Utility Week

10 | 21ST - 27TH JUNE 2019 | UTILITY WEEK Policy & Regulation Analysis T he first set of RIIO price controls have worked out rather well for energy net- works so far. According to Ofgem's most recent annual report, nearly all are on course to achieve returns higher than the baseline – some, the gas distribution net- works in particular, by quite substantial mar- gins (see graph, right). Indeed, some observers believe they have fared too well. Citizens Advice has spent the past several years pushing the regulator to lower returns for the next round, RIIO2. The consumer advocate says Ofgem over- estimated the level of risk faced by investors, assumed interest levels would be higher than they have been, and allowed energy networks to game the system by submitting inflated cost forecasts at the beginning. It says these failures, taken together, will hand investors £7.5 billion in "unjustified profits". Fair returns? Network operators claim these high returns are merely a mark of their success in responding to the incentives posed by the price controls. Ofgem clearly disagrees. The regulator recently revealed its final decision on the methodology it will use when setting the RIIO2 price controls. If applied today, Ofgem said the baseline allowed return on equity would be set at 4.3 per cent. However, this is based on the new CPIH measure of inflation, which Ofgem is adopt- ing for RIIO2. Under the old RPI measure, the number would be just 3.3 per cent. With baseline returns currently ranging between 6 and 7 per cent, it represents a reduction of more than half for some sectors. Explaining its motivation, Ofgem execu- tive director for system and networks Jona- than Brearley said: "Our proposals are on track to deliver a tough, fair settlement that strikes a better deal for consumers. "Lowering the cost of capital for network energy companies will put money back into consumers' pockets while service standards are required to remain high." The figure has increased slightly from the 4 per cent proposed by Ofgem in December, but energy networks say it is still too low. National Grid has suggested a rate of 5.5 per cent would be more appropriate. "What you're seeing there effectively is for transmission and gas distribution an almost 60 per cent cut to allowed return on equity, which is significant to say the least," says Energy Networks Association (ENA) head of regulation John Spurgeon. "That will drive investment to be very constrained," he adds. "Returns need to be sufficient to attract the level of investment we're going to need – not just to maintain and operate the system we have but to build on to that and improve it and deliver the smart future that we need." Network companies are especially opposed to Ofgem's decision to set the base- line return half a percentage point below its actual estimate for the cost of equity. The regulator says this adjustment is necessary to account for investors' expectations that net- works will outperform the baseline. ENA head of policy Tony Glover describes this as "crystal ball gazing", akin to stick- ing your finger in the air to check which way the wind is blowing. "It's essentially a ran- dom approach," says Spurgeon. "It doesn't hold water." Like many of the changes to the meth- odology, the downward adjustment reflects concerns held by Ofgem over its inability to accurately forecast costs. Having failed, in its view, to calibrate the current price con- trols correctly, the regulator is keen to avoid repeating the same mistakes. These changes also include the shorten- ing of the price controls to five years, the indexation of the baseline return to the risk- free rate – a component of the cost of equity – and the introduction of return adjustment mechanisms. Spurgeon says there are pros and cons to indexation: "Something that needs to be right is how you actually do it – what's the mechanism – so that no-one gets short- changed, both the consumers and the com- panies… It is a big change insofar as that what it does is put the risk of increasing rates solely with the consumer." However, he is less ambivalent about return adjustment mechanisms, which would raise or lower network returns if they fell too far outside of Ofgem's expectations. "We see them as ex-post regulation by the back door, which we see in other countries such as America, and we know that our RIIO incentive-based approach is far superior to rate of return regulation," he says. He also has concerns more generally about the number of new mechanisms Ofgem is introducing for RIIO2 and how they will all fit together: "Not only was it not clear how individual mechanisms would work, but how those mechanisms would interact and start to play with each other once you get into the price control". Gas networks Spurgeon is at least happy that Ofgem has listened to feedback over the exact type of return adjustment mechanism that will be applied to gas distribution. Under the anchoring model originally proposed by the regulator, all returns would be adjusted pro- portionally if the sector average breached a certain threshold. Following strong pushback, the regula- tor now intends to apply the sculpted shar- ing model not only to transmission but gas distribution as well (a decision on electricity distribution is yet to be made). Under this model, returns would be adjusted on an indi- vidual basis (see graph, right). "I think we've all come to the conclu- sion anchoring is not a good idea – Ofgem, networks and wider stakeholders," says Spurgeon. That said, sculpted sharing is only the "least worst" option: "Our preference would be that they don't exist at all. We don't think they're needed. If you set the price control Setting the bar for RIIO2: how low can networks go? After Ofgem announced that baseline returns will fall to the "lowest ever" level during the RIIO2 price controls, Tom Grimwood gets the response from energy networks.

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