The Competition and Markets Authority (CMA) has issued its provisional decision on the appeals brought by all of the transmission and gas distribution networks against their final determinations for the RIIO2 price controls, largely upholding Ofgem’s decision to drastically reduce returns to investors.
The CMA found in favour of Ofgem on most of the 12 grounds of appeal, stating that energy networks had failed to demonstrate that the regulator had erred in determining in the cost of equity and the component in its calculation – total market returns, the risk-free rate and the equity beta – under the Capital Asset Pricing Model.
The authority said it had seen “no compelling evidence” that Ofgem had set the cost of equity too low or that the regulator should “aim up” from this rate, describing the latter as a matter “regulatory judgement”.
However, the CMA has ruled against Ofgem’s decision to set allowed equity returns 25 basis points below its actual estimate of the cost of equity.
This downward adjustment, known as the outperformance wedge, was introduced as part of the RIIO2 price controls to reflect investors expectations that returns would exceed the baseline based on past performance. The deduction would be returned to investors at the end of the price controls if the anticipated outperformance failed to materialise.
The CMA said there were “a number of errors” in Ofgem’s analysis of the extent to which outperformance should be expected. It said even if Ofgem’s expectations of outperformance had been “robustly substantiated”, the outperformance wedge is a “poorly targeted” method of addressing these concerns that could “undermine broader regulatory certainty” and increase costs to consumers over time.
The authority has also provisionally overturned Ofgem’s decision to apply an “innovation uplift” of 0.2 per cent when determining the cost reductions expected from improvements in efficiency in the sector. The adjustment is intended to reflect the efficiency benefits of past innovation funding. The CMA said although these benefits are likely to be above zero, the appellants did show they had been materially overestimated by Ofgem.
The CMA additionally ruled that Ofgem had acted beyond its powers in introducing special license conditions that could be modified during the course of the price control to manage uncertainty and contingent allowances. It said license conditions may contain mechanisms for their subsequent modification if they specify the manner, the time and circumstances in which they may be changed but this was not the case for the particular conditions subject to appeal.
Furthermore, the CMA found errors in the setting of Cadent’s totex allowance and Northern Gas Networks’ business plan incentive. It upheld Ofgem’s final determinations on all other grounds of appeal.
The CMA said the impact of its decision on energy bills is expected to be minimal: “Although the findings are currently provisional and could change, and the actual effects cannot be determined until Ofgem has updated its modelling, the CMA estimates the potential impact on consumers’ annual bills to be an increase of around £1.”
The provisional findings were welcomed by Ofgem chief executive Jonathan Brearley, who said: “Ofgem is fully focussed on keeping bills as low as possible for customers while supporting investment to net zero greenhouse gas emissions.
“We welcome today’s provisional announcement by the CMA as an important step forward towards this goal. The CMA has found in favour of Ofgem on most grounds of appeal, including the reduction in returns for investors.
“We will continue to engage with the CMA to finalise these price controls and look forward to working with the industry to deliver efficient investment which will benefit both consumers and the planet.”
David Smith, chief executive of the Energy Networks Association, said: “These are provisional findings which we will now review in detail. It is vital that the final settlement gives network companies a robust framework to invest in a sustainable, net zero energy system in the most efficient way possible for customers.”
National Grid said in a statement: “The CMA has published its provisional determination in relation to the RIIO2 price control this morning. We are pleased to note that it has found in favour of the technical arguments on the outperformance wedge, although we are disappointed that it has not found in favour on the cost of equity.
“We will now review the detailed documents to determine the CMA’s rationale for this provisional determination and will be responding within the statutory timeline.”
James Plunkett, executive director at Citizens Advice, described the decision as a “good result” for consumers but criticised the proposed removal of the outperformance wedge: “The CMA’s decision to confirm lower returns is a significant step forward in tackling the excessive profits made by network companies at the expense of their customers.
“But there remains a fundamental problem with the price control process. Networks have a clear advantage in terms of access to information, which continues to lead to favourable settlements and easily achievable performance targets.”
He continued: “The CMA’s failure to tackle this means these companies could still make hundreds of millions of pounds in unearned profits, while customers receive nothing additional in return. At a time when so many households are struggling financially, this is deeply unfair.
“The current appeals process is costly, it’s skewed against consumers and is in desperate need of reform. There needs to be better coordination across markets to make sure the process for setting monopoly company profits genuinely delivers value for money for consumers.”