Ofgem’s draft determinations for the RIIO ED2 price controls were “slightly tougher than expected” due to higher levels of assumed productivity gains and reduced scope for operational outperformance, according to ratings agency Moody’s.
In the case of the latter, Moody’s said the potential financial rewards from output delivery incentives, which would be significantly reduced when compared to the current price controls, would be harder to achieve due to tighter targets, and would also be outweighed by potential penalties by a ratio of more than 2:1.
In an update to the industry, the ratings agency said most of the key regulatory parameters in the draft determinations for the RIIO ED2 price controls were “broadly in line” with Ofgem’s sector-specific methodology and the amended price controls for transmission and gas distribution networks following their partially successful appeal to the Competition and Markets Authority (CMA).
In accordance with the CMA’s ruling, Ofgem removed its proposed outperformance wedge – a downward adjust to the cost of equity of 25 basis points to reflect information asymmetry between itself and networks, and investors’ resulting expectation of outperformance. This left distribution networks operators (DNOs) with an allowed return on equity of 4.75% in real terms based on the CPIH measure of inflation.
The regulator approved baseline total expenditure (totex) allowances of £20.9 billion for the five-year price controls beginning in April 2023 – a 17% decrease on the £25.2 billion requested by DNOs in their business plans submitted in December. This reduction included a £1.3 billion – or 5% – decrease in spending allowances due to the application of an ongoing efficiency challenge of 1.2% per year.
Ofgem had sought similar savings from cost efficiencies in the RIIO2 price controls for transmission and gas distribution. However, Moody’s noted that the regulator had tried to do this by combining an ongoing efficiency challenge of 1% with an “innovation uplift” of 0.2%. As with the outperformance wedge, the innovation uplift was ultimately removed by the CMA for those that appealed against it.
Speaking to Utility Week, Moody’s senior analyst Phil Cope said Ofgem appears to have attempted to achieve the same effect for electricity distribution as it originally intended for transmission and gas distribution by effectively folding the innovation uplift into the ongoing efficiency challenge.
With regards to output delivery incentives (ODIs), Moody’s noted that these have been the main driver of outperformance by DNOs against their baseline return of regulatory equity (RoRE) during the RIIO ED1 price controls. This is in contrast to other sectors, where outperformance has primarily been driven by totex underspends.
Forecast RoRE over RIIO ED1
However, Moody’s said the value of the rewards on offer from financial ODIs was significantly reduced in the draft determinations for ED2, dropping to a maximum of 1.95% of RoRE.
Cope said although it is not possible to provide an equivalent percentage for ED1, as some incentives are expressed in terms of revenue rather than returns, the ODI for network reliability is by itself currently worth plus or minus 2.5% of RoRE.
He said this was previously expected to stay the same for ED2 but the maximum reward has instead been reduced by three-fifths to 1% of RoRE. Meanwhile, the maximum penalty has been kept at 2.5% of RoRE.
In general, Moody’s said ODIs are heavily skewed towards penalties in the draft determinations, with the maximum penalties amounting to 4% of RoRE – more than double the maximum rewards. This is in contrast to the current price controls, in which the rewards and penalties are symmetrical.
What’s more, the ratings agency said the targets DNOs will need to meet or exceed to secure rewards have been tightened significantly, drawing attention to the ODI for customer service.
Cope said the target for ED1 is an average survey score of 8.2 out of 10, with a score of 8.9 on each survey element securing the maximum reward. He said 8.9 out of 10 is instead the target score in the draft determinations and Ofgem has also proposed to introduce a dead band, meaning DNOs would only start to earn rewards at a score of 9.2.
He said he believed it would be “very hard” for DNOs to achieve rewards of more than 1% of RoRE across all financial ODIs.
Ofgem is additionally introducing a return adjustment mechanism (RAM) to limit any deviations from the baseline RoRE. Any outperformance that exceeds the baseline by more than 300 basis points will be shared equally with consumers, whilst consumers will receive 90% of any outperformance that exceeds the baseline by more than 400 basis points. This mechanism will also apply to underperformance.
However, Moody’s said the reduction in ODI rewards, the tightening of targets and lowering of sharing factors for totex underspends means this mechanism is “unlikely to be triggered.”
The sharing factors for DNOs currently range between 53% and 58%, with the exception of Western Power Distribution, which as the only company to be fast-tracked due to the quality of its ED1 business plan has a sharing factor of 70%. All DNOs are set to receive sharing factors of 49% to 50% for ED2.
“While we do not believe any licensee could deliver the level of operational outperformance, under the draft determination, required to trigger the primary RAM threshold – Ofgem estimate this to be earning 100% of available ODI-F incentive income and delivering totex outperformance of 8% – it continues to show Ofgem is increasing focus on promoting network legitimacy,” Moody’s remarked.