Utility Week

14 | 17TH - 23RD MAY 2019 | UTILITY WEEK Policy & Regulation Analysis B y the end of this month, Ofgem will issue its nal decision on how it intends to implement the RIIO frame- work for the next round of price controls starting in 2021, RIIO2. The regulator pub- lished its second consultation on price con- trols in December and has been mulling over the responses since the middle of March. In contrast to the rst consultation, which considered the framework in general terms, this one examines in more detail how it will be applied for each of the individual price controls. This excludes the price control for electricity distribution, which will begin two years later than the rest in 2023. Neverthe- less, the six-part consultation does explore a number of mechanisms that will be applied across the industry, including to distribution network operators (DNOs). Although the core principles are essen- tially the same, Ofgem has proposed a num- ber of tweaks to the framework, which taken together will have a substantial impact on how networks are incentivised and how much money they can earn. Perhaps the biggest single change is to the baseline allowed cost of equity – the rate of return it considers necessary and suf- cient to attract investment. Depending on the sector, this ranges between 6 and 7 per cent for the current set of price controls. Pressure over pro ts In recent years, Ofgem has experienced mounting pressure to reduce this range, in particular from Citizens Advice. The charity claims network companies are on course to rake in £7.5 billion in "unjusti ed pro ts" over RIIO1, partly because Ofgem overesti- mated the level of business risk faced by net- work companies and therefore set the cost of equity too high. In its rst consultation published in March 2018, Ofgem said it planned to lower it to between 3 and 5 per cent for RIIO2, thereby saving consumers £5 billion over the shortened ve-year price controls. Ofgem said in December its working assumption for the allowed cost of equity was around 4 per cent, although this number is based on the new CPHI (consumer price index including housing) measure of in— a- tion, which it intends to adopt. It did not give an equivalent gure using the old RPI meas- ure of in— ation, although the consultation suggests it would be around 3 per cent when calculated on this basis. This means that for some networks the cost of equity could be less than half of what it was previously. The move was praised by Citizens Advice in its response: "Ofgem has proposed an ambitious package of measures that prom- ises to deliver signi cant bene ts to consum- ers. It is particularly the case with the cost of capital where our analysis has demonstrated the signi cant gains which should be made." But the networks argue Ofgem has gone too far. National Grid, for example, said the reduction "runs counter to the concept of a stable, predictable regulatory regime". "The allowed equity return gure is a full 100 basis points below the proposals for the water sector, where less market disruption is expected in the next price control period and construction risks are lower," it remarked. "The consequences of applying such a reduction in the core incentive to invest would impact consumers in the short and long term… Companies would be forced to become more cautious on investment, need- ing funding security before beginning any work leading to risks being passed on to consumers…" It said these reactions and other unin- tended consequences "would quickly o› set any short-term bill reductions". Flawed thinking The 4 per cent cost of equity proposed by Ofgem incorporates a 0.5 per cent reduction to re— ect investors' expectations of outper- formance by network companies. National Grid said this adjustment is both "conceptu- ally and practically — awed". "From a conceptual perspective, the jus- ti cation confuses windfall gain from poor price control setting and outperformance from incentives. "If the wedge is meant to apply to windfall gain, then this suggests lack of con dence in proper calibration of the price control even before it has been attempted. "If instead, the wedge is being introduced in relation to outperformance from incen- tives, then the approach does not recognise and appreciate the consumer bene t of incen- tives-based regulation, the widely accepted solution to the existence of monopoly." Cadent said the measure was "conceptu- ally — awed and arbitrary in nature" as well as being "duplicative to other proposed mechanisms". "It is noteworthy that Ofgem has set the baseline cost of capital lower than its mid- point estimate of the [capital asset pricing model] based cost of equity, which appears to be a signi cant departure from regulatory precedent," the company remarked. Citizens Advice said it supported the measure in principle but called for a "more formal approach" to deriving the adjustment. It suggested the 0.5 per cent reduction was "overly cautious" in that it "does not re— ect the actual past outperformance levels of about 3 per cent in RIIO1". Volatility concerns Ofgem has also proposed to index the cost of equity against the risk-free rate – one of the components of the cost of equity. This refers to the rate of return an investor would expect to receive from a government bond, where there is no risk of the money not being repaid. While not opposed to this change out- right, SP Energy Networks raised concerns that volatility in the risk-free rate driven by short-term business cycles could make it more di¥ cult for networks to secure nancing. Northern Gas Networks similarly expressed fears that a move to indexa- tion could lead to "increased volatility and reduced predictability of customer bills, of cash — ows and of returns for shareholders". "We understand that indexation of the risk-free rate has been designed to avoid forecasting errors and to substitute the estab- lished 'ex-ante + aiming up' approach which has been a common practice among utility RIIO reality bites For its next iteration of RIIO, Ofgem has taken a tough stance with network companies. Tom Grimwood assesses company responses before the regulator pronounces on their fate.

• Cover