Ofgem recently announced its decision to more than halve the returns that energy networks can earn and, as Head of UK Regulatory Finance, I have the unenviable task of convincing Ofgem and our stakeholders that a fair return for RIIO-T2 is higher than the current political and public narrative would have us believe.
That’s felt a bit like trying to push water up a hill over the last few months.
I’ve been arguing that investors and consumers both need a fair financial framework to minimise long term costs; especially during the transition to a new low-carbon, low-cost energy system.
Currently, I think that Ofgem is looking too much at the short-term. That’s not surprising as affordability is important for all of us. But for me this needs to be over the long term and not focus on short term fixes that will just increase costs further in the future. We have an opportunity today to transform the energy system. That won’t happen without the right investment and return.
But first a bit of background…
Late last month Ofgem confirmed its sector-specific price control methodology decision for RIIO-2. A mouthful, I know, and one that is at risk of leaving a bitter taste.
In its decision, Ofgem set the allowed return on equity at 3.3%, which is less than half of what it was in the previous price control RIIO-T1 (7%). We recognise there are arguments for why it could be lower, but our evidence shows that a 5.5% cost of equity would be a fairer reflection of the risks we manage.
Historically transmission has been seen as higher risk than other regulated utilities, reflecting greater construction complexity and uncertainty about how many and what type of new investments will be needed. These are risks that investors need to be adequately rewarded for otherwise they won’t invest.
The numbers are material here. A 1% change in allowed return is about £100m of revenue every year in the price control period. To more than halve the figure is therefore a big change, which gets even bigger when you think about what this would do to the behaviours and investment required to modernise Great Britain’s energy system. It won’t drive the future investment or future ability to deliver things like whole system outcomes, which will ultimately help keep down consumers’ bills and improve our impact on the environment over the longer term.
With such a low cost of equity, we would end up being more cautious on investment, needing funding security before starting any work. This is because the risk to consumers is not that you delay investment until after it is needed because we have outputs we need to deliver, but you end up constraining the delivery into a shorter time period and increasing costs overall. This would have the most impact in driving whole system focus where the requirements are far from clear.
In practical terms, this translates directly to tackling the big issue of decarbonisation by making heat and transport cleaner and at a low cost for energy users. We need to invest in innovations to find a better way – e.g. how we can use hydrogen in our networks and that the right electric vehicle ultra-rapid charging points are rolled out along the motorway. Ultimately, we need to transition to a new low-carbon, low-cost energy system where consumers can see the clear benefits of the energy transmission networks.
We are not a lone voice either. I think that Scottish and Southern Electricity Networks (SSEN) was spot on when it said: “…the proposed framework fails to fully balance stakeholder and consumer needs with the requirement to provide investor confidence and attract the significant investment needed to enable the clean energy transition.”
So where to go from here?
We will continue to develop our business plans that fully deliver on stakeholder ambitions. Our first draft submission to the Ofgem Challenge Group will be on Monday 1 July and a final submission to Ofgem is due on Monday 9 December 2019.
During this time, we will continue to advocate, constructively and robustly, for a regulatory framework that strikes the right balance between ensuring efficiency and affordability with delivering the necessary investment to improve services for consumers and drive further progress towards a low-carbon, flexible energy system that achieves government policy objectives.
Head of Regulatory Finance