Ofgem seem to be pushing energy networks’ buttons – but they could be braver

Steve Horne, principal policy manager at Citizens Advice, outlines the charity’s response to Ofgem’s draft determinations for the RIIO2 price controls and calls for further cuts to networks’ profits.  

Energy networks have been in the news this week pushing back on Ofgem’s proposals for the new set of energy network price controls due to start next year. These companies are responsible for the infrastructure that transports gas and electricity around Great Britain and into homes and businesses. This process determines how much they are allowed to charge us over the next five-year period. It’s worth billions of pounds of consumers’ money.

The networks argue that Ofgem has set the level of revenue they can collect too low. Some have even claimed it will put net zero and the green recovery in jeopardy and raised the risk of blackouts? These arguments are not new for monopoly providers. They want to achieve the most generous settlement possible. But what does this debate mean for people?

There are three key parts of the price control decisions which are important, and hold the key to answering these questions:

• The cost of funding investment (the cost of capital)
• How much it costs to run the networks (baseline costs)
• Making sure funds are available for net zero

Each of these three areas require billions of consumers’ money to be spent over the next five years. Here’s what we are recommending to Ofgem:

Getting the level of rewards right

This is one of the areas that matters the most to consumers but is also one of the most complex. The key thing is that small changes in the assumptions that make up these costs can translate into millions on bills.

In 2017, we found that energy networks were making £7.5 billion in unjustified profits due to errors by the regulator. The majority of this came from the cost of shareholder investment, normally referred to as the cost of equity and the cost of borrowing from the debt markets, otherwise known as the cost of debt.

Under its current proposals for the next price control (RIIO2), Ofgem has so far cut the proposed returns of energy networks by half, saving consumers £3.3 billion in the gas and transmission sectors alone.

Companies themselves have said they may accept a lower cost of capital than RIIO1, but this isn’t the same as accepting Ofgem’s proposals.

In fact, we think Ofgem can still go further. The calculations are really complex but done correctly, making changes to key assumptions in the cost of equity (equity beta – or how risky companies are – and the total market return) could save consumers £1.7 billion over the course of the price control.

An alternative, separate to the cost of capital assumptions, would be a greater adjustment to the cost of equity for expected outperformance of -1.60 per cent that would reduce allowed returns by up to £1.2 billion.

Agreeing the funding for the day job

Ofgem has pushed down hard on energy networks’ business as usual costs. These are the costs of maintaining the existing network and running the business on a day-to-day basis. We would expect Ofgem to do this as companies become more efficient after each price control period and so costs for consumers should consistently come down as a result.

In the business planning phase, Ofgem asked companies to put together plans for the funds they need for the next five years. The quality of these plans varied. Some of these plans were better than others. This is consumers’ money and ultimately Ofgem bears the responsibility of making sure the level of funding will meet all our needs. Ofgem’s proposals in the draft determinations gives us the first view of how confident they are about these costs.

Networks have responded aggressively to Ofgem’s proposals. National Grid have even suggested that the lights could go out as a result, despite the fact they are set to underspend on asset health (e.g. maintenance) by a third (£2 billion of the £6 billion Ofgem approved) for the current RIIO-1 price control period. It’s imperative that consumers’ money is spent well. National Grid has submitted 22,000 pages of evidence to Ofgem. But this really has to be about quality, not quantity. If networks haven’t provided adequate justification for their spending plans, it’s only right that Ofgem doesn’t approve them. Where networks are worried that the level of funding isn’t right, it’s up to them to provide the hard evidence that funding should be higher.

Getting net zero investment right

Networks have a key part to play in delivering net zero, and Ofgem has made net zero an important part of the RIIO-2 price control. A massive £10 billion worth of funding has been kept aside and a process of “uncertainty mechanisms” and “re-openers” should make funds available when these are needed. Although this would add costs on bills, the right money invested now can lower bills in the future. The idea is that when something happens, for example a change in government policy, this triggers one of these mechanisms — opening up this funding.

There are some drawbacks. Ofgem has not required companies to provide a clear pathway to net zero or modelled how to reach net zero. The use of these mechanisms in the middle of the price control could be a significant administrative exercise. There’s a risk that some very specific re-openers could be too restrictive and prevent more effective solutions that are identified later.

Some networks have argued that some of the money should be made available up front. Where there is good evidence, we support this. But it’s in consumers’ interests for their money to be spent appropriately. It’s irresponsible to provide this money up front or to invest it where the need for more investment may never actually occur so it’s prudent to wait. In fact, our evidence says that the impact of Covid-19 and consumer protections required around net zero mean there are good reasons to wait.

This is also a balance. Where networks say this money needs to be provided quickly, they are right. Once we’re confident of what a company needs to spend to meet their net zero commitments, the funding process should be as efficient as possible. But it also needs to be robust, and make sure that the proposals are value for money. We think networks will need to continue to consult with stakeholders and engage with consumers to make sure that their proposals are the right ones.

So, yes, in our view Ofgem can reduce the known costs of networks – the cost of capital and the baseline costs – but by its very nature addressing net zero is less certain. We know there will be additional costs but we can’t be sure what these will be yet. What we can be sure about is the need, in the current context, to make sure now more than ever that consumers get value for money. Ofgem has moved things in the right direction, but there’s still more to do around net zero.

Stew Horne, principal policy manager, Citizens Advice