Energy network operators have long enjoyed and relatively sheltered existence. Aside from moments when storms rip through the UK, when response times are put to the test, they have been able to hunker down out of the harsh wind of public scrutiny, unlike their battered cousins in energy generation and supply.
But this is changing. Energy networks are becoming increasingly central to shifts in energy policy – as demonstrated by the influential call for evidence on smart and flexible energy systems, and the high profile of smart grids within government’s new industrial strategy. And as this swing continues, so the expectation for clarity and transparency around network performance will increase.
In line with this, and a wider agenda to improve the accessibility of the energy industry, Ofgem recently published a new-look set of annual reports which detail how well energy networks are doing in relation to measures set out in their regulatory settlements.
Overall, networks operators will have been pleased with their reviews. Ofgem had relatively few “could do better” comments to hand down. NGGD disappointed it in terms of customer satisfaction levels and SHE Transmission was mildly rapped for lagging behind its classmates on SF6 leakage reduction.
But taken across the board, the RIIO annual reports show that networks are driving up service levels – earning many millions of pounds in regulated rewards – whilst also underspending their investment allowances.
That’s a nice mix for shareholders and investors will have been particularly pleased to see Ofgem’s calculations on the return on regulated equity (Rore) which networks can expect across their eight-year price controls.
Rore levels vary across individual networks and networks type – gas distribution had the highest top range Rore (12 per cent) while power distribution included the lowest level of return (7.2 per cent). Overall however, networks are enjoying a Rore of around 10 per cent.
This is very healthy. So healthy in fact, that some observers were less than impressed.
On seeing the updated Rore figures, Citizens Advice swiftly concluded that networks are earning excessive profits which could be redistributed to reduce UK energy bills.
In a blog, the charity’s senior policy researcher Morgan Wild said that the 10 per cent returns being reaped are “huge” for regulated monopoly businesses.
“Given networks are a major component of energy bill costs (around a quarter), it’s crucial to answer whether these profits are justified,” insisted Wild.
It will be no surprise to the reader that Citizens Advice concluded they are not.
As low risk enterprises which are “too big to fail” networks are safe stock for investors and, as such, their return on capital should be low compared to riskier businesses. In fact, analysis carried out by Citizens Advice shows network returns are double the UK-wide long run average of around 5 per cent. Networks are also earning much higher returns than comparable companies like water networks.
The nub of the problem is the overly generous cost of equity which Ofgem has allowed for networks in the current price control, says Citizens Advice.
While it looks kindly on the general premise of rewarding companies for good work – and recognises the need to increase network risk appetite in order to stimulate innovation – the charity is firm that offering lavish cost of equity levels is the wrong approach. (Interestingly, the use of cost of equity as a lever to stimulate more ambitious innovation is exactly an apporach being explored by Ofwat for the water sector – it is looking at examples in Victoria, Australia.)
Tiny adjustments to the current cost of equity for networks could “mean hundreds of millions of pounds in difference to the amount consumers pay,” said Wild’s blog.
For example, a 0.1 per cent reduction in the cost of equity “would reduce consumers’ total networks’ bill by around £190 million over the course of the price controls.”
Ofgem cannot move to change the current cost of equity for networks until the end of the RIIO 1 cycle. But with preparations for RIIO 2 soon to begin, Citizens Advice is urging the regulator to make the issue a central consideration.
In reply to the concerns over network returns, Ofgem issued a statement saying it is “determined” to ensure customers get the “best possible deal” from their networks “both in term of service and value for money”.
It also pointed out that, since we are only half way through even the most advanced of the RIIO cycles, any calculations of profits over the whole eight-year period are still speculative.
That said, Ofgem has already indicated that it is open to some substantial changes to the RIIO framework in its second iteration.
The eight-year period itself is up for review and there may be tweaks coming for the innovation incentive regime to promote greater risk taking, involvement of third parties and transfer to businesses as usual.
Investors are unlikely to be keen on moves to curtail their network investment returns. But as pressure mounts for Ofgem to prove itself the champion of “just about managing” customers, it seems it seems likely that adjustments to the cost of equity could well find their way onto the regulator’s “to do list”.
Afterall, Ofgem isn’t worried about losing face by admitting miscalculations in the original RIIO framework. As chief executive Dermot Nolan has said: “When you set up a new regulatory framework, you’re never going to get everything right.”
Other insights
News about the contents of Ofgem’s annual RIIO reports was dominated by the criticism of network returns by Citizens Advice. But here are a handful of other insights:
- A mid-point review for gas transmission slashed National Grid Gas Transmission’s (NGGT’s) spending allowance for RIIO-GT1 by £168.8m. Consequently, the company has moved from a position of forecast outperformance for the eight-year cycle (expecting an underspend of 0.4 per cent), to anticipating an allowance overspend of around £192m (9 per cent).
- National Grid Gas Distribution (NGGD) is the only gas distribution network not to meet required standards for customer satisfaction. NGGD missed its target scores for customer views on planned interruptions and on connections. The network received a £1.6m penalty in 2016 for this failure.
- In the first three years of their price control, electricity transmission owners (TOs) earned a collective £60m in outperformance rewards.
- Scottish Hydro Electric Transmission was the only TO to underperform on SF6 leakage. It has received a penalty of £50,000 for this failing for the year 2015-16 and a retrospective penalty of £0.4m for SF6 leaks for the year 2014-15 because errors were discovered in its reporting.
- In first year of their price control, the UK’s electricity distribution companies earned a collective £160m in rewards for improved customer service.
Ofgem’s full annual RIIO reports can be accessed via the following links: