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Ofgem looks to slash energy returns

The regulator is proposing to cut the allowed return on equity in half, much to the consternation of National Grid and SSE
July 9, 2020

Ofgem has revealed that it intends to almost halve the allowed returns energy companies will be able to make in the next regulatory period, running from 2021 to 2026. The regulator is proposing that the allowed return on equity – based on the ‘consumer price index including owner occupiers’ housing costs’ (CPIH) – be set at 3.7 per cent for electricity transmission and 3.95 per cent for gas transmission and distribution, down from the current 7-8 per cent level. The new plans are also a step down from the 4.3 per cent threshold it had proposed last year.

Justifying its decision to cut the rate of return to a historic low, Ofgem said it was so that “less of consumers’ money goes towards network companies’ profits, and more towards driving network improvements". It estimates that the reduction in energy companies’ earnings will save £3.3bn over the next five years, translating into a £20 annual saving for the average household bills. Despite the lower returns on offer, the regulator believes investors will still be willing to fund system upgrades given that the UK’s energy networks are a “low-risk and attractive sector”. Dame Gillian Guy, chief executive of Citizens Advice, believes Ofgem has “struck the right balance between shareholder returns and value for money for energy customers”.

Shareholders might be inclined to disagree. Ofgem is proposing that the cost of equity – the rate of return energy companies pay their shareholders – be reduced to between 3.9 per cent and 4.2 per cent, down from 7-8 per cent in the current regulatory period.

The energy companies are certainly unimpressed by the regulator’s plans. Keith Anderson, chief executive of ScottishPower – which is owned by Iberdrola (Sp:IBE) – was particularly scathing in his response, suggesting investment in green energy projects would be undermined. “Slamming the door in investors’ faces by offering one of the lowest rates of return of any developed country traps the UK in an economic cul-de-sac,” said Mr Anderson.

National Grid (NG.) said it was “extremely disappointed” and also believes such a regulatory framework will not incentivise investment or protect consumers, particularly as the UK looks to fulfil its 2050 net zero carbon emissions target. Meanwhile, SSE (SSE) has vowed to “keep all options open” unless significant changes are made. It is worth noting that several non-listed water companies appealed to the Competition and Markets Authority (CMA) earlier this year over industry regulator Ofwat’s ‘final determination’. Energy providers could follow suit.

The question is how this will impact the income case for investors. Both National Grid and SSE have come under pressure from Covid-19 due to higher customer bad debts and other pandemic-related costs. National Grid is bracing for a £400m hit to underlying operating profit this year, while SSE is anticipating a £150m-£200m blow. Still, while many others’ dividends have not survived this crisis, National Grid increased its final dividend for the year to 31 March and SSE stuck to its plans for an 80p full-year payout.

But dividend cover remains precarious – National Grid’s 2020 payout is only covered 1.2 times by adjusted EPS and for SSE it is even thinner at a multiple of 1.05. If Ofgem’s current blueprint comes to fruition and squeezes earnings, the sustainability of their payouts could be in jeopardy. Both are vulnerable – regulated electricity and gas transmission activities accounted for more than half of National Grid’s adjusted operating profit last year, while SSE’s transmission and distribution businesses generated almost two-fifths of its total.