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Tougher returns for energy investors – Ofgem sets off on the long road to RIIO-2

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The process for the development of the next set of price controls – RIIO-2 – has begun. Ofgem recently outlined its initial thinking on the overriding objective and principles for the RIIO-2 Framework (see Ofgem RIIO-2 Letter). This is the start of the consultation process. The full RIIO-2 Framework is not due until Q2 2018. The price controls are further away still –  April 2021 (for electricity and gas transmission and gas distribution) and April 2023 (for electricity distribution). However, Ofgem has clearly set its sights on introducing tougher controls.   

Ofgem’s five-fold approach to RIIO-2 – tougher price control with tougher outputs

Ofgem promises that “RIIO-2 will ensure that regulated network companies deliver the value for money services that consumers want and need”. In this regard, Ofgem is committed to:

  • Giving consumers a stronger voice in setting outputs, shaping and assessing business plans. In particular Ofgem is reviewing the existing approach to stakeholder engagement, and is considering borrowing best practice approaches from the water and aviation sectors. Ofgem is also focused on reviewing the outputs framework to ensure output targets and associated financial incentives reflect what customers value and are willing to pay for.
  • Incentivising companies to drive consumer value by shaping or proactively responding to changes in how networks are used and services are delivered. In particular Ofgem is considering how to incentivise whole system coordination, possibly by aligning the electricity price controls (for transmission and distribution – as is done for gas). Ofgem will also review whether RIIO-1 uncertainty mechanisms adequately manage future developments that might arise in RIIO-2.
  • Using the regulatory framework, or competition where appropriate, to drive innovation and efficiency. In particular Ofgem is looking to improve the way it evaluates business plans to ensure efficiency, and is asking whether the eight year price control is appropriate. Ofgem is also looking to expand new models of competition (citing the success of OFTOs), as part of RIIO-2.  
  • Simplifying the price controls by focusing on items of greatest value to consumers.  In particular, developing a common methodology for business plans, considering whether “fast-tracking” is still appropriate and reviewing Ofgem’s existing monitoring and information collection.
  • Allow regulated companies to earn fair returns that represent good consumer value, properly reflecting the risks faced and prevailing financial market conditions. 

Attack on rates of return – more for less from operators and investors

Ofgem suggests that RIIO-2 is likely to see significantly lower costs of capital than RIIO-1.  Ofgem believes investors are prepared to accept considerably lower long-term yields for investments in utilities – which Ofgem sees as stable assets, subject to a predictable and robust regulatory regime. Ofgem cites recent sales (e.g. Gas Distribution Networks, and water sector acquisitions), where sale price exceeded regulatory asset value.

Potential gaps between Ofgem and investor perceptions

However, it is arguable that Ofgem’s position does not necessarily reflect the difficulties which operators and investors currently face. In particular:

  • Public opinion and political scrutiny – there has been a recent notable shift in public and political opinion against energy networks. The industry has faced scrutiny from the Competition and Markets Authority (CMA) in its energy market review. During the recent general election, the Conservatives called for the imposition of price caps in their election manifesto, albeit that this was not subsequently included in the Queen’s Speech. There have even been suggestions that the industry should be renationalised. Most recently, a further review of energy costs (to be led by to be led by Professor Dieter Helm CBE) was announced on 6 August by Department for Business, Energy & Industrial Strategy (BEIS) (see previous BLP Blog). The combination of reviews, reforms and political pressure, together with political proposals to restrict foreign ownership of critical infrastructure, could have significant negative impacts on investor appetite. This concern isn’t new – indeed the CMA made these points in its contributions to the recent consultation on strategy by BEIS.
  • Interest rates – historically low interest rates are likely to rise soon. Even though the Bank of England has yet to increase its rates, market rates have begun to increase. Utility investments may become significantly less attractive if rates of return significantly diverge from market rates. 
  • Overseas investor appetite – Brexit will also have an impact.  Since the referendum there has been a notable increase in concern about UK investments from foreign investors. Whilst in the short term the devaluation of the pound has enabled foreign investors to get more for their money, sterling-denominated long-term returns may suffer. 
  • Portfolio spreads – finally, Brexit may have a further sting in the tail for the industry. With many foreign investors seeking to meet targeted percentages of their investment within the EU, a UK outside the EU may well result in investors diversifying funds into mainland Europe.

It is clear that there has been significant historic appetite to invest in energy network assets, including via funding operator-delivered outputs, both through equity and debt funding. However, Ofgem’s proposals may overstate the stability of the regulatory regime, and consequently may misjudge likely future investor and operator sentiment.

Next steps

Ofgem has outlined its direction of travel.  However, while there are clear political and pressures on the regulator to be “tough on returns”, there remains an opportunity to help shape Ofgem’s RIIO-2 proposals.  Ofgem’s consultation is the first step in developing the regulators’ approach to RIIO-2 over the coming weeks and months.     

Getting in touch

We have extensive experience of competition and regulatory issues in the energy sector.  If you have any questions, please get in touch with one of the authors.

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