Can networks overturn Ofgem’s ‘victory’ with the CMA?

The Competition and Markets Authority’s (CMA) provisional ruling on the RIIO2 appeals represented a “victory” for Ofgem, according to industry experts. However, the appellants are unlikely to give up without a fight. Tom Grimwood asks whether they can expect any movement from the CMA in its final determination and what the future holds for the “outperformance wedge”.

Martin Young, senior analyst for Investec, told Utility Week the regulator was likely to be the “happier party” after the CMA upheld its decision to slash the cost of equity to 4.55 per cent in its ruling on the appeals by the transmission and gas distribution networks against their final determinations.

Young said it was “a bit of a surprise” there was no increase after a poll of analysts by Ofgem ahead of the ruling last month found that consensus expectations were that the rate would be raised to 4.76 per cent.

“Ofgem is going to be buoyed by the fact the CMA have not said they are wrong in the way they did the cost of equity,” he remarked.

However, Young said it was “no surprise whatsoever” that the CMA proposed to remove the outperformance wedge – a downward adjustment of 25 basis points to the cost of equity to reflect the expected outperformance of networks due to the asymmetry of information between themselves and the regulator.

Young said its removal is “a big matter of principle” for the networks and will return “robustness” to the price control process, which involved “a lot of very, diligent detailed work” by Ofgem and the submission of “reams and reams” of evidence by networks. He said applying an adjustment “at the final whistle” is almost like “pulling a number out of thin air.”

Another industry expert agreed that the ruling is a win for Ofgem but said the regulator “may regret not having gone 10 basis points lower because I suspect they may have won that too.” They said maintaining the cost of equity at the level proposed by Ofgem represents the easy option for the CMA, avoiding the need to present its own calculations.

They said energy networks will still “fight like hell” for a higher cost of equity until the CMA issues its final ruling at the end of October but said: “My sense is it will be very, very difficult to change the CMA’s minds. Not impossible but very difficult.”

The source acknowledged that the CMA did change its position between its provisional and final rulings on the PR19 appeals by water companies but said its executives were caught off guard by the strong response from Ofwat: “Ofwat then basically threatened to appeal, which would have been very painful for the CMA and possibly for Ofwat, and thus there was sort of a messy compromise rushed out in water.”

They said the CMA will not get the same reaction from Ofgem, which will largely be happy with its provisional ruling on the RIIO2 appeals. They said it was their understanding that the appeals panel had “basically ignored the water precedent,” emphasising the different legal tests for appeals in the energy and water sectors, and also ignored arguments by the gas networks that they should have a higher cost of equity than electricity networks.

The source said it is not clear what else energy networks can now do to convince the CMA that Ofgem got its estimate wrong as they have already “thrown the kitchen sink” at the numbers and the appeals panels is “drowning in detail”.

They said the best line of attack would be make a “qualitative” argument that Ofgem should have “aimed up” from the mid-point of its estimated range to guard against the risk of underinvestment, although this is still unlikely to succeed.

On the outperformance wedge, they said Ofgem may regret changing the mechanism so that the reduction is returned to networks if the expected outperformance fails to materialise, noting that this “never looks good from a procedural point.”

“Ofgem was saying it’s not that punitive because we’re giving money back if we don’t get outperformance but that then creates weird incentives,” they added.

They said the CMA could give Ofgem the chance to propose an alternative remedy to information asymmetry but said if the CMA strikes it down in its final ruling, Ofgem will likely accept the decision and carry it over the ED2 price controls beginning in April 2023: “If the wedge goes by October, then the wedge is dead.”

Colm Gibson, managing director of Berkely Research Group’s London office, agreed that Ofgem may regret altering the wedge: “Once you start moving your position on an issue in this type of debate, you are often perceived as less credible, so I think the material changes Ofgem proposed, might have undermined its position.”

“I don’t think the CMA objected to the concept that there is some information asymmetry, or the associated risk that returns might be set at an unduly high level if this was not accounted for by regulators,” he added. “However, the CMA did find that the outperformance wedge did not provide the right incentives on companies to deal with this risk.”

He said decision to return the reduction to networks if they do not outperform weakens the incentive for them to be as efficient as possible: “I suspect that if Ofgem came back with some form of sharing mechanism, where outperformance was shared between customers and investors, or returns above a certain level were shared, then the CMA would be reasonably well disposed to it. So, I think this issue will still be on the table for future reviews.”

Gibson noted a disparity between the appeals in the water and energy sectors, explaing: “The CMA has given Ofgem a significantly wider margin of regulatory discretion than they allowed Ofwat in the PR19 appeals. I don’t think this can be explained by any difference in the legal frameworks which appear to allow Ofwat and Ofgem a similar degree of regulatory discretion.”

He said this may be due to the different people on the appeals panels or because “Ofwat’s shot across the CMA’s bow in the PR19 appeals made it more cautious about overturning Ofgem’s decisions.”