Utility Week

22 | OCTOBER 2021 | UTILITY WEEK Policy & Regulation Analysis Can networks overturn Ofgem's 'victory' at the CMA? Tom Grimwood explores the fallout from the CMA's provisional determination on the RIIO2 appeals and asks whether the networks can claw back any ground in the final decision. I ndustry commentators considered the Competition and Markets Authority's (CMA) provisional determination on the RIIO2 appeals to have been a "victory" for Ofgem. However, the transmission and gas distribution networks did manage to land some important punches. Returning its dra- verdict in August, the CMA found in favour of Ofgem on most of the 12 grounds of appeal, stating that energy networks had failed to demonstrate that the regulator had erred when working out the cost of equity or the component in its cal- culation – total market returns, the risk-free rate and the equity beta – under the Capital Asset Pricing Model. However, the watchdog did rule against Ofgem's decision to set allowed equity returns 25 basis points below its actual esti- mate of the cost of equity. This downward adjustment, known as the outperformance wedge, was introduced as part of the RIIO2 price controls to reflect investors' expectations that returns would exceed the baseline based on past perfor- mance. The deduction would be returned to investors at the end of the price controls if the anticipated outperformance failed to materialise. The CMA said there were "a number of errors" in Ofgem's analysis of the extent to which outperformance should be expected. It said that even if Ofgem's expectations of outperformance had been "robustly sub- stantiated", the outperformance wedge is a "poorly targeted" method of address- ing these concerns that could "undermine broader regulatory certainty" and increase costs to consumers over time. A big win for Ofgem over calculation of the cost of equity For Maxine Frerk, former Ofgem director and now head of Grid Edge Policy, the result largely appears to be a win for the regulator. "While many people had assumed the CMA approach on water would stand the energy companies in good stead, the test in energy is different and is about whether Ofgem was 'wrong' to take the decision it did. The CMA unsurprisingly concluded that Ofgem's cost of equity was within the bounds of its regulatory discretion." Martin Young, senior analyst for Investec, agrees the regulator was likely to be the "happier party" a-er the CMA upheld its decision to slash the cost of equity to 4.55 per cent in its ruling on the appeals by the transmission and gas distribution networks against their final determinations. Young says it was "a bit of a surprise" that there was no increase a-er a poll of analysts by Ofgem ahead of the ruling last month found that consensus expectations were that the rate would be raised to 4.76 per cent. "Ofgem is going to be buoyed by the fact the CMA has not said it was wrong in the way it did the cost of equity," he says. Both Young and Frerk see it as no surprise that the CMA proposed removing the outper- formance wedge. For Young, its removal is "a big mat- ter of principle" for the networks and will return "robustness" to the price control pro- cess, which involved "a lot of very diligent, detailed work" by Ofgem and the submission of "reams and reams" of evidence by net- works. He describes applying an adjustment "at the final whistle" as almost like "pulling a number out of thin air." Frerk says: "The CMA has some sympathy with the problem Ofgem is trying to address but says it simply hasn't made its case. To me, it was always clear that the mechanism was flawed and Ofgem's concession – not to apply it if there isn't outperformance – cre- ates perverse incentives."

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