Ofgem has issued its final determinations for the RIIO2 price controls beginning in April next year, raising the baseline profit margin for investors in the transmission and gas distribution sectors by more than a third of a percentage point when compared to its draft determinations in July.
The regulator has increased the allowed return on equity for a notional company geared at 60 per cent from 3.95 per cent in real terms to 4.3 per cent. It said a typical investor could also expect to receive 0.25 per cent in performance incentives to give an overall cost of equity of 4.55 per cent.
Ofgem said this still represents a reduction of around 40 per cent when compared with the current regulatory period. Along with improvements in efficiency, the cut to returns is expected to save consumers £2.3 billion.
The regulator has also approved an extra £5 billion of upfront spending over the shorter five-year RIIO2 price controls – a fifth more than in its draft determinations and bringing the total to £30 billion. It has flagged a further £10 billion of net-zero investment that could be approved during the period but said there is no limit on funding so long as companies make a good business case.
Ofgem chief executive Jonathan Brearley said: “Our £40 billion package massively boosts clean energy investment. This will ensure that our network companies can deliver on the climate change ambitions laid out by the prime minister last week, whilst maintaining world-leading levels of reliability.
“These costs must fall fairly for consumers. We are reducing the amount paid to shareholders so that they are closer to current market levels. This means that companies can attract the vital investment we need whilst making sure that consumers don’t pay more than is necessary to achieve this.”
Despite the increase in returns over the draft determinations, Scottish and Southern Electricity Networks (SSEN) said it is “very disappointed” they do not reflect the “robust evidence” available to Ofgem. The company said it had expected the decision to be “at least in line” with the provisional findings of the Competition and Markets Authority in the ongoing appeal of four water companies against their price controls, adding that it will “continue to keep all options open”.
Rob McDonald, managing director of SSEN Transmission, said: “We were greatly encouraged by the broad support for our stakeholder-led business plan throughout Ofgem’s consultative process and cautiously welcome Ofgem’s movement on a number of fronts.
“However, at this stage in our assessment, we continue to have concerns and will need to reflect further as we review and analyse the full settlement in the round over the coming weeks.”
Scottish Power chief executive Keith Anderson said: “This is a large and complex document and we will now take our time to analyse it in full and consider our next steps. We remain concerned that Ofgem’s proposals on the headline rate of return will not attract the global investment our transmission business requires if we are to support the clear net zero ambitions of the UK and Scottish governments, including the prime minister’s ten-point plan.”
After rejecting more than £8 billion of requested expenditure at the draft determination stage, Ofgem has decided to increase totex allowances back up by £4.1 billion.
National Grid, which back in July had nearly half of its £10 billion in proposed spending disallowed, said it too is reviewing the regulator’s latest decision.
It said in a statement: “Given the current expected timeline, we anticipate that we will make any final decision on whether to accept or appeal the licence modifications implementing Ofgem’s final determination to the CMA no earlier than late February 2021.”
Citizens Advice has previously pushed Ofgem to go further than in its draft determinations, cutting network returns by billions of pounds more. Acting chief executive Alistair Cromwell said: “Today’s announcement is genuine progress. For too long network companies were able to make excessive profits, not because they were efficient firms, but simply because previous price controls were too generous.
“We recognise these are hugely complex decisions in which the regulator has to balance value for consumers against profits and shareholder returns. Although we are pleased with this progress, we’ve argued that Ofgem could have gone further in limiting shareholder returns and still believe that to be the case.
“Beyond the headline figures, there is much to welcome in this price control.”
The main basis of its argument is that regulated networks with reliable, long-term returns are less risky to investors than Ofgem has estimated in its calculations. However, the equity beta – a measure of the relative risk of a sector or company when compared to the market average – has actually been raised above the draft determinations from 0.725 to 0.759.
Ofgem said this was the main reason for the increase in the cost of equity to 4.55 per cent and that it has not changed its view that a typical investor in the UK could expect to generate total market returns of between 6.25 and 6.75 per cent.
It said the cost of equity for energy network now offers a “premium” over water networks, both when compared to Ofwat’s final determination of 4.09 per cent for PR19 and the Competition and Market Authority’s preliminary findings in the subsequent appeal of four water companies, for which Ofgem said the equivalent figure is 4.37 per cent.
The final determinations published today (8 December) cover the price controls for the gas and electricity transmission and gas distribution sectors as well as the electricity system operator. The price controls for electricity distribution will begin two years later than the rest in April 2023.