Ofgem has urged the Competition and Markets Authority (CMA) to dismiss the appeals sought by the transmission and gas distribution networks against their final determinations for RIIO2, arguing they are “without merit”.
Responding to their notices of appeal in a submission to the CMA, Ofgem said the networks’ complaints “amount to no more than disagreements” with way it has exercised its “expert regulatory discretion”.
Ofgem noted that under the Gas Act 1986 and the Electricity Act 1989, the CMA may only allow an appeal if the regulator has failed to fulfil its principal objective and statutory duties, its decision was “based, wholly or partly, on an error of fact” or its decision was unlawful. It said it is not the CMA’s role to substitute its judgement for that of Ofgem “simply on the basis that it would have taken a different view of the matter if it had been the regulator”.
The regulator said the appellants’ main challenge to the cost of equity should be rejected because they do not demonstrate that its decision was wrong on one or more of the statutory grounds of appeals. It said estimating the cost of equity is “an exercise in the unknown,” with the parameters under the capital asset pricing model (CAPM) – the risk-free rate, total market return and the equity beta – being “inherently uncertain and not directly observable.”
Concerning the risk-free rate– a measure of the rate of return investors would expect to receive for a completely risk-free investment – Ofgem accused the appellants of mischaracterising its position, stating it does not view index-linked gilts as a “perfect, error-free proxy”. It said index-linked gilts instead offer the best possible proxy for what the appellants accept is a “hypothetical number” without requiring “a series of discretionary adjustments” as would be required if the regulator followed their suggestion of using AAA-rated corporate bonds.
Ofgem said the assertion that this approach is inconsistent with CAPM theory is “misplaced”, stating that there is a “long regulatory precedent” for using index-linked gilts to estimate the risk-free rate, and that it is the networks instead who are putting forward arguments that are “contrary to well-established regulatory practice”. It said none of their objections “withstand scrutiny or provide a basis for a successful statutory appeal.”
On total market returns (TMR) – a measure of the average returns an investor would expect to receive for investing within the market as a whole – Ofgem said appellants raised “narrow, esoteric points, all of which concern matters of regulatory judgement, in a context where it is common ground that TMR is, as a measure of investors’ ex ante expectations of equity returns, unobservable.” The regulator said it “sought to take a cautious approach and set the range at the higher level of investors’ expectations” and that the CMA should be “very slow” to interfere with this judgement.
With regards to the equity beta – a measure of the relative risk of investing in a particular company or sector when compared to the market as a whole – Ofgem noted that no “pure play” energy network company is listed on the stock market. It said it was therefore necessary to use National Grid and SSE, the three listed water companies and publicly traded European companies as proxies, whilst making adjustments to reflect their gearing and composition and giving different weights to each.
Ofgem said the appellants’ criticism over the use of water company stocks to estimate the equity beta appears to arise from the “misapprehension” that it gave them equal weight to that of National Grid. “Given the inherent difficulties in making beta comparisons across jurisdictions,” the regulator also said it was “entirely justified” in placing limited weight on the observed betas of European companies and relying on UK observations “rather than making a speculative adjudication on the relative merits of different European samples and how these would translate into the UK context.”
Responding to gas networks’ complaints that it failed to recognise the higher systemic risks they face when compared to electricity networks, Ofgem said it carefully considered the qualitative evidence but found it to be “inconclusive”. It said the higher weighting given to estimates of National Grid’s beta should “mitigate concerns about risk differences between electricity and gas – as it would incorporate risks associated with National Grid’s gas transmission and gas distribution businesses.”
On its decision to set allowed returns below the mid-point of its estimated range for the cost of equity, Ofgem acknowledged that it is common for regulators to instead “aim up” as the CMA did in its PR19 redetermination. However, the regulator said there is “no general rule that ‘aiming up’ is required” and that the merits of doing so are dependent on its level of confidence in its estimates and its assessment of the level of risk of underinvestment.
It said its downward adjustment of 25 basis points to reflect investors’ expectations that networks will exceed the baseline profit margin based on past performance – known as the outperformance wedge – is “strongly grounded in economic evidence, which supports the view that information asymmetry is a structural feature of price controls and that a degree of outperformance based on information asymmetry cannot be excluded.”
As to the argument that gas networks face “stranding risk” if decarbonisation leads to their declining use, Ofgem said it considers accelerated depreciation to be a more appropriate response and highlighted that this mitigation was not sought by any of the gas distribution networks themselves.
In a submission responding to its final decision on the PR19 appeals by water companies, Wales and West Utilities (WWUs) argued that the CMA’s redetermination had “no material bearing” on its ground for appeal. The CMA issued its findings just days after the transmission and gas distribution networks announced their intention to appeal their final determinations for RIIO2.
WWU’s argument was in stark contrast to the rest of the appellants, which cited the CMA’s redetermination as supporting their case.