changes to arrangements for post-privatisation hires, this may be difficult to achieve in practice. All but two (Western Power Distribution and the EDF Energy distribution businesses) have a defined contribution scheme for new employees. In these schemes employees take all the investment risk and, based on Ofgem's data, the average cost per person is as little as one-tenth of the continuing costs in some of the defined benefit schemes.

So what else can companies do to manage pension costs? The current economic climate has resulted in pay freezes and caps in many industries in both the public and private sectors. Distribution network operators may be able to control pensionable pay in the future as a mechanism to control pension costs. Similarly, it may be possible to limit or further restructure benefits for employees who joined after privatisation or to increase contribution rates for existing employees.

Divided workforce

But such measures must be considered carefully and implemented consensually. Changing benefits or contribution rates, for example, has the potential to create a divided workforce, with different groups of employees receiving different benefits. More generally, such changes have the potential to pit companies against unions, which Centrica found to its cost in 2005 when it tried to close its engineers' final salary scheme. That said, many companies in the private sector have recently made changes, so there are some successful precedents to follow.

On the deficits themselves, the companies will be allowed to recover the full value of their pension deficit, measured as at 31 March 2010, from customers. The cost will be met by customers over a 15-year period and will be £1 billion over the next five years.
Distribution network operators must also agree a funding plan with the pension scheme trustees and, under law, deficits must be paid off as quickly as affordably possible. At the moment, the companies are funding deficits over periods of between six and eleven years and, based on statements made last month by the Pensions Regulator, trustees are likely to be reluctant to extend this to the 15 years allowed for by Ofgem. Companies will need to negotiate carefully with trustees when agreeing deficit funding plans.

Management review

At the end of the five-year period in 2015, Ofgem will ask the Government Actuary's Department (GAD) to review costs for distribution network operators' pension schemes to determine whether they are being managed efficiently. If the companies are found to have been efficient, they will be able to recover their pension costs from their customers. If not, a more in-depth analysis will be triggered to determine how much of the overspend should be paid by customers.

The involvement of GAD means the network operators will need to look carefully at the investment strategies for their pension schemes and consider issues such as diversification of assets and use of hedging strategies. They should also consider whether there are alternative ways to fund the deficit, such as contingent assets or charges over property.

To this end, the companies should consider, if they have not done so already, having company representatives attending trustee and investment sub-committee meetings and establishing a mechanism to monitor pension risks as part of their corporate processes.

Overall, these changes will lead to network operators taking more involvement in pension fund decision-making. Essential key actions will include: identifying key pensions risks and ways to control them; agreeing appropriate strategies with pension scheme trustees; assessing opportunities to make savings on continuing pension costs; and taking employee relations issues into account in advance of making decisions.

Ian Smyth is partner in the energy utility and regulated industries practice and Colin Haines partner in the corporate pensions practice at Lane Clark & Peacock.

The cost to customers

Electricity customers pay £3.6 billion annually for distribution of electricity to homes and businesses. Ofgem has proposed that almost 10 per cent of this will be used to cover pension costs. Over the next five years, distribution network operators can expect to receive £1.7 billion from customers, of which £1 billion will be used to fund deficits and £650 million spent on continuing pension costs. This is a significant sum. For example, it far exceeds the £500 million earmarked by Ofgem for a new low-carbon fund to allow network operators to invest in projects that will combat climate change.

Comment on this story

Screen name

Email (For verification only. Your details will not be retained or passed on. Not for publication)

Comment

Report Abuse

Sign up to our free email newsletters