‘Civil service solution’ enough to avert RIIO2 appeals

Ofgem’s decision to raise the baseline profit margin for investors as part of its final determinations for the RIIO2 price controls has “probably done enough” to deter network companies from appealing the settlement, an industry analyst has told Utility Week.

Colm Gibson, a managing director for the Berkeley Research Group, said the uplift represents a compromise between the regulator’s draft position and the preliminary findings of the Competition and Markets Authority (CMA) in the appeal of four water companies against their final determinations for PR19.

Gibson said the decision by the CMA to raise the weighted average cost of capital for the appellant water companies by 0.54 percentage points above Ofwat’s estimate left Ofgem in “a very difficult position”.

The regulator had to choose between “sticking to its guns and aligning itself with Ofwat”, with the risk that the CMA would “completely pull the rug out from under it” and network companies would appeal, or adopting the CMA’s position and “admitting Ofgem was wrong in its draft determinations and undermining Ofwat”.

Gibson said Ofgem appears to have opted for a “civil service solution”, explaining: “Price controls tend to either look like they’ve been designed by economists or designed by civil servants and this one looks very much like it’s been designed by civil servants.”

He continued: “They’ve kind of gone half-way between the two and that’s an odd position for an economist to take. If you think of the CMA and Ofwat position as heads and tails, there’s a bunch of economics that gets you to heads and there’s a bunch of economics that gets you to tails but there isn’t an obvious justification for sitting halfway in between.”

Gibson noted this was despite Ofgem criticising “fundamental errors of approach” in its response to the CMA’s preliminary redeterminations: “I’ve never quite seen the likes of it in regulatory language before”.

Back in July, in its draft determinations for RIIO2, Ofgem proposed a real cost of equity of 4.2 per cent but set allowed returns for investors a quarter of a percentage point lower at 3.95 per cent to account for expected rewards from performance incentives.

The regulator has now decided to increase the cost of equity and allowed returns by 0.35 percentage points each to 4.55 per cent and 4.3 per cent. It said its new estimate for the cost of equity is higher than both Ofwat’s final determination and the mid-point of the CMA’s proposed range, which it gave as 4.09 per cent and 4.37 per cent respectively once adjusted to only cover the network activities of water companies.

However, its cost of equity figure remains below the level actually proposed by the CMA which, in contrast to Ofgem, opted in favour of “aiming up” to 5.08 per cent – “the midway between the midpoint and the top of the range” – to avoid what it saw as the asymmetric risk from underinvestment when compared to overcompensation. Ofgem’s allowed return on equity is also less than both the mid-point of the CMA’s range for the cost of equity and its proposed rate.

Nevertheless, when combined with a smaller but still significant increase in the cost of debt – the other part of the cost of capital – and the approval of another £5 billion of upfront investment, Gibson said Ofgem has “probably done enough” to dissuade networks from filing their own appeals with the CMA. Although they may think they can get “a bit more” from the CMA, he said they probably don’t think its enough to be worth making an appeal.

Ofgem said the higher cost of equity is primarily the result of an increase in the notional equity beta from 0.725 to 0.759. The equity beta measures the financial risk of a company when compared to a typical firm, with a value of less than one indicating a company is less risky than average.

Speaking to Utility Week in a call with reporters, Ofgem senior financial advisor Simon Wilde said this is in turn the result of changes to two components in the calculation of the notional equity beta – the unlevered beta, which measures the financial risk to investors if the company had no debts, and the debt beta, which measures the financial risk to lenders.

Explaining the decision to raise the unlevered beta from 0.3025 to 0.3111, Wilde said Ofgem had received evidence that energy network are “slightly riskier” to investors than water networks: “We continue to think that listed regulatory networks, including water, are relevant but we increased slightly the weighting we put on evidence that National Grid’s beta is consistently above water.”

Wilde conceded that its reduction in the debt beta, which drives down the notional equity beta if its value is positive, was “at least partly informed by the CMA’s work”, falling from 0.125 to 0.075. The former is the same as in Ofwat’s final determinations for PR19, whilst the latter is equivalent to the mid-point in the CMA’s range.

On Ofgem’s decision to offer investors returns lower than its actual estimate of the cost of equity, Wilde said: “We continue to believe the average efficient company will outperform the targets we have set them on totex and output delivery incentives. That is a considered view of the executive and the board.”

“However,” he added, “we accept we are estimating this with error. This is the first time we have done this and as a result we have strengthened our failsafe mechanism.”

He said if networks have not outperformed their baselines by a quarter of a percentage point, then Ofgem will “adjust up their returns to the cost equity” when it closes out the price controls: “Although we think it’s right that consumers get some of the outperformance, we are still committed to companies earning their cost of capital in the long run in this sector.”