The provisional decision by the Competition and Markets Authority (CMA) earlier this week to uphold the cost of equity set by Ofgem for the RIIO2 price controls represents a “victory” for the regulator, one of its former partners has stated.
However, the transmission and gas distribution have also landed some “punches” with their appeal against Ofgem’s final determinations after the CMA concluded the regulator should not have applied a downward adjustment the baseline rate of returns to account for expected outperformance.
“Importantly, Ofgem won on the centrepiece of the appeal, challenged by all companies, which was the cost of equity,” said Maxine Frerk, director of Grid Edge Policy.
“While many people had assumed that the CMA approach on water would stand the energy companies in good stead, the test in energy is different and is about whether Ofgem were ‘wrong’ to take the decision they did. The CMA unsurprisingly concluded that Ofgem’s cost of equity was within the bounds of their regulatory discretion.”
“They did however conclude that Ofgem was wrong on the associated point about the outperformance wedge – an adjustment to the cost of equity that Ofgem proposed introducing to reflect the fact that companies almost invariably outperform price controls,” she added.
“The CMA have some sympathy with the problem Ofgem is trying to address but say they simply haven’t made their case. To me, it was always clear that the mechanism was flawed and Ofgem’s concession – not to apply it if there isn’t outperformance -creates perverse incentives.”
The CMA said its provisional ruling would result in a £1 increase in annual bills for customers.
Frerk said this is “not huge but not insignificant in the context of a network cost per customer of around £100.” She said an increase was somewhat inevitable given that the appeals, covering a number of different grounds, represent a “one-way bet for the companies”.
“That’s enough to justify the costs of the appeal for the companies – and there is a benefit for them as well in having put down a marker,” she remarked.
Ofgem also lost on several other grounds of appeal, including its decision to apply an “innovation uplift” when determining the cost reductions expected due to improvements in efficiency in the sector.
“This has echoes of the point that Ofgem lost on in the ED1 appeal around smart grid benefits,” said Frerk. “It is hard to prove the cost savings that will arise from innovation.”
She said even though the regulator won on the central issue, “it’s not a great result.”
“For the DNOs watching this play out, this should provide some helpful clarity as they finalise their business plans.
“While in principle Ofgem could try again with new arguments, it should be a safe bet that the outperformance wedge will be off the table for ED2 but the companies will have to face up to an underlying efficiency target of around 1 per cent per annum.”