Utility Week

UTILITY WEEK | OCTOBER 2021 | 23 Policy & Regulation Another industry expert agrees that the ruling is a win for Ofgem but points out that the regulator "may regret not having gone 10 basis points lower because I suspect they may have won that too". They said maintain- ing the cost of equity at the level proposed by Ofgem represents the easy option for the CMA, avoiding the need to present its own calculations. They said energy networks will still "fight like hell" for a higher cost of equity until the CMA issues its final ruling at the end of Octo- ber, but adds: "My sense is it will be very, very difficult to change the CMA's minds. Not impossible but very difficult." The source acknowledges that the CMA did change its position between its provi- sional and final rulings on the PR19 appeals by water companies but says its executives were caught off guard by the strong response from Ofwat. "Ofwat then basically threat- ened to appeal, which would have been very painful for the CMA and possibly for Ofwat, and thus there was sort of a messy compro- mise rushed out in water," they said. They say the CMA will not get the same reaction from Ofgem, which will largely be happy with its provisional ruling on the RIIO2 appeals. They say it is their understanding that the appeals panel had "basically ignored the water precedent", emphasising the different legal tests for appeals in the energy and water sectors, and also ignored arguments by the gas networks that they should have a higher cost of equity than electricity networks. The source says it is not clear what else energy networks can now do to convince the CMA that Ofgem got its estimate wrong as they have already "thrown the kitchen sink" at the numbers and the appeals panels is "drowning in detail". They said the best line of attack would be make a "qualitative" argument that Ofgem should have "aimed up" from the mid-point of its estimated range to guard against the risk of underinvestment, although this is still unlikely to succeed. The outperformance wedge On the outperformance wedge, they said Ofgem may regret changing the mechanism so that the reduction is returned to networks if the expected outperformance fails to mate- rialise, noting that this "never looks good from a procedural point". "Ofgem was saying it's not that punitive because we're giving money back if we don't get outperformance but that then creates weird incentives." They said the CMA could give Ofgem the chance to propose an alternative remedy to information asymmetry but adds that if the CMA strikes it down in its final ruling, Ofgem will likely accept the decision and carry it over into the ED2 price controls beginning in April 2023: "If the wedge goes by October, then the wedge is dead." Colm Gibson, managing director of Berkely Research Group's London office, agrees that Ofgem may regret altering the wedge: "Once you start moving your posi- tion on an issue in this type of debate, you are o"en perceived as less credible, so I think the material changes Ofgem proposed might have undermined its position." "I don't think the CMA objected to the concept that there is some information asym- metry, or the associated risk that returns might be set at an unduly high level if this was not accounted for by regulators," he says. "However, the CMA did find that the outperformance wedge did not provide the right incentives on companies to deal with this risk." He says the decision to return the reduc- tion to networks if they do not outperform weakens the incentive for them to be as effi- cient as possible: "I suspect that if Ofgem came back with some form of sharing mech- anism, where outperformance was shared between customers and investors, or returns above a certain level were shared, then the CMA would be reasonably well disposed to it. So, I think this issue will still be on the table for future reviews." Gibson points to a disparity between the appeals in the water and energy sectors, explaining: "The CMA has given Ofgem a significantly wider margin of regulatory dis- cretion than it allowed Ofwat in the PR19 appeals. I don't think this can be explained by any difference in the legal frameworks, which appear to allow Ofwat and Ofgem a similar degree of regulatory discretion." He says this may be due to the different people on the appeals panels or because "Ofwat's shot across the CMA's bow in the PR19 appeals made it more cautious about overturning Ofgem's decisions". The CMA suggested its provisional posi- tion would add around £1 to customers' bills. Frerk says this is "not huge but not insignificant in the context of a network cost per customer of around £100". She says an increase was somewhat inevitable given that the appeals, covering a number of different grounds, represent a "one-way bet for the companies". "That's enough to justify the costs of the appeal for the companies – and there is a benefit for them as well in having put down a marker," she says. Ofgem also lost on several other grounds of appeal, including its decision to apply an "innovation upli"" when determining the cost reductions expected due to improve- ments in efficiency in the sector. "This has echoes of the point that Ofgem lost on in the ED1 appeal around smart grid benefits," says Frerk. "It is hard to prove the cost savings that will arise from innovation." She believes even though the regulator won on the central issue, "it's not a great result." "For the DNOs watching this play out, this should provide some helpful clarity as they finalise their business plans. "While in principle Ofgem could try again with new arguments, it should be a safe bet that the outperformance wedge will be off the table for ED2 but the companies will have to face up to an underlying efficiency target of around 1 per cent per annum." Tom Grimwood, energy editor "The CMA has some sympathy with the problem Ofgem is trying to address but says it simply hasn't made its case." MAXINE FRERK, HEAD OF GRID EDGE POLICY

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