What’s the point of appeals?

After the Competition and Market Authority’s (CMA) published its final determination on the RIIO2 appeals by transmission and gas distribution networks at the end of October, Maxine Frerk, director of Grid Edge Policy and a former Ofgem partner, asks whether the appeals processes in energy and water need to be reviewed to provide consistency within and across sectors.

There was an initial flurry of interest at the start of the year when all transmission and gas distribution networks appealed their RIIO2 price control determinations. However, the CMA’s final determination published at the end of last month has prompted relatively little comment. In large part that reflects the fact that there were minimal changes from the provisional decision published in August. But the publication of the full text of the final decision amounting to 5 volumes and over 1200 pages does give regulatory enthusiasts plenty to chew on.

At the time of the provisional decision, I described the result as a victory for Ofgem but with companies having landed some punches. Ofgem won on the central issue of the cost of equity but lost on their attempt to apply a reduction to the cost of equity through the novel device of an “outperformance wedge”. They also lost on the innovation uplift they had applied to the ongoing efficiency rate and on the process around some of the key uncertainty mechanisms where Ofgem’s approach would have left companies without a right of appeal against significant decisions. While not huge in financial terms these wins will have covered the companies’ costs in lodging an appeal and have set down a marker for Ofgem about the level of evidence it needs if it wants to push out the regulatory envelope.

However, at this stage, what is interesting is not so much the final score but what all this says about the appeals regime overall, in particular when viewed alongside the earlier PR19 appeal in water.

As a reminder, the appeals regime in energy requires appellants to demonstrate that Ofgem was “wrong” on a point of fact or law or on the weighting of its duties. In contrast, in water the CMA is carrying out a full re-determination – deciding what they would do if they were in Ofwat’s shoes. Throughout the RIIO2 decision the CMA reiterates that this is not what they are doing here.

What this means in particular is that they allow Ofgem a margin of discretion on issues which are a matter of judgement. Unsurprisingly, Ofgem argued that almost everything was a matter of judg(e)ment. If the CMA had accepted that, it would have made a mockery of the appeals process – but they didn’t. However, there was lengthy legal debate on exactly how much discretion should be allowed to the regulator, with the companies noting that the CMA itself is an expert regulator with experience across sectors. In terms of overall approach, the CMA made clear that while Ofgem should be afforded a margin of appreciation as an expert regulator, that margin of appreciation is not unbounded.

Expanding on this the CMA set out a principle that the fact there were alternative approaches the regulator could have taken is only relevant if they were “clearly superior”.

This then takes us into some interesting territory in terms of the interplay with the CMA’s decision on the cost of equity in PR19. Unsurprisingly one of the arguments mounted by the companies was that Ofgem’s approach was wrong where it took a different approach to the CMA in the way that it built up the cost of equity. For example, in PR19 the CMA had used AAA corporate bonds as a benchmark for the risk-free rate. However, in the RIIO appeal the CMA says that its own approach was not clearly superior and also describes its own decision as “novel in a regulatory context” and needing scrutiny. Ofgem was therefore not wrong to depart from the approach taken by the CMA. This line that the CMA’s PR19 approach was not clearly superior appears several times in the decision. After a year of submissions and hearings on PR19, Ofwat must be wondering what the point of it all was.

More generally there is no recognition of the value in consistency across regulatory regimes. The CMA play down the relevance of the PR19 case arguing that this was a different decision, in a different sector under a different regulatory framework. Never mind that they have some of the same investors and that one strength of the CMA is that it does look across sectors and should therefore be able to help drive greater consistency. Indeed, it explicitly rejected the companies’ argument that Ofgem was wrong not to pay more regard to the CMA’s PR19 decision in the round, dismissing the idea that this created regulatory uncertainty for investors. It did acknowledge the work of the cross-regulator group (the UKRN) but only to show that Ofgem’s views were informed by wider practice (and hence not wrong).

It does feel as if out of all this must come calls for a review of the appeals mechanism. It is not clear why the CMA “judgment” on subjective issues should be superior to Ofwat’s and an approach, as on energy, that allows the regulator a margin of discretion (but not too much) feels more appropriate.

However, on cost of equity, where the UKRN work was done in order precisely to try to provide consistency, there are good grounds for questioning whether either appeals model has really worked. A fresh approach is needed to the cost of capital, to make the process less confrontational and to drive consistency. The UKRN process is not a transparent one but could perhaps be built on. Scottish Power have called for some sort of Commission on the cost of capital. What is clear is that an appeals regime that can come up with two quite different answers really doesn’t help.

In contrast, the CMA’s reflections on the outperformance wedge make for interesting reading as a guide to good regulatory practice. The CMA make clear that some outperformance by companies can be justified if it is a reward for delivering improved outcomes for customers that they value. They acknowledge the problem of information asymmetry but see it as a core part of the regulator’s job to try to find ways to address that, pointing to the various steps that Ofgem had taken in RIIO2. In essence what they conclude is that to justify an outperformance wedge Ofgem would have to show that there is still an expectation of outperformance after all these steps have been taken (i.e. not just that there was outperformance historically). They are also clear that an adjustment to the cost of equity is not the best way of dealing with the problem – the aim should be to get the incentives and allowances correct – and that the proposed form of the wedge would dampen incentives on companies to perform.

Throughout the decision the formulation the CMA use is that the appellants did not demonstrate that Ofgem was wrong or (where it was wrong) that Ofgem did not provide the evidence to support its approach. That essentially reflects the legal framework in which energy appeals are considered but does create the sense that if you tried again with better arguments you might win.

As such there is no sign yet in ED2 that Ofgem are rowing back on the outperformance wedge or that companies have now accepted Ofgem’s cost of equity and ongoing efficiency level (although we wait on the final business plans to see how far they have moved). That may simply be a part of the regulatory “dance” at this stage but in the past a CMA decision would have been seen as setting down a definitive marker. The different outcomes between water and energy in large part reflects the different regimes but may also simply reflect a different panel composition. The CMA repeat regularly that their past decisions are not binding. The appeals regime is not providing the certainty it should if parties think they can roll the dice again and hope for a different result.

One final reflection is that huge credit has to be given to the CMA for managing the process of 8 concurrent appeals and delivering a verdict in 7 months (as against the 12 taken for water). They achieved this by joining appeals where they covered common issues. This will have created problems for the companies who all had their own legal advisers and economic consultants. It is clear from the CMA decision that on technical points around cost of equity, for example, the companies all had their own views on the right approach. Although not articulated in the decision, one cannot help but feel that this range of views will have only reinforced the sense that there is no “right answer” and hence that it is hard to argue that Ofgem was “wrong”.

No doubt the process was frustrating at times, with companies limited to a single spokesman on particular issues at the oral hearing. But it is hard to see how it would have worked otherwise. There is nothing in the CMA’s decision to suggest that the companies raised major procedural concerns which is a credit to all concerned (although the companies formally have 3 months to lodge a judicial review if they feel the process was unfair).

The end result would seem to be in broadly a sensible place viewed as a decision in its own right. But it raises serious questions about how the appeals processes across energy and water (and more widely) needs to evolve to facilitate a consistent approach across regulators which commentators have long been calling for. That needs Treasury and BEIS to make clear that this is a policy outcome they would like to see, but without a bit more noise being made about the CMA’s decision it’s unlikely to happen any time soon.