PR19 – Reasons to be cheerful for energy network CEOs?

Four water company chief executives will have been breaking open the champagne last week following the Competition & Markets Authority (CMA)’s provisional findings on their business plans, while a few others will have been kicking themselves for not being on this particular bandwagon. But, what does the CMA’s response mean for the energy networks who have put in their responses to RIIO2 draft determinations and are awaiting the final determinations in December?

As I argued in a previous article, there is not an automatic read across from water. The legal frameworks for appeals are different – in energy the bar is set high and the CMA has to conclude Ofgem is “wrong” on specific points – ie outside the bounds of what a reasonable regulator might decide – whereas in water the CMA is re-determining the whole price control and deciding what its would do in Ofwat’s shoes. In addition, the panel structure at the CMA means that precedents aren’t binding.

That said, regulators will normally pay a lot of attention to principles coming out of the CMA and the energy companies will be scouring the 800 pages for points that might help them in an appeal.

The most obvious area is on the cost of capital. The CMA has always been seen as the arbiter on this issue and for example during the RIIO ED1 process, Ofgem shifted its proposed cost of capital sharply downwards following the then Competition Commission’s provisional decision on NIE.

Will Ofgem follow suit this time? At first blush, it doesn’t necessarily have to – the CMA has come up with a range and Ofgem could simply say it has chosen a different point in that range. But it would still need a good reason for doing so.

The CMA argues for “aiming up” on the cost of capital given the uncertainty around the right figure – that the “well established” long term detriment to consumers from too low a figure and the resultant underinvestment is greater than the detriment from customers potentially over-paying. The asymmetric nature of the incentives in water is another reason given for upping the equity return. In contrast, Ofgem is still arguing for a reduction in the cost of equity through an “outperformance wedge” while also proposing a range of penalty-only incentives. While Ofgem doesn’t have to simply take the cost of capital figure the CMA has come up with for water, it will need to be broadly aligned in terms of approach and that almost certainly means a higher figure than at draft determinations.

Efficiency gains

What else can energy companies pick up on?

Efficiency is another obvious area. One bone of contention in GD2 has been the use of the 85th percentile as the benchmark for efficiency, setting a tougher standard than the usual upper quartile metric.

The CMA has made clear that the decision on the appropriate threshold should essentially be tied to how confident one is in the underlying econometrics (so you can be sure that what the model finds as efficiency is not just modelling error).

In water the CMA pulled Ofwat back to upper quartile. Given the major concerns being raised about the quality of Ofgem’s modelling – and the fact that time pressure means it has this time only used one model not two – it feels like it would be hard for Ofgem to defend the use of anything more than upper quartile. And then on the annual efficiency gain (“frontier shift”) the CMA has gone for 1.1 per cent per annum (pa) in contrast to Ofgem’s proposed 1.2 per cent pa for capex / repex and 1.4 per cent pa for opex. Of course, there may be good arguments why energy is different – the level of innovation spend in past years being one – but Ofgem would need to make that case.

The other areas of big concern for the energy networks are the level of anticipatory investment allowed on transmission and repex on gas distribution – both areas that are important for de-carbonisation.

Obviously, there isn’t the same read across here, but the CMA did allow several specific “enhancement” projects on water put forward to address resilience issues. In 6 out of 8 cases the CMA allowed some or all of the extra spend noting the clear link to Ofwat’s duties on resilience and simply taking, say, 10 per cent off the cost forecasts where the need was clear but the costs were uncertain. E

nergy will be different but companies could expect a receptive hearing if they can make a clear case linked to Ofgem’s duty around reducing greenhouse gas emissions.

Of course, Ofgem’s defence in this area will be that it has allowed funding through uncertainty mechanisms. The analogy there is with the costs that Anglian sought for tackling a pollutant (metaldehyde) where the environmental legislation was uncertain. Ofwat had proposed a re-opener that Anglian could trigger subject to materiality thresholds. The CMA is proposing a base allowance with a claw back. Obviously, this is very case specific but will be worth the networks studying.

A missed opportunity on engagement

The big disappointment for me was the debate around how much weight should be given to customer evidence in setting the price controls. The companies had raised Ofwat’s disregard for consumer views as a ground for appeal and the customer challenge groups gave their support on a number of points.

This seems to have had little impact on the CMA’s own considerations. It makes clear that it sees consumer research and engagement as a valuable part of the process but then cautions against an over reliance on willingness to pay in areas outside customers’ direct experience, for example.

While I can’t disagree with the panel’s line on the specifics it didn’t feel as if they were looking for ways to reinforce the importance of consumer engagement more broadly. But hopefully that won’t deter Ofgem from doing the right thing in this space.

Finally, the PR19 appeals don’t touch at all on process. That is a result of the different appeal regimes. But questions of process have been raised on the RIIO2 determinations given the number of errors identified in the models and the lack of any opportunity to comment on corrected numbers. The lack of any procedural points in water does not mean that they won’t be a feature of any energy appeals.

Looking across the piece then there are good reasons for energy networks to feel optimistic that if they appeal Ofgem’s final decision they will get a fair hearing from the CMA.

They might also reasonably hope that Ofgem will study the CMA decision closely and at least seek to avoid some of the obvious pitfalls.

The challenge for Ofgem is that wanting to be tough isn’t enough in the context of a CMA appeal – you have to have done your homework and have the detailed evidence to support your decisions.

Ofgem has put some effort into trying to avoid the problems of a “cherry-picking” appeal by highlighting interlinkages and the need to look at the issues in-the-round. The water appeals are in-the-round but what they show is that that is not a panacea. The important thing is getting the individual elements of the decision right in the first place.

Ofgem hasn’t got long to digest all the responses to the draft determinations as well as the CMA decision. It has a real challenge on its hands.

Maxine spent 15 years at Ofgem, latterly taking on responsibility for all aspects of the regulation of distribution networks. Since leaving Ofgem she has been working as an independent consultant for a mix of regulated company and consumer / community group clients.