Media

'Badly designed' regulatory framework driving equity investors away from utilities

8th May 2009 media

UTILITY WEEK article

The UK's "badly designed" regulatory framework has been responsible for driving equity investment from privatised utilities, a process which could see them return to public ownership, according to Dr Dieter Helm, professor of Energy Policy at the University of Oxford.

Addressing the Competition Commission, Helm said: "On current trends, it is quite possible that equity will be eroded further, and more mutuals and de facto nationalisations may follow. Though privatisation has come to be taken for granted, there is nothing inevitable about this form of utility ownership."

Criticising the RPI-X method currently used to regulate monopoly energy and water companies, Helm said "it is an open invitation to financial engineering, to replace equity with debt, and once complete, for equity to complete its exit". "The process is in large measure the outcome of a badly designed regulatory framework. British Utility regulation does not reward equity properly. RPI - X is designed to promote high-powered incentives, and that requires equity. But RPI - X does not set the financial framework in harmony with these incentives," Helm said. "On the contrary, it offers a weighted average cost of capital (Wacc), which definitionally averages between debt and equity. In a normal commercial business this would not matter much, but in the utilities its effects are altogether more pernicious. The reason is the special status and role of the regulated asset base (Rab). The Wacc does create incentives, but these are not the ones RPI - X is meant to deliver."

Helm's proposed solution is based on treating the low risk, completed assets in the Rab differently from new assets that are riskier and so more expensive to finance. "The reforms necessary are not revolutionary," he said. "There are two key steps: to further define the duty to finance functions so that it guarantees the sunk costs in the RABs; and to follow this through by implementing the split cost of capital."

He continued: "The Rabs become potentially tradable, and are likely to be debt-financed by institutions such as pension funds. By indexing the cost of debt appropriately, a major extension of index-linked debt becomes available. For the business of delivering the opex and capex, the split cost of capital enhances the role of equity and hence the power of incentives. It harnesses the private sector to the challenge of efficient delivery. The split cost of capital approach
maximises the scope for competition and cost minimisation in a way that would probably be appreciated by the original architects of RPI - X.