“Fool me once, shame on you. Fool me twice, shame on me.” This well-known aphorism may well have been running through the minds of regulators when they decided to introduce a new outperformance wedge as part of the RIIO2 price controls.
The wedge – expected to be set at a reduction of 0.5 per cent – refers to the difference between what Ofgem considers a fair return for network investors and what it will actually allow them. The mechanism was partly justified on the grounds of the asymmetry information between itself and the networks – i.e. that companies will be able to exploit their deeper knowledge of their businesses and assets to get one over on the regulator.
Ofgem will tomorrow (9 July) publish its draft determinations for the gas and electricity transmission and gas distribution sectors, giving its initial assessment of their multi-billion-pound business plans for the five-year regulatory period beginning in April 2021.
The wedge is emblematic of Ofgem’s efforts to ensure the next price controls are not as generous as the current set, which have seen some companies reporting a regulatory return on equity (RoRE) in the double-digit percentages.
It has also become “lightning rod” for networks’ frustrations, an industry source told Utility Week. Multiple companies have criticised it as arbitrary in nature and duplicative of other measures such as the return adjustment mechanisms, which will lower their share of additional underspends once they pass set limits.
With the wedge applied, Ofgem’s latest indicative figure for the cost of equity is 4.8 per cent. This is based on the new CPIH inflation index it intends to adopt for RIIO2. Under the old RPI measure, this equates to around 3.8 per cent, meaning that network companies will see their cost equity almost halved from between 6 and 7 per cent.
The source, who works for one of the networks, expressed concerns that Ofgem is “whittling away” the incentives that underpin the RIIO framework. But they also said it will be important for networks to consider the package as a whole and not get too caught up on any one part.
They said companies will be very keen to obtain a good score under the new business plan incentive (BPI) .The BPI is replacing the information quality incentive (IQI), which Ofgem deemed to have failed in its aim of encouraging networks to submit accurate cost estimates.
The IQI offered a higher sharing factors to companies whose business plans were fast-tracked upon initial assessment by Ofgem. The others were required to submit revised business plans to the regulator. These were then compared between each other and the regulator’s own cost estimates to determine their sharing factors.
This time around there will no fast-tracking and networks will not be incentivised through their sharing factors. They will instead be rewarded or penalised up to 2 per cent of their totex based on the regulator’s judgement of the quality and cost of their business plans.
With Ofgem putting the squeeze on profits in general, the industry source said the new incentive represents an opportunity to relieve some of the pressure they otherwise face.
They also noted the opportunity for the regulator to accelerate investment as part of a green recovery from the coronavirus pandemic – one that was also highlighted recently by Maxine Frerk, who previously served as the senior partner for networks at Ofgem.
The source said it will be difficult to bring forward investment immediately due to the long lead times but that Ofgem could speed things up by pre-approving funding for projects that were expected to be covered by an uncertainty mechanism.
If they are needed, networks would avoid having to apply for the funding nearer the time. If not, the funding could always be recovered by the regulator anyway.
Whatever is revealed in tomorrow’s draft determinations, the source said they would be very hesitant to follow in the footsteps on the water companies that have appealed against their settlements to the Competition and Markets Authority. Their own personal view was the networks should do every they can avoid this option, which would swallow up times and resources – possibly with nothing to show for it – and instead focus on delivering their plans as best they can.