Utility Week

8 | JANUARY 2023 | UTILITY WEEK Electricity distribution Analysis Ofgem delivers ED2 verdict After many months of haggling, the regulator has delivered its final determinations for the next DNO price control. So did it get the balance right between affordability and the need for investment? O fgem has given upfront approval to £22.2 billion of investment by electric- ity distribution networks (DNOs) over the five-year RIIO-ED2 price controls begin- ning in April 2023. The final determinations represent a £2.9 billion decrease when compared to the total expenditure (totex) allowances requested by distribution network operators in their busi- ness plans but a £1.3 billion increase when compared to the regulator's dra‡ determina- tions in June. Ofgem has reduced its assessment of the net benefits to consumers from £1.3 billion in its dra‡ determinations to £428 million as a result of changing market conditions, specif- ically the recent rise in interest rates, which impacted both the cost of capital and totex allowances. In the case of the former, the cost of equity has increased when compared to the dra‡ determinations, from 4.75% in real terms based on the CPIH measure of inflation to 5.23%. This reflects a rise in the risk-free rate of return expected by investors based on observed yields of index-linked gilts. The cost of equity is nevertheless down when compared to the equivalent figure for the current electricity distribution price controls of 6.7%. The allowed cost of debt has also risen when compared to the dra‡ determinations, from 2.32% to 3.07% for most DNOs, giving a weighted average cost of capital (Wacc) of 3.93% based on a notional gearing of 60%. As part of the package, Ofgem has approved £3.1 billion of load-related expend- iture to support the rollout of low-carbon technologies such as electric vehicles, heat pumps and wind and solar generation. The regulator said this figure factors in a £429 million upli‡ to totex allowances to reflect the outcome of its Significant Code Review (SCR) of network access arrangements. All six DNOs have seen an increase in annual totex allowances when compared to the latest figures for annual expenditure dur- ing the current regulatory period. The allow- ances incorporate an ongoing efficiency challenge of 1% per year. Ofgem interim director of infrastructure and security of supply Akshay Kaul said the package "delivers value for consumers, safe- guards security of supply and helps ensure Britain is no longer at the mercy of interna- tional energy prices or geopolitical events. "We've set the initial amount of invest- ment that local DNOs can make in the 2023 to 2028 period, with every pound represent- ing value for money for consumers and no increase in bills." Gillian Cooper, head of energy policy for Citizens Advice, welcomed the reduction in the cost of capital when compared with the current price controls, saying networks had been allowed to make "excessive" profits for far too long and that Ofgem was right to challenge them on efficiency. "However," she added, "network profits will still be too high and targets too easy. We believe Ofgem could have gone fur- ther and cut at least £1.5 billion more off people's bills." Investec senior analyst Martin Young told Utility Week he believes DNOs are unlikely to follow in the footsteps of the other energy networks in appealing their RIIO2 final deter- minations to the Competition and Markets Authority as there were "no nasty surprises." He said the one change where there was an "element of surprise" concerned the cost of debt. The increase from dra‡ determina- tions included a 55 basis point "calibration adjustment" to the underlying foundation for the allowance – a 17-year trailing average of an index of utilities' debt costs. Young said an adjustment was needed given the recent rise in interest rates and the expected uptick in investment by DNOs over the ED2 period: "The sector is likely to have more need to raise debt in the next five years than it has done in prior years which basi- cally means the idea of this simple average has its weaknesses." Given that Ofgem also raised totex allow- ances by 6% – a much larger increase than the 1% bump between dra‡ and final deter- minations for the slow-tracked DNOs in ED1 – Young said the package suggests a change in priorities for the regulator. "If you look at the regulatory approach in recent years, it's been to push down on totex, it's been to push down on returns," he stated. "I think the name of the game, both in energy and water, has changed. It's about bringing forward what is needed." Incentives Ofgem has set seven common financial output delivery incentives (ODIs), three of them new. The regulator has increased the strength of the upside incentives for the DSO and Interruptions Incentive Scheme ODIs by 20 basis points and 50 basis points respec- tively, raising the upper limit of the incen- tive package from +1.95% to +2.65% of return on regulatory equity (RoRE). The lower limit remains -4%. Suleman Alli, director of customer ser- vice, strategy and regulation at UK Power Networks, told Utility Week: "It's a shame that Ofgem has skewed the ED2 incentives more towards the downside at a time when other regulators seem to be copying Ofgem's approach in ED1 and making incentives more balanced. "This could, however, be seen as a com- pliment to the sector reflecting the strong past performance and Ofgem wanting to lock in improvements and prevent networks from sliding backwards." He continued: "We advocated for Ofgem to introduce specific customer service incentives for the connection of low-carbon technologies to ensure that networks are responsive to new customer needs and do not become a blocker to decarbonisation." PA Consulting asset management expert Allan Boardman said the disparity between rewards and penalties is understandable given how well DNOs are already performing on some metrics. "We've seen really good improvements over the past two or three price controls," he explained, "whereas this time, rather than adapt incentives to find other ways to improve, it's more incentives not to get worse." Boardman said on some areas of perfor- mance, such as supply interruptions, the

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