Networks see £1.5bn boost from surging inflation

Energy networks have seen their regulatory asset value (RAV) grow by £1.5 billion as a result of higher than expected inflation, Ofgem has estimated.

The claim is included in a new call for input from the energy regulator on how the impacts of high inflation should be addressed through price controls.

The document suggests potential options to claw back any excess financial benefit, including introducing a cap on inflation-driven outperformance, a true-up adjustment at the end of a price control or a tightening of the rules on how dividends can be shared.

However, networks have warned the regulator that any retrospective steps would “compromise the longstanding consistency and integrity of the regulatory regime”.

Under the current methodology for the price control, calculations are made at the outset about a reasonable long-run assumption of inflation. Temporary divergences from this assumption have not previously been considered a problem as the pattern evens out over the course of the price control. However, Ofgem is now concerned that large peaks, such as the one currently being experienced, could skew average inflation levels over an entire price control. It warns this could result in excess equity outperformance and RAV growth which would ultimately be paid for by consumers in terms of higher bills.

This outperformance is linked to the cost of debt allowance and how it is deflated by a long-run assumption of inflation. Because the interest paid on fixed rate debt does not change with inflation this means that when inflation rises sharply the real cost of fixed rate debt plummets, generating a mismatch between the allowance and the cost of debt incurred. The range of outperformance will vary across networks depending on the proportion of index-linked debt in their respective capital structures.

Ofgem’s initial analysis suggests that from the start of RIIO-1 to April 2023, networks have seen approximately £1.5 billion RAV growth as a result of inflation deviating from the long-run assumption. This equates to around a £2.30 annual increase in the average domestic customer bill.

The call for input stresses that any estimate of the overall impact across RIIO-1 and 2 is highly sensitive to assumptions made on future inflation. For example, based on the Office for Budget Responsibility (OBR)’s March Consumer Price Index (CPI) forecast, Ofgem estimates a total of £1.2 billion extra RAV growth over the full period (adding £1.50 to the average annual bill). However, basing the same calculation on Treasury forecasts from May would increase the outperformance to £3.4 billion (£5.10 bill impact).

While emphasising that the call for input does not signal it is minded to take action, Ofgem has set out five high level policy options it could pursue.

These include the options to take no action at this time, to accept voluntary submissions from networks on how they could share any inflation-driven benefits or to enhance existing requirements on financial reporting performance.

Ofgem suggests a number of ways in which future price controls could manage inflationary risk, including ways of deflating the cost of debt allowance or introducing a return adjustment mechanism-type threshold. Alternatively it considers the approach of applying an adjustment, for example to RAV, at the end of RIIO-2 price controls to account for over or under performance.

A spokesperson for the Energy Networks Association said it was appropriate for the regulator to examine the impacts of high levels of inflation through consultation.

They added: “Any retrospective steps from Ofgem would compromise the longstanding consistency and integrity of the regulatory regime. Such steps would also lead to significant additional cost to consumers in the long run.

“Networks need to secure very significant additional investment to meet the government’s energy security targets. The consistency and integrity of the regulatory regime helps ensure our sector remains attractive to investment, particularly in the face of increasing international competition. We will continue to work with Ofgem throughout their consultation period.”

Comments in response to the call for input are being accepted until 26 September.