Citizens Advice: Ofgem should pursue potential £4.1 billion network savings by rethinking ‘cost of equity’ calculation

Ofgem has overestimated the amount of risk investors bear when they take a stake in energy networks,  Citizens Advice has argued in a new report. It says that Ofgem could save customers over £4 billion over the next price control period (five years from 2021), if the regulator looked again at how it calculates the return for investors in network assets.

The regulator has already warned that it expects to cut back on investor returns by some £5 billion in the next period. But Citizens Advice (CA) argues that, because Ofgem assumes investors have to take on risks typical of other stocks in the market, it is still overestimating how much return companies have to make to their investors to stop them withdrawing their investment.

Ofgem compares energy networks with other stocks over periods of 2-5 years to assess the necessary return, CA says. But networks are very stable investments and over longer periods the risk is much lower – 30-50% less than other stocks. As a result, it says Ofgem can allow a much lower return – down from 4% to between 1.3% and 3.6%. Because this is a major component of costs, that could save consumers between £900 million and £3.3 billion over the period. In addition, Ofgem could make a further adjustment to the proportion of funding it assumes comes from equity investors (instead of debt funding). That could bring the reduction in customer bills up to £4.1 billion over the period.

Citizens Advice notes that the change -  based on work for the UK Regulators Network (UKRN) – might cut returns so low that it might affect networks’ financeability, meaning investors would not want to buy shares in the companies. It might also lead companies to shift towards more debt financing, which is more expensive. But it argued both issues should be dealt with separately, once the risk methodology has been confirmed.

The watchdog said it recommended Ofgem change its calculation and start with “full and prompt analysis” of the UKRN work (which it noted had prompted some dissent among the authors over what action was desirable). That should be done now to ensure the methodology was robust, and any necessary changes could be made, before the next price control period starts.

Gillian Guy, chief executive of Citizens Advice, said: “These decisions may seem extremely technical, but they matter. Get them wrong and it hits consumers directly in the pocket.

“Regulators face a difficult balancing act. Firms need to be able to attract investment and investors need suitable levels of returns. But regulators need to ensure that the decisions they make don’t allow companies to make billions in excess profits and leave customers to pick up the bill.

“A new approach to analysing the risk of these firms will mean lower returns for investors, but the result is a better deal for consumers.”

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