Utility Week

UTILITY WEEK | 16TH - 22ND MARCH 2018 | 11 Policy & Regulation "Energy networks are the nerve- centre of a smarter, cleaner energy market, responsible for delivering a range of exciting new services for our homes, businesses and communities. Balanced regulation is fundamental to delivering these and the price control system should evolve to suit the changing needs of consumers. RIIO2 must deliver that while being founded on the principles of transparency and stability to provide predictability for investors, innovators and consumers alike. We will be working through the proposals… including Ofgem's opening view on what the cost of equity should be." David Smith, chief executive, Energy Networks Association "The announcement is a major step forward. These proposals should prevent a repeat of the billions in excess profits energy network companies are making under the current price controls. This means better value for consumers and potentially lower bills. The outcome of this consultation will be the acid test for Ofgem. It's crucial that the regulator holds its nerve and sees through these changes." Gillian Guy, chief executive, Citizens Advice Reaction It's unclear yet whether the network Wacc will equal or even exceed this historic low, given that Ofgem has not made any firm decisions on its formula for setting the cost of debt over the next price control. However, it has used a very similar meth- odology to that employed by Ofwat for set- ting the cost of equity – the baseline rate of return that it considers necessary and suffi- cient to attract investment. The suggested range for RIIO2 is between 3 and 5 per cent, which compares with a RIIO1 level of between 6 and 7 per cent. Some network leaders will no doubt take issue with the methodology for making this cost of equity assumption. There's a school of thought, for instance, which argues current negative risk free rates – a consequence of quantitative easing in the wake of the global financial crisis – are likely to be a relatively short-lived phenomenon and should not unduly influence the regulator's calculations. However, with Ofgem stressing that its cost of equity calculation remains extremely tenta- tive at this stage, executive teams may hold their fire for more critical financial elements within the framework – for instance, seek- ing to influence progress on the cost of debt methodology, which was the dominant factor in finalising the Wacc – and giving feedback on a range of other measures proposed to introduce tighter control of network returns. For example, Ofgem's option of capping the regulated RAV-weighted average return across the sector in order to provide absolute confidence that the sector as a whole will not achieve an excessive return on regulated equity, was met with some consternation by at least one power network. A senior network spokesperson tells Utility Week such an approach to curtailing returns could significantly undermine the incentives-based principle on which RIIO was originally built, since outperformance benefits would be slashed if the sector per- formed strongly across the board. They say anchoring would "introduce a high level of uncertainty around the accessibility of out- performance incentive payments and drive up the risk involved in investment". Ofgem's appraisal of the potential pros and cons of its options for controlling excessive returns are summarised in the table below. Overall, networks have received their dra framework for RIIO2 with reserved positivity. Official and unofficial comments on the con- sultation document approve the emphasis on customer value and continued support for innovation – including plans to extend this to third parties and to focus funding on projects that promise to uncover resolutions to key energy system transformation challenges. But there is a palpable nervousness that the regulator's schemes for ensuring "fairer" network returns could become overzealous and undermine the effectiveness of the RIIO regime's performance-focused incentives. Next steps to refine the framework are likely to bring an escalation of this tension between the need to address immediate political and economic issues and the need to retain the interests of patient capital. POTENTIAL STRENGTHS/WEAKNESSES OF OPTIONS TO PROTECT AGAINST HIGHER THAN EXPECTED RETURNS Source: Ofgem Anchoring Provides absolute assurance that a sector average RoRE would not exceed a cap. Might increase companies' scrutiny of other companies' business plans. RoRE Sharing Factor When linked to information- revealing devices, it might provide an incentive to companies to improve quality of business plans. Combines and simplifies a number of framework elements. Extends protection to include all incentives. Constraining totex and output incentives Provides more protection against high returns in comparison with RIIO1. When linked to information- revealing devices, it might provide an incentive to companies to improve quality of business plans. Discretionary adjustment Mitigates against drivers of performance that we do not believe warrant additional profits. Hard cap/floor Complete mitigation against high returns at both the sector and company level. Companies will not be able to achieve a cost of equity above a certain point. STRENGTHS WEAKNESSES Eliminates incentives to deliver output improvements and find cost efficiencies when a RoRE cap is breached. Requires us to define circumstances when we would make an adjustment. Unclear definition of reopening criteria might increase regulatory uncertainty. The mechanism is not bulletproof to higher than expected returns. The mechanism is not bulletproof to higher than expected returns. Under certain circumstances, company returns can be affected by the performance of other companies in the sector and would not be solely based on their own performance. Differences in company size and/or activities may exacerbate the impact of high/low performance by other companies.

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