RIIO2: Ofgem sets the ball rolling

Ofgem's opening gambit for RIIO2 reveals keen eyes on outputs, spending plans and returns. Nigel Hawkins reviews the lay of the land.

In his legendary epistles, such as those to the Corinthians, the great letter-writer, St Paul, wrote at considerable length. Ofgem, in its opening salvo on RIIO2, has done likewise.

Its recent 19-page letter covered many aspects of the RIIO2 regulatory process; it also posed no fewer than 37 questions.

RIIO1 was the mechanism introduced in 2010 to set price controls for electricity and gas networks; it was based on prescribing allowable revenues, which also incorporated incentives to innovate and to deliver the required outputs.

RIIO2 will be applied to the electricity and gas transmission networks as well as to the gas distribution businesses, whose existing price controls expire on 31 March 2021: for the electricity distribution businesses, the relevant expiry date is two years later.

However, unlike the water sector where innovation has been at the margins for decades, Ofgem must regulate an energy sector where fundamental change is underway.

Most notably, electricity and gas demand is falling as energy saving initiatives kick in.

Renewables generation, with its concomitant challenges to grid management, has come of age. To such an extent that, as Ofgem notes, the “first working day without coal power since the Industrial Revolution”, was recorded in April.

Add to that the development of distributed generation, the troubled installation of smart meters and the potential impact on electricity demand from step-changes in transport, especially the arrival of electric cars, and it is clear that Ofgem faces many unknowns.

Three principles

In undertaking RIIO2, Ofgem has highlighted three over-arching principles.

First, ensuring that outputs are delivered is key. Certainly, electricity and gas networks regulation has succeeded on that count.

To have done so is certainly not a given as another price-regulated monopoly, Network Rail, has demonstrated; in recent years, several key railway projects have fallen hopelessly behind and vastly exceeded budgets.

Secondly, Ofgem must project future electricity and gas networks expenditure – a major challenge.

In RIIO1, Ofgem estimates that revenues of c£96 billion will have accrued to electricity and gas companies over the eight-year period – chunky money indeed.

This time round, totex – the combination of operating and capital expenditure – will be rigorously scrutinised.

Thirdly, financial issues are pivotal, particularly to shareholders but also, less directly, to consumers.

Generally speaking, shareholders in UK electricity and gas networks companies have prospered in recent years – and certainly compared with most generation-related investments: many have also out-performed their regulatory assumptions.

Inevitably, as in the water sector, the Weighted Average Cost of Capital (Wacc) figures will be crucial. Ofgem points out that the RIIO1 Wacc figures ranged between 3.76 per cent for slow-tracked electricity distribution companies to 4.76 per cent for electricity transmission businesses.

Lower costs

Ominously, perhaps, Ofgem has noted how much 10-year bond rates have fallen since December 2012 when the final proposals for RIIO1 were set – a clear signal that lower Wacc figures are probable.

This view is reinforced by Ofgem’s observation that the recent sales of stakes in gas distribution networks have taken place at premia exceeding 40 per cent of their Regulated Asset Value – hardly the equivalent of selling infrastructure assets at distressed prices.

More generally, Ofgem has highlighted its responsibilities to consumers – “RIIO2 will ensure regulated network companies deliver the value for money services that consumers want and need.”

Of course, generation costs are the key factor in driving retail electricity prices, whilst the cost of gas supply is pivotal to retail gas costs – both are out with Ofgem’s RIIO2 regulatory process.

Nonetheless, lower network costs do bear down on retail prices.

Ofgem knows, too, that the issue of rising energy prices has been moving up rapidly up the political agenda as the on/off energy price cap debate has demonstrated.

In terms of the quoted companies, RIIO2 will most directly impact National Grid, currently capitalised at c£33 billion.

In 2016/17, £1.37 billion of its underlying £3.77 billion operating profit was earned from its UK electricity transmission business – the eventual RIIO2 outcome will, therefore, be very price-sensitive.

Whilst none of the 12 Regional Electricity Companies, privatised in 1990, are independently quoted, some remain key divisions of other utilities, notably SSE which acquired Southern Electric in the late 1990s.

Nonetheless, these companies – and their gas equivalents – will accord the highest priority to the RIIO2 regulatory process, especially if Ofgem seeks to squeeze their existing financial returns.

It is, though, early days for RIIO2; expect further lengthy epistles from Ofgem.