Conviction or desperation? British Gas refers network costs to the CMA

The gloves are off. This week, the UK's largest energy supplier, Centrica-owned British Gas, took the unprecedented step of referring another part of the energy industry, the power networks, to the Competition and Markets Authority, as exclusively revealed by Utility Week. To be more precise, it referred Ofgem's eight-year price settlement, RIIO-ED1, effectively putting the regulator and five of the six network companies in the dock.

The referral will be seen in some quarters as a declaration of war – but the battle lines were drawn months ago. With energy affordability top of the political agenda, there has been growing heat around network costs, which make up around one-fifth of the bill. The Energy and Climate Change select committee, under the leadership of Tim Yeo, ended an investigation into network costs late last month with the conclusion that Ofgem’s price settlements have been “too generous, and performance targets too low.” British Gas gave evidence to the committee last May, claiming a tougher regulatory regime could slice £500 million a year off network costs. The supplier was also thought to have attempted to bring networks into the remit of ongoing CMA inquiry into the energy market, to which it itself is subject.

That having failed, the supplier’s decision to go a step further and make a referral itself, using its status as an “interested party” raises numerous questions. Is British Gas acting out of conviction or desperation? What are its grounds, and how likely is the referral to result in an eventual change to RIIO-ED1? What does this mean for the networks and the beleaguered energy regulator Ofgem? The picture is further complicated by the fact that one of the networks, Northern Powergrid, has also chosen to refer itself, arguing the opposite of British Gas, that the settlement is not generous enough.

First up, British Gas. An investor note from Deutsche Bank utilities analyst Martin Brough this week sounds a note of scepticism over the supplier’s motives. Brough notes that British Gas’s parent company Centrica slashed its dividend by a third earlier this year after dismal results for 2014 saw profits fall 35 per cent. Under the heading “if you’re in a glass house, don’t throw bricks’, Brough’s note reads: “Centrica’s British Gas does not own networks but pays for network delivery and is presumably claiming that the price control is too generous. It chose not to appeal against the transmission and gas distribution price controls in 2012/13 but that was before the CMA’s retail inquiry and Centrica’s 30 per cent dividend cut. While the company might like the idea of paying less for network delivery, it needs to be careful about arguing for a low cost of capital when the CMA is just applying a ROCE framework to British Gas. It might also be odd that it argues that financeability is not a concern for the networks when Centrica has just cut its dividend by 30 per cent apparently on financeability grounds.”

While British Gas isn’t making any public statements about the referral, Utility Week has obtained a copy of the legal document in which it sets out its grounds. A cross-reference of this with the company’s written evidence to the select committee inquiry gives a good sense of what its arguments will be.

The first issue is Ofgem’s decision not to return “double-recovered revenues”. In its select committee evidence, British Gas claimed the networks had “double-recovered” £91 million in connection costs that had been recouped both through network charges, affecting all customers, and direct from the connectees.

Second, British Gas alleges Ofgem’s targets around interruptions to service and customer service are too lenient and based on old information.

Third, it takes issue with changes to the Information Quality Incentive scheme.

Fourth, the transitional arrangements to a new asset life policy. In its select committee evidence, British Gas states: “Ofgem has determined that 45 years is the appropriate asset life, longer than in previous price control periods. However, a transition is applied meaning this does not fully come into force until the end of the eight year price control. If brought forward to the beginning of RIIO-ED1 in April of 2015 this provides greater savings for consumers. “

Fifth is the cost of equity, which was set at six per cent for RIIO ED1. In its evidence, British Gas cites Ofwat’s decision to set the cost of equity for water companies at 5.65 per cent (later reduced further).

Finally, British Gas alleges procedural defects throughout RIIO-ED1, claiming Ofgem “has repeatedly failed to set out sufficient reasons to justify its conclusions, or allow effective engagement by stakeholders.”

The CMA’s response is hard to call. It must now officially decide whether to act on the referrals and, from the point it announces a review, has six months to make a decision.

Undoubtedly, the networks will make a strong counter-case, led by Northern Powergrid, which itself took the unusual step of referring its own settlement to the CMA in the conviction that it could do better. Its argument is believed to centre around the cost of embedded debt, though the company refused to comment beyond a statement that said: “The company recognises that the regulatory process involves judgement – that’s an important protection for customers. But if a flawed decision creates a material underfunding of the costs of providing the improved services customers want, it should be corrected.”

While the other four affected networks chose to swallow their settlements, they were not happy about them, with SSE and UKPN both releasing statements that highlighted their “disappointment”. The final determinations sought savings of £1.4 billion from the networks’ original business plans – a level which, they claimed, would significantly impact investment.

Rather than getting on with the business of ED1, the networks now have six months of legal squabbling to look forward to. Traditionally a sector that has traded on its stability and flown under the radar, the network business now faces an increasingly hostile public, and must reassure investors, who were looking forward to an eight-year return that was certain, if not generous.

For Ofgem, a regulator under siege, it’s a further blow. As Brough says: “The opposition Labour Party has promised to abolish Ofgem if elected and replace it with a tougher energy regulator. However, the current government and National Grid have already taken over wholesale markets with Contracts for Difference and the capacity auction, while the CMA is reviewing wholesale and retail energy and now network regulation. Ofgem now appears to be fully emasculated.”

Ofgem’s handling of the price review was thrown into further doubt with the allegation, contained in the ECC select committee’s report on network costs, that its fast-tracking of Western Power Distribution had cost that company’s customers £860 million. While WPD has escaped the CMA, the fairness of its settlement has now publicly been called into question.

With the entire utilities sector up before the CMA under three separate inquiries – energy retail, Bristol Water’s appeal against PR14 and now network costs – the authority holds all the cards. Last month, it advertised for a new sector specialist for utilities. Perhaps it should hire two.