Network operators ‘cannot justify’ budget increases requested for RIIO2

The challenge group created by Ofgem to scrutinise network operators’ business plans has said the companies cannot justify the additional £4.1 billion of non-load-related expenditure they have requested for the RIIO2 price controls beginning in April 2021.

The majority of the increase was requested by the electricity transmission networks. National Grid Electricity Transmission (NGET) and Scottish Hydro Electricity Transmission (SHET) – the transmission arm of Scottish and Southern Electricity Networks – were judged to have the least convincing plans of those submitted to Ofgem in December.

National Grid Gas Transmission (NGGT) and National Grid Electricity System Operator (ESO) also requested large increases in non-load-related expenditure.

“After stripping out expenditure related to the load on their systems, the companies are asking for an additional £4 billion of expenditure compared to RIIO1, representing around a 20 per cent increase,” the challenge group stated in its report. “We don’t think an increase of this size has been, or indeed can be, justified.”

According to the document, the decarbonisation of the energy system will require a large boost in spending on the power grid, but this is not a major factor in their plans, “which are still based to a large extent on business as usual”. It said there is still room for “significant improvements” in cost efficiency.

Comparison of non-load-related expenditure between price controls

The quality of the initial business plans submitted in July was “generally low”, with “gaps in the information provided and insufficient justification supporting the expenditure figures”.

The revised drafts submitted in October showed mixed levels of improvement, “although they were all still incomplete to a greater or lesser extent, and there was significant variability across the companies.” Some companies did provide “a great deal” of new information in December but the challenge group was left with “little time” to assess it.

The best business plans were ultimately assessed to be those from Northern Gas Networks (NGN), SGN, Wales and West Utilities (WWU) and SP Electricity Transmission (SPT), which provided “clear evidence” of the cost efficiencies they expected to achieve over the first RIIO period and convincingly demonstrated how they would be carried over to the second.

By contrast, the challenge group said that despite concerns they are actually the result of a generous settlement, it is “unconvinced” that the efficiency gains implied by the forecast underspend for NGET over the first RIIO period have been carried over. It expressed fears that already funded asset health expenditure has been deferred into RIIO2.

It likewise said the evidence to support the efficiency of their forecast spending during RIIO1 was “generally of poor quality” for SHET and “limited” for both NGGT and Cadent.

Business plan quality ratings

The group highlighted particular concerns over £3 billion of proposed spending on IT systems, including £2 billion by National Grid companies.

The report explained: “While some increase may be justified for the ESO and for cyber security, we think this increase of expenditure is not what we would expect for these mature businesses, where assets and activities are relatively unchanged between price control periods, and with downward cost drivers from efficiency and reducing demand.”

Ofgem is planning to drastically reduce the cost of equity – the baseline profit margin for shareholders – after judging the current settlement to be too generous. Its latest indicative figure for the real cost of equity is 4.8 per cent. This rate is based on the CPI-H measure of inflation it intends to adopt and was calculated using the methodology confirmed by the regulator in May 2019.

The challenge group said: “Despite vigorous protestations from every company, none has persuaded us that Ofgem’s working assumptions for the cost of capital make their businesses unfinanceable.”

Business plans were “almost entirely” focused on lobbying for a higher rate and there was “little evidence that the companies had actively sought to achieve financeability”.

“Most companies explored the sensitivity analysis which they had performed in some detail but failed to use that information to support an appropriately nuanced and considered approach to financeability,” the report added.

It said network operators had failed to properly justify their across-the-board targeting of a credit rating greater than BBB as they were told would be necessary.

The business plans submitted in December envision £13.7 billion of spending by transmission networks and £10.7 billion by gas distribution networks. The electricity distribution networks are operating on a delayed timetable, meaning they will not submit their final business plans for another two years.