Utility Week

12 | 16TH - 22ND MARCH 2018 | UTILITY WEEK Policy & Regulation Analysis O fgem has just published its consulta- tion document that seeks to establish the framework of the next periodic review – dubbed RIIO2 – for the regulated electricity and gas companies. To a considerable extent, it fleshes out the 15-page letter sent to the companies by Ofgem last July. It is clear that, aer years of light regula- tion – the most notorious example was when the then Office of Electricity Regulation's 1994 distribution review was humiliatingly reversed in March 1995 – regulated utilities are now set for a more aggressive approach. By far the largest UK company impacted by the forthcoming periodic review is National Grid, whose shares – on the expec- tation of tighter regulation and in fear of renationalisation by a future Labour gov- ernment – have performed poorly in recent months; they are down by around a third since mid-May 2017. In its RIIO2 consultation document, Ofgem focuses on price reviews whose impact dates will vary. In the case of National Grid, the new regime will apply as from April 2021; the date is the same for the gas distribution companies. However, the electricity distribution com- panies have a more extended timetable, with new price controls planned to kick in during April 2023. Technological advances In its consultation document, Ofgem has indicated that it plans to stick to these dates, although it has raised the issue of a default five-year review. With the many uncertainties attached to such issues as electric vehicles, energy stor- age and distributed generation, Ofgem has concerns that its financial model could be superseded by technological advances. Of course, for investors and investment analysts, most interest focused on the weighted average cost of capital (Wacc). It has been accepted for some time that a markedly tighter Wacc will be prescribed despite the likelihood of higher interest rates. Indeed, Ofgem has stated that it pro- poses a "significantly lower range of returns for investors". What has focused the minds of util- ity investors in recent months is the parsi- monious 2.4 per cent Wacc that Ofwat has proposed for the next water review. Much of the analysis between the two regulatory bodies, Ofwat and Ofgem, is subject to overlap. Hence, the read-across is self-evident. Interest rates In terms of equity, the lesser component of a utility's Wacc, a reduction to a 3 to 5 per cent range has been proposed – this leaves Ofgem with a lot of "wiggle room". The crucial debt element is less clear cut – for the moment, at least, Ofgem has kicked this ball far into touch. It plans to "refine how it sets the cost of debt". In the final analysis, it may adopt a debt mechanism that is linked to market rates, such as ten-year gilts. With the interest rate outlook far from clear, a market-based link has obvious advantages. However, Ofgem talks of con- sumers continuing "to benefit from the fall in interest rates". Few economists would be backing against interest rates rising between now and April 2021, when most of the new periodic review determinations would become applicable. It is also the case that Ofgem's claim of "a stable, predictable and low-risk regula- tory regime" sits uncomfortably alongside the radical renationalisation proposals put forward by the shadow chancellor, John McDonnell. Robust investment record For consumers, Ofgem is flagging price cuts of between £15 and £25 off a dual fuel bill that currently averages about £1,100 per year. Ofgem's senior partner for networks, Jonathan Brearley, set out Ofgem's priority: "We will capitalise on this [investment in the sector] by getting network companies to work harder to deliver better value for consumers in the next price controls." Like the water sector, the investment record of the regulated electricity and gas companies is robust – unlike non-nuclear baseload generation, it has not stalled. Since 1990, when the 12 electricity distri- bution companies were privatised, the net- work companies, including those in the gas sector, have invested around £100 billion in the national and local grids. Furthermore, power cuts have almost halved since 2001, while electricity transpor- tation unit costs have come down sharply since the mid-1990s. Ofgem has also stated that it is keen to inject more competition into tenders for major transmission schemes, especially as offshore wind investment is expected to rise sharply. Share prices Following Ofgem's publication of the consul- tation document on 7 March, the share price of the company most affected, National Grid, rose by almost 2 per cent. Of course, National Grid also has consid- erable earnings from its US operations so, unlike in the 1990s, it is not totally at the mercy of Ofgem to deliver a favourable price regulation settlement. SSE, another poor share price performer of late, is also directly impacted by Ofgem's networks regulation. It does, though, have sizeable generation capacity – and is a major renewables player, a sector in which govern- ment subsidies remain key. SSE's share price dried slightly higher early in the day of the publication of the RIIO2 consultation. In terms of the timeline, the consultation period ends on 2 May. Thereaer, the process will meander along until Ofgem's price deter- mination conclusions are revealed by the end of 2020. Nigel Hawkins, director, Nigel Hawkins Associates RIIO2: the noose tightens After years of light regulation, electricity and gas companies must brace for a more aggressive approach. Could Ofgem follow Ofwat's proposed 2.4 per cent Wacc for water in RIIO2, asks Nigel Hawkins? Ofgem has stated that it proposesa"significantlylower range of returns for investors"

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