Gas networks push for higher returns to compensate for shutdown risks

Gas networks have pushed Ofgem to set a higher rate of return for their investors to reflect the perceived risk that they may be unable to recover their investments due to the electrification of heating.

Responding to Ofgem’s consultation on the methodology for the RIIO3 price controls, Cadent warned that without “a clear and unambiguous commitment” from both the government and Ofgem, “there will be an investor perception that the allowed revenues that we are entitled to recover may be at risk”.

“The suite of pathways towards and past 2050 is wide-ranging with uncertain probabilities of each of them materializing,” it explained.

“However, no matter which one of them plays out, there’s no possible opportunity to over-recover income, but a non-zero probability of a downside for investors in gas networks.

“This has created an asymmetric risk, which is perceived and priced in by investors today, but which is unremunerated within the current framework.”

Cadent welcomed Ofgem’s assurances that gas networks will be able to fully recover their regulatory asset values (RAVs) if some of them are shut down due to the electrification of heating. But it said this risk cannot be “regulated away” through accelerated asset depreciation unless this is underpinned by a firm agreement between Ofgem, the government and networks.

While acknowledging that this is outside the scope of the price control process, Cadent urged Ofgem to work with the government and networks to reach such an agreement, “thus mitigating the risk which will ultimately be in the long term interests of customers.”

It said there is already evidence that asset stranding risks are affecting the cost of both debt and equity investment: “European comparators and debt market cross checks point to a premium being applied today that needs to be included in the assessment of an appropriate cost of capital.”

Cadent was responding to the sector specific methodology for the RIIO3 price controls for transmission and gas distribution, which are due to begin in April 2026.

The company has raised concerns over the proposed calculation of the equity beta – a measure of the risk to shareholders of a particular company or sector in comparison to the market average. The equity beta is one of three inputs in the calculation of the cost of equity under the Capital Asset Pricing Model – the others being the risk-free rate and total market returns.

In line with the methodology for the RIIO2 price controls, Ofgem has proposed to estimate the equity beta for energy networks based on the observed returns of National Grid and the three listed water companies in the UK – Severn Trent, United Utilities and Pennon Group.

For the RIIO2 price controls, Ofgem decided not to distinguish between sectors when calculating the equity beta, but the regulator has said this could change for RIIO3.

Cadent said the set of companies used to estimate the equity beta is “too limited given the strategic pivot from National Grid away from the gas sector in light of net zero risks”.

National Grid sold its remaining stake in Cadent in 2019 and recently confirmed its intention to offload its remaining 20% stake in National Gas Transmission this year. Both were formerly wholly owned by the group.

“As there is currently no UK listed equity with gas transmission or distribution included, it is even harder to be confident that the beta estimate is accurate,” Cadent argued.

The firm cited a report commissioned by the Energy Networks Association and submitted as part of its response to the consultation, which found that the equity beta is higher for gas networks than for electricity networks when analysing companies in Italy and Spain.

Cadent said the report, which was produced by the consultancy Oxera, also found “an observable gas premium” when comparing the debt costs of gas and electricity networks.

“The beta estimate should include a premium for gas risks and this can be validated through appropriate analysis of European comparators and the observable cost of debt,” it concluded.

If National Grid continues to be used as a comparator, Cadent said “more weight should be applied to the 10-year window which contains the gas-specific risks when Cadent was a part of their asset portfolio.”

These concerns were also expressed by other gas networks such as SGN, which said: “Cash-flow remedies, such as accelerated depreciation and re-openers, which Ofgem is considering using to address the asset stranding risk in RIIO3, do not eliminate the risk.”

The company said this risk should be addressed either “directly through a RAV guarantee” or through “an appropriate uplift” to allowed returns on equity. It said compensation for asset stranding risk would not represent a “double count” if a RAV guarantee is not implemented: “It would be a compensation for the risk not mitigated by a change in depreciation policy “

It cited France and New Zealand as “two examples of countries where both depreciation policy changes and a cost of capital uplift or ex ante allowance have been implemented to address the asset stranding risk.”

In its response to the consultation, Citizens Advice said “it’s not appropriate or necessary to increase allowed returns on capital in compensation for this perception of increased risk to the long-term value of the RAV”.

The charity said this risk is only perceived rather than actual: “The uncertainty is simply over what route will be taken to ensure investors receive the return for which they had legitimate expectations.”

“Ofgem should explore with government what assurances can be provided to negate arguments over asset stranding risk,” it added.

Former Ofgem partner Maxine Frerk will address the wider responses to Ofgem’s consultation in her next column exclusively for Utility Week members, available next week