Ratings agency Moody’s says “many uncertainties remain” following Ofgem’s decision on its methodology for setting the RIIO2 price controls.
Ofgem made the announcement last Friday (24 May) and said the baseline allowed return on equity would be set at 4.3 per cent based on the new CPIH measure of inflation it intends to adopt.
The regulator says it is the “lowest ever” rate proposed for energy networks and represents a 50 per cent reduction on the current level.
The allowed return remains below that proposed by water regulator Ofwat for the PR19 price control in that sector. Moody’s however says that in arriving at the allowed return, Ofgem has assumed that companies will be able to “outperform” due to incentives and cost outperformance, a divergence from past practice and the approach taken by Ofwat.
Furthermore, Moody’s says that the use of an extended trailing average to set the cost of debt means that the allowance will fall “more slowly” through the period. However, the effect will be smaller if rates begin to rise, as it currently expects, and could be negative in theory if the rates rose sharply.
Changes to the return adjustment mechanism that Ofgem plans to implement for gas distribution networks mean that the cash flow of individual companies will not be affected by the performance of their competitors, as would have occurred under earlier proposals.
The ratings agency adds that the decision to exclude borrowing costs from the calculation is likely to increase the scope for outperformance to support credit metrics at companies with low borrowing costs, such as Northern Gas Networks and Cadent, but reduce it for companies with high borrowing costs, particularly Wales and West Utilities.
Moody’s notes that Ofgem has “abandoned” the most significant measure it had considered to support the credit quality of companies, namely a cash flow floor mechanism that would have required gas consumers to provide “potentially unlimited liquidity” to operating companies that were otherwise unable to service their debt.
In addition, Moody’s believes Ofgem’s “harder line”, namely the fact that it does not believe it has a duty to ensure all licensees are financeable in all circumstances, is negative for Wales and West Utilities in particular because of its higher borrowing costs.
Responding to the report, a spokesperson for Wales and West Utilities said:“We are fully engaged with Ofgem in the RIIO2 process, which is still at an early stage.
“We will be strongly making the case for a financial settlement that not only allows us to continue to deliver the services our customers want and need and prepare the energy system for the future, but also delivers a fair return for investors.”