Citizens Advice urges Ofgem to cut network profits by an extra £4.1bn

Citizens Advice has urged Ofgem to cut the “excess profits” of network operators by up to £4.1 billion more during the next round of price controls.

The regulator has already outlined plans to reduce networks returns by around £5 billion over RIIO2. Citizens Advice says it should go even further and save consumers as much as £9.1 billion in total.

In a new report, titled ‘Things can only get beta’, the charity claimed the current methodology for setting the cost of equity is flawed. The cost of equity refers to the rate of return which Ofgem considers necessary to attract investment.

The report said the equity beta for the sector – a measure of financial risk, which is used to calculate the cost of equity – has been set too high. Despite being regulated monopolies, the current equity beta puts networks companies almost on par with the average stock market firm.

“It has always been intuitively plausible that these are low risk businesses: their revenue is all but guaranteed by regulators,” the report stated.

“And as lower risks require lower reward, this has material consequences. Regulators assumed a much higher risk than can be justified, with higher bills as a consequence.”

Citizens Advice cited as evidence a “landmark study” into capital costs commissioned by the UK Regulators Network (UKRN).

If an investment is riskier than the market average, then the equity beta is set at more than one. If an investment is lower risk than average, then the equity beta is set at less than one.

Whilst there was a split in opinions, three out of the four authors of the study concluded that the current equity betas for regulated companies (currently 0.9 for energy networks) are too generous to investors.

They said the periods of data which regulators use to model the risk of regulated companies should be much longer, going back over a decade or more. At the moment, they cover just two to five years.

On this basis, they estimated that the equity beta for the only two listed pure-play utility companies – Severn Trent and United Utilities – would be between just 0.3 and 0.5 if judged according to their stock market performance. By comparison, Ofwat has set the equity beta for water companies at 0.8 during the present price controls.

Citizens Advice said its own analysis showed if this approach was applied to energy networks for RIIO2 then the cost to consumers would fall by up to £4.1 billion. This is on top of the £5 billion which Ofgem estimates would be saved if its initial proposals for the price controls are adopted.

Back in March, the regulator announced its intention to lower the cost of capital from between 6 and 7 per cent to between 3 and 5 per cent in an effort to rein in profits. It also proposed changes to the way it calculates the cost of debt and floated the possibility of introducing “failsafe mechanisms” to prevent returns from exceeding expectations.

Citizens Advice has called on Ofgem to extend the risk analysis applied to Severn Trent and United Utilities in the UKRN study to “all relevant comparator companies”. It said the regulator should also conduct further research to establish whether the existing methodology for calculating the equity beta is “as flawed as this suggests”.

The charity said the alternative methodology is “implementable and defensible”, and commands the agreement of the majority of experts commissioned to study this question.

“Having commissioned experts to study the best available evidence, Ofgem should follow their recommendations,” it added.

The report continued: “These would represent a very significant reduction in energy network companies’ returns to equity and Ofgem would rightly need to examine whether such adjustments were consistent with their duty to make sure that these companies are financeable.

“However, this cannot be an excuse for ignoring the empirical evidence. If the data indicates that the cost of equity is indeed this low, Ofgem should not be constrained by financeability tests or concerns. A separate assessment on financeability can be made following its cost of equity decision.”

Commenting on the report’s findings, Citizens Advice chief executive, Gillian Guy, said: “Regulators face a difficult balancing act. Firms need to be able to attract investment and investors need suitable levels of returns.

“But regulators need to ensure that the decisions they make don’t allow companies to make billions in excess profits and leave customers to pick up the bill.

“A new approach to analysing the risk of these firms will mean lower returns for investors, but the result is a better deal for consumers.”

The response from the networks

Energy Networks Association (ENA) chief executive David Smith said the report released by Citizens Advice ignores crucial differences in the risks faced by water companies and energy networks.

He said it makes no reference to decarbonisation, renewable energy or electric vehicles, or the “changes that energy network companies are delivering to build a smarter, cleaner energy system for Britain’s homes and businesses.”

“Slashing the money available for investment means these critical innovations will be the first to suffer and over time the security and dependability of our networks will also be called into question,” he added.

“Now is not the time to lose sight of Britain’s infrastructure needs when we are at the cusp of an exciting energy future.”

Smith drew attention to the findings of independent research conducted by economic consultancy Oxera on behalf of the ENA, which concluded that the risk profile of water companies may be different to those for energy networks due to the radical transformation they are undergoing.