Rating Manual section 6 part 3: valuation of all property classes

Section 371: electricity distribution networks

This publication is intended for Valuation Officers. It may contain links to internal resources that are not available through this version.

1. Introduction

This section deals with those electricity distribution networks that are required to be shown in the central rating lists and which, prior to 1 April 2005, were subject to formula rating.

2. Coordination

The Utilities Rating Team is responsible for assessment of networks occupied by electricity Distribution Network Operators (DNOs).

3. UK Electricity Distribution

Before the electricity industry was privatised the functions of both electricity distribution and supply in England and Wales were carried out by twelve Area Boards. The Electricity Act 1989 enabled their twelve successor companies to be floated in December 1990. At the time these were known as Public Electricity Suppliers (PES) before becoming known as Regional Electricity Companies (RECs) and most recently as DNOs. Initially these companies retained a monopoly of both electricity distribution and electricity supply in their licence areas.

Electricity distribution comprises the physical act of transporting electricity taken from the National Grid transmission system at 400kV to consumers. This is achieved using a regional distribution network operating at 132kV and progressively transforming power down to 33kV and 11kV at a series of substations until it is finally delivered to customers at 415V or 240V via a service cable and meter.

Electricity supply comprises the purchase of electricity (from a generator or elsewhere) and sale to the ultimate consumer. The supplier incurs use of system charges in respect of both the National Grid transmission system and the regional distribution system. These charges are passed on to the consumer and ultimately form part of the retail price of electricity.

Government policy has encouraged competition in electricity supply and the industry regulator arranged for the retail market to be liberalised in tranches. By 2000 the retail market for electricity was fully open and the original incumbents had lost their regional supply business monopoly. The Utilities Act 2000 created entirely separate licences for the purposes of electricity distribution and electricity supply and prohibited any one person from holding both a supply licence and a distribution licence.

Each licensed electricity distribution business remains a monopoly within its network area. To give an idea of the scale of activity and assets involved the average network distributes 22,559 GWh of electricity per annum to 1,976,444 customers via a 54,929 km long network of overhead lines and underground cables.

4. The Electricity Distribution Markets

Each DNO has a monopoly in its licence area. If an electricity supplier wishes to supply electricity to a customer then they must use the electricity distribution network for that area and pay distribution use of system (DUOS) charges to the host DNO. In the absence of competition, and to protect the interests of consumers, the electricity distribution business is subject to regulation by the Office of the Gas and Electricity Markets (Ofgem) in the form of a price control.

Every five years Ofgem undertakes a detailed analysis of the financial and operational performance of the networks. For each network they determine the costs that will be incurred in performing their functions in an efficient manner. These costs comprise:

  • the costs of operating and maintaining the network,

  • depreciation of network assets,

  • capital investment in new assets to meet forecast growth,

  • the cost of financing the business.

Following extensive consultation, Ofgem then decides how much in total each DNO should receive from DUOS charges over the 5 years of the price review to match these costs. This 5 year total is then restated as annual amounts – generally expressed as an initial price cut (P0) to give customers the benefit of efficiencies achieved in the last price control period followed by constant annual adjustment (X factor) plus RPI adjustment. Thus if X factor is set at 3% and inflation in a given year turns out to be 2% the change in DUOS tariff will be –3% + 2% = -1% and customers will benefit from a reduction in the DUOS element of their electricity bills. This is an example of incentive based regulation; Ofgem control prices, not profits, and if the companies can outperform the regulator’s expectations they can earn superior returns.

5. Electricity Distribution Hereditaments

DNO hereditaments are shown on the Central Rating Lists for England and Wales (the two Scottish networks are the responsibility of the Scottish Assessors). The hereditaments are prescribed by regulations 13 and 14 of the Central Rating List (England) Regulations 2005, SI 2005 No 551 and regulations 13 and 14 of the Central Rating List (Wales) Regulations 2005, SI 2005 No 422 (W.40). Broadly speaking, these regulations provide that:

  • the DNOs in England and Wales each have their own hereditament for their operational property (DNOs which span England and Wales, such as SP Manweb, have one hereditament in the English list and one in the Welsh list), and

  • meters are assessed separately on the central lists. Meters are deemed to be occupied by the person who occupies the wire to which they are connected. Therefore, whilst various companies may own the electricity meters, the DNOs are deemed to occupy those meters attached to their network. The meters are grouped into hereditaments in line with the deemed occupation.

The regulations provide that each of these assessments is assumed to be a single hereditament (rather than an assessment comprised of several distinct hereditaments).

The central list regulations determine the hereditaments which appear on the central rating lists but they do not determine which parts of the property are rateable. Rateability is decided in the normal way by reference to statute, case law and, in particular, the plant and machinery regulations. The main rateable parts of the electricity distribution networks are:

  • the buildings and structures at sub stations and depots,

  • the underground cables and ducts,

  • the overhead lines, towers and poles (which are rateable plant and machinery),

  • the “land” within which the wires sit, and

  • the meters.

Property occupied by the DNO which falls within the definition of “excepted hereditament” should appear in local rating lists and is not included in the central rating list hereditament. Rating Manual section 2 part 2 explains the roles and responsibilities of GVOs and the Central Valuation Officer in dealing with hereditaments on the local list and central list interface.

6. Plant and Machinery

Between 1949 and 2005, the electricity industry was subject to prescribed rating assessment. Under prescribed assessment the Government disabled the normal rules of rating and, instead, prescribed by regulation the rateable value of the networks (formerly the Area Boards and then PESs). As a result, detailed examination of the rateable/non-rateable boundary was unnecessary.

In the late 1990s the Government established a Committee to examine the rating of plant and machinery in the utilities and to recommend where the rateable boundary should fall. The Committee was chaired by Derek Wood CBE QC who had chaired a similar committee in the early 1990s – hence it was known as the “2nd Wood Committee”. All parties agreed that the wires should be rateable so much of the debate was concerned with the associated plant and machinery. The Committee recommended that most process plant and machinery on an electricity transmission or electricity distribution hereditament (primarily the transformers, switchgear and telemetry) should not be rateable. This recommendation is embodied in Class 3(c) and Class 3(d) of the 2000 Plant and Machinery Regulations. See Rating Manual section 6 part 5 PN5:2005 for more details.

The wires sit within land which is also rateable. Very early rating cases cast doubt upon whether plant and machinery such as pipes and wires could, on their own, be rateable but this was ended by R v West Middlesex Waterworks (1859) in which Wightman J said:

“The first question is, whether the company are rateable for their mains which are laid under the surface of the highway, without any freehold or leasehold interest in the soil thereof being vested in the company. We think they are. These mains are fixed capital vested in land. The company is in possession of the mains buried in the soil, so are de facto in possession of the space in the soil which the mains fill, for a purpose beneficial to itself. The decisions are uniform in holding gas companies to be rateable in respect of their mains, although the occupation of such mains maybe de facto merely, and without any legal or equitable estate in the land where the mains lie, by force of such state.”

The rating of meters has been the subject of more recent consideration. The 2nd Wood Committee considered meters and recommended that they should be rateable (and they are therefore named items in the plant and machinery regulations). However, doubts remained concerning whether meters were rateable when not occupied with the associated network and so the Government, under section 66 of the Local Government Act 2003, amended section 64 of the Local Government Finance Act 1988 to provide that

“(2A) In addition, a right is a hereditament if it is a right to use any land for the purpose of operating a meter to measure a supply of gas or electricity ….”

This provision ensures that meters are rateable irrespective of whether they are occupied with the associated network.

7. Method of Valuation

No rental evidence exists for this sector so the choice of valuation method is between the receipts and expenditure method and the contractor’s basis.

Historically, the R&E has been the preferred method of valuation and for a period of time was, by rule of law, the only method of valuation for public utility undertakings. The rule, established by the House of Lords in Kingston Union Assessment Committee v Metropolitan Water Board (1926) AC 331 was that the profits basis should, in the absence of special circumstances, be adopted for utilities. There were no reported cases of “special circumstances” to the extent that the basis was applied to a loss making port to give a nil rateable value (British Transport Commission v Hingley (VO) [1961 8 RRC 68]).

However, the rule of law was abolished from 1 April 1990 by regulation 3 of the Non-Domestic Rating (Miscellaneous Provisions) (No.2) Regulations 1989 SI 1989/2303 which states:

“Notwithstanding any rule of law requiring the rateable value of a hereditament occupied by a public utility undertaking to be estimated solely by reference to the accounts, receipts or profits of the undertaking, in arriving at [the rateable value] in relation to such a hereditament, any evidence relevant to estimating the amount of rent in accordance with that provision is to be taken into account.”

Accordingly, we must consider both the contractors and the receipts and expenditure as possible methods of valuation. The following factors are relevant:

  • the property is occupied for profit. All the DNO companies are owned by shareholders whose sole interest in the property is to generate profit. Therefore, it is profit which drives the value for the actual occupier,

  • to generate those profits, the DNOs must occupy the network – it is an effective monopoly. They could not generate the revenue without occupying the property and they could not build or rent a similar property elsewhere. Therefore, the link between the occupation of the property and the profits of the business is very strong, and

  • the revenue and expenditure associated with the property can be identified with ease as the DNOs are required to ring fence their operations and publish regulatory accounts.

These factors all support strongly the use of a receipts and expenditure valuation. In the real world the actual occupiers make their business decisions by examining the receipts and expenditure associated with occupation. In the rating world, the hypothetical tenant would do the same. Therefore, the VOA has adopted a receipts and expenditure method for the 2005 revaluation of electricity distribution network hereditaments.

The Receipts and Expenditure Method

General

For electricity hereditaments, the VOA has adopted a form of receipts and expenditure method which explicitly forecasts valuation inputs over future years. This is because both the income and expenditure can be forecast with reasonable accuracy. In particular, future income is set by the regulator and, therefore, is certain.

The valuation is taken over a 5 year forecast. Whilst in rating the agreement is for a year to year tenancy, it is assumed that the tenant has a reasonable prospect of continuance. For utilities, this prospect of continuance is likely to be significant and considerably longer than 5 years but it is felt that 5 years is sufficient time to capture an accurate rateable value. All forecast figures, including depreciation and tenant’s share are expressed in nominal terms, or “money of the day”, and reflect inflation expectations at the AVD. The result is a series of rental values for each of the years in the forecast. An equivalent rent calculation is then carried out to convert to an equivalent constant rent assuming quarterly in advance rent payments.

See Rating Manual section 4 part 2 for guidance on the receipts and expenditure method of valuation. The basic approach is:

  • Gross receipts from all sources, less

  • Operating costs, leaving

  • A divisible balance, from which is deducted

  • The tenant’s share, leaving

  • The rental value

Receipts

As discussed above, most of the revenue for DNO hereditaments is set by the regulator, Ofgem, for 5 year periods. At the time of the 2005 revaluation, the 2000 price review covered the period 2000/01 to 2004/05, with no scope to revisit the price control during that period. For each DNO the hypothetical tenant could therefore predict the first two years’ income accurately. Total income comprises:

  • price controlled revenue (having regard to likely volume of units distributed, price control X factor and forecast RPI),

  • some non-price controlled revenue (including EHV distribution), and

  • “pass through”.

The “pass through” element is specified uncontrollable costs incurred by the DNO and added directly to DUOS charges without adjustment.

The final proposals of the 2005 price review were announced in November 2004 and, therefore, were not available at the 1 April 2003 valuation date.

Operating Costs

Operating costs were forecast having regard to:

  • evidence of outturn costs for the 3 years leading up to the AVD,

  • Ofgem’s forecasts of operating costs for the 2000-2005 price review,

  • the forecast business plans of the DNOs,

  • general forecasts on costs (such as forecasts on inflation).

Operating costs can be split into the following categories:

  • controllable costs. These are costs which the operators can influence through their actions – for instance by adopting more efficient practices, and

  • non-controllable costs. These are costs which the operators have to meet but over which they have no control. They include NGC exit charges, operator licence fee and network rates.

Ofgem allow the DNOs to recover their non-controllable costs in full via revenue. Ofgem consider rates to be non-controllable because much of the bill (the rates poundage and transition) is wholly outside the operators’ control and, furthermore, the operators cannot minimise their rates liability by changing the way they occupy the property. Therefore, any changes in rates is matched with a change in income so the level of rates has no impact on rateable value.

As with all receipts and expenditure valuations, each item of operating cost must be considered to decide whether it is relevant for the rating hypothesis. For example rents and wayleaves paid by the DNOs in respect of network property have to be deducted because these form part of the residual rental value which is the ultimate aim of the exercise. Some items of expenditure in one year may be atypical, and by definition not a good guide to ongoing future costs. This might include exceptional costs associated with storm damage, and past expenditure on restructuring the business (mostly staff redundancies) to give greater operating efficiencies. These are historic costs and would not be incurred again by the hypothetical tenant.

In contrast the level of operating costs shown in the accounts may understate some costs borne by the hypothetical tenant. This affects the issue of repair in particular. The accounting policies incorporated in regulatory accounts require expenditure by the DNOs on replacement of assets to be recognised in their accounts as capex. This expenditure therefore appears as an addition to fixed assets on the balance sheet rather than as an operating cost in the profit and loss account. However in rating repair is considered in the context of the whole hereditament. Therefore, replacing a single large asset on a very large hereditament could, in rating, be repair. Advice on repair is given in Rating Manual section 3 part 6.

By way of example the Special Commissioners in Transco plc v Dyall (HMT) 2002 accepted that replacing 2,500 km per year of pipes was, within the context of the gas network, repair. We have followed this judgement for network rating valuations and, therefore, all projected non-load capital expenditure on rateable assets appears in the valuation as an operating cost. However load related capex is not an allowable operating cost because it represents an improvement to the hereditament rather than repair.

It is sometimes argued that the hypothetical tenant will need to make significant charges to the profit and loss account to address pension fund deficits. At the AVD all the DNOs had a deficit in their pension funds. The VOA’s approach to pensions has been to:

  • include suitable employer contributions to cover the underlying cost of future pensions. In particular, the hypothetical tenant would recognise that life expectancy was growing and the returns from funds were diminishing. As a result, greater contributions would be needed from both employees and employers to pay for future pensions. This is reflective of the attitude adopted by business generally, but

  • ignore deficits. Historic deficits are a feature of the occupier and not the hereditament – they are accidental and not essential. As such, they were not relevant to the valuation and should be ignored.

At the valuation date, the Government was considering a scheme under which utilities would have to pay “lane rentals” to work in the public highway. Clearly a considerable amount of public highway work is carried out by the DNOs so this represented a potential new area of operating costs. However, at the valuation date, lane rentals had been the subject of discussions for some time and had fallen in and out of favour. Neither the Transport Committee nor the Government’s own consultants felt that lane rentals influenced the utilities’ practices. Powers existed in the New Roads and Street Works Act 1991 but these were acknowledged to be insufficient. Therefore, a working group had been established in January 2003 to consider the legislative options. At AVD the group had not reported and there was no legislative slot secured. Therefore, at AVD, the steps needed to be taken before the utilities would first pay lane rentals were:

  • legislative options being agreed upon,

  • a legislative slot being secured and a Bill passing through Parliament,

  • secondary legislation being prepared in draft and subjected to consultation,

  • secondary legislation being made,

  • individual local authorities deciding to operate a lane rental scheme preparing the details of such a scheme and submitting them to the Secretary of State for approval,

  • the Secretary of State granting approval, and

  • the local authority then implementing the scheme.

It is felt that such a process would take, at a minimum, 2 years. Also, many uncertainties exist about the scheme. In particular it was unclear how many local authorities would operate the scheme. Lord MacDonald (Government Minister in the Lords) had said in debate (House of Lords 2 November 2000 1131 – 1141):

“We should make it clear that should we decide to introduce regulations activating the power to operate lane rental schemes, authorities will not be forced to put such a scheme in place in their area. After all, it is quite clear that the disruption caused by street works is a greater problem in some parts of the country than in others. Given this, subsection (2) makes it clear that authorities wishing to proceed with a scheme will need to submit details of it to the Secretary of State or the Welsh assembly, as appropriate, for approval. In considering whether to approve a scheme, we shall want to satisfy ourselves that authorities are acting responsibly and that the detail of the scheme is commensurate with the disruption caused by street works in their area. It would not be acceptable, for example, if it became clear that an authority’s motive in introducing a scheme was purely to raise extra revenue for itself.”

Therefore, at the valuation date, it was far from clear which local authorities would introduce a scheme, what they would charge and which works would be exempt. Furthermore, Ofgem had said, in a letter of comfort, that they would reopen the price review if lane rentals had a material impact upon a utility’s finances. In view of this, very little allowance has been made in the valuation for lane rentals.

Depreciation

Most of the electricity distribution hereditaments are rateable. Nevertheless, the hypothetical tenant will still need to acquire the non-rateable assets to run the business. The main items of tenant’s assets are:

  • transformers,

  • switchgear,

  • tele-control/SCADA equipment,

  • computers, and

  • vehicles and office equipment.

For large properties such as the utility networks, it is assumed that the incoming tenant purchases these assets from the outgoing tenant. The purpose of tenant’s depreciation is to ensure that:

  • the tenant has sufficient funds to replace the assets at the end of their working life, and

  • his capital (the sum invested in the assets) is maintained in real terms.

To achieve this, we normally adopt either the modern replacement cost of the items over their full lives or the depreciated value over the remaining life. However in the case of the DNOs this was not possible because from analysis of capital asset information it was apparent that there was significant inconsistency across the companies. Although it was possible to establish a view on the split of total assets between landlord and tenant one could not determine the absolute level of asset values. Having regard to all available data a non-cash charge for tenant’s depreciation was set at 20% of all other operating costs.

Tenant’s Share

The tenant’s share is the cash which the tenant takes out of the business so as to induce him to take the tenancy. For large hereditaments, such as the DNOs, it is important to consider who is the hypothetical tenant. All the individuals employed by the hypothetical tenant, including the senior management and the Board, are paid for their time and expertise. Their salaries appear in expenditure in the valuation. Therefore, tenant’s share does not compensate the individuals running the business - it is merely there to provide a return for those that have invested in the business. In effect, the “tenants” are the shareholders.

In the real world, shareholders make decisions on whether to invest in an undertaking by considering the possible returns. The same would apply in the rating world. Therefore, the preferred means of calculating tenant’s share for a DNO hereditament is a return on tenant’s capital. In order to undertake this exercise it is necessary to know the market value of all non-rateable assets used in the business. However it was clear from analysis of all available fixed asset information that it would not be possible to determine accurately or consistently across all DNOs the value of assets identified as non rateable. This appears to be due to legacy issues concerning the way in which assets are categorised in regulatory accounts. In any event, it was not possible, either during the currency of the 2005 List, or preparation of the 2010 List, to reach any degree of agreement over the relative value of the Landlord and Tenant’s assets.

In these circumstances and in order to achieve a measure of consistency between companies, an alternative approach to tenant’s share is required and the method adopted was a proportion of the divisible balance going to the tenant by way of his share. Both Landlord and Tenant face cash flow risks: the tenant for example as a result of unexpected or unforeseeable occurrences in the business for which he is not compensated through the price control mechanism, the Landlord as a result of the tenant defaulting on rent payments due to his own cash flow problems, or even bankruptcy of the tenant.

The DNO valuations for the 2005 and 2010 Rating Lists reflect a narrow range of values for Tenant’s share from 32 to 35% of divisible balance.

Forecast Period Within Next Price Control

As noted above from the year commencing 1 April 2005 the DNOs were subject to a new price control, the detail of which was not known until November 2004. Indeed the initial consultation paper on the 2005 price control review was not published by Ofgem until July 2003. However at AVD the philosophy and general methodology of price control likely to be adopted by the regulator was established. This was set out in an August 2002 initial consultation and a February 2003 update document on “Developing Network Monopoly Price Controls”.

For the post 1 April 2005 years in the valuation the prevailing level of tenant’s depreciation was maintained in real terms and non-load capex to rateable items was still allowed as repair. Pass through cost items were assumed to be matched exactly by equivalent revenue. A direct forecast was made to estimate the likely surplus of allowable revenue over other controllable operating costs. This is based on:

  • the DNOs forecasts of annual increases in regulatory asset value (RAV),

  • a calculation of regulatory asset value depreciation,

  • estimates of the rate of return on RAV likely to be adopted by Ofgem,

  • additions for rent/wayleaves payable in practice by the DNO,

  • estimate of efficiency savings representing outperformance of the price control.

This part of the forecast period is less certain and to reflect associated risk, particularly involving the calculation of future RAV and resultant return, the tenant’s share was increased as detailed above.

Excepted Properties

The result of the R&E valuation represents the rental value of the whole undertaking comprising the network, depots, workshops, stores, control rooms and offices. The hereditament required to be shown in the central rating list should exclude the value of excepted hereditaments as defined. The next part of the exercise is therefore to deduct the rateable value of excepted hereditaments to avoid double counting.

Electricity Meter Hereditament

All the meters attached to a DNO network are aggregated and shown in the central rating list as a separate hereditament. The income arising from meters together with the operating costs and repairs applicable to meters have been examined across all DNOs. This exercise produced a divisible balance of £1.63 per meter and an adopted rateable value of £1.14 per meter. Multiplying up by the number of meters attached to the DNO network in each case produces the rateable value of the meter hereditament. The final part of the exercise is to deduct the value of the meter hereditament from the previously obtained rateable value of the network including meters.

Section 371: Electricity distribution networks: Practice Note 2017

1. Market Appraisal

The industry, particularly the Independent Distribution Network Operators (IDNOs) referred to below, is an emerging and growing industry.

Whilst the electricity distribution industry was opened up to competition for new connections some years ago, the lack of transparency from existing distribution network operators (DNOs) has meant that new independent companies had difficulty in estimating their total costs - including clarity on the upstream costs of connecting to the existing DNO system.

As a result they found it difficult to compete effectively, and the take up of customers using IDNOs had a slow start.

IDNOs are subject to Relative Price Control whereby customers connecting via an IDNO cannot be charged more than customers connecting via the host Distribution Network.

OFGEM had threatened recourse to the Competition Appeal Tribunal and imposed requirements on the existing DNOs, but at the same time incentivising them on transparency to facilitate effective competition.

IDNOs are now able to compete in this sector and the take up of connections via IDNOs has increased significantly in recent years.

2. Changes from the last Practice Note

There was no Practice Note for the 2010 Rating List

3. Ratepayer Discussions

Accounts of the IDNOs have been obtained. Discussions are taking place with their representatives to analyse recent trading evidence to inform a basis for 2017. This will be expressed as a rate per connection.

4. Valuation Scheme

Electricity Undertakings (Non Statutory) - SCAT Code 094 comprise Independent Distribution Network Operators (IDNOs) and on-shore cable connections for off-shore wind farms.

This class of properties is valued by a limited number of specialist caseworkers who are part of the Utilities and Transport team of the National Specialists’ Unit.

IDNOs are valued on a Receipts and Expenditure basis which has been analysed as a rate per connection to be applied to all IDNO hereditaments.

On-shore cable connections from off-shore wind farms comprise cables, civil works (including cable ducts) and substation buildings. The hereditament excludes those cables lying outside the parish (generally below low water mark). These hereditaments are the means by which electricity generated from off-shore wind farms is connected and transferred from Direct Current (DC) to Alternating Current (AC) and fed into direct into the National Grid or more commonly a DNO network. These hereditaments are valued on the contractor’s basis of valuation.

Any queries from Units in respect of this class of property should be addressed to nsumailbox@voa.gsi.gov.uk