Ofgem’s failure to use up-to-date evidence when determining electricity network returns for the first set of RIIO price controls is expected to cost consumers £800 million, according to a new report from the National Audit Office (NAO).
The watchdog says network operators’ spending allowances are also too generous and their performance targets too lax. It has urged the regulator to improve its evidence gathering for future decisions.
The report says electricity network returns are currently forecast to average 9.2 per cent over the full eight-year settlement period.
This is towards the high end of Ofgem’s anticipated range of 2.5 per cent to 10.5 per cent, which it only expected to be reached by the best performing companies. Despite regulated utilities being considered less risky by investors, it is also higher than Ofgem’s estimate of the average return for a FTSE-listed company of 5.35 per cent to 5.75 per cent. A recent survey by the regulator suggested investors now expect even lower returns of 3 per cent to 4 per cent.
The NAO says this is partly the result of Ofgem setting the cost of equity – the baseline profit margin for shareholders – too high.
“At the time of RIIO1, other regulators tended to adopt estimates which were on the high side, as this was thought to be necessary to provide additional certainty that companies will not need to be financially rescued by consumers or taxpayers,” it explains.
“In addition, it ensures companies are capable of raising enough finance for significant programmes of investment, such as the investment Ofgem was expecting in RIIO-1.
“Nevertheless, in our assessment, Ofgem erred in placing too much weight on consistency with previous regulatory decisions when it set the baseline rate of return, and not enough weight on the most up-to-date market evidence, which suggested network company risk was lower.
“We estimate that if Ofgem had placed greater weight on this evidence, consumers could have paid at least £800 million less.”
The report says returns have also surpassed expectations because network companies have been able to exceed nearly all of the performance targets set by the regulator: “Of the average 9.2 per cent returns forecast by network companies, 1.2 percentage points come from network companies spending less than their full allowances for costs and 1.5 percentage points from operational performance other than underspend.”
“Targets for this scheme were fixed too far in advance,” it adds, “meaning network companies were already beating their targets before the price control started.”
It says these issues have been exacerbated by Ofgem’s decision to lengthen the price control period from five years to eight – one it has since reversed for RIIO2. It was hoped this would encourage innovation and long-term thinking, but the NAO says it has instead “locked consumers into paying higher costs for longer”.
The report notes that Ofgem decided against amending the settlement as part of its mid-period to return some of this windfall to customers. It worried that reneging on its previous commitments could shake investors’ confidence and ultimately raise costs for consumers.
But the NAO says the regulator lacks the “robust evidence” required to accurately assess the cost impact of such a decision. It says Ofgem “needs to do more work to show in clear and simple terms that the overall cost-effectiveness of networks has improved over price control periods.”
“Under Ofgem’s current regulatory framework, electricity network companies have provided a good service, but it has cost consumers more than it should have,” the report concludes.
“It is now clear that targets were set too low, budgets too high, and the impact of these decisions was compounded by Ofgem extending the regulatory period from five years to eight.”
It does, however, credit the regulator for seeking to learn lessons from these failures.
The report makes a number of specific recommendations, including that Ofgem should:
- Develop and publish summary indicators of the overall value for money of energy networks across price controls.
- Improve its evidence base on the impact of regulatory decisions on investor confidence and the cost of capital.
- Assess the extent to which spending allowances were set too high and apply these findings when scrutinising companies’ business plans for RIIO2.
- Ensure that networks companies publish information on their dividend policies, tax rates and executive pay.
It also calls for the Department for Business, Energy and Industrial Strategy (BEIS) and the Department for Transport to work with Ofgem to achieve “as much clarity as possible” on the implications of the decarbonisation of heat and transport before the regulator makes any major decisions on the RIIO2 price control for electricity distribution.
Furthermore, it says BEIS should investigate the potential benefits of more strategic coordination in the energy system as part of its review of industry governance and bring forward heat decarbonisation policies to ensure emissions targets are met during the 2020s.
Responding to the report, Ofgem director of network price controls Akshay Kaul said: “We welcome the NAO’s findings that Ofgem’s regulation has delivered consumers a good service, increasing customer satisfaction and sharply reducing power cuts to half the European average, whilst attracting £70 billion investment to connect record levels of renewable power.
“We acknowledge that the overall costs to consumers to date have turned out to be higher than they needed to be. That’s why our tough new round of price controls will lower returns to save consumers money, whilst pushing companies to go further on decarbonisation and ensuring we retain one of the world’s most reliable energy systems.
“Under our regulation, companies must share any savings they’ve made during the price control period with consumers. So far, over £6 billion has been clawed back across all networks through reduced revenues or voluntary contributions.”
The findings chime with those of a 2017 report from Citizens Advice, which claimed energy networks were on track to receive £7.5 billion in “unjustified profits” over the course of the current settlement period, primarily because Ofgem overestimated the level of risk faced by investors.
In a report published the following year, Citizens Advice urged the regulator to go beyond its initial proposals and cut another £4.1 billion from networks returns between the first and second round of RIIO price controls. It had already suggested a £5.1 billion reduction as part of its consultation on the RIIO2 framework.
Ofgem confirmed the sector specific methodologies it will use to set the price controls for transmission and gas distribution in May 2019.
If applied at the time, the regulator said this would result in a real cost of equity of 4.3 per cent based on the new CPIH measure of inflation it intends to adopt. The equivalent figure for the current price controls is 7 to 8 per cent. Ofgem has since raised its indicative estimate to 4.8 per cent.
Networks operators have warned that a reduction of this size would make it difficult to attract the level of investment needed to decarbonise the energy systems cost effectively. Those in the transmission and gas distribution sectors continued to protest the decision in their draft business plans submitted to the regulator in December.
However, the RIIO2 challenge group – a panel of industry experts and consumer representatives assembled by Ofgem to scrutinise the plans – said: “None has persuaded us that Ofgem’s working assumptions for the cost of capital make their businesses unfinanceable.”
It also said they could not justify £4.1 billion of non-load-related expenditure detailed in the plans, the majority of which was requested by electricity transmission networks.