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Regulator plans to cut investor returns of UK energy networks in half

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Power network operators in Britain are set to get squeezed by new price controls proposed by regulator Ofgem.
Source: TransnetBW

Britain's energy regulator wants to slash returns for investors in U.K. electricity and gas network companies and cap the operators' profits in a bid to save money for consumers as the energy system transitions to renewables. The announcement of the plan sent shares in National Grid PLC and several other network operators tumbling.

The baseline rate of return for operators of power transmission and gas transmission and distribution networks would be cut to 4% for a five-year period starting in 2021 under the proposals, announced on Dec. 18 by the Office of Gas and Electricity Markets, or Ofgem, which regulates the revenue that network companies can recover from their users.

This would reduce the cost of equity, or how much firms can pay their investors, by almost half from the 7% to 8% that is set under the current price control period. Ofgem also wants to reduce the cost of debt at which network companies can borrow annually, to better reflect falling interest rates. The changes also reflect a change to its inflation index from RPI, or the retail prices index, to CPIH, or the consumer prices index including housing.

Network costs are recouped from consumers via their energy bills and Ofgem said its proposed reforms, including mechanisms that would limit overall profits for network companies, would save a total of £6.5 billion, reducing individual bills by an average of £30 a year, or £45 a year when other proposals to reform network charges are factored in.

Ofgem suggested companies could cut their shareholder dividends to retain more cash as one way to mitigate the effect of the reforms, in a presentation to analysts and investors.

Shares in National Grid, which operates the British power and gas transmission network, closed down by more than 9% at 758.70 pence on Tuesday versus Monday's closing price. SSE PLC and Scottish Power owner Iberdrola SA, which run the electricity transmission in Scotland, saw more modest declines over the same period.

National Grid and SSE both said they were disappointed with the proposal and that the cost of equity range did not reflect the level of risk borne by transmission operators for critical upgrades across the grid.

"In order to deliver the major capital programme required across our networks in a rapidly changing energy market, we need to ensure the regulatory framework also provides for fair returns to shareholders," National Grid said in a statement.

Ofgem argues the proposals will reduce the burden on consumers as networks raise the billions of pounds of investment needed to prepare the energy system for increasing amounts of renewable energy and the millions of electric vehicles expected to be on the roads in the coming decades.

"We want to cut the cost to consumers for accommodating electric vehicles, renewables and electricity storage, and make sure that all consumers benefit from these technologies," said Jonathan Brearley, Ofgem's executive director for systems and networks. "This will mean driving a harder bargain with network companies."

But David Smith, chief executive of the Energy Networks Association, said the plans could instead "jeopardize the innovation and investment" for building a cleaner energy system.

Rui Dias, an equity analyst at Swiss investment bank UBS, said that the cost of equity cut — which came in at the bottom end of a range indicated by Ofgem in March — was below market expectations and would hit National Grid the hardest, followed by SSE and Iberdrola. Although UBS estimates that the lower cost of capital alone could impact National Grid's earnings by approximately 9% "into the next period," Dias said in a note to clients that he did not expect the dividends of the companies to be at risk, at least for now.

Ofgem's proposed changes are part of the so-called RIIO2 price control reform. The consultation process will continue until March 2019 and the reforms would take effect in April 2021. As part of the review, the price control period would be shortened from eight to five years.

Ofgem said it will also "press ahead" with other measures to "squeeze more capacity out of the electricity grids", including incentives for drivers to charge electric vehicles outside of peak demand times and, possibly, more flexible grid access arrangements for renewable generators.

Last month, the regulator already suggested phasing out financial incentives for businesses and households that reduce their power demand. Under that proposal, on-site generation and electricity storage assets would no longer benefit from lower network costs or receive certain payments from suppliers for reducing system balancing costs, starting between 2020 and 2023.