Citizens Advice says Ofgem still off the mark on network returns

Citizens Advice has warned that Ofgem’s methodology for determining appropriate rates of return is still too generous to energy network investors.

In its response to a call for evidence on the RIIO2 business plans submitted to the regulator in December, the consumer advocate said Ofgem appears to have overestimated the level of financial risk posed by network companies.

Ofgem confirmed the methodology for setting the price controls in May 2019. If applied at the time, the regulator said it would produce a real cost of equity of 4.3 per cent, based on the CPIH measure of inflation.

It determines appropriate returns using the capital asset pricing model, which features three key metrics: the total market return (TMR), the rate of return that a typical stock market investor would expect to earn across all sectors; the equity beta – a measure of the financial risk posed by a specific company or sector when compared to the wider market; and the risk-free rate, the rate of return an investor would expect to earn if they faced zero financial risk.

Based on this model and cross-checks with other data, Ofgem concluded that investors in network companies could expect to receive a real return on equity of 4.8 per cent. It subsequently applied a downward adjustment of 0.5 percentage points – the performance wedge – to reflect investors’ expectations that network companies would exceed the baseline returns due to incentives, giving an allowed cost of equity of 4.3 per cent.

It has since increased its indicative figure to 4.8 per cent.

Ofgem’s estimate of the equity beta is derived from a sample of just five stock-listed companies. Only two of them actually operate a regulated energy network (SSE and National Grid); the other three operate water companies (Pennon Group, United Utilities and Severn Trent).

Whilst acknowledging the difficulties in making direct comparisons, Citizens Advice said its estimate for the asset beta – a component in the calculation of the equity beta – is significantly higher than that suggested by recent data on network companies in the US.

“In contrast to the views of network companies given in their recent business plans, this evidence suggests that Ofgem may currently be estimating the equity beta too high – and so given the framework it has already identified we think it would be appropriate for Ofgem to use its lowest estimate of its range of equity betas for RIIO-2.”

The consumer advocate also urged Ofgem to retain the performance wedge but formalise the mechanism. It argued that an adjustment equivalent to half of historical outperformance would be justifiable, suggesting a higher rate of 1.5 percentage points.

“Because of this we think it is imperative that Ofgem retains the proposed 0.5 per cent performance wedge, and we have not seen any compelling evidence from network companies that this should not apply.”

Citizens Advice additionally raised concerns over the regulator’s calculation of the TMR. A supporting report from HMK Advisory released alongside its response noted: “Instead of using actual investor market forecasts, Ofgem, like other UK regulators, have used a proxy forecast – their own forecast based on historical long-term actual returns.

“This approach has the benefit that it can readily be measured in an objective way and is capable of rigorous statistical analysis.”

“However,” the report added, “if the evidence shows, as it does, that actual forecasts are lower than the proxy forecast, it is clear that regulators must amend their approach to avoid setting an unnecessarily high allowed rate of return – either by adjusting their own forecast or using actual market forecasts.

“This reality check is critical if shareholders are not to be gifted unnecessarily high returns.”

Citizens Advice said Ofgem did cross-check its forecasts against those of investors but said some dated back to as early as September 2017: “Consequently, at the determination stages, we think Ofgem should seriously consider updating its assessment of fund managers’ forecasts of the TMR.”

“Ofgem’s current proposal has moved a long way from RIIO-1 in protecting consumers from expected outperformance adjustments in companies’ favour,” the group concluded. “In our view, this is laudable progress, but looking forwards there is further scrutiny of these methodologies to be considered to ensure value for consumers.”

Energy networks are also already facing a sharp reduction in the allowed cost of equity, which currently ranges between 6 and 7 per cent when stated using the old RPI measure of inflation and between 7 and 8 per cent when converted to the new CPIH measure that Ofgem is planning to adopt for RIIO2. All have argued for higher rates, with some warning that the cut may make them unfinanceable.

However, commenting on their business plans, the RIIO2 challenge group said: “Despite vigorous protestations from every company, none has persuaded us that Ofgem’s working assumptions for the cost of capital make their businesses unfinanceable.”

The panel of industry experts said the plans were “almost entirely” focused on lobbying for a higher rate and there was “little evidence that the companies had actively sought to achieve financeability”. It additionally criticised them for lacking ambition on decarbonisation, saying none except the electricity system operator had shown “true leadership” on achieving the new net zero goal.

A recent report from the National Audit Office also noted real returns on equity are forecast to average 9.2 per cent (RPI) for electricity networks during current price control period, whilst Ofgem’s latest estimate of average returns a FTSE-listed company is just 5.35 per cent to 5.75 per cent. It said a recent survey by the regulator suggested stock market investors now expect even lower returns of 3 per cent to 4 per cent.

The transmission and gas distribution sectors submitted their final business plans to the regulator in December. Their next price controls will begin in April 2021. The price control for electricity distribution will start two years later in April 2023.