Regulatory Trends: Next steps in energy and water regulation – confluence and convergence
United Kingdom | Publication | July 2022
The last few weeks have seen publication of key documents in both energy and water regulation. On 29 June 2022, Ofgem published its Draft Determinations proposals for Electricity Distribution Network Operator allowances under the RIIO-ED2 price control covering the five-year period 2023-2028 (RIIO-ED2 Draft Determinations). Then, on 7 July 2022, Ofwat published its Draft Methodology for the upcoming PR24 Price Review setting price controls for water and sewerage companies for the five-year period 2025-2030 (PR24 Draft Methodology). The consultations in respect of these documents finish on 25 August 2022 and 7 September 2022 respectively, and both regulators are working to a December 2022 timetable for next steps – namely publication of RIIO-ED2 Final Determinations and a PR24 Final Methodology.
Despite the significant page-count – around 2,000 pages from Ofgem and more than 1,500 pages from Ofwat – much has already been written about the main headlines arising. Slashed baseline cost allowances, stretching efficiency targets and a seemingly arbitrary ongoing efficiency challenge, strengthened sharing factors, the use and operation of a complex suite of (largely common) uncertainty mechanisms, a lower cost of capital, the issue of high inflation, measures to address outperformance, and increasing competition are, among other things, giving companies much to think about as they try, simultaneously, to ensure affordability and rise to the challenge of enabling net zero. We do not seek to repeat that commentary here.
Instead, in keeping with our ‘regulatory trends’ theme, we examine the regulatory convergence in the energy and water sectors apparent from these latest proposals, and consider the actual and potential consequences of this confluence for companies.
A merging of the ways
In some respects, cross-sectoral regulatory alignment is neither new nor a surprise given, in particular, the BEIS ‘Economic Regulation Policy Paper’ earlier this year which indicated that greater regulatory consistency might promote greater transparency for consumers, business and investors and highlighted alignment of price control methodologies, where appropriate – particularly for setting the Weighted Average Cost of Capital (WACC) – as a priority area for the sector regulators to take forward via the UK Regulators Network (UKRN). We note that Ofwat states in the PR24 Draft Methodology that it is “working with other regulators to develop this common methodology, which [it] expect[s] would be adopted on a forward looking basis”, and the proposed BEIS review of economic regulator duties will consider whether any changes to those duties could enhance cross-regulator collaboration – so it is, and has been for some time, clear which way the wind is blowing.
However, the precise form this convergence is taking, evident in the RIIO-ED2 Draft Determinations and the PR24 Draft Methodology, is noteworthy. In particular:
- Increased cross-referencing: There is a proliferation of cross-sector references, including to the recent CMA appeals, which are predominantly used as a foundation for or to bolster the regulator’s proposals. For example, Ofgem states that its “approach has parallels with approaches adopted in other regulatory contexts, for example, the approach adopted by Ofwat for PR19 (a principle that was maintained in the CMA PR19 redeterminations)”, is “informed by our approach for RIIO-GD&T2, which was upheld on appeal to the CMA”, “is consistent with the evidence base which CEPA used in its advice to Ofgem ahead of RIIO-GD&T2, by the CMA in the RIIO-GD2/T2 appeals, and Ofwat and the CMA for PR19”, and it “take[s] confidence that the CMA considered Ofgem’s analysis and interpretation … in the RIIO-GD&T2 appeals and found that Ofgem was not wrong”. Ofwat specifically refers to “closer working with … fellow regulators” and, on the issue of inflation, Ofgem states “as you would expect we are discussing these matters, not just within Ofgem, but across with other regulators as well” (see Investor Call transcript).
- Linguistic alignment: There is evidence of a common regulatory lexicon and strategic positioning emerging. For example, Ofgem makes some considerable play of “ensuring any new investment is made in the right place, at the right time, and at the right price” in the RIIO-ED2 Draft Determinations and Ofwat employs a similar formulation in the PR24 Draft Methodology of delivering “the right outcomes, at the right time” and “[e]nsuring that the right interventions are made at the right time”. The language of “stretching but achievable” targets has filtered from the water sector into energy, and reference to “regulatory judgement” is now used consistently to emphasise when the regulator considers itself to be operating in margin of appreciation territory.
- Cross-fertilisation: Most notably, the Business Plan Incentive (BPI) has been ‘lifted and shifted’ from the energy sector to the water and sewerage sector. Inevitably, this cross-fertilisation comes with some refinement, and we address further below the potential utility of this in terms of horizon-scanning.
- Strength in numbers: The regulators are opting to deal with contentious issues consistently – most notably around the WACC, but also in relation to matters like financial resilience and outperformance. This means that they can mount a cross-sectoral defence if necessary, and we have already seen evidence of this in the PR19 redetermination (in which Ofgem participated in support of Ofwat) and the RIIO-GD&T2 appeals (in which Ofwat participated in support of Ofgem). Of particular note is the systematic rebuttal of the CMA’s PR19 redetermination in favour of the approach adopted by the (different) CMA Panel in the RIIO-GD&T2 appeals. For example, Ofwat states: “We do not propose to place weight on AAA-rated corporate bonds to inform our risk-free-rate estimate. The CMA’s PR19 redetermination used a synthetic index of AAA-rated corporate debt to inform the upper-end of its risk-free rate range because of its view that the yield was a more relevant borrowing rate to market participants than index-linked gilts. This notwithstanding, the CMA’s RIIO-2 redetermination [sic] agreed with Ofgem that the use of such an index was difficult to implement and defend, due to the limited number of index constituents. In addition, we consider that the likely presence of liquidity, inflation, and default risk components in the AAA-rated synthetic index yield is an additional challenge to estimating a risk-free rate which should not be affected by these risks”. We expect this approach to be reflected in the UKRN common methodology in due course, with the CMA’s PR19 redetermination positioned as an outlier and aberration.
- Procedural consistency: The regulators are also beginning to learn – and lift – from each other’s procedural playbook. This can be seen with, for example, the introduction of open meetings or so-called ‘challenge sessions’ on companies’ plans in the water and sewerage sector, which appear to be a build on public Open Hearings for energy companies. Companies should expect to see increasing procedural alignment as the regulators identify best practice in terms of efficiency, effectiveness and robustness to legal challenge.
Additional examples of the regulatory convergence between energy and water regulation are not difficult to identify. The Energy Security Bill (now known as the Energy Bill), introduced into Parliament on 6 July 2022, includes provisions amending the Enterprise Act 2002 to require the CMA in certain circumstances to assess whether a merger between energy network companies substantially prejudices Ofgem’s ability to carry out its functions when Ofgem compares data from all these companies to set price controls. Given Ofwat’s focus on comparative competition, this type of special merger legislation has been in place in the water sector for many years. Also, the CMA’s ‘Regulatory appeals rules and guidance: energy, water, airports and air traffic services’ consultation – finally published on 12 July 2022 after some delay – makes clear that the proposed Water Rules and Water Guidance are modelled on the amended Energy Rules and Energy Guidance because the statutory framework for the water appeal function is similar to (and modelled on) that of energy.
The subject of appeals returns us, full circle, to the BEIS ‘Economic Regulation Policy Paper’, which also highlighted greater alignment between appeal processes as a priority area to be explored. At present, one significant difference between the energy and water sectors is that, whilst energy licence modifications moved to an appeal regime in 2011, water and sewerage price control licence modifications remain subject to a redetermination regime. As previously touched on in Keeping your head above water a practical guide to non-price control licence modification appeals, we think this is likely to change and the main question is whether the redetermination regime will remain in place for PR24. With this in mind, companies should be aware that the regulatory appeals rules and guidance put in place by the CMA for non-price control licence modifications in the water and sewerage sector now may acquire greater scope and importance in due course, and we would encourage engagement on this basis. The CMA’s consultation on its proposed Water Rules and Water Guidance closes at 5pm on 9 August 2022.
How it started, how it’s going
We think there are three key consequences of this regulatory convergence in energy and water for companies.
The first is increased jeopardy. Regulators are using cross-sector referencing and read-across to create greater jeopardy around appeals (and, for the time being, redeterminations). For example, because the introduction of the BPI was not appealed in the energy sector it makes it more difficult for it to be challenged when introduced in the water sector. In this way, the staggered nature of regulatory price controls allows the regulators to build on each other’s successes – and learn from failures – which increases the risk profile for companies and potentially makes it harder for them to mount a successful challenge.
The desire to increase the jeopardy for companies around appeals also has another manifestation in the RIIO-ED2 Draft Determinations. The section entitled ‘RIIO-ED2 in the round, post appeals review and pre-action correspondence’ positions the price control as “interlocking decisions” within a system made up of “three distinct but closely linked pillars”, namely outputs, expenditure allowances and uncertainty and other risk mitigating mechanisms to manage and maintain a fair balance of risk between consumers and companies. Ofgem states that the “intrinsic links between these three pillars mean that each of them affects and is affected by decisions taken in relation to the other two pillars” so “a change to a component that sits in one of these pillars may have an effect on the other pillars, and the impact this change has on the other pillars would need to be taken into consideration”. It provides detailed examples – noticeably focused on areas most likely to be contentious e.g. cost of equity, cost of debt, BPI, RPEs, ongoing efficiency, Return Adjustment Mechanism and approach to cost assessment – and frequently refers back to its interlinked “pillars” in the text, for example “Overall, we think that the component parts that make up our RIIO-ED2 pillars are appropriately balanced to ensure that the notional licensee will have sufficient, but not excessive revenues to finance its activities. We think our price control taken in the round represents a good outcome and a fair deal for companies and their investors.” The point is hardly subtly made. Ofgem is making clear upfront that if the CMA were, on appeal, to destabilise one of its carefully constructed pillars, the interlinked aspects of the price control may topple and potentially significant changes be required as part of the reconstruction work. And it proposes that non-appealing licensees be insulated from such downside as a further deterrent. If this approach to interlinkages has the desired effect, you can be sure it will catch on …
This leads to our second key consequence, namely a greater need for systematic horizon scanning by companies, looking across sectors and identifying what might be coming next (including any refinement to common mechanisms and taking into account international regulatory cooperation where relevant). In case of assistance, some of the things currently on our watch list include: procedural streamlining (e.g. Ofwat combining the business plan assessment and draft determination phases, resulting in two phases rather than three), greater use of centralised customer research and the recent recommendation by the Regulatory Horizons Council for the establishment of investor panels, open challenge sessions held both during development of the business plan and after final business plans are submitted, and Ofwat’s standards for conducting high-quality research, expectations for company business plans and narratives (at pages 116-118) and public value principles. In addition, Ofgem’s work – highlighted in its ‘Net Zero Britain: Developing an energy system fit for the future report published on 8 July 2022 – to develop and consult on a framework of ‘consumer interests’ may prove to be of wider cross-sector relevance and interest.
The third key consequence is the need for companies to marshal defensive counter-arguments and pick the right battles at the right time. We recommend that companies use their horizon scanning to identify key potential risks, and then garner their defensive arguments promptly. In our view, future successful appeal arguments are likely to be grounded in compelling sectoral differences, so companies are well placed to take the lead in this regard. In addition, based on what we have already said about cross-sector referencing and read-across and the staggered nature of regulatory price controls, companies may – individually or collectively – wish to consider the scope for cross-sector interventions, i.e. seeking to intervene in appeals in different sectors, in circumstances where the issues raised are of sufficient importance. It would therefore be sensible to review the CMA’s current consultation on proposed regulatory appeals rules and guidance with this in mind.
One to watch
Finally, a note of caution for Ofwat, Ofgem and other regulators as they swim towards a regulatory confluence. You might recall that the Penrose Report (February 2021) called to “normalise as much of these [regulated] industries as possible”, “whittle each industry down to this remaining ‘hard core’ [of network monopolies with Regulated Asset Bases]” and stated that “the economic regulation teams in each of the sector regulators ought to be a great deal smaller than they are today”. It also called for the creation of a Network & Data Monopolies Unit (NDMU) within the CMA as an expert, cross-sector network regulator to whom, ultimately, the residual economic regulation duties of the regulators should be transferred. This ‘sector normalisation’ project plan is neither the first, nor probably the last, recommendation for a change to the current system. In fact, as anyone who has ever worked within an economic regulator knows, the so-called ‘bonfire of the quangos’ never really dampens down. Against this backdrop, it occurs to us that striking out hard towards greater standardisation risks losing sight of what makes each regulated sector unique and may inadvertently play into the hands of those who would willingly fan the flames.
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