Will the RAB model last?

Tim Briggs, a partner in Herbert Smith Freehills’ competition, trade and regulation practice, on why the UK’s regulatory framework has been so successful, its greenfield potential and how it could all fall apart.

Perhaps because I grew up in the 1980s, I have always been fascinated by the privatised utilities. I recall the ‘Tell Sid’ advertising campaign for shares in British Gas and the pylons striding across the landscape in ‘stop-go’ animation. And as I entered the world of work, I quickly became interested in the regulatory mechanisms that made the private ownership of public services possible.

At the time, that meant sector regulators such as Offer and Ofgas (now Ofgem), but of particular note was the regulatory asset base, or RAB, model that is the foundation of price-control regulation in the UK. It helped that one of my first tasks as a trainee lawyer was to assist in the judicial review of a regulator that refused to implement the conclusions of the country’s Competition Commission (now the Competition and Markets Authority) after a six-month price-control investigation (we won, since you ask, but we had to go to the Court of Appeal).

As a result of this grounding in regulated infrastructure, I became a big fan of the RAB model. It has excelled in delivering much-needed investment in water, gas and electricity networks. People forget that it was commonplace in the 1990s for raw sewage to be continuously discharged into our seas. When in public ownership, utilities had to compete with the NHS, schools and other public institutions for resources, and they were rarely a priority. Private sector investment has enabled the UK’s utilities to make progress on the backlog of outstanding capital works and to bring the country’s networks into the 21st century.

But there’s more to it than that. The involvement of private capital has ensured that private sector discipline is applied to previously state-owned services. That has led to greater efficiency and, in most cases, better performance for customers. It doesn’t mean things are perfect across the board. Some companies do need to do better. Yet, it can be argued that performance on quality and customer service is generally much improved since privatisation.

What do I mean by the RAB model? It is purely a regulatory construct and not embedded in legislation or any licence, though regulators do have a duty to ensure that networks can finance their functions. Like most good ideas, it is essentially simple. It proceeds on the basis that investors can expect to achieve a return on the capital employed in the regulated business. The capital base is the RAB and the return is the weighted average cost of capital (WACC).

In an established utility, the RAB is determined by taking the market value of the utility on flotation and adding the network expenditure permitted by the regulator, with a deduction for annual depreciation. The RAB is indexed to inflation – in the UK, this was historically the Retail Price Index (RPI), though it is now increasingly an amended version of the Consumer Prices Index that includes housing costs (CPIH).

The regulator determines the WACC during periodic reviews, which take place approximately once every five years. It increasingly includes an in-built adjustment for changes to the cost of debt. The utility typically has the right to appeal against the regulator’s decision with the Competition and Markets Authority, which therefore acts as custodian of the high-level principles of RAB-based regulation. The arrangement is designed to give investors confidence that their investment will be preserved and earn a reasonable, market-based, return.

What I’ve described is applicable to an established utility, but the stability of the RAB-based model can also be used to attract investment for greenfield projects. That is a new role for the model, of which the prime example is the Thames Tideway Tunnel, the 25km ‘Super Sewer’ that will run beneath London.

However, there is no pre-existing asset base with a greenfield development, and so the model in this instance requires that expenditure incurred in connection with the project be added to the RAB as construction progresses. Project expenditure is not subject to any form of regulatory efficiency assessment. Instead, the operator is incentivised to keep costs low by means of comparing out-turn costs with a target cost profile. In the case of the Thames Tideway Tunnel, the operator gets to keep 30 percent of any outperformance, relative to the target, but is accountable for 40 percent of any overspend.

Another difference in the greenfield context is the way in which the WACC is determined. It is the primary focus of the tender process. In short, the bidder that is prepared to accept the lowest WACC will be best placed to win the tender. The tender for the Thames Tideway Tunnel resulted in a WACC of 2.497 percent, which was considerably lower than the equivalent WACC for an established utility at the time.

The project earns this WACC on the RAB accumulated throughout the construction period. This avoids the need to capitalise interest during construction, which would push up the cost of the project during the operational period. This is significant in the context of future uses for the greenfield RAB model, and particularly its proposed use for the Sizewell C nuclear power project in Suffolk on the east coast. The availability of a return during Sizewell C’s construction, together with savings associated with delivering a ‘next-of-a-kind’ project, are expected to result in a £/MWh cost that is roughly a third less than that for the ‘first-of-a-kind’ Hinkley Point C in the south-west.

It is the scope to use the RAB-based model for complex greenfield projects like Sizewell C that makes the future for this regulatory mechanism so exciting.

However, there are clouds on the horizon. There remains the possibility of nationalisation under a new government, a policy that appears to have attracted some popular support.

Yet I am less concerned about ideological opposition to the private ownership of utilities than I am with certain actions of those currently in the regulatory driving seat.

I am referring principally to a campaign led by the government’s Department for Environment, Food and Rural Affairs (Defra) and the water regulator Ofwat to change the framework for water sector regulation. The stated aim is to “put the sector back into balance”, and the proposed measures afford Ofwat greater flexibility and will perhaps produce some favourable headlines. Yet I doubt they are in the long-term interests of consumers, given the implications for regulatory certainty and the long-term cost of capital.

The RAB model has promoted stability and facilitated billions in much-needed infrastructure investment. It deserves to be treated with respect so that it remains available for use for future generations.

Key features of campaign to ‘rebalance’ water regulation

‘Gearing tax’ This is a new requirement whereby companies with gearing of more than 70 percent have to share with customers the financial upside of that higher gearing. It will be introduced barely two months prior to the deadline for companies to submit business plans as part of the PR19 price control review. The affected companies have had no meaningful opportunity to adjust their gearing in order to avoid the tax, which flies in the face of the long-established policy that it is for companies to determine their financial structure.

Defra proposal to change how Ofwat modifies company licences No longer will the regulator require the consent of the companies concerned. Instead, Ofwat will be able to make changes unilaterally, subject only to a right of appeal to the Competition and Markets Authority. That will alter the dynamic between the regulator and the companies when it comes to driving through unpopular policies.

New licence conditions These will force companies to comply with broadly framed principles specified by Ofwat. It will expose companies to the risk that the regulator will change its interpretation of a broadly framed principle. Companies can never be sure where the line is.