Regulating the new normal

Operating in a price controlled industry can leave little room for manoeuvre if an unforeseen event - such as a global pandemic - impacts the whole economy. Ofwat and Ofgem have urged companies to focus on customers, staff safety and essential work without worrying about regulatory implications. Colm Gibson and Adam Mantzos of Berkeley Research Group examine the regulatory mechanisms and options available for utility companies

Every company in the economy is likely to experience cost revenue impacts from coronavirus. Once things return to the “new normal”, the hope is that our strong market-based economy will rebalance itself, and prices will adjust to ensure that companies can survive and recover their financial health.

However, most, if not all, regulated utility companies charge prices that are tightly constrained by price caps set by their economic regulators. In contrast to most of the economy, these price constraints do not automatically adjust to reflect coronavirus costs. It will be necessary, therefore, for companies to make use of one of a number of regulatory mechanisms, or to fall on the mercy of their regulators to make allowances.

It is particularly important for utility companies to:

• identify and forecast the short, medium and long-term impacts of coronavirus on costs, revenues and performance outcomes;
• understand the regulatory options available to them to deal with those impacts; and
• ensure that the relevant evidence is collected, collated and checked to ensure it is in the right format and to the right standard to access those regulatory options.

Immediate cost and revenue impacts

There are a number of potentially immediate impacts on regulated companies, including:

• reduced revenues, mainly as a result of business and household customers conserving cash and not paying bills;
• increased operating costs in terms of covering for people who are self-isolating, additional PPE, adopting priorities specified by regulators, the costs of social distancing in the workplace, and potentially a cost of home working;
• increased regulatory penalties and/or reduced regulatory performance rewards that would ordinarily result from a reduced ability to deliver performance outcomes in these conditions; and
• reduced short term capex spend, as many capital projects face significant delays or have come to a halt due to labour shortages and disruptions of supply chains as a result of delays in equipment manufacturing and transportation embargoes.

There may well be other costs for individual companies, such as voluntary rebates, free services or subsidies for NHS staff and other key workers, increased requests for social tariffs and additional support for community funds.

For companies with significant capex programmes that get delayed as a result of coronavirus, it may be that in the very short term, the lower capex may well outweigh the other costs – so, interestingly, this may mean that some utility companies will exit the period of lockdown with more cash than they started. However, smaller independent “last mile” network companies that don’t have material capital expenditure programmes, may be put under increasing financial pressure even in the short term.

There are some mechanisms already in place to help companies, as certain changes can be accounted for automatically (at least partially) in some existing regulatory frameworks – such as through a revenue correction mechanism, capex incentive scheme or totex sharing mechanism. Regulators have signalled that they will take some coronavirus impacts into account, for example, by not imposing performance penalties for failing to meet company performance targets, and/or by allowing revenue adjustments for deferral of expenditure.

Further impacts

Whilst there is no doubting the good intentions of the regulators, companies can be subject to significant cost and revenue impacts that will not be picked up – either because they are simply not addressed (such as the impact on credit ratings or a future windfall tax, industry specific inflation such as demand-based costs rising for suppliers or skills, or the impact of a recession caused by the lockdown), are only partly covered by an existing mechanism or because evidential requirements are unclear. For example:

• How can regulators distinguish the extent to which a capital programme is delayed due to coronavirus as opposed to other factors?
• To what extent do companies need to be able to demonstrate that they could not deliver, rather than simply decided not to deliver, as a result of coronavirus?
• To what extent are out-turn bad debt levels attributable to coronavirus?

It seems likely therefore that there could be a material residual exposure, and companies will need to consider whether additional regulatory mechanisms need to be deployed, such as interim determinations or direct approaches to their regulator or government.

Types of remedy available

The regulatory remedies available depend upon the details of companies’ regulatory frameworks, and where they are in the regulatory cycle. Broadly speaking companies fall into one of five categories:

• rejected a recent price control determination and referred it to the CMA;
• not due a price control for some time;
• in the final stages of a price control process;
• near the end of a regulatory period; and
• simple price caps, or prices capped relative to a larger incumbent.

Rejected a recent price control determination and referred it to the CMA

For such appellant companies, the remedy is to ask the CMA to take the incremental coronavirus costs into account when redetermining the price control. Interestingly, the four water companies at the CMA have taken different approaches to the issue in their statements of case. Yorkshire Water dedicated the foreword of its statement of case to the issue, whereas it is only mentioned by Anglian Water’s document as not being a cause of financeability issues with the notional structure.

Not due a price control for some time

These companies that accepted Ofwat’s final determinations may need to make an application for an interim determination (IDoK). In the case of water companies, this will mean claiming either that coronavirus has caused a “Substantial Adverse Effect”, or, now that emergency legislation is in place, it might also be possible to use the standard IDoK process, as the legislation may count as a “Relevant Change of Circumstances”.

In the final stages of a price control process

Such companies, including electricity and gas transmission and gas distribution companies subject to RIIO-2 framework, as well as Royal Mail and BT, will need to collate persuasive evidence for their regulator to allow incremental costs to be taken into account in the final determination. They may also need to take a view on whether to ask for the price control to be delayed and the existing framework rolled over, notwithstanding regulators’ intentions to press ahead regardless.

Near the end of a regulatory period

Companies in this position, namely those subject to Ofgem’s RIIO-2 framework, will probably find it difficult to argue for an in-period adjustment, and will need to collate the evidence, in the same way as companies in the previous categories to enable their regulators to include the costs in the next price control, in due course.

Simple price caps, or prices capped relative to a larger incumbent

Such companies will need to approach their regulators and ask for a bespoke adjustment. Regulators will be unlikely to make a permanent change to price levels, so the proposal needs to be for a temporary mechanism to allow the incremental coronavirus costs to be recovered over a reasonable timeframe (to avoid price shocks). One option would be to include the incremental costs in a temporary, mini RAB or RCV, which funds additional revenue over and above the existing constraints (which can remain unchanged), until the RAB/RCV has run off.

Companies need the right evidence

Whether companies are simply planning to take advantage of the commitments already made by regulators, or are in one of the five categories above and need to make a specific regulatory claim, the evidence base has much in common (as does the required standard of proof). Established rules of evidence, such as those published by the CMA, and by Ofwat for its interim determination mechanism, tend to set out what is generally good practice for regulatory submissions of this nature and specify the usual tests that regulators apply to evidence submitted by companies.

The letters that Ofgem and Ofwat have published also contain significant suggestions as to the evidential requirements. Whilst, technically, it might be argued that they only relate to the issues covered by those letters, they undoubtedly have wider application to any claim for coronavirus-related costs. These are:

• the burden of proof falls on the companies (e.g. Ofgem uses phrases like “where … companies can demonstrate that …”);
• companies need to be able to show that they have balanced the interests of customers and shareholders (e.g. Ofwat states: “The industry has an opportunity to demonstrate its commitment to its public purpose by all companies providing effective support, compassionate treatment and clear advice to customers at this time”);
• companies need to make reasonable attempts to identify and adopt best practice (e.g. Ofwat “would like to see companies across the sector learning lessons from each other”); and
• impacts have to be genuinely attributable to coronavirus, and beyond the reasonable control of management (e.g. Ofwat states “This will require that companies can demonstrate how their operations have been impacted by COVID-19 and how they made their decisions”).

These are very much the requirements for any regulatory submission. However, whilst companies usually have a good understanding of the relevant facts and access to sufficient data, they can find it difficult to convince regulators that those requirements have been met. In our experience, this can be for purely presentational reasons, such as:

• inappropriate structure leading to a document being misinterpreted as biased;
• evidential documents assuming too much of the reader;
• documents being presented in a way that is frustrating for a busy, intelligent lay reader to navigate; or
• documents providing insufficient detail regarding the source and derivation of data for an intelligent reader to decide how much weight to place on them.

It will be important, therefore, that in addition to collating and validating the relevant evidence, companies need to ensure that the are able to present that evidence in a persuasive way.

Conclusions

There are substantial direct and indirect impacts on regulated companies from coronavirus. Regulators have shown some willingness to adjust price caps and ameliorate performance penalties to account for some – but not all – of the short-term impacts, but have typically remained quieter on the – potentially very significant – medium- and long-term impacts. Companies will need to present compelling evidence to take advantage of the offers regulators have made, and will need to press regulators for further concessions to deal the medium and longer-term impacts. All companies should expect regulators to test claims for short, medium or long-term coronavirus impacts rigorously before any allowance is made.