A hostile environment for core

UK regulatory price controls threaten companies’ ability to secure financing, argue Tim Briggs and Silke Goldberg, partners at Herbert Smith Freehill.

Tim Briggs
Silke Goldberg

These are challenging times for investors in UK regulated businesses, especially those responsible for water, electricity and gas networks. The latest regulatory price control decisions saw reductions in returns on capital of around 50 percent, coupled with cost-efficiency and performance targets that incorporate an unprecedented degree of stretch.

At almost every opportunity, regulators have ramped up pressure on companies and their investors. Faced with the choice between affording companies the benefit of the doubt and tightening the economic thumbscrews, they have overwhelmingly opted for the latter.

First hit

Ofwat led the charge when it published its PR19 final determination for water companies. On a retail price index basis, wholesale returns were slashed from 3.6 percent to 1.92 percent. Ofgem adopted a similar theme with its RIIO2 draft determinations for gas and electricity, proposing to almost halve the return on equity.

That incorporates a circa 25 basis point downward adjustment for ‘expected outperformance’; in other words, it has deliberately set the allowed return up to 25bps below the return it thinks investors expect. That’s an unprecedented attack on investor returns and a shift away from evidence-based decision-making.

Without a change of direction by regulators, the squeeze on investor returns is likely to have serious implications for the ability of network companies to secure the investment required to meet future challenges. This difficulty will be compounded if regulators are perceived to move away from an evidence-based price control regime. It also stands in sharp contrast to other European jurisdictions.

In Germany, the network incentive regulation provides ranges of investor returns based on securities listed in the past 10 years, with an in-built mechanism for efficiency and innovation incentives for network companies. It seems to provide a clearer framework with less opportunity for regulators to apply drastic changes. German network companies are, in the current regulatory period, benefiting from a regulated rate of return on equity before corporation tax of 7.39 percent.

The desire of UK regulators to be perceived as ‘tough’ is driving them to make decisions that risk undermining investor confidence, ultimately to the detriment of the customer interest.

Chance of reprieve

Most UK regulated businesses can appeal their price control determinations to the Competition and Markets Authority, which, as the arbiter of disputes across regulated sectors, has the ability to signal a change of direction that  regulators are likely to follow.

It missed an early opportunity to put down a marker with its July decision in relation to National Air Traffic Services. However, that decision was significantly impacted by the covid-19 emergency so it may not set a precedent. It now has an opportunity with PR19, the provisional determination for which is expected in the early autumn.