Ofgem sets outs plans to rein in network profits

Ofgem has proposed a series of changes to the way it sets spending allowances and financial incentives for energy network operators in an effort to rein in profits.

The regulator has launched a consultation on its plans for the second round of RIIO price controls starting in 2021 which it expects to reduce the average household energy bill by around £20 per year.

Most notably, Ofgem has suggested a massive reduction in the cost of equity – the baseline rate of return which it considers necessary and sufficient to attract investment – to between 3 and 5 per cent. Over the first RIIO period it ranged between 6 and 7 per cent.

Ofgem is also exploring changes to the way it calculates the cost of debt.

The consultation comes as networks face growing public scrutiny over their earnings, which have substantially exceeded baseline returns. A report published by Citizens Advice last year concluded network companies are set to rake in £7.5 billion in “unjustified profits” over the current price controls.

In January, a group of MPs called for Ofgem to be scrapped if it fails to curb network profits in future, whilst business and energy secretary Greg Clark accused distribution network operators (DNOs) of becoming “fat and lazy” at the expense of consumers.

Explaining the proposals for RIIO2, Ofgem senior partner for networks Jonathan Brearley told reporters: “The evidence is telling us investors around the world value stable assets and stable regulatory regimes, and Ofgem is delivering one of the most stable in the world. This has resulted in us being able to say to investors they should invest at the lowest ever cost of equity.

“We’re bringing cost of equity to a level of between 3 per cent and 5 per cent, and we’re also proposing changes to the way we set the cost of debt. We think these proposals will result in savings of around £5 billion over five years, which results in around £20 off of the typical household bill”.

Cost of capital

The cost of debt is currently calculated on the basis of a trailing average of market rates over the previous decade. The consultation document says the introduction of indexation for the first RIIO period has “worked well” and Ofgem is inclined to stick with the status quo.

But it also concedes that in “most cases” the actual cost of debt for network companies has been “lower, sometimes significantly,” than the regulator’s benchmark index.

Ofgem has therefore put forward three potential options to improve the process further: recalibrating the existing indexation policy; implementing a fixed allowance for existing debt, whilst retaining indexation for new debt; and implementing a pass-through allowance for all debt.

It has also floated the idea of introducing indexation for the cost of equity.

Business plans

Another area where Ofgem is considering reforms is the process for evaluating the accuracy of network companies’ business plans.

Under the present arrangements, business plans undergo an initial assessment by Ofgem and those which pass muster are fast-tracked. Networks which are fast-tracked are awarded a lower “sharing factor”, meaning they get to keep a greater proportion of any underspend against their allowance.

The networks which are slow-tracked are required to submit revised business plans which are then used alongside Ofgem’s own cost estimates to calculate the information quality incentive (IQI) benchmark. Slow-tracked networks are assigned their sharing factor based on the difference between their business plans and the IQI benchmark.

According to the consultation document, network companies have “systematically given forecasts that turn out to be significantly above their actual costs”. Given the scale of the underspend, it says it is “very hard to conclude that the IQI was effective in its primary purpose of getting companies to reveal their best view costs, despite the incentive that it offered.”

“Instead, companies may have considered the gains from inflated forecasts (and their potential influence on our baseline view of costs) would be greater than any foregone IQI rewards,” it adds.

Ofgem has proffered three potential solutions: amending the IQI across all sectors; removing the fast-tracking route for distribution; or replacing both the IQI and fast-tracking for distribution with a “single business plan incentive”.

Despite the problems detailed in the document, Brearley denied the current process had failed: “What we are trying to do is actually maintain what we think is a very good incentive in fast-tracking, which encourages companies to compete with each other.”

He continued: “It is clear that the incentives have worked. This is about building on what we have and making sure we continue to drive incentives to get the right business plans in”.

Helen Poulter from the Exeter Energy Policy Group has previously told Utility Week that the lack of sufficient incentives for accuracy has allowed DNOs to “game the system”.

‘Failsafe’ mechanisms

As a further measure to ensure network profits do not exceed expectations, Ofgem has additionally proposed five options for “failsafe” mechanisms. They are:

• Implementing a hard cap/floor which restricts returns from rising above or falling below pre-determined levels.
• Making discretionary adjustments based on conditions specified in advance.
• Introducing constraints on total expenditure (totex) and output incentives. Totex incentives could be “sculpted” so that consumers receive a greater share of any underspend the more a company’s actual spending deviates from its allowed expenditure. Meanwhile, output incentives could be set on a “zero-sum” basis, whereby networks would be judged against the average performance of the sector. Those performing above average would earn a reward and those performing below average would be penalised. Alternatively, companies could compete against each other for a share of a “fixed pot” of rewards.
• Applying sharing factors to regulated returns on equity, thereby extending sharing factors to include all incentive payments.
• Anchoring average sector returns to a pre-determined range. If the average exceeded this band then network companies would be forced to refund consumers by an appropriate amount.

Brearley said Ofgem does not yet have a preferred option: “This is an area where we think more detailed work needs to happen.

“The principle behind this is that we are in a very fast changing energy market and we are in a very fast changing financial environment.

“So therefore, what we want to do is set some very clear rules up front that say to investors: ‘Look. If these things deviate from what we expect there is some way that is clear and predictable to bring them back to where they should be’.”

The deadline for responses is 2 May 2018.