What’s in this report?

Utility Week’s new CEO Insight research series will provide regular access to the sentiment of industry chief executive on key themes and developments impacting the sector, and their businesses individually.

Our analysis of the findings from the first iteration of this research will be published in easy to digest instalments, however, a complete research report will also be made available.

This instalment of research analysis focuses on CEO views of the regulatory regimes under which they currently operate and the direction of travel being taken for future regulatory periods/approaches.

Meanwhile, a previous instalment of research analysis covered CEO sentiment about the macro political and economic environment in which they are operating.

Future instalments will cover:

• Business model transformation
• Consumer perceptions and satisfaction
• Access to finance and investor confidence
• Conclusion

Executive Summary

As utilities grapple with the transformational change sweeping the sector, company chief executives face challenges on many fronts. In the first of a new, regular series of research reports – CEO Insight – Utility Week surveyed the leaders of the UK’s major utilities, to understand their views on the political and economic climate their organisations are operating in, the regulatory and policy landscape surrounding them and what the future holds in terms of change and challenge.

The results paint a picture of chief executives poised for sector disruption. They expect radical changes to business models, even in the short term; are dissatisfied with or lukewarm to the regulatory regimes they operate under and express concern in relation to wider economic and political factors impacting their businesses.

While responses to some questions show significant variation in opinion between different utilities subsectors, qualitative commentary on the survey findings, provided by sector leaders, showed the findings generally resonate with chief executives across the board.

Even in areas where a single subsector stands out from the crowd – for example with regards to networks’ support for their regulatory regime – qualified comments shows that there are significant and growing concerns about the direction of travel for the future, and the influence that political interventions are having on this.

In this first iteration of our CEO research, respondents from the water sector – spanning wholesale and water retail – provided especially robust responses to questions about satisfaction levels with the regulatory and market structures which envelope company operations and profitability.

To acknowledge this, as well as including observations on water responses in our general commentary, we have broken them out in a special subsector focus chapter.

The next iteration of our CEO Insight series will gather evidence over spring 2018, with a second report appearing in the summer.

Regulation

• Overview
• Network regulation

Read more about CEO sentiment surrounding water wholesale and retail regulation in our subsector focus.

Overview

As the highest rated business impact factor in the survey, perceived uncertainty and change to utilities’ regulatory structures merit close attention.

It is concerning that, when asked whether they believed the regulatory regime under which their businesses operate is fit for purpose 57 per cent of CEOs said “no”, though confidence levels did vary considerably by sector.

Least satisfied with their regulatory regimes were challenger energy retail brands and water retailers.

Verbatim comments from leaders in the latter subsector exposed particular concerns with Ofwat’s use of ex-post regulatory tools, which were deemed ineffective for a new market, as well as the level playing field provided by regulatory rules for new entrants competing against incumbents.

Digging down for more detail on water retailer concerns with their new market structure, Utility Week found significant dissatisfaction with the quality of service provided to retail businesses by wholesalers, with some 50 per cent of subsector respondents saying this is currently causing problems for their business. This finding resonates with wider market intelligence picked up by Utility Week and its sister title Water.Retail where calls have been registered for tighter rules to standardise minimum wholesaler service levels.

The dissatisfaction of challenger energy retail brands with their regulatory regime is unsurprising given the well-documented complaints of new entrants in recent years, about rules which have restricted their ability to innovate and bring new business models to market quickly, as well as market conditions which are perceived to have perpetuated the dominance of the big six retail brands.

But it seems that these historical sources of dissatisfaction for challenger brands are no longer the nub of issues with the regulatory regime. Indeed, commentary revealed that significant challenger brand dissatisfaction is now focused on the continuation of certain “special treatments” for new entrants, which are no longer deemed relevant in a market where many challenger brands have achieved mid-scale customer bases.

Commenting on the findings, Coop Energy chief executive David Bird, for example, spoke of his growing concern about the ongoing exemption of suppliers with customer numbers below 250,000 from schemes like the Warm Homes Discount.

“This is a rule that was put in place seven or eight years ago to drive competition. It has achieved its aim but now it is actually discriminating against some of the customers which are in most need of support,” he observed.

In short, dissatisfaction here, and anecdotally within larger retailers too, centres around the perceived inability of the regulator to adapt regulatory structures and mechanisms in a way which keeps pace with market conditions.

Bird suggested this is an endemic challenge for all regulators, which “are often behind the industry dynamic” and he sympathised with Ofgem’s “difficult role”. However, he and other energy retail representatives, large and small, urged the regulator to find ways to become more fleet of foot when considering and then implementing regulatory changes.

Ofgem’s shift towards principles-based regulation and its introduction of an Innovation Link and Innovation Sandbox to support challenges to current regulatory structures were broadly welcomed as positive early signs that the regulator is taking this message on board. However, a feeling remained among commentators that Ofgem could do more to reduce friction around both the development and implementations of certain high impact regulations.

“In core areas, Ofgem needs to be more appreciative of the business planning that is required to become ready for new regulation,” said Bird. “We are now into budget year and we have no idea about the potential financial impact of some of these things. That make it hard to plan and hard to invest.”

Perhaps surprisingly, Ofgem’s work to implement price regulation in the energy retail market drew little direct comment from either survey participants or qualitative commentators – though several verbatim survey responses did express concern, even anger, at Ofgem’s rapidly eroding position as an apolitical regulator.

Network regulation

CEOs from the UK’s regulated power and gas networks expressed the highest levels of satisfaction with their regulatory regime – RIIO (revenue = incentives + innovation + outputs) – which was implemented in 2013 for gas and power transmission networks and gas distribution networks and 2015 for power distribution companies. It replaced the legacy DPCR regulatory model.

Survey comments commended the RIIO framework for its success in driving performance improvements while also delivering cost reduction for consumers and its “balanced” approach to supporting shareholder returns while protecting service levels. Furthermore, 83 per cent of network CEOs said they agreed that the introduction of the RIIO regime has “positively changed the way we do business”. The remaining respondents were neutral in their feelings about this statement, with none opposing it.

These comments reflect Utility Week’s broader appreciation of network sentiment and the opinions of commentators. Electricity North West chief executive Peter Emery said his company – and the networks industry more broadly – support the RIIO framework.

“The RIIO concept and the ED1 framework provide incentives for continuous improvement and cost reduction and that benefits customers, shareholders and other stakeholders – including the government,” he commented. “So, certainly in terms of RIIO ED1, we are very supportive of it and I would say it is fit for purpose.”

This said, and acknowledging widespread network support for the RIIO concept, it is notable that  both survey responses and commentary highlighted significant and rising concern among networks about the susceptibility of the regulator to pollical influence and the impact this could have on the financial stability of networks in the future.

Survey respondents also expressed high levels of scepticism about the idea that investors will accept lower rates of return under the next RIIO settlement, an outcome Ofgem has indicated it will push for via a reduced weighted average cost of capital. 67 per cent of respondents disagreed with this concept and none supported it.

One gas network leader said: “Our good framework is at risk of falling down due to political intervention and it’s our frank opinion that the regulator is losing its independence.” The leader went on to clarify that this concern follows on recent the recent exertion of political pressure on Ofgem to curb “excessive” network returns, as they have been reported in studies conducted by bodies including Citizens Advice and the Energy and Climate Intelligence Unit. The leader described such studies as “misleading and uninformed”.

Focussing on the question of future returns, the same gas network executive took a more temperate view than survey respondents, saying its investors would accept a challenging rate of return if they were confident the level at which this was set was tied to clear econometric modelling and understanding of market conditions.

Again however, they emphasised that any suggestion that the rate of the return had been set to accomplish political goals, would not be acceptable.

Electricity North West’s Peter Emery took a slightly different view on the debate around future investor returns. “Our next regulatory price regime is five years away,” he observed. “So talking about rates of return in the next period today is a bit of an academic debate.”

He did however urge government and Ofgem to take into account when deciding what rates of return they believe to be reasonable for the next regulatory period, that investor decisions are made in the context of global market conditions.

“Investors’ willingness to accept the rates of return available from networks in the UK will boil down to how these compare to other opportunities worldwide. And the problem with markets is that they do not gradually switch off. They are either attractive, or they’re not and there’s practically nothing a CEO can say to influence this. It’s always a risk for government or Ofgem to take to set a rate of return that they think is reasonable in a global context. And if they get that wrong, they will have a problem – capital will move away.”

As a final observation observation, Emery added that debate over the rates of return for networks should consider economic factors such as currency value fluctuations. He said that a continued decline in the valuation of the pound relative to the US dollar could significantly negatively impact the real value of returns from UK utilities for non-UK based investors.

The recent call from MPs including Conservative John Penrose, for Ofgem to reopen network revenue settlements as part of its RIIO1 midpoint review, elicited consternation among commentators, with one power network leader saying a mid-period adjustment would deliver a “massive” blow to investor confidence and trust in the integrity of the regulatory environment in the UK.

Overall, network commentators expressed hopes that the RIIO model will endure for the foreseeable future, avoiding significant damage from political intervention. However, it was also acknowledged that however fit for purpose the regulatory regime may be today, the risks associated with regulatory uncertainty will increase as networks head into the next price control period, simply as a product of big picture energy system trends such as decentralisation and decarbonisation.

Such trends are directly liked with the mooted transformation of distribution network operators (DNOs) into distribution system operators (DSOs) and to the future role of gas in the provision of domestic heating. With significant question marks over the commercial and regulatory frameworks which would surround networks with significantly changed roles and responsibilities, network leaders agreed with the overall view that regulatory change and uncertainty is the highest impact factor for their businesses.