To achieve our net-zero targets we must transition to green energy. However, vast amounts of investment are required to transform our energy sector. Here Ania Zalewska explains how important it is to set an appropriate ‘cost of capital’ in order to fund these projects, as well as how regulation impacts this cost.
The transition to a zero-neutral economy by 2050 (NZE50) cannot happen without clear and consistent policies, regulation and - critically - without appropriate financing. In the UK alone the cost of transition is vast. The Treasury and the Department for Business, Energy and Industrial Strategy (BEIS) have estimated the cost of transition to net-zero to be around £70bn per year. In aggregate, this will amount to more than £1 trillion by 2050.
Private capital on a large scale will be needed to meet the net-zero target. Some of this cost will be borne directly from owners of companies which need to adjust to the low-carbon emission business environment, but the bulk will have to be sourced from both domestic and international investors.
The importance of the regulated sector
It’s often overlooked how important the regulated sector, notably the energy and water sectors, are to this process.* One reason this sectors matters is that regulators have objectives they must follow when regulating their sector - since the companies’ investments have to be approved by the regulator, this increases the regulated companies’ focus on net-zero. For example, Ofgem (the UK energy regulator) has made it a strategic priority to facilitate decarbonisation at lowest cost, which clearly impacts the type of investments undertaken by and the speed of decarbonisation of regulated energy companies.
The other main reason why the regulated sectors are important is that these sectors are at the forefront of the decarbonisation process. For example, Ofgem has recently approved about £30bn new investment over the next five years by network transmission companies (e.g. National Grid) and gas distribution companies, with at least an additional £10bn investments to be approved during these five years. By the end of 2022, it’s expected that Ofgem will approve similar amounts of investment by the electricity distribution companies. These investments are needed to connect new generation, to strengthen networks to meet growing demand (e.g. from electric vehicles), and to increase flexibility because wind and solar generation is less predictable.
The trade-off: investment or low prices?
This focus on increasing investment in regulated industries to achieve net-zero seems obviously beneficial. However, there is a major tension at the centre of the process, the outcome of which will have enormous impact on achieving net-zero. The regulated companies must be allowed to charge high enough prices to attract funding from domestic and international investors to be able to undertake the required investment. All this money must eventually be repaid, however, and this will have to be recouped over time from consumer and business bills. High prices ensure that investors will be willing to lend the money needed to fund the net-zero programme but may not protect consumers or help the UK’s international competitiveness. Low prices protect consumers and aid competitiveness but risk an investment shortfall. Regulators are caught in the middle of this and must decide how to resolve this. This decision has been made even harder due to the COVID pandemic.
The cost of capital
The cost of capital lies at the heart of this tension. Loosely, the cost of capital is how much investors need to be paid to be willing to supply the money to fund a capital project. The regulator must decide what cost of capital it will allow companies to charge. The higher the allowed cost of capital is, the higher the profits companies are likely to earn (making it easy to attract funds to pay for the investment). However, the higher the allowed cost of capital, then the higher the prices consumers will have to pay for the services. As heating and water are essential services this can impose a significant burden, particularly for the poorest in society. Not surprisingly, companies and international investors argue for a high cost of capital and consumer agencies argue for low cost of capital.
In the last two years Ofgem and Ofwat have significantly reduced the allowed cost of capital for regulated companies. Companies and investors have argued strongly against this, claiming that it will make it impossible to fund the vast investment programme needed, particularly given the impact of the COVID pandemic and the fact that the huge scale of the investment programme and associated regulatory uncertainty around net-zero increases the risk. In this period alone, four regulated water companies have spent £26 million pounds appealing against Ofwat’s judgement. In addition, every network transmission and gas distribution company has appealed against Ofgem’s judgement and we are awaiting a decision. In contrast, consumer groups such as Citizens Advice have welcomed the regulators stance.
This all raises an obvious question: has the allowed cost of capital been set too low to achieve the path to net-zero? Though we will only know the answer with time, my research suggests that there are several reasons why the companies’ concerns are unlikely to materialize.
First, it’s unlikely that the aftermath of the COVID pandemic will lead to greater risk (and hence need for a higher cost of capital) for regulated companies. We can look to the aftermath of the Financial Crisis (GFC) of 2008 and its effect on utilities for some guidance. I analysed the impact of the GFC on the market risk of industrial companies and on the regulated sector in a 2016 paper.
Analyzing stock market data for the 13 G12 countries we found that the GFC had a clear effect on the market risk of the industrial sector. We show that in every G12 country where the banking sector was riskier than the average sector before the GFC, there was an increase in the risk of industrial sector in the aftermath of the crisis. In contrast, this effect was not seen on the market risk of utilities. In general, the market risk of utilities either declined or had a much smaller rise than industrials.
Of course, we are particularly interested in the UK. The privately owned utility sector is particularly large in the UK, suggesting what happens to the average G12 country might not be a good guide to the UK. In the UK we found that the market risk of Industrials increased by over 20% in the aftermath of the GFC, but the market risk of utilities declined. This is not as strange as it may initially appear. When the market risk of typical industrial investments is rising the investment funds seek out investments where the returns are less volatile. Regulated utilities become particularly attractive since their prices are fixed by regulators and the companies are typically monopolists so face no competition. Essentially regulated utilities find it easier to raise money when the economy is riskier. So, while there is no guarantee that utilities will not become riskier post-COVID, the evidence from the GFC suggests the opposite.
Will changes in regulation increase the cost of capital?
Similarly, it seems unlikely that the future will be riskier because regulators will have to change their regulation to deal with net-zero. In 2019, jointly with Paul Grout, I produced a report, commissioned by the National Infrastructure Commission (NIC), to assess the potential impact of changes in the structure of utility regulation on the cost of capital of regulated utilities. In our report “Adaptive regulation, market risk and the cost of capital”, we used data from UK utility companies to show that significant regulatory changes have had limited effect on the cost of equity and cost of capital for regulated companies. The NIC accepted this view stating that “(t)he evidence does not suggest that the implementation of regulatory policies such as putting more emphasis on environmental performance, the public interest or helping vulnerable customers, would necessarily increase the cost of capital of these companies”.
A balance needs to be found
However, it is important to recognise that companies do have legitimate needs as the result of the rapidly changing market conditions. The above-mentioned appeal of four water companies against the decision of Ofwat and earlier appeal of NATS (En Route) against a decision of the Civil Aviation Authority (CAA) are clear examples of this. I provided an expert opinion on the cost of debt used by the CAA in setting regulatory requirements for NATS (En Route) and showed that the CAA’s estimates of the market risk of debt were incorrect. The CAA decided to use my estimates in setting the regulatory rate of return of NATS (En Route). Only a few months later, this research was used by the Competition and Markets Authority (CMA) in resolving the dispute between water companies and their regulator Ofwat. My findings on market risk were used to rule in favour of the appealing companies, ruling that the allowed cost of capital should be increased.
As a result of the CMA decision Ofgem incorporated this adjustment in the final approved cost of capital for electricity and gas companies. The general point here is that these rulings that allowed for the cost of capital to be increased have already been taken into account in most recent regulation.
The CMA will announce their final view as to the appropriate allowed cost of capital for the electricity and gas companies this month. The provisional findings suggest that the CMA generally agree with Ofgem’s view. Unless there is a major turnaround, it’s likely that the issue of what cost of capital will be allowed will be put to bed for at least two years.
However, the critical test will come as the companies seek to borrow vast sums to implement the net-zero strategy. I believe the correct balance has been struck between doing what is necessary to facilitate the net-zero investment and to protect consumers and aid the UK’s international competitiveness. We will only know for sure as time progresses.
*UK regulated energy and water assets are worth around GBP144 billion (source: National Infrastructure Commission. 2019. Strategic Investment and Public Confidence. https://nic.org.uk/app/uploads/NIC-Strategic-Investment-Public-Confidence-October-2019.pdf).
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