Morgan Wild, senior policy researcher at Citizens Advice, thinks it is time for Ofgem to re-examine its assumptions. Market comparisons justify lower returns and reduced cost allowances in the next RIIO period
Energy networks are making bumper profits. Ofgem’s RIIO reports recently revealed they are, on average, earning a 10% return. This matters partly because energy networks are regulated monopolies – it’s the job of the regulator to decide how much profit they can earn. And it matters because energy networks represent about a quarter of consumers’ bills. At a time when energy bills are rising and real incomes stagnating, it is crucial to answer whether these profits are justified.
Profit for energy networks should be led by risk: if risk is low, profits should be as well. Networks are perhaps our most critical piece of national infrastructure and, as such, the government and the regulator will never let them fail. There are important challenges where networks play a role – such as decarbonisation and the smart energy transition – but their core business remains making sure energy gets safely from A to B. This is not a particularly risky business.
Is 10% a fair return for a low-risk business? Market evidence suggests not. The average UK share return is 5%. The big six retailers’ margin is 4%. Why are fundamentally low-risk businesses making double the average equity return?
Citizens Advice thinks there are a few reasons, as forthcoming research will suggest.
The graph below shows a breakdown of how networks make their profits. As we can see, the lion’s share of profits is made out of cost of equity and total expenditure incentives. It’s here we should look for any unjustified profit.
Why are low-risk businesses making double the average equity return?
Ofgem has been far too generous in setting the cost of equity, by assuming networks are a far riskier investment than they are. In fact, Ofgem has assumed that energy networks are almost as risky as the typical company.
Even Ofgem’s own consultants suggested that there is “strong evidence” that energy networks’ risks are much closer to half those of the typical company. When we looked at data for comparable listed companies’ risks, as measured by their equity beta, it was consistent with this. Since 2011, their risk hovered at about half that of the average company. And this has dramatic consequences for the cost of equity – in gas distribution alone, it reduces equity’s cost from 6.7 to 4.6%, wiping over £1 billion off consumers’ bills.
Second, networks are considerably outperforming their total expenditure incentive.
Ofgem sets a total allowed expenditure for each network. Rightly, however, Ofgem wants to incentivise network companies to run their businesses as efficiently as possible. That’s why, if the energy networks underspend their allowed expenditure, Ofgem allows them to keep a proportion as profit. The remainder is returned to consumers. If Ofgem thinks that pipeline will cost £180 million, can you build it with £140 million? If so, keep some of the difference as profit.
But that’s not the only thing driving energy networks’ profits. Actual industry-specific costs such as materials and labour are – according to Ofgem’s analysis – likely to be almost £2 billion lower over the course of the price control than they forecast. This accounts for a substantial proportion of companies’ efficiencies over the price control. Some of it gets returned to consumers. But over £1 billion ends up in companies’ profit lines – for price changes over which they have no control. This is consumers’ money and it should be staying in consumers’ pockets.
These aren’t the only sources of excess profits in the energy network industry, but they are some of the most significant.
The Energy Networks Association recently argued that rather than focusing on their members’ profits, Ofgem ‘should focus on completing the RIIO regulatory framework… reducing risk for customers and companies alike.’
Finishing the current regulatory price control is important. But Ofgem is starting to design the next round of price controls now, and it must make more accurate decisions in future. To do this, learning from what did not work in this price control will be crucial.
Citizens Advice thinks Ofgem will have to be much more robust, and rooted in real market data, when it sets the cost of equity next time, basing its decision on comparable companies. And it should reduce its reliance on forecasts – which even the best regulators can’t possibly get right over an eight-year period – and increase its use of indexation. For example, rather than make educated guesses about industry-specific costs, it should index to real industry-specific costs over the course of the price control. If Ofgem had done both these things for the current RIIO period, costs to consumers would have been substantially reduced.
It is really positive that Ofgem accepts there are lessons to learn for the next price control. Overall, despite these concerns, RIIO has been a real improvement on previous price controls. But there are still significant opportunities to reduce consumers’ bills. Ofgem should grasp them.