Utility Week

10 | 6TH - 12TH JULY 2018 | UTILITY WEEK Interview Edwards also says the figures published by Ofgem do not give the full picture. He tells Utility Week the return on regulatory equity (RoRE) metric assumes the actual cost of financing for networks was the same as the regulator's debt index: "If you've raised debt more efficiently than the debt index, that will add to your return, whereas if you have raised debt and had to incur debt at a cost which is above the index, that will reduce your return. "If we are going to highlight an issue with network returns, let's make sure we use the right metric to show returns." Whether the "right metric" would help his case is ques- tionable. Of the £7.5 billion of "excess" profits that Citi- zens Advice has previously claimed networks will receive over the current price controls, £3.4 billion it attributed to a windfall from below-index borrowing costs. Discussing the latest report from the charity, Edwards says: "I thought it was quite surprising really that Citizens Advice were focusing on an equity beta at this point in time, when we've got significant fuel poverty to address, customer service improvements and what outputs we should be focusing on for RIIO2." In its consultation, Ofgem itself stressed that it is still "very early" in the settlement process and that the cost of equity will not be finally determined until 2020 "at the earliest". The regulator said it would update the preliminary figures over the summer. "There's a lot of water to go under the bridge to set the cost of equity when we get to the first RIIO2 price controls – that will be gas and electricity transmission," he explains. "And electricity distribution is even further away." More generally, Edwards is disappointed that Citizens Advice has put forward the message that consumers are getting a bad deal when "there are a number of areas where they recognise the merits of the existing system". He says the regulatory regime needs to strike the "right balance" between providing value for money for customers and securing the billions of pounds of invest- ment that the networks will require for the UK to meet its climate change targets. Britain has "got to remain attractive" to international investors, who could easily take their money elsewhere. The ultimate effect of continuing to tear chunks out of network returns, he argues, will be to "undermine the crucial investment in innovation that is required to deliver further cost savings and further service improvements". Ofgem's consultation didn't just look at profits. Other proposals included reducing the length of the price control from eight to five years and stripping back innovation funding to focus on big, strategic issues. With regards to innovation, Edwards says networks are thinking along the same lines: "We have now already moved to providing a more strategic view across the networks in terms of what those big strategic challenges are." He points to their work on hydrogen grids as an example of networks working together to address one of these challenges. However, he also expresses concern that smaller and less ambitious innovation projects, which nevertheless deliver clear benefits to consumers, will be unable to access funding and will be frozen out. Ofgem also declined to align the price control for elec- tricity distribution with those for electricity transmission and gas. It is scheduled to start two years later than the others, as was the case for the first RIIO period. Edwards believes this was a misstep by the regulator: "In terms of a whole-systems approach you should really do them all together and assess the plans at the same time so you've got that comparator." He says it would also be an improvement "if we could recognise somehow through the settlement that gas can play a role in helping the electricity network". Edwards says electricity generation "used to be the domain of the national gas transmission pipeline" but there are now more than 30 power stations connected to the gas networks that Wales & West Utilities operates. Other gas distribution networks have seen similar changes. The firm has just installed 75 hybrid heating systems in Bridgend in South Wales for its Freedom innovation project. They will enable the participants in the trial to use electricity to provide "baseload" heat when power is plentiful, and the grid has spare capacity. Gas can then be used to provide intense bursts of heat during evening peaks in demand. "It's in effect like a bit of demand-side response," says Edwards. "We are trying to think at the moment how we can recognise that." That said, even in its current state, Edwards believes there is room within the RIIO framework for networks to invest on the basis of cross-sector benefits: "It's up to the networks in our business plans to be demonstrating that the investments that we are putting in towards Ofgem are the lowest-cost energy solutions on a whole-system basis." While improvements can always be made, his main hope for RIIO2 is that Ofgem stays the course and resists pressure to start chipping away at the framework, which he argues has been successful so far: "Let's not forget, other sectors within the UK, and indeed other regula- tors around the world, hold up this framework as the exemplar." With Ofgem's next update due this summer, he won't have long to wait to see if his wish has been granted. "I thought it was quite surprising really that Citizens Advice were focusing on an equity beta at this point in time" Putting a price on risk The latest report from Citizens Advice, Things can only get beta, centred on the equity beta – a measure of financial risk to investors that is used to calculate the cost of equity. If an investment is riskier than average, then the equity beta is more than one. If an investment is lower risk than average, then the equity beta is less than one. For the first RIIO period, the network operators were assigned an equity beta of 0.9, meaning they were considered only slightly less risky than the average company. Based on recommendations of a study by consultancy CEPA, Ofgem's proposals assume a lower equity beta of between 0.71 and 0.8. However, Citizens Advice said it should be lower still, citing another study com- missioned by the UK Regulators Network (UKRN), which suggested changes to the current methodology for establishing equity betas (although one of the four authors dissented). The consumer group said the new methodology should be applied to the energy networks, leading to an equity beta in the range of 0.36 to 0.69. But Edwards says there was a glaring omission from Citizens Advice's report, which makes "no mention of the decarbonisation of energy, the growth of electric vehicles or the work that we are doing to create smarter, more sustainable networks". Responding at the time, the ENA said the report ignored the risks to investors of the huge transformation they will undergo during the next price controls. The dissenting voice from the UKRN study might well agree with the ENA on this point, stating that the "estimation of beta is the one component of the cost of equity where the regulator must use its judgement and discretion".

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