Setting the bar for RIIO2: How low can networks go?

After Ofgem announced that baseline returns will fall to the “lowest ever” level during the RIIO2 price controls, Tom Grimwood gets the response from energy networks.

The first set of RIIO price controls have worked out rather well for energy networks so far. According to Ofgem’s most recent annual report, nearly all are on course to achieve returns higher than the baseline – some, the gas distribution networks in particular, by quite substantial margins.

Indeed, many believe they have fared too well. Citizens Advice has spent the last several years pushing the regulator to lower returns for RIIO2.

The consumer advocate says Ofgem overestimated the level of risk faced by investors, assumed interest levels would be higher than they have been, and allowed energy networks to game the system by submitting inflated cost forecasts at the beginning. It says these failures, when taken together, will hand investors £7.5 billion in “unjustified profits”.

Network operators claim these high returns are merely a mark of their success in responding to the incentives posed by the price controls. Ofgem clearly disagrees.

The regulator recently revealed its final decision on the methodology it will use when setting the RIIO2 price controls. If applied today, Ofgem said the baseline allowed return on equity would be set at 4.3 per cent.

However, this is based on the new CPIH measure of inflation which Ofgem is adopting for RIIO2. Under the old RPI measure, the number would be just 3.3 per cent. With baseline returns currently ranging between 6 and 7 per cent, it represents a reduction of more than half for some sectors.

Explaining its motivation, Ofgem executive director for system and networks Jonathan Brearley said: “Our proposals are on track to deliver a tough, fair settlement that strikes a better deal for consumers.

“Lowering the cost of capital for network energy companies will put money back into consumers’ pockets while service standards are required to remain high.”

The figure has increased slightly from the 4 per cent proposed by Ofgem in December, but energy networks say this is still too low. National Grid has suggested a rate of around 6.5 per cent would be more appropriate.

Forecast return on regulatory equity during RIIO1

Source: Ofgem

“What you’re seeing there effectively is for transmission and gas distribution an almost 60 per cent cut to allowed return on equity, which is significant to say the least,” says Energy Networks Association head of regulation John Spurgeon.

“That will drive investment to be very constrained,” he adds. “Returns need to be sufficient to attract the level of investment we’re going to need – not just to maintain and operate the system we have but to build on to that and improve it and deliver the smart future that we need”.

Network companies are especially opposed to Ofgem’s decision to set the baseline return half a percentage point below its actual estimate for the cost of equity. The regulator said this adjustment is necessary to account for investors’ expectations that networks will outperform the baseline.

ENA head of policy Tony Glover describes this as “crystal ball-gazing”, akin to sticking your finger in the air to check which way the wind is blowing. “It’s essentially a random approach,” adds Spurgeon. “It doesn’t hold water.”

Like many of the changes to the methodology, the downward adjustment reflects concerns held by Ofgem over its inability to accurately forecast costs. Having failed, in its view, to calibrate the current price controls correctly, the regulator is understandably keen to avoid repeating the same mistakes.

These changes also include the shortening of the price controls to five years, the indexation of the baseline return to the risk-free rate – a component of the cost of equity – and the introduction of return adjustment mechanisms.

Spurgeon says there are pros and cons to indexation: “Something that needs to be right is how you actually do it – what’s the mechanism – so that no one gets short changed, both the consumers and the companies… It is a big change insofar as that what it does is put the risk of increasing rates solely with the consumer.”

But he is less ambivalent about return adjustment mechanisms, which would raise or lower network returns if they fell too far outside of Ofgem’s expectations: “We see them as ex-post regulation by the back door, which we see in other countries such as America, and we know that our RIIO incentive-based approach is far superior to rate of return regulation.”

He also has concerns more generally about the number of new mechanisms Ofgem is introducing for RIIO2 and how they will all fit together: “Not only was it not clear how individual mechanisms would work, but how those mechanisms would interact and start to play with each other once you get into the price control”.

Spurgeon is at least happy that Ofgem has listened to feedback over the exact type of return adjustment mechanism that will be applied to gas distribution. Under the anchoring model originally proposed by the regulator, all returns would be adjusted proportionally if the sector average breached a certain threshold.

Following strong pushback, the regulator now intends to apply the sculpted sharing model not only to transmission but gas distribution as well (a decision on electricity distribution is yet to be made). Under this model, returns would be adjusted on an individual basis.

Impact of sculpted sharing on network returns

Source: Ofgem

“I think we’ve all come to the conclusion anchoring is not a good idea – Ofgem, networks and wider stakeholders,” says Spurgeon.

That said, sculpted sharing is only the “least worst” option: “Our preference would be that they don’t exist at all. We don’t think they’re needed. If you set the price control properly and calibrate it properly and get your incentives and sharing factors right, they’re not needed.”

On this front, there is some measure of agreement with Citizens Advice.

“In a perfect situation, we think that you wouldn’t need the return adjustment mechanisms because if the calibration is perfect then actually you wouldn’t need to have this kind of safety valve at the end,” says its head of energy networks and systems, Stew Horne.

“But,” he adds, “consistently the price controls have gone against consumers and in favour of industry, so we think it’s sensible to keep this on the table.

“We’ve argued consistently that these aren’t something that should be used on a regular basis in every price control. These should be for occasions when something has gone awry on an exceptional basis.”

And Horne is on the same page as the ENA when it comes to anchoring: “We thought that might have some unintended effects that should be avoided, so we’re pleased that’s gone.”

“We’re in favour of the sculpting mechanism, that seems to be quite a reasonable and proportionate approach.” He says the thresholds for triggering the mechanism that Ofgem has suggested of 3 per cent above or below the baseline “seems sensible”, although he would need to see more details and analysis before taking a firm position.

Overall, Horne is very happy with what he’s seeing from Ofgem: “What we’ve been advocating for is regulators to stop forecasting and use the market evidence that’s available and that’s what Ofgem has done…

“What’s really important now is they hold their nerve in the face of what’s likely to be quite formidable industry lobbying and actually deliver on this for consumers in the next price control… The current saving they’ve got on the table is £6 billion, which is pretty significant”.

He says Ofgem should be given credit for being bold: “They’ve responded to the criticism that’s been made of them and been willing to do some soul-searching and look at what the right solution is for consumers.

“Things did go wrong in RIIO1, and regulators have – not just Ofgem but Ofwat as well – paid attention and are now looking to put things right.”

Glover, by contrast, says the changes will discourage ambition by network operators and make it harder to attract the huge amount of investments which will be needed to transform Britain’s energy system over the coming years: “There feels a very strong mismatch between the level of ambition it claims it will achieve… and the package itself… The two don’t go together”.