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UTILITY Week 21st July 2017

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18 | 21ST - 27TH JULY 2017 | UTILITY WEEK Policy & Regulation Analysis T he starting gun has now been fired on the second round of the RIIO price con- trols, as last week Ofgem published an open letter to stakeholders seeking views on how the framework should evolve to adapt to the fast-changing energy environment. The letter set out an array of poten- tial reforms that the regulator is consider- ing, many of which have been called for by energy networks themselves. However, it also came with a warning that the next price controls will be "tougher" – something they will be less pleased to hear. As part of this pledge, Ofgem will review the way in which it sets the allowed cost of capital for networks – a key component of company returns. According to the letter, the current market condition for both debt and equity financing have "diverged significantly from expectations at the time the cost of cap- ital for RIIO1 was set". "At the same time, we have seen inves- tors willing to buy regulated assets at high premia to the regulated asset values, suggest- ing a willingness to accept long-term yields considerably lower than the cost of capital set for RIIO1," the letter adds. It was largely on this basis that Citizens Advice concluded that energy networks are line to receive £7.5 billion in "unjustified profits". Anthony Legg, EY head of power and utilities economic advisory, says the signal from Ofgem does not come as a great sur- prise: "The question is how much lower, and Ofgem didn't say much about that specifi- cally in the document." The letter did, however, point to water regulator Ofwat's preliminary estimates for the cost of capital for the PR19 price con- trols for the water sector as an example of what can be expected for energy networks. A consultation published by Ofwat earlier in the week warned water companies to expect a "significant reduction" in the weighted average cost of capital (Wacc). The water regulator cited research from PwC last month which suggested that the cost of equity – if it were set on the same RPI-linked basis as at PR14 – would be 3.8-4.5 per cent at PR19, "quite a step down" from the PR14 number of 5.65 per cent. By comparison, the cost of equity for the ED-1 price controls is currently 6 per cent for all but one of the electricity distribution networks. "I think Ofwat's numbers were a little bit lower than people were expecting," says Legg. "I would imagine people are looking at Ofgem's reference to Ofwat in a similar kind of light." The debt portion of the Wacc is indexed to a rolling average of historic market costs, typically covering the previous ten years. The equity portion is not, something Ofgem says it may change. Citizens Advice argues it should, claiming that the failure to index the equity segment to real market data has by itself le consum- ers overpaying by £3.4 billion. According to the charity, market prices are "always going to be a better, less biased guide to actual costs than long-term regulatory forecasts". It also says that the period of historic data used to index debt costs should be shortened to make the Wacc more responsive to market developments. Mike Huggins, director of Frontier Eco- nomic's energy practice, believes Ofgem should take a cautious approach when con- sidering such changes. "Long-standing UK regulatory practice has been to set allowed equity returns by reference to long-run aver- ages. That has great benefits in terms of sim- plicity, transparency and stability. "But if long-run averages are used, inevi- tably there will be periods when spot rates are below the long-run average, as seems to be the case now. The question of whether it is now right to abandon the long-run approach is complicated and requires careful analysis, to explore whether short-run benefits may create long-term costs." Ofgem has also said it will get tougher on the allocation of spending allowances. Under the current arrangements, net- works can be fast-tracked through the settle- ment process if Ofgem is satisfied with their initial business plans. They are rewarded with a lower "sharing factor", meaning they get to keep a greater proportion of any underspend against their allowance. Capital punishment? Amid criticism that the energy networks are making billions in "unjustified profits", Ofgem has warned that RIIO2 will be tougher. But how low will the cost of capital go? Tom Grimwood reports. RIIO1 ALLOWANCES AND FORECASTS Price Control Company Allowance (£m) Forecast (£m) Variance (£m) Variance (%) ED-1 Electricity North West £1,924 £1,872 -£52 -2.8% Northern Powergrid £3,171 £3,198 £28 0.0% Western Power Distribution £7,479 £7,902 £423 5.6% UK Power Networks £6,392 £5,464 -£929 -14.5% SP Energy Networks £3,370 £3,358 -£12 0.0% Scottish and Southern Electricity Networks £3,746 £3,450 -£296 -7.9% Total £26,082 £25,244 -£838 -3.2% GD-1 Cadent (formerly National Grid Gas Distribution) £8,335 £7,614 -£721 -8.70% Northern Gas Networks £2,002 £1,746 -£256 -12.8% SGN £4,960 £4,118 -£842 -16.9% Wales and West Utilities £2,031 £1,719 -£312 -15.4% Total £17,327 £15,196 -£2,130 -12.3% ET-1 (Transmission Operator) National Grid Electricity Transmission £13,170 £11,652 -£1,519 -11.5% SP Transmission £2,325 £2,212 -£113 -4.8% Scottish Hydro Electric Transmission £3,037 £2,770 -£267 -8.8% Total £18,532 £16,633 -£1,899 -10.3% ET-1 (System Operator) National Grid Electricity Transmission £1,156 £1,138 -£18 -1.6% GT-1 (Transmisson Operator) National Grid Gas Transmission £2,235 £2,427 £193 8.6% GT-1 (System Operator) National Grid Gas Transmission £797 £756 -£41 -5.1%

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