RIIO-2: Is Ofgem up for a fight?

On 9 July 2020 Ofgem published its draft determinations (DD) for the new set of price controls from 2021 to 2026 for transmission, gas distribution and electricity system operators, the so called RIIO-2. Together they set out tight regulatory constraints for network companies to deliver a £25bn investment programme (with option for £10bn more) and achieve Net-Zero carbon targets — at the lowest cost for consumers. Notably, the DD:

• Sets Total expenditure (Totex) substantially lower, on average, than company bids (45% and 20% in the transmission and gas distribution).
• Sets a new bar in terms of the extent and complexity of ex-post reopener mechanisms.
• Halves the allowed returns on investments for companies compared to RIIO-1.

We set out our views on the strategic background to the DD and what companies should expect to come next as Ofgem gears up to publish its Final Determinations (FD) in December.

A major reset at draft determinations was always in the air

Perhaps unsurprisingly, companies on the receiving end have been immediately critical of Ofgem’s DD package of proposals, arguing they may deter investments. Interestingly, reactions have focused less on the level of the WACC — where one might expect them to be — and more on the significant cut in Totex and the wide scope of uncertainty mechanisms.

For gas distribution, the 20% cut in Totex is almost twice the level of cuts proposed by Ofwat at this stage and four times as high as Ofwat’s final decision. The position for transmission operators is even more stark, with Ofgem’s opening cut at around 45%. While Ofgem remains open to be persuaded, reconciling such large differences before FD will not be easy, and appeals to the CMA may ensue: We note that a mere 5% gap between Ofwat final allowances and the water companies’ investment plans was enough for 4 out of 17 licensees to refer it to the CMA for redetermination.

Returns under RIIO-1 were rather generous to network companies. A recent report by the National Audit Office (NAO) found that “Network companies’ returns are high relative to comparable companies and Ofgem’s expectations.” These returns were always expected to be reduced significantly, and Ofgem had signalled that the next round of price control would see a stark resetting.¹

The DD have also generated immediate concerns arising from the extent and complexity of uncertainty mechanisms. Targeted reopeners seem part of an overall strategy to make RIIO-2 more adaptable, given uncertainty about the extent and timing of investment plans. Ofgem seems to have reflected on the RIIO-ED-1 mid-period reopener in 2018, when it contemplated changing rules and incentive design in the ED1 settlement, but eventually felt it was too risky.²

The intensity of challenge is unlikely to go away at final determinations

Broader reactions to the DD include a sense of deja-vu, drawing parallels between Ofgem’s choices and Ofwat’s shrinking ambitions from draft to final proposal: in that case, the gap between the companies’ bids and the regulator-allowed cost reduced by about 50% between draft and final determinations. Looking further back in time, Ofgem’s own DD in RIIO-GD1 suffered a similar fate, as the gap halved from initial to final proposals, with cost allowances increasing by around £1.5bn, or 12%.³

But precedents may be an unreliable guide in this case. Ofgem has a mixed track record; recently it did not back down on its Consultation proposals for the default tariff cap,⁴ dashing hopes that it would be softened in the final decision.⁵ Furthermore, circumstances have changed materially since RIIO-1, which may lead to minimal deviation from DD.

First, pressure by politicians means regulators are increasingly tough on utility companies, often perceived as making returns worthy of riskier businesses. Damning public reports by the NAO or the aptly named “Many happy returns?” report by Citizen Advice, may be the final nail in the coffin for any hopes of significant backtracking by Ofgem.

Second, Ofgem learned the hard way with RIIO-1 that reopener mechanisms are not a credible tool to claw back higher than expected returns, because this would undermine regulatory confidence in the long term. To avoid the same thing happening again, RIIO-2 will be top of mind for the Ofgem Board: the choir of allegations of incompetence — or worse, capture — would be deafening.

Ofgem won’t be afraid of an appeal

We suspect this time round Ofgem will push through this assertive “resetting” RIIO-2 settlement in its FD — so what then?

1/ The companies may back down and settle: Ofgem wins. If RIIO-2 proves too strict to attract the required investments, Ofgem will find it much easier to re-open in favour of the companies than was the case with RIIO-1.

2/ Some companies may appeal to the CMA. While no regulator is particularly attracted to the prospect of a long and costly appeal, a large regulator like Ofgem has the resources to withstand it, and the reputational downside for Ofgem is limited:

• The CMA may side with the regulator’s tough approach, Ofgem wins.
• The CMA may side with the companies and revise allowances upwards. Unless the CMA decision is egregiously scathing of Ofgem, its reputation as a consumer champion will not be largely affected. What’s more, Ofgem will be able to shift blame on the CMA if the revised settlement turns out again to be overly generous. This may not count as a win for Ofgem, but it is not a loss either.

Razor sharp business plans to withstand scrutiny and underpin appeals

Previously, absence of appeals has been considered an indicator of success for a price control review. This time Ofgem may well be agnostic towards the prospect of appeals- indeed it may even look forward to proving its work in a legal challenge.

Transmission and gas distribution companies will already be considering how stepping up their engagement with Ofgem and political lobbying can increase the likelihood of reaching a satisfactory final settlement: However it’s also the time for them to be starting to think about their strategy for an appeal to the CMA. Experience suggests if this is to be a viable strategy — to maximise chances of success at the CMA — companies need to start with razor sharp positioning of their DD responses. Delaying thinking about CMA positioning until after DD responses would be a huge missed opportunity.

Electricity Distribution companies should carefully monitor the developments in RIIO-2 over the next six months, as Ofgem may come out of it more assertive and empowered. Sharpening business plans now with an emphasis on high-quality consumer and stakeholder engagement will stand them in good stead when it comes to withstanding Ofgem’s assertive scrutiny.

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¹ See for example Dermot Nolan’s speech at Ofgem’s Future of Energy conference held in London on 10 January 2019 “We signalled clearly, as we have done for some time, that we expect a tougher round of price controls, with lower overall average returns across the sector”.

² Ofgem considered that the estimated £680m of short term savings on consumers bill could be completely offset by an increase in the cost of equity of 0.5% (50 basis points) or in the cost of capital of 0.2% (20 basis points) due to increased regulatory uncertainty. See paragraphs 3.21 and 3.22 of the ED1 decision.

³ See table 1.1 of RIIO-GD1 Final Proposals

⁴ This is the retail price cap that applies to standard variable tariffs and other default tariffs.

⁵ For example, the assessment of efficient costs in the November 2018 Decision (paragraph 1.17) only increased by £1 (out of a initial cap of £1,137 p.a. for a typical default tariff customer on dual fuel paying by direct debit), compared to the September 2018 Consultation.