RIIO2 appeals present headache for CMA

All eight of the gas and transmission networks are appealing Ofgem’s final determinations for RIIO2. But, what arguments have they put forward and what are their chances of success? Former Ofgem executive Maxine Frerk summarises the points raised and the challenges they pose for the Competition & Markets Authority (CMA).

While the CMA is experienced in managing quick turnaround appeals and merger decisions, the prospect of running eight parallel appeals on the RIIO2 price controls (for transmission and gas distribution) must present them with a bit of a headache.

Formally the next step in the process is for Ofgem to make any comments on whether the appeals should be allowed and for the CMA then to grant permission (by the end of March). This is largely a formulaic process and there is no real prospect of the appeals not being allowed.

Aside from deciding on the panel members, the CMA’s next task will be to think about the logistics, timelines and how far the appeals can be run in parallel.

How far is there common ground?

All the appeals cover the cost of equity and the “outperformance wedge” with all of the companies apart from National Grid then appealing on at least one other topic as well.

On cost of equity, the companies all structure their appeals around the same three key areas – errors in the calculation, including Ofgem’s choice of evidence; errors around the cross-checks carried out and the failure to “aim up” (ie to use a number in the upper part of the range to avoid the risks of under investment).

All companies argue that energy is higher risk than water and hence should have a higher cost of equity. The gas distribution networks (GDNs) also argue that gas is higher risk because of the potential for stranding. Interestingly NG Gas Transmission don’t make this argument and has presented an identical case to NG Electricity Transmission (so at least these two appeals can be combined).

On the outperformance wedge (the adjustment Ofgem has made to the cost of equity to reflect the fact that historically companies have always out-performed their price controls), the companies are all running similar arguments that this is unjustified and undermines incentives.

On the basis of that high level summary, it might sound like the CMA could run the appeals together in this area. However, once you get below this initial level, the specific evidence cited by each company is different and they are using different consultancies to help them. Given the nature of the focussed appeal in the energy sector, the CMA has to decide each case on the evidence presented – which is different in each case.

This raises an interesting question (for regulatory geeks like me) as to whether you could have one network succeeding at appeal when others fail just because one has made better arguments? Or will the companies’ arguments evolve through the process so that by the end any “winning” arguments will be woven into everyone’s narrative? The CMA could try to get the companies to work together but the legal framework doesn’t readily accommodate that. However, one has to hope that common sense will prevail and they will find a way to make this a manageable process and one that provides a coherent answer at the end of the day.

What else have companies appealed on?

Beyond the cost of equity there are a couple of other common themes and then some company-specific issues.

The first additional theme is around the ongoing annual efficiency target applied by Ofgem on gas distribution which all GDNs are challenging along with Scottish Power on the transmission side. Ofgem came up with an initial figure of 1 per cent and then applied a 0.2 per cent uplift for the impact of innovation projects in GD1. All the GDNs are appealing against the innovation uplift (which is redolent of the so-called “smart grids benefit” that Ofgem lost on at ED1) but in addition some are citing other errors in Ofgem’s calculation.

At the end of the day SGN has made clear it would settle for the 1 per cent it put in its business plan while Wales & West Utilities (WWU) continues to argue for the 0.5 per cent it included in its plan. The CMA could in theory come up with a different efficiency target for different companies if it accepted some of the arguments made by WWU that others have not made – but that would feel like a slightly odd result.

The second additional theme is the extent of change that Ofgem can make during the price control period in ways that leave the companies without their statutory right of appeal to the CMA. Ofgem has made “adaptive regulation” a cornerstone of its approach to RIIO2, to cope with the uncertainty around net zero and more broadly, but in doing so has arguably undermined the appeal rights of companies.

SSEN and Scottish Power have highlighted in particular the LOTI funding for large investments (to be agreed in period), as well the large number of reopeners where Ofgem can simply direct changes. WWU has focussed on the proliferation of associated documents that they are required to comply with and which again Ofgem can change without going through the full licence change process.

I have some sympathy with these arguments. If government has decided there should be a right of appeal, then the regulator circumventing that by the way it does things doesn’t feel right, especially where there could be significant financial impacts. However, SONI made a similar argument in 2017 but lost on the basis that it still had the option of judicial review. The question is whether what Ofgem has done is “wrong” or just poor regulatory practice. No doubt companies will be raising their concerns with policymakers as well as through the appeal route. But faced with the current deluge of appeals it’s not clear that Ofgem (or government) will be very receptive to the idea of extending these rights.

Finally, there is a list of company specific gripes. For the most part these relate to claims that Ofgem has not allowed sufficient totex funding in particular areas, based on quite technical arguments about Ofgem’s modelling.

SGN focuses on the efficiency adjustment and the choice of the 85th percentile as the efficiency benchmark as well as details of how it is applied.

Cadent raises the inclusion of LTS diversions in the benchmarking model (which disadvantages them) and the lack of sufficient regional adjustment for the costs of its London network.

Northern Gas Networks highlights the BPI mechanism and the failure to reward them as a frontier company (as well as the use of the 85th percentile).

WWU, which has the longest list of complaints, pick up on the cost of debt (and the use of average rather than company specific rates), the repex allowance (compared to the initial tenders it has run) and a tax clawback mechanism (and how derivatives are treated within that).

Finally, SSEN picks up a specific point around the transfer of cashflow risk on TNUOS from the ESO to them.

All of these points will have to be considered on their individual merits. In some cases they are points of principal on Ofgem’s side, in others one suspects that Ofgem simply ran out of time.

A mountain of evidence

The appeal documents from the companies vary in length with Scottish Power the shortest at 42 pages and WWU the longest at 186. A total of just over 1,000 pages. And in each case the appeal documents are supported by half a dozen expert reports from the consultancies, witness statements and other evidence. The CMA is used to managing lorry loads of information but trying to digest it enough to work out how to structure the appeals is a formidable task. Ofgem too will presumably be struggling with how to handle this volume in a world of homeworking.

Linked to the length of their documents, the companies also vary in how clearly they spell out the specific “errors” of fact or law that constitute the basis for their appeal. That is essential for the CMA to tease out what exactly they have to decide.

To address all of this the CMA may well request skeleton arguments from each of the parties where they have to boil down exactly what their argument is into a few pages. However, one feature of these focussed appeals is that such procedural steps are not visible to the outside world which sits oddly in the context of a RIIO process where stakeholder engagement was so central throughout.

In ED1 the appeals were clearly seen by the CMA as bilateral disputes between the company and Ofgem – not part of a wider policy landscape. On some aspects, of course, the CMA’s hands are tied by the legal framework. However, there are still things it could do to make the process more transparent, coherent and to avoid some of the potentially perverse outcomes identified above. Wider stakeholders need to be assured that the appeal regime strengthens rather than undermines the regulatory process. This is not simply a set of bilateral disputes (which might also involve a tightly defined set of interested parties) – we all have a stake in the outcome.

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.