Regulatory appeals should be ‘harmonised’ between energy and water

Former Ofgem chief executive Dermot Nolan has called for the appeals processes for price controls in the energy and water sectors to be “harmonised in some fashion”.

Nolan, who is now a director at the regulatory consultancy Fingleton, was responding to the Competition and Markets Authority’s (CMA) decision this morning (17 March) on the appeal of four water companies against Ofwat’s final determinations for PR19.

The CMA set the weighted average cost of capital for the four water at 3.2 per cent in real terms based on the CPIH measure of inflation.

This is lower than the 3.5 per cent proposed by the CMA as part of its provisional findings in September but remains higher than the 2.96 per settled upon by Ofwat in its final determinations. The equivalent figure for the previous regulatory period is 4.7 per cent.

Speaking at Utility Week’s Investor Summit this afternoon, Nolan said the appeal has highlighted the need to align the processes between energy and water. All of the transmission and gas distribution networks are appealing their final determinations for the RIIO2 price controls starting next month.

Nolan said “it would be fair to say the water companies that did not appeal feel somewhat sore over the fact that they have a considerably lower cost of capital than those who did. And maybe that’s wrong but I think the whole appeals system itself may be looked at the by the Treasury in the coming years.”

“I think it’s been a very messy process,” he remarked. “I think it’s been much longer than the CMA wanted. It was originally talking six or seven months and it’s basically been a full year and I know it’s consumed a lot of CMA resources in a context where the CMA has stated it doesn’t want this function.”

Qualifying that ongoing Ofwat chief executive Rachel Fletcher is “a very good friend of mine”, Nolan said that when the CMA issued its provisional findings, “Ofwat threw it’s toys out of the pram and the CMA reacted”.

He said the CMA now seems to have “handed down the wisdom of Solomon in terms of choosing between Ofwat and the various appellants,” reaching a “form of compromise that is likely perhaps to avoid further appeals.”

“I think judging from Rachel’s comments this morning it doesn’t look like Ofwat wants to do it,” he added.

Nolan continued: “It does show in terms of the process in my view that frankly, not to put too fine a point on it, the process is a mess in terms of having two different appeals systems.

“We’re going to use an Ofgem appeals system with a different legal standard, a different type of test. Whenever investors would talk to me at Ofgem from abroad, they would say: ‘Why do you have a totally different system in this regard?’ I would look embarrassed, shrug my shoulders and say: ‘Well, I don’t really know. We just do.’

“But I think if anything the Ofgem appeals as they evolve over the next seven months will hopefully convince someone in government to say we need harmonise these in some fashion. I’m not saying that one system is better than the other – they have their pros and cons – but I do think investors look at this and say: ‘What the hell is going on. This is very confusing.’”

His comments were later echoed by Peter Antolik, a partner at Arjun Infrastructure Partners, who said: “It was a pretty bruising process between Ofwat and the CMA and as an investor, that doesn’t necessarily inspire confidence that these things are dealt with on an impartial merits basis.

“I heard Rachel Fletcher a couple of weeks ago bemoaning some of the statements made about Ofwat and it really seems to have been quite bitter behind the scenes and I don’t actually think that serves any of the industry really.”

He said Nolan was “absolutely right” that the different appeals processes for the energy and water sectors are “a bit of a nuisance.”

“As an investor what you really want is to just understand the rules of the game, to understand that the case will be considered on its merits,” he explained.

Antolik said the CMA’s decision to set the cost of equity 25 basis points above the mid-point of its estimated range to avoid the risk of underinvestment and Ofgem’s contrasting decision to set allowed returns on equity 25 basis points below its mid-point cost estimate to reflect the expected outperformance of energy networks both “feel fairly arbitrary in their nature.”

He said this suggests “the science doesn’t really support some of the approaches that are being taken and that’s a bit of a concern as an investor because you want to be able to see things and analyse them.”

The CMA’s new weighted average cost of capital figure of 3.2 per cent was derived from a cost of equity of 4.73 per cent and a cost of debt of 2.18 per cent based on a notional gearing level of 60 per cent.

In its final determinations in December, Ofgem estimated the cost of equity for transmission and gas distribution networks at 4.55 per cent but subtracted 25 basis points – the so-called outperformance wedge – to give an allowed return on equity of 4.3 per cent. The regulator recently proposed equivalent figures of 4.65 per cent and 4.4 per cent for electricity distribution networks whose price controls begin two years later than the rest in April 2023.

Unlike Nolan, who declined to give his predictions, Dominic Nash, head of European utilities research at Barclays Investment Bank, said he expected that the CMA’s decision on water appeals would feed through to the appeals by energy networks: “Underlying that 4.73 per cent real cost of equity that came this morning, there are ranges on betas, there are ranges on risk-free, there are ranges on total market returns, and I think when you take those building blocks together, it’s going to be quite hard for someone in six months’ time to say the world has changed materially”.

He said there is also an argument “that gets brought up continuously and I’ve got quite a lot of sympathy for it” that the equity betas for energy networks – a measure of the financial risk of a company to investors when compared to the market average –should be higher than those for water companies.

On this basis, Nash said the allowed return on equity for energy networks could potentially be set “even higher” than for water companies.

Taken alongside the challenges to Ofgem’s outperformance wedge, he said: “As an investor, and speaking to investors this morning, I think that there’s probably a feel out there that this will lead to a slight increase of 50 basis points or so in the allowed returns for the power names.”