Utility Week

UTILITY WEEK | 27TH MARCH - 2ND APRIL 2020 | 19 Finance & Investment Other participants, meanwhile, questioned why both Ofwat and Ofgem seem unwilling to take more note of evidence that consum- ers are generally willing to pay more for their utilities if they can be confident this contribution will be used to combat climate change and promote resilience. Ofwat chairman Jonson Cox confidently knocked back these queries, saying there were no worthwhile resilience schemes put forward in PR19 business plans that did not receive funding. That said, conference participants from both management and investor communities did not waste much time quibbling over regu- lated return rates or consumer bill contributions to fund the infra- structure investments and development of key technologies – such as hydrogen production and carbon capture and storage – which were universally acknowledged to be necessary within the coming decade and beyond in order to combat climate change. Rather, discussion focused on the required shape of new flex- ibility mechanisms in upcoming price controls, the continued need for regulated innovation funding – for both the energy and water sectors – and the need for a significant rethink of the logic under- pinning today's wholesale energy market in order to unlock value in new service-based business models for a low or no carbon economy. Another key debate issue was the growing role that local area planning and devolved climate change ambitions will have in stimu- lating low-carbon investment, and the importance of responding to this trend, especially for regionally based utility monopolies which must maintain legitimacy with the communities they serve. Ofgem chair Martin Cave acknowledged this local dynamic to decarbonisation and the need to deliver for key stakeholders. But he also admitted Ofgem is "wrestling" with what all this should mean for its approach to RIIO2 settlements. "How do we react to those democratically elected mayors who have chosen to achieve more aggressive decarbonisation targets than the government?" he asked, pointing to the potential for regional inequality and consumer detri- ment if networks become focused on serving the needs of certain stakeholders over others. Ultimately, discussion showed a keen awareness among manage- ment teams, investors, regulators and policy leaders of the impor- tance of backing a new wave of massive investment in low-carbon infrastructure and technology demonstration projects. Any failure to be proactive on this would, it was agreed, endanger long-term returns for investors – with the potential for major social detriment where pension funds are concerned – and also create a legitimacy vacuum among companies which consumers expect to be environ- mental trailblazers. There was some acceptance that this situation might mean taking the risk of stranded assets on the chin, and will certainly require patience from those investors waiting to benefit from business mod- els based on smart home operations and flexible energy services. Where there was less agreement was on the extent to which this situation requires fundamentally new thinking around government incentives, a change of direction in taxation or the restructuring of markets. These are areas of uncertainty that need urgent clarification if utilities are to fulfil their social purpose and pioneer the route to more a sustainable society. The key question now, though, is to what extent the unexpected and all-consuming distraction of the global coronavirus outbreak will derail the net zero roadmap, or in fact provide a timely recalibration of the available options and economic drivers for governments and markets to animate a dramatic low- carbon revolution in its wake. Jane Gray, content director, Utility Week T he climate change agenda implies a dramatic increase in the investment needs of the regulated utility sectors. In the UK water sector, for example, the National Infrastructure Commission estimates that investment of about £930 million a year will be required; for the power sector as a whole, the expenditure require- ment could be £20 billion a year to deliver net zero targets by 2050. Against this backdrop of significant investment needs, the notion of legitimacy in regula- tion appears to have taken on a life of its own, encompassing widespread public trust. One regulatory response to the legit- imacy challenge is a higher level of risk aversion. It could be argued that this has manifested in recent regulatory price con- trols through lower allowed returns and a lower scope for outperformance, achieved via the use of various mechanisms. Mechanisms to reduce the scope for high- powered incentives or outperformance include, for example, indexation, volume drivers, lower sharing rates and return adjustment mechanisms. A resultant concern is that if there is a lower scope for outperformance, a reduced profit impetus may disincen- tivise delivery of relatively high-risk and innovative net zero investments. For context, a 1 per cent movement in the allowed weighted average cost of capital presently implies an approximate £1.4 billion change in annual network returns, or about £1 per week for the regulated proportion of the average UK gas, water and electric household bills. A large movement in network returns therefore moves household bills slightly, which raises questions about whether this has a significant potential impact on legitimacy. Looking beyond the present five-year controls, bal- ancing concerns about affordability and financeability is imperative if long-term legitimacy is to be achieved. If companies are challenged in financing resilience and the energy transition, then that may itself induce a perception of illegitimacy, if the networks of tomorrow do not deliver what society then wants. A corresponding objective of the evolving regulatory model is to ques- tion whether the regime offers sufficiently high-powered incentives for private capital to undertake value-for- money investment in the real options today that create pathways for the net zero transition tomorrow. Sahar Shamsi, CFA, Partner Oxera "Legitimacy means balancing affordability and financeability" Expert view Sahar Shamsi, Oxera Brought to you in association with The notion of legitimacy in regulation has taken on a life of its own, encompassing widespread public trust

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