The chair of Ofgem’s RIIO2 challenge group has reaffirmed its view that there is no case for raising the cost of capital beyond the levels currently proposed by the regulator for the next set of network price controls.
Speaking in a series of open hearings on the price controls beginning in April 2021, Roger Witcomb said the coronavirus pandemic has made the stable returns of regulated utilities more attractive to investors, meaning “if there is argument at all, it will be for a reduction”.
According to its draft determinations for the sectors released in July, Ofgem currently expects the cost of equity to be set an average of 4.2 per cent in real terms for gas transmission and distribution, 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.
Networks have complained that these rates, which represent a reduction of around a half when compared to the current price controls, will leave them struggling to secure investment. They have been particularly critical of the decision to, for the first time, draw a distinction between the expected and allowed cost of equity.
On the subject of this so-called “outperformance wedge”, Witcomb said: “Probably most of us when we first saw that were extremely doubtful about whether that was a good idea. Since then, we’ve looked at it further and we’ve decided it probably isn’t a very good idea but is better than all the others to address what is a real problem.
“The problem is one of historical outperformance,” he explained. “That’s not just the fact that RIIO1 has seen some very high returns to the network companies. It’s over the entire tapestry of utility regulation; across all the utility sectors that are price regulated and across not just the UK but other countries as well.”
He continued: “On average, if you look at it from a statistical point of view, they have significantly outperformed the rates of return which were expected and that’s an obvious consequence of the asymmetry of information and occasionally asymmetry of resources as well.
“You’d expect that to happen so the question is what can you do about it? We looked quite hard at various things that could be done and concluded an outperformance wedge, even if it looks a bit odd, is actually the least bad way of solving that particular issue.”
Witcomb said the RIIO2 challenge group lacks the resources to establish whether Ofgem has landed at the right rate of return by conducting its own economic modelling: “We’ve gone in the other way and asked investors and the advisors of investors as well.”
Based on the “limited information” they have received so far, he said: “We still see no reason to change our view that’s in appropriate rate of return and that the companies in general, and Scottish Power in particular, will be financeable under that rate of return.”
Witcomb made the comments during a session on the draft determination for Scottish Power’s transmission business.
In a prior meeting on the draft determination for Wales and West Utilities, Ofgem networks director Akshay Kaul said the regulator was reviewing its approach to setting the cost of capital following the provisional decision by the Competition and Markets Authority (CMA) to raise the allowed returns for four appellant water companies by more than half a percent and set them above the mid-point for expected returns to mitigate the risk of underinvestment.
Kaul said: “Although the CMA’s determination for PR19 is provisional and we await their final findings, even at this stage, we do consider this to be an important contribution to the debate of the cost of capital.”
But he also said, whilst there may be some crossover, the regulator believes the CMA’s “aiming up” argument for setting allowed returns above expected returns is “more specific to sectoral circumstances”.