Why we should crack down on network revenues

Citizens Advice says the returns being made by energy networks could be converted into massive consumer savings.

Ofgem today revealed that energy networks are once again making bumper profits. Across networks, our estimate of the amount of consumers’ money they’ll be taking home in profit this year is over £2bn.

Every network company is enjoying the good times: the average return is almost 10 per cent. For regulated, monopoly businesses, that’s a huge amount.

And recent sales data tells us that network companies expect the good times to continue rolling – as Citizens Advice has previously pointed out, National Grid sold part of its gas distribution business at a 60 per cent premium above its official value, suggesting investors expect outsized returns to continue.

Given networks are a major component of energy bill costs (around ¼), it’s crucial to answer whether these profits are justified. Earlier this month, nPower blamed rising network costs in part for its decision to raise prices by 10 per cent.

And there are very good reasons to think these profits are too high and that consumers are overpaying for energy networks.

Our starting point in thinking about this should be that energy networks are low risk investments. So pivotal are they to our economy that the government and the regulator will never let them fail.

The worst case scenario for investors’ capital is a lower rate of return than they have come to expect. Instead, returns are far in excess of the long run average UK share return of 5 per cent, for a less risky investment. The Big Six energy suppliers earn roughly a 4 per cent profit margin by comparison.

Profit should be led by risk: if risk is low, profits should be as well. Why, then, are energy networks’ profits so high?

We argue that there are at least two major explanations for why consumers are overpaying and set out the changes Ofgem should make:

1)    Ofgem’s forecast of costs like materials and labour are likely to be incorrect to the tune of almost £2bn over the course of the price control. Ofgem should use a real world index to measure these market specific costs.

2)    Ofgem has been too generous in setting the cost of equity, particularly in assuming that networks are far riskier investments than they are. This leads to billions in increased costs. Ofgem should reduce the cost of equity – which represents the biggest component of network profits – to match actual market conditions.We estimate that each 0.1 per cent reduction in the cost of equity would reduce consumers’ total networks’ bill by around £190 million over the course of the price controls.

Ofgem will be setting out its strategy for designing the next price control in the coming year. It’s crucial that it’s much more robust in interrogating these issues. Citizens Advice, as the statutory consumer advocate, will propose more realistic values for the cost of equity and argue for greater price indexation, so that consumers get a fairer deal.

This is an abridged version of a longer blog from Citizens Advice. The longer version can be read here.