Mixing energy and water

In the latest of a series of articles exclusively for Utility Week members, Maxine Frerk – former senior partner networks at Ofgem – gives her view on the price control processes across the utilities sector. She examines the themes emerging from the PR19 appeals and what read across we can identify for the price reviews in energy.

Perversely, the most significant event in energy regulation last month was the decision by four water companies to appeal Ofwat’s PR19 price control decision.

Energy networks have been waiting with anticipation to see whether water company appeals might help them in pushing back against what is seen in both sectors as a focus on short-term politically-driven price cuts at the expense of future consumer interests. But how much of a read across is there?

At this stage it is still not totally clear where the battle lines lie in water. When presented with the price control decision in water all the companies have to do is say “no” and it is then over to Ofwat to refer the matter to the Competition and Markets Authority (CMA) setting outs its arguments as to why its proposals are in consumers’ interests. It is only then that the companies have to reveal their hands and to set out what their concerns are.

The CMA’s job is then, in effect, to re-determine the whole price control for each of these four companies – although in practice they will tend to focus on the more contentious areas. As past experience shows, this sort of appeal can lead to the company being worse off than they were before – but no doubt they will be hoping that in the current context this is unlikely.

The companies’ press releases (and subsequent interviews and comments) give some flavour of the range of issues that will be raised.

Anglian had the biggest gap between its proposed investment and its allowance and said that customers want it to invest now. Northumbrian argues its settlement is contrary to the best interests of customers and does not provide for sustainable investment, including for what customers say are priorities around reducing the impacts of climate change in the region. Yorkshire talks about the risks to long term resilience and to customers, with the incentive structure forcing it to focus on short term performance at the expense of long-term investment. And finally for Bristol the main issue is how its finance the business.

These are all issues that are very live in the RIIO2 debates, which is why there is significant interest in the water appeals from those in the energy sector.

Cost of capital precedent

But will any findings from the water appeals read across into energy? The first point is that – again somewhat perversely – a decision by the CMA on the cost of capital in these appeals would be potentially more helpful to the energy sector than it would be for the other water companies who have accepted the control and now must live with it for the next five years.

In RIIO ED1, Ofgem shifted late in the process to take on board the CMA decision that set a lower cost of capital in the Bristol Water appeal. As a result, the electricity distribution companies already face a lower cost of capital than transmission or gas distribution – a point that is often overlooked in discussions about energy networks returns.

However, aside from questions of timing (which might limit Ofgem’s ability to take anything on board for transmission and gas distribution) it is important to remember that the appeals regime is different between the sectors.

While in ED1 it may have suited Ofgem to go for a lower cost of capital with the CMA decision providing back-up to its decision, it would remain open to Ofgem to stick with a lower number this time even if the CMA went for a higher figure in water. The test that the CMA have to apply on energy appeals is whether the decision is “wrong” (ie outside the bounds of what a reasonable regulator might decide). That is different to water, where they have to come up with what they think the “best” answer is – and that does give Ofgem some leeway to stick with a different figure if it wanted to – provided it had good arguments for so doing.

More broadly, while the themes that are likely to be central to the water appeals will resonate strongly with the energy networks, they are very context and fact-specific so it is not clear that there will be any crossover – although all sides will be carefully reading between the lines of the final CMA decision for helpful quotes.

What does it mean for customers and investors?

Of particular interest to me is what influence the consumer voice has in the process. Both Ofwat and Ofgem have talked about the importance of consumer engagement and have required companies to establish Customer Challenge Groups in water and Customer Engagement Groups in energy. In an appeal between the company and the regulator it ought to matter what customers themselves have to say on the matter in hand – and these groups were set up to ensure that voice was heard (and accurately reflected) in the business plan.

One concern aired by water companies is that Ofwat is ignoring this critical input in taking its decisions. I don’t know how far that is a fair criticism but I am well aware of the risk that regulators can get caught up in their own analysis and lose sight of the consumer as the price control process moves forward.

I hope the CMA does give due weight to the CCG views in the water appeals, or that tendency will be reinforced and we may as well say goodbye to what I believe is an important regulatory innovation.

Finally, the appeals do signal a shift in investor attitudes – wanting to see the companies stand up to the regulator. This machismo is likely to spill across into energy and increases the likelihood that RIIO2 will see a proliferation of appeals.

This was already a risk given that in energy appeals the companies can “cherry pick” the individual issues where they have the strongest arguments and – unlike in water – can’t end up with a worse outcome than they went in with. The only costs in appealing are the legal fees and management time and distraction – though these should not be ignored. Ofgem did try in its original RIIO2 framework consultation to find ways of creating some disincentives to appeal but I suspect found that this was legally too difficult to do.

So, whichever way the water appeals go (and probably almost regardless of what Ofgem does) I think we can expect to see a similar flood of appeals in energy. And in the meantime the sport of “CMA watching” will keep regulatory experts well occupied over the coming year.