‘Aiming-down’
The RIIO-2 Final Determinations for electricity transmission confirmed Ofgem’s approach of deducting 0.25% from its estimate of the cost of equity to allow for its expectation that that companies will outperform Ofgem’s regulatory determination. Ofgem’s reasoning is that during the determination process there is an information asymmetry such that the regulator lacks information on the full extent of the cost efficiency or service delivery levels the companies are able to achieve. Evidence of the information asymmetry, according to Ofgem, is shown from the tendency of the companies to have outperformed past determinations, providing a basis for its downward adjustment to avoid a repeat of this in RIIO-2.
So far Ofgem is the only UK regulator to adopt this reasoning. In early 2021 we will see whether the downward adjustment is acceptable to the energy network companies and, if not, how the CMA will view Ofgem’s approach.
Aiming-up
Ofgem’s cost of equity adjustment can be viewed as ‘aiming-down’, the opposite of ‘aiming-up’ – the practice more commonly used by regulators and by the CMA in its Provisional Findings to appeals of Ofwat’s PR19.
Aiming-up and aiming-down are opposite effects but their respective rationales differ. Whereas aiming-down is argued to be necessary to address an information asymmetry, aiming-up is used to address the impact of an information deficit – specifically information on the “true” cost of equity. Regulators can only make their best unbiased estimate within a range of uncertainty. The argument for aiming-up in this range is based on the asymmetry in costs between setting a value too low compared to too high.
If the cost of equity is set too high customers will pay too much for the regulated service. If the cost of equity is too low, however, the regulated company may seek to forego investments that would otherwise provide value to customers. There is no reason why the quantum of these two effects will balance, but there may be a presumption that stifled investment will have a greater negative long term impact than higher prices. If this is the case regulators are correct to aim-up within the cost of equity range.
The strength of the argument for aiming up is sector specific. A clear cut case for aiming up can be made if investment delivers externality benefits over and above those that accrue to the companies’ own customers. Consider two very different sectors – both of which I have experience of working with.
Superfast/ultrafast broadband: “marginal investments” will be network rollout in areas of lower household or business density. The externality is essentially the network benefit of larger on-line B2B, B2C, C2B and C2C communities, as well as leveling up under-served areas of the country.
Electricity transmission and distribution networks: significant investments will be needed to deliver the UK’s carbon Net Zero objective, for example network capacity to distribute power for electric vehicle charging and heat pumps, or non-network investment in energy storage. These investments will have huge positive environmental externalities to offset the impact of climate change. Ensuring this investment happens is essential – a case for aiming-up.