Cost of capital
The main point of contention between the networks and Ofgem so far has the been the baseline rate of return that shareholders will be able to recoup on their investment. The regulator has for the first time drawn a distinction between the rate of return investors should expect to receive and the rate it will actually allow them.
This difference is intended to reflect investors’ expectations that average returns will exceed the baseline in line with the outcome of past price controls.
Ofgem anticipates the cost of equity for gas transmission and distribution to be set at an average of 4.2 per cent in real terms, from which it plans to subtract 25 basis points for expected outperformance to give an allowed return on equity of 3.95 per cent.
As a result of a lower assumed gearing level – 55 per cent versus 60 per cent – the cost of equity for electricity transmission is expected to be set at 3.93 per cent and the allowed return on equity at 3.7 per cent.
The figures are all based on the CPIH inflation index which Ofgem is adopting for RIIO2. The equivalent cost of equity range for the current price controls is 7 to 8 per cent, meaning the regulator’s proposals represent a reduction of around a half. This decrease is expected to save consumers a total of £3.3 billion.
Ofgem intends to continue indexing the cost of a debt to a long-run historical average. It also plans to introduce indexation for the cost of equity, which will be tied to the risk-free-rate – the rate of return an investor would expect to receive on a completely risk-free investment. Treasury bonds – the next best thing – will be used as a proxy.
Based on a notional gearing of 55 per cent, the allowed return on equity for National Grid Electricity System Operator (ESO) is expected to average a much higher rate of 5.28 per cent. Given that the ESO will be subject to its own price control for the first time, Ofgem will not make a deduction to reflect expected outperformance.
Totex allowances
The electricity transmission and gas networks asked for around £24 billion of baseline total expenditure (totex) over the five-year price controls beginning in April 2021. Ofgem took an axe to their plans, chopping away more than £8 billion of requested spending.
The axe fell heaviest on the transmission networks, which lost nearly half of their requested allowance. Ofgem said £1.4 billion was moved to uncertainty mechanisms, £2.1 billion was cut by applying cost efficiencies and £2.7 billion was disallowed due to insufficient justification. The majority of the proposed reductions covered asset replacement work.
The spending plans of gas distribution networks were left relatively unscathed by comparison, with Ofgem proposing totex allowances around 20 per cent less than they requested. Around a third of the reduction – £860 million – is for proposed expenditure on the irons mains replacement programme, which the regulator deemed is “discretionary, uncertain or has long paybacks”.
Ofgem said nearly half of proposed baseline spending is covered by price control deliverables (see outputs) and uncertainty mechanisms such as volume drivers and reopeners.
The regulator intends to introduce a new whole-system reopener known as the coordinated adjustment mechanism to allow activities and the associated allowances to be transferred from one company to another, as well as a net-zero reopener to allow the regulator to adapt the price controls in response to changes connected with the decarbonisation of the energy system.
It has identified around £10 billion of additional investment which could be allocated funding as part of a net-zero reopener. Potential projects include a motorway charging network for electric vehicles and a transmission circuit running along the east coast to enable the connection of large amounts of offshore wind generation.
As things currently stand, all of the transmission and gas distribution networks are facing significant reductions in annual spending, both when compared to their allowed and forecast expenditure over the current price controls.
In the case of transmission, Ofgem said a better comparison could be made by excluding load-related investments as shown the graph below. With this spending removed, Scottish Hydro Electricity Transmission – the transmission arm of Scottish and Southern Electricity Networks (SSEN) – is actually facing a sizeable increase in annual expenditure.
Across transmission and gas distribution, Ofgem has proposed an annual cost efficiency target of 1.2 per cent for capital expenditure and replacement expenditure (in the gas distribution sector) and 1.4 per cent for operational expenditure.
Incentives and outputs
Under the new Business Plan Incentive (BPI) being introduced for RIIO2, Ofgem will apply rewards or penalties worth up to 2 per cent of networks’ total expenditure allowances based on value for money and the quality of the information provided.
The regulator has proposed to apply penalties to all but two of the companies it examined – Wales and West Utilities, which is set to receive neither a reward nor a penalty, and Northern Gas Networks, which is in line for a reward of £1.6 million. Both National Grid Electricity Transmission and SSEN are set to receive their maximum possible penalties of £66.6 million and £32.2 million respectively.
The BPI is replacing the Information Quality Incentive, which was also used to determine the sharing factor for network companies – the proportion of any over or underspends they will be liable to cover or receive.
For RIIO2, these sharing factors are instead being determined based on the respective proportion of forecast costs in which Ofgem has a high or low level of confidence. They will be calculated in such a way that if Ofgem has high level of confidence in all of a network company’s costs, then it will receive a sharing factor of 50 per cent, and if Ofgem has a high level of confidence in none of their costs, then it will receive 15 per cent.
Ofgem has proposed significantly lower sharing factors for the transmission networks than the gas distribution networks, with all of the latter receiving 50 per cent or marginally less.
Companies will be required to deliver three main types of outputs:
- Licence Obligations – minimum standards that network companies must achieve
- Price Control Deliverables – outputs with attached funding that can be refunded to customers if they are not delivered (or not delivered to a specified standard)
- Outcome Delivery Incentives (ODIs)– outputs intended to drive service improvements through reputational and financial incentives
These will be further divided between “common” outputs that apply to all sectors or the whole of a sector and “bespoke” outputs that apply to individual companies, which are grouped into three different categories, as seen below:
There are upper and lower limits on the total rewards and penalties associated with ODIs set at the following rates for each sector as a percentage of their Return on Regulatory Equity (RoRE):
- Electricity transmission – minus 1.1 per cent to plus 0.2 per cent
- Gas transmission – minus 0.7 per cent to plus 0.6 per cent
- Gas distribution – minus 0.8 per cent to plus 0.4 per cent
To ensure their earnings do not exceed its expectations, the regulator is also introducing a new Return Adjustment Mechanism, whereby any RoRE more than 3 per cent above or below the baseline will be cut in half.
The following graph graphs shows Ofgem’s proposed RoRE for each company and how they would be affected by the various mechanisms described:
The £25 billion package
Ofgem has proposed a further £8.8 billion of investment outside of the baseline totex allowances for transmission and gas distribution, bringing the total value of the package to £25 billion. The regulator said a large chunk of this – £3 billion – would go towards upgrades to power grid to allow more renewable generation to be connected.
It has set aside at least £630 million for a new Strategic Innovation Fund to replace the Network Innovation Competition but will continue to provide the Network Innovation Allowance, with funding proposed at the following amounts:
Furthermore, there is £500 million of funding to reduce networks’ own environmental impacts, including visual impacts, emissions from gas transmission compressors, resource use and waste.
The £8.8 billion additionally includes the budget for the ESO, whose price control will be diverge significantly from the rest. Although it will still last for five years, the company will operate according to a two-year investment cycle.
Given its large influence over costs in the rest of the energy industry, Ofgem wants to give the ESO the flexibility to make whatever investment it deems necessary. It will therefore be excluded from the totex incentive mechanism, whereby network companies share over or underspends with customers.
Its expenditure will instead be treated as a passthrough cost. Each year Ofgem will issue rewards of up to £15 million or penalties up to £6 million, based on an assessment of the organisation’s performance in delivering its business plan. Ofgem said it wanted to offer greater rewards than penalties to encourage the company to be ambitious and stretch itself.
The ESO requested £514 million over the first two years of the price controls. Ofgem subtracted £34 million for expected efficiencies and £106 million for costs it felt were too uncertain, giving a proposed totex allowance of £374 million – or £187 million per year. This would represent an almost 6 per cent increase compared to what it receives currently.