‘No nasty surprises’ in ED2 final determinations

Electricity distribution networks are unlikely to follow in the footsteps of the other energy networks in appealing their RIIO2 final determinations to the Competition and Markets Authority (CMA), an industry expert has told Utility Week.

While qualifying that you should “never say never,” Investec senior analyst Martin Young said his gut feeling is distribution network operators (DNOs) will want to “move on” given there were “no nasty surprises” in the final determinations.

Young said the main changes between the draft and final determinations were all beneficial to DNOs, with Ofgem raising the cost of both equity and debt, significantly increasing total expenditure (totex) allowances, and boosting rewards to make the incentive package more balanced between potential upsides and downsides.

Although still down by almost a third when compared to the current price controls, Ofgem increased the cost of equity from 4.75% to 5.23% in real terms based on the CPIH measure of inflation.

Young said this was “just a mechanical update,” reflecting the change in macroeconomics conditions since the draft determinations, specifically a rise in the risk-free rate of return expected by investors as gauged by observed yields on index-linked gilts.

“The cost of equity is mechanical but it’s mechanical within a range so you could theoretically have had a situation whereby Ofgem could turn around and say we’ve updated our macro inputs but we’ve repositioned ourselves within the range of outcomes, and obviously they haven’t done any repositioning on the cost of equity within the range of outcomes,” he explained.

Young said the one change where there was an “element of surprise” concerned the cost of debt, which Ofgem boosted from 2.32% to 3.07% for most DNOs. This increase included a 55 basis point “calibration adjustment” to the underlying foundation for the allowance – a 17-year trailing average of an index of utilities’ debt costs.

He said an adjustment was needed given the recent rise in interest rates and the expected uptick in investment by DNOs over the ED2 period: “The sector is likely to have more need to raise debt in the next five years than it has done in prior years which basically means the idea of this simple average has its weaknesses”.

Meanwhile, the incentive range has got “a little more on the positive side,” with Ofgem raising the maximum rewards available through the DSO and Interruptions Incentive Scheme output delivery incentives by 20 and 50 basis points respectively. This will leave DNOs with an overall range in terms of returns on regulatory equity of -4% to +2.65%.

“Technically there is still a bigger downside than upside,” added Young, “but I think they’re at pains in the documentation to point that doesn’t necessarily mean they are more likely to be negative than positive. That’s another small positive shift.”

Furthermore, Ofgem has raised totex allowances across the sector by more than 6% to £22.2 billion.

Young acknowledged that some of this expenditure may have been disallowed by the regulator at the draft determination stage on the understanding that it would ultimately be approved once networks had presented further justification. Nevertheless, he noted that this increase is significantly more than the 1% boost in allowed totex between the draft and final determinations of the slow-tracked DNOs for the ED1 price controls.

Overall, Young said the ED2 final determinations suggest a change in priorities for Ofgem from minimising costs and clamping down on network profits to making sure networks do not become a blocker for the decarbonisation of the energy system: “If you look at the regulatory approach in recent years, it’s been to push down on totex, it’s been to push down on returns. I think the name of the game, both in energy and water, has changed. It’s about bringing forward what is needed.”

“There’s a huge amount of work that need to be done and I just feel like we’ve got a price control here that is taking a constructive direction,” he added.