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The WACC adjustment factor for the Gas to the West Pipeline Final report for Mutual Energy

March 2014

© Economic Insight Ltd 2014

Economic Insight EstimatingtheWACCadjustmentfactor Confidential

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Report contents

1. Summary ......................................................................................................... 3

2. Introduction ................................................................................................... 4

3. The amount of controllable opex .................................................................. 6

3.1.TheNIAUR’sapproach 6

3.2.OurreviewoftheNIAUR’sapproach 7

3.3.Additionalanalysisregardingtheamountcontrollableopex 7

3.4.Ourconclusionsregardingtheamountofcontrollableopex 8

4. The variability of controllable opex .............................................................. 9

4.1.TheNIAUR’sapproach 10

4.2.OurreviewoftheNIAUR’sapproach 11

4.3.Additionalanalysisregardingthevariabilityofopex 13

4.4.Ourconclusionsregardingthevariabilityofcontrollableopex 20

5. Conclusion ..................................................................................................... 22


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1. Summary In order to compare applications for the Gas to the West Pipeline on a like-for like basis, a WACC adjustment factor must be calculated to reflect the fact that equity holders will be exposed to opex risk under revenue cap models, but not under cost pass through models.

The Northern Ireland Authority for Utility Regulation has proposed that the appropriate WACC adjustment factor is between 0.09% and 0.53%, with a medium point of 0.22%. Our analysis and evidence gathering, undertaken on behalf of Mutual Energy, suggests that the appropriate WACC adjustment factor is between 0.04% and 0.14%, with a medium point of 0.11%.

We therefore recommend that a figure of 0.11% is applied to the pre-tax WACC of those applications proposing a cost pass-through model.


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2. Introduction TheNorthernIrelandExecutivehasapprovedthesubventionofupto£32.5mfortheextensionofthegasnetworktotheWest.Relatedly,theNorthernIrelandAuthorityforUtilityRegulation(NIAUR)isoverseeingtheapplicationprocessfortheawardofthelicensetoundertaketheextension(andsubsequentlytooperatethepipeline).GiventhevarietyofregulatorymodelsthatcurrentlyexistinNorthernIreland,theNIAURisproposingtoallowapplicationsonthebasisofeither:

therevenuecapmodel;or theopexcostpass‐throughmodel.

Thecomplicationthisraisesisthatapplicationsunderthedifferentmodelsarelikelytohavedifferingriskprofiles,whichmakesalike‐for‐likecomparisonoflicenseapplicationschallenging.Thekeyissueisthatapplicationsundertherevenuecapmodelwillimplicitlyinclude‘opexrisk’withintheassumedweightedaveragecostofcapital(WACC),whereasapplicationsunderthecostpass‐throughmodelwillnot(andso,allelseequal,theWACCassociatedwithanycostpassthroughmodelislikelytobelowerthanthatofarevenuecapbasedmodel).TheNIAURhasthereforeidentifiedthatitwouldbeappropriatetomakeanupwardsadjustmenttotheWACCassociatedwithanycostpass‐throughapplicationtoreflectthedifferenceinriskprofile,sothatapplicationsarecomparedonafairbasis.

Inpractice,preciselyidentifyingtheappropriateWACCadjustmentfactorischallenging.ThisisbecauseoneisultimatelyattemptingtoisolatetheequityriskwithinaWACCsolelyarisingfromopexvariance.However,theWACCcapturesawidespectrumofrisks,including:

capexrisk; volumerisk; financingrisk; regulatoryrisk; strandingrisk;and theriskassociatedwithdivergencesbetweenactualandallowedopex.

Giventheabove,appropriatemethodologiesforidentifyingopexrelatedequityriskwouldseemtodependonthebenchmarkingofkeyparametersusingcomparators.Indeed,theNIAUR’sproposedmethodologyisconsistentwiththis–andhasthreemainsteps:

» Firstly,theNIAURbenchmarksthepotentialcontrollableopexassociatedwiththeGastotheWestPipelinebyusingboth:(i)top‐downcomparatorstoidentifyratiosofopextoassetvalues(thenapplyingthoseratiostotheassetvalueoftheGastotheWestPipeline);and(ii)bottom‐upcostestimatesfromcomparators.

» Secondly,theNIAURreviewsevidenceonopexvolatilityfromthehistoricalperformanceofoperators,suchasBGEandOfgem'sanalysisintheUK.TheNIAURhasassumed10%volatilityasitsmediumcase(withanupperboundof20%andalowerboundof5%)andassumedanormaldistribution.

» Thirdly,toconverttheopexvarianceintoavarianceinequityreturns(assuminganormaldistribution),theNIAURcalculatesabetabydividingthestandarddeviationintheimpliedreturnonequity(arisingfromtheopexvariance)bythatofthemarketasawhole.TheimpliedbetaisfinallyconvertedintotheWACCadjustmentbyapplyingthegearingratio.


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Usingtheabovemethodology,theNIAURisproposingthatthepotentialrangefortheWACCadjustmentfactorshouldbebetween0.09%and0.53%,withamediumpointof0.22%.OnFebruary6th,theNIAURpublishedaconsultationsettingoutboththeseproposedadjustmentfactorsandthedetailsofthemethodologyithasappliedtoderivethem.1

Intheabovecontext,MutualEnergycommissionedEconomicInsighttodevelopevidenceandanalysisastowhattheappropriateWACCadjustmentshouldbe.Thisreportsetsouttheresultsofourassessmentandisstructuredaroundthethreekeymethodologicalstepsdescribedabove–namely:

evidenceregardingthebenchmarkingofcontrollableopex; evidenceregardingthevariabilityofopex;and theimplicationsofopexriskforequityreturnsandtheWACC.

Foreachofthesethreestepswesetoutboth:(i)ourviewsregardingtheNIAUR’sanalysisandtheappropriateinterpretationofthatanalysis;and(ii)ouradditionalevidenceandanalysis.

1 Gas Network Extensions in Northern Ireland: Approach to Comparing High Pressure Licence Applications. A consultation

Paper.’ NIAUR (2014).


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3. The amount of controllable opex InthissectionweexaminetheevidencerelatingtotheappropriateamountofcontrollableopexfortheGastotheWestPipeline.WefirstlysummarisetheNIUAR’sapproachandevidence.WethenprovideourviewsontheevidenceprovidedbytheNIAURbeforesettingoutadditionalevidenceandanalysisrelevanttodeterminingcontrollableopex.

3.1. The NIAUR’s approach

InordertoestimatethecontrollableopexassociatedwiththeGastotheWestPipeline,theNIAURusesbotha‘top‐down’and‘bottom‐up’approach.

Thetop‐downapproachisbasedoncalculatingtheratioofcontrollableopextoassetvaluesforasetofcomparators,andthenappliesthatratiototheopeningassetvalueofthepipeline.TheNIAURsuggeststhatthethreeexistinggashighpressurelicenseholdersinNorthernIrelandarethemostrelevantcomparators;andinitsconsultationdocumentreportstheirratiosofcontrollableopextoopeningassetvaluestobe:

BGE(NI):1.51%; PremierTransmission:3.05%;and BelfastGasTransmission:0.85%.

TheNIAURproposesthatBGErepresentsthebestcomparatoras,consistentwiththeGastotheWestpipeline,itismainlylocatedwithinaruralenvironment.Ontheotherhand,theNIAURnotesthatthePremierTransmissionassetissub‐seaandsoislikelytohavea“radicallydifferent”operatingcostbase.2FinallytheNIAURalsonotesthattheBelfastGasTransmissionhassub‐seaelementsandamuchhigheropeningassetvaluethantheothercomparators.Consequently,takingtheBGEratioof1.51%andapplyingittotheGastotheWestPipelineopeningassetvalueof£96.67mgivesanimpliedannualcontrollableopexfigureof£1.46mforthetop‐downmethodology.

Thebottom‐upapproachemployedbytheNIAURconsistsofexaminingthecontrollableopexofBGEfortheperiod2012‐2017.TheNIAUR’srationaleforthisisthat“wearenotawareofanyreasonwhythestructureofcostsoftheGastotheWestPipelinewouldbemateriallydifferentfromthoseofanotheronlandhighpressuregaspipelineinNI.”TheNIAURstatesthatthemajorityofBGE’scostsconsistofmaintenanceandagriculturalliaisoncostsandthat,whilsttheremightbesomeeconomiesofscale,itisreasonabletoassumethatthesearescalablewithpipelinelength.AstheGastotheWestPipelinewillbe58%ofthelengthofthecurrentBGEnetwork,theNIAURassumesthatthecontrollableopexforthenewpipelinecanbeassumedtobe58%ofthoseofBGENIforthesecostcategories.Inaddition,theNIAURassumesthat:

theGastotheWestPipelinewillalsohavesomemarginalsystemoperationcosts,whichareassumedtobe25%ofthoseforBGE;and

theremaybesomenon‐routineprojectcost(suchascompliancewithEUdirectives).Theseareassumedtoamountto£0.1monanannualisedbasis.

Consistentwiththetop‐downmethodology,theNIAUR’sbottom‐upapproachsuggeststotalannualcontrollableopexof£1.505mfortheGastotheWestPipelineasacentral

2 ‘Gas Network Extensions in Northern Ireland: Approach to Comparing High Pressure Licence Applications. A consultation

Paper.’ NIAUR (2014). Page 15.


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case.TheNIAURfurthersuggestsalowerboundof£1.2mandanupperboundof£1.8m,givingaspreadof+/‐20%onthebasecaseforthecontrollableopexestimate.

3.2. Our review of the NIAUR’s approach

Thetop‐downandbottom‐upapproachesemployedbytheNIAURgivealmostthesameestimatesoftheimpliedannualcontrollableopexof£1.460mand£1.505m.However,astheNIAURnotes,theGastotheWestPipelinewillnotincludeanyentry/exitpointswithotherjurisdictions,meaningthat“…itwillnotrequirecostsassociatedwithcrossborderflowswhichcanbesignificante.g.regulatoryandITcosts.”3Onthisbasis,onewouldexpectthecontrollableopexoftheGastotheWestPipelinetobelowerthan£1.5m(becausethe£1.5misbasedonBGE(NI’s)costs,inclusiveofentry/exitpoints).Therefore,weconsiderbelowwhatfurtheradjustmentscouldbemadetoreflectthis.

WeagreewiththeNIAURthatthefeaturesofPTLmeanthatitisunlikelytorepresentarobustcomparatorforthereasonssetoutintheconsultation.

3.3. Additional analysis regarding the amount controllable opex

TherearetwooptionsformakingadjustmentstothefiguresestimatedbytheNIAURinordertobetterreflecttheavailableevidence.

3.3.1. Top-down estimate

OneoptionwouldbetotaketheaverageoftheBGE(NI)andBelfastGasTransmissionfiguresof1.51%and0.85%‐thiswouldresultinafigureof1.18%,or£1.14m.ThisisonthebasisthattherearefeaturesoftheBGE(NI)comparatorthatleadtotoohighafigure,andfeaturesoftheBelfastGasTransmissionfigurethatleadtotoolowafigure,butthatthereisalittleevidencetosaywhichoneis‘moreright.’

3.3.2. Bottom-up estimate

Theotheroptionistomakefurtheradjustmentstothebottom‐upfigure.Inparticular,wenotethattheNIAURexpectsanycosts“associatedwithsystemoperationtobemarginalandproposethattheyequal25%oftheBGE(NI)allowance.”WenotethattheopeningassetvalueofBGE(NI)is£205mandtheopeningassetvalueoftheGastotheWestPipelineisexpectedtobe£64m–aratioof31%.Therefore,anassumptionof25%seemsparticularlyhigh–itisequivalenttoassumingthata100%increaseinassetvaluegivesrisetoan80%increaseinsystemoperationcosts(25%/31%)–andsoisinconsistentwiththeviewthatsystemoperationcostswillbemarginal.

Tohelparriveatamoreappropriateassumption,MutualEnergyhastoldusthatwhenittookonBGTLinadditiontoPTL,itssystemoperationcostsincreasedby10%.TheassetvaluesofBGTLandPTLareroughlythesame.Therefore,inthisinstance,a100%increaseinassetvaluewasassociatedtoa10%increaseinsystemoperationcosts,whichismoreconsistentwiththeviewthatsystemoperationcostswillbemarginal.SincetheincreaseinassetvalueinrelationtotheGastotheWestPipelineis31%,abottom‐upapproachwouldimplythatsystemsoperationscostsforthepipelinewouldbe3.1%(i.e.10%x

3 ‘Gas Network Extensions in Northern Ireland: Approach to Comparing High Pressure Licence Applications. A consultation

Paper.’ NIAUR (2014). Paragraph 4.17.

“…as the NIAUR notes, the Gas to the West Pipeline will not include any entry/exit points with other jurisdictions…On this basis, one would expect the controllable opex of the Gas to the West Pipeline to be lower than £1.5m.”


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31%)ofBGE(NI’s)systemoperationcosts,ratherthan25%.Alternatively,onecouldusepipelinelengthasthecostdriver,astheNIAURhasdoneinrelationtothecomponents.Thiswouldgiveafigureof5.8%(i.e.10%x58%).Giventherangeimpliedbyouradjustednumbers,weproposetoapplyaroundedfigureof5%toestimatesystemoperationcosts(whichisconservativecomparedtothefigureof3.1%basedonassetvalue).

Inaddition,wehavebeentoldbyMutualEnergythatmanyoftheothercostsincludedin“Other”–training,safetycampaign,admin,consultancy/legalservicesandsharedservices–wouldbemarginaltoo–andsoinlinetheabove,afigureof5%wouldseemtobemoreappropriate.Thisgivesarevisedfigureof£1.27masshowninthefollowingtable.

Table1Revisedbottom‐upopexamount

Component BGE(NI) % NewPipeline

Maintenance £1.744m 58% £1.012m

AgriculturalLiaisons £0.167m 58% £0.097m

SystemOperation £0.433m 5% £0.022m

Other £0.752m 5% £0.038m

NonRoutine £0.100m

Total £1.268m

Source:EconomicInsightanalysis

Wenotethattheabovefiguresincludeinsurancecosts(£0.21mincludedin“Other”)astheyarecurrentlyclassifiedas‘controllable’bytheNIAURinotherrelevantpricecontrols,suchasBGE(NI).However,theNIAURcoulddecidetoreclassifythesecostsandthiswouldfurtherreducetheproportionofcontrollablecosts.

3.4. Our conclusions regarding the amount of controllable opex

Ourrevisedtop‐downestimatefortheamountofcontrollableopexis£1.141mandourrevisedbottom‐upestimateis£1.268m.Theaverageis£1.20m.Weconsiderthatthis,whichisthesameastheNIAUR’s‘low’estimate,representsabettermidwayorcentralestimateofthecontrollableopexinvolvedintheGastotheWestPipeline.Amoreappropriatelowestimatemightbe£1.0mandahighestimatemightbe£1.4m.


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4. The variability of controllable opex InthefollowingweconsidertheevidenceregardingthelikelyopexvarianceriskassociatedwiththeGastotheWestPipeline.Inturnweaddress:(i)theNIAUR’sapproachtoassessingthevariance;(ii)ourviewsregardingtheNIAUR’sevidence;and(iii)furtherevidenceonopexvarianceusingadditionalcomparators.

AttheoutsetwenotethatthevariabilityanddistributionofopexarecriticalassumptionsintheNIAUR’sanalysis.Toillustratethis,thebelowshowsthe(pre‐tax)riskfactoradjustmentsusingtheNIAUR’slow,mediumandhighassumptionsforboth:(a)theamountofcontrollableopexand;(b)thevariabilityofopex.Allotherassumptionsareaspertheconsultation.

Table2Sensitivityofpre‐taxriskadjustmentfactorstoopexvariabilityassumption

Assumedcontrollableopex Low(5%) Medium(10%) High(20%)

Low£1.2m 0.09% 0.18% 0.35%

Medium£1.5m 0.11% 0.22% 0.44%

High£1.8m 0.13% 0.27% 0.53%


TheredfiguresarethesameasthosepresentedinTable7oftheconsultation.Theblackfiguresshowtheriskfactoradjustmentresultingfromdifferentoperatingexpenditureamountandvariabilityassumptions.Forexample,thefigurehighlightedinboldshowsthatthe‘riskfactoradjustment’wouldbe0.11%usingthe‘low’variabilityassumption(5%),butthe‘medium’amountassumption(£1.5m).Theaboveindicatesthattheriskadjustmentfactorisprimarilydrivenbytheassumedvariabilityofopex.TofurtherdemonstratethisthefollowingtableshowsthebreakdownofthechangeintheWACCadjustmentfactorfromtheNIAUR’slowtomediumscenarios(0.09%to0.22%).Thisrevealsthat67%oftheincreaseintheadjustmentfactorbetweenthetwoscenariosisduetotheassumedincreaseinopexvariability(andonly17%duetotheincreaseintheabsoluteamountofcontrollableopex).


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Table3BreakdownofchangeinWACCadjustmentfromtheNIAUR’slowtomediumscenarios

ScenarioWACC

adjustmentfactor

ChangeinWACCadjustment(%

points)

%ofchangeaccountedfor

NIAURlowscenario 0.09%

+increaseinopexvariability +0.09% (66.7%)

+increaseinopexamount +0.02% (16.7%)

+combinedeffectofincreasedvarianceandamountofopex

+0.02% (16.7%)

NIAURmediumscenario 0.22%


4.1. The NIAUR’s approach

Initsanalysisofthevariabilityanddistributionofopex,theNIAURpresentsthreescenarios:

thelowscenarioassumesthat9timesoutof10,opexwillbewithin+/‐5%oftheopexallowedintherelevantpricecontrols;

themediumscenarioassumesthatopexwillbewithin+/‐10%;and thehighscenarioassumesthatopexwillbewithin+/‐20%.

Furthermore,allscenariosassumethatthegapbetweenactualopexandthosethatwouldbeallowedinrelevantpricecontrolsarenormallydistributed.Thisisequivalenttoassumingthat:(a)largergapsbetweenactualandallowedopexarelesslikelytoarisethansmallergaps;and(b)apositivegapbetweenactualandallowedopexisaslikelytoariseanegativegapofthesamesize.

Toarriveatthescenariosandassumptionssetoutabove,theNIAURhasreliedonfoursourcesofevidencefromtheenergysector.

» BGE(NI).TheNIAURfoundthatBGE’sactualcontrollableoperatingexpenditurewas4.1%lowerthanitsallowancebetween2007and2012.

» PowerNI.TheNIAURstatesthatitfoundagapbetweenactualandallowedcontrollableoperatingexpenditureof10%initsworkonthePowerNIretailpricecontrol,althoughitnotesthat“…PowerNIactualcostsshowedmuchhighervariancethanwehaveevidenceforingaspipelinecostswithalotofthisbeendrivenbybaddebtissueswhichwouldnotpertaintotheGastotheWestlicence.”

» Ofgemmodellingassumptions.TheNIAURnotesthatinitsrecentworkongasandelectricitytransmissionpricecontrols,Ofgemassumedagapof+/‐10%initsfinanceabilitymodellingwork.

» Reopenerparameters.Finally,theNIAURnotesthatthepricecontrolwouldbereopenedifactualopexdeviatesfromallowancesbymorethan15%(whichtheNIAUR


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statesisequivalenttoavariancebetweenactualandallowedcontrollableopexof+/‐20%).

4.2. Our review of the NIAUR’s approach

OverallweagreewiththeapproachadoptedbytheNIAUR,inthesensethatthemostrobustwayofconsideringthescopeforopexvarianceregardingtheGastotheWestPipelineistoexamineevidenceonactualopexvarianceforsuitablycomparableprojectsorindustries.However,regardingthedetailoftheNIAUR’smethodology,wewouldmakethefollowingobservations:

» First,thattheassumptionof+/‐10%varianceinthecentralcaseisbaseduponOfgem’sapproachunderRIIO‐T1.However,onexaminationofOfgem’sevidence,the10%figureisitselfanassumption,ratherthanpurelyreflectingactualmarketdata.

» Second,Ofgem’sownanalysissuggeststhatcostvarianceislikelytobelowerforgastransmissionthanforelectricity,indicatingthattheappropriateinterpretationofthedatawouldbeacentralestimateoflessthan+/‐10%inanycase.

» Third,theNIAUR’sownqualitativeassessmentofthisissueindicatesthatitexpectsonlyalowlevelofopexvariabilityriskfortheGastotheWestPipeline.

» Finally,theevidencebasedonactualmarketdata(i.e.thevarianceforBGE)isconsistentwithamuchlowerlevelofvariancethan+/‐10%.

Inthefollowingwebrieflyexpanduponeachoftheaboveissuesinturn.

4.2.1. Ofgem’s 10% variance figure is an assumption

OurunderstandingisthattheNIAUR’schoiceofmidwayestimateof+/‐10%issignificantlyinfluencedbyOfgem’smodellingassumptions:“Overall,wetaketheviewthattheOfgemapproachrepresentsanappropriateestimateforvariationthatcanbeappliedinthecaseoftheGastotheWestPipeline.”4

InordertoevaluatethebasisforOfgem’sassumptionof+/‐10%,wehavereviewedtheImrecon/ECAreportreferencedintheconsultationpaperandrelevantdocumentspublishedbyOfgemaspartofRIIO‐T1.TheImrecon/ECAreportdoesnotsetoutthedatathatOfgemreliedupon,butsuggeststhata“broadjudgement”wasused:“Ofgemhasexplainedtoushowithasreachedabroadjudgementthat+/‐10percentfortotexvariabilityfairlyrepresentsplausibleupsidesanddownsides.Itisnoticeablyaroundsumamount.Inourview,reflectingourcommentonhighlevelassumptionsabove,usingaroundsumamountdoesnotinvalidatethejudgementbutitdoeshighlightthefactitisajudgement.”5

Similarly,theappendicestoOfgem’sFinalProposalsinRIIO‐T1donotcontainactualmarketdatatosupporttheassumption,butnotethat“Theseassumptionswerebasedonamixtureofhistoricalperformanceandprojectedplausiblevalues.”6Clearly,wherepossibleandcomparable,itwouldclearlybebesttobasedecisionsonactualmarketdata–andwe

4 ‘Gas Network Extensions in Northern Ireland: Approach to Comparing High Pressure Licence Applications’, NIAUR (2014),

paragraph 4.30.

5 ‘RIIO reviews – Financeability study’, Imrecon/ECA (2012), page 6.

6 ‘RIIO‐T1 Final Proposals for National Grid Electricity Transmission and National Grid Gas’, Ofgem (2012), Finance Supporting Document, Appendix 4, paragraph 1.3.


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providefurtherevidenceofthisbelowandinouranalysisofadditionalcomparators(seelater).

4.2.2. A review of the evidence relied upon by Ofgem indicates a lower volatility for gas than for electricity, indicating the appropriate interpretation is a mid-point for variance of less than +/-10%

Ofgem’s‘FinanceSupportingDocument’containsfurtherscenario‐basedanalyses(alsoincorporatinganumberofassumptions),whichcanbeusedtohelpinformthejudgementastothelikelyscopeforopexvariability.Inparticular,thedocumentshowsthevariabilityoftoteximpliedbyOfgem’sanalysesforelectricityandgastransmissionseparately.Notably,Ofgemconcludesthat“NGGTfaceslessriskintermsoftotexvariabilitythantheelectricitytransmissioncompanies,andsimilarrisktotheGDNs[GasDistributionNetworks].”7Figure3.2showsthattheestimatedtotexvariabilityforNGGTisaround+3%to‐5%.Althoughwearenotsuggesting(basedonthisevidencealone)that+3%to‐5%representstherightrangeinthiscase(asitreflectsanumberofassumptionsandfeaturesoftheGBregulatoryregime)wethinkthatitisimportanttheNIAURreflectstheevidencethatexpenditurevariabilityriskforgastransmissionislowerthanforelectricitytransmission.

4.2.3. The NIAUR expects a low level of opex variance

Initsconsultationdocument,theNIAURstatesthat“thebulkofthecostsmadeupbymaintenanceandagriculturalliaisonsofficersarepredictableandbasedonregulartenders.”TheNIAURfurtherstatesthat“systemoperationandregulatorymanagementcostswouldbeexpectedtoberelativelyflatandpredictable.”8Thissuggeststhat,atleastqualitatively,theNIAURexpectsthevariabilityofcontrollableoperatingexpendituretobelow.

4.2.4. Actual market data is consistent with a central estimate for opex variance of lower than +/- 10%

Inourviewitisimportanttoensurethatanybenchmarkingofopexvarianceisprimarilybasedonactual(andverifiable)marketdataonvariancethathasoccurredelsewhere.Giventhis,wethinkthattheevidencepresentedbytheNIAURregardingtheopexvarianceofBGE(NI),whichshowsvariabilityofjust4.1%,ishighlyrelevant.Asageneralprinciple,wesuggestthatmarketdatashouldcarrymoreweightthananalysisthatisprimarilyassumptionbased,suchasthe+/‐10%figurereferencedbyOfgem.

4.2.5. Summary of our review of the NIAUR’s approach

Insummary,weagreewiththeoverarchingapproachadoptedbytheNIAURregardingthedeterminationofthelikelyscopeforopexvarianceregardingtheGastotheWestPipeline.Inparticular,weconsideritsensibletoexaminedataonopexvarianceforcomparators.However,weconsiderthatthat:(i)moreweightshouldbeattachedtocomparatorsthatreflectactualmarketdata,ratherthanassumptions.Consequently,theopexvarianceforBGE(NI)isthemostrelevantdatapoint;and(ii)theappropriateinterpretationoftheOfgemanalysiscitedbytheNIAURisthatthecentralpointforopexvarianceregardinggastransmissionshould,inanycase,belessthan+/‐10%.Insummary,therefore,weconsiderthattheevidencepresentedbytheNIAURintheconsultationdocumentisitself7 ‘RIIO‐T1 Final Proposals for National Grid Electricity Transmission and National Grid Gas’, Ofgem (2012), Finance Supporting

Document, paragraph 3.37.

8 ‘Gas Network Extensions in Northern Ireland: Approach to Comparing High Pressure Licence Applications. A consultation Paper.’ NIAUR (2014). Page 16.

“We think that it is important the NIAUR reflects the evidence that expenditure variability risk for gas transmission is lower than for electricity transmission.”


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consistentwithanopexvarianceassumptionoflowerthan+/‐10%and,mostlikely,thattheappropriatefigurecouldbeaslowas+/‐4%(althoughinthefollowingsectionweprovideevidencefromadditionalmarketcomparatorstoexaminethisfurther).

4.3. Additional analysis regarding the variability of opex

InadditiontoreviewingtheNIAUR’sanalysisofopexvariance,wehavedevelopedfurtherevidenceofthescopeforvariability(andtheimplicationsforequityreturns)basedonawidersetofcomparators.Inparticular,wehavelookedatvariationsinactualversusallowedopexfor:

energycomparators; waterindustrycomparators;and airportandrailcomparators.

Basedonourcomparatoranalysis(whichissetoutinmoredetailintheremainderofthissection)wesuggestthattheappropriaterangeforopexvarianceisbetween3%and7%,witha‘midway’estimateof6%.Ourviewisthat,ofthecomparatorswehaveexamined,energyandwatercomparatorsarethemostappropriateforthepurposeofbenchmarkingopexvariability,astheriskprofilesofairportsandrailnetworkoperatorsarelesscloselyalignedtothoseofgastransmission.

4.3.1. Additional energy related comparators

Thissectionsetsoutouranalysisofenergysectorcomparators.Specifically,weanalyse:

» GastransmissioninGB.Inparticular,weevaluatewhattheactualmarketevidencesaysaboutthedifferencebetweenactualandallowedcontrollableoperatingexpenditureofNationalGridGasTransmission(NGGT).

» GastransmissioninNI.Specifically,wecomparetheactualcontrollableopexofBGTLandPTLtotheshadowpricecontrolbetween2008/09and2012/13.

4.3.1.1. Gas transmission in GB

SinceOfgem’smodellingworksuggeststhatcostvariabilitymaybelowerforgastransmissionthanforelectricitytransmission;andthe+/‐10%figurerelatestoboth(andisitself,atleastinpart,ajudgement),itisimportanttotakeintoaccountoftheactualmarketdatarelatingtogastransmissioninGB.

Helpfully,OfgempublisheddataNGGT’sactualcontrollableoperatingexpenditurecomparedtoitsallowedcontrollableoperatingexpenditureforthelastpricecontrol–coveringtheyears2007/08to2010/11.9Asillustratedbythetablebelow,thedatashowsthatNGGT’sactualexpenditurewas£65.6monaverageoverthefouryears,whereasitsallowancein2010/11was£70.1m–adifferenceof‐6.4%.

9 ‘Transmission Annual Report for 2010/11’, Ofgem (2012), Figure 8.


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Figure1NGGTactualversusallowedcontrollableopex2007/08‐2010/11

Source:EconomicInsightanalysisofOfgemdata

Thisfigureissignificantlylowerthanthe10%figureusedintheNIAUR’smidwayscenarioand,indeed,isclosertoboththefigureusedintheNIAUR’slowscenarioandthefigureimpliedbytheBGE(NI)data.

4.3.1.2. Gas transmission in NI

Ourclient,MutualEnergy,hasprovideduswithdataontheactualand‘allowed’controllableoperatingexpenditure(undertheshadowpricecontrol)ofPremierTransmissionandBelfastGasTransmissionbetween2008/09and2012/13.Thefigurebelowshowsthat:

BelfastGasTransmission’sactualexpenditureoverthefiveyearswas£6.18manditsallowedexpenditurewas£6.24m–agapof‐0.9%;and

PremierTransmission’sactualexpenditureoverthefiveyearswas£18.2manditsallowedexpenditurewas£19.4m–agapof‐6.2%

£70.1

£65.6

£0.0

£10.0

£20.0

£30.0

£40.0

£50.0

£60.0

£70.0

£80.0

Allowedcontrollableopexin2010/11 Actualaverageannualcontrollableopex2007/08‐2010/11

AllowedandactualcontrollableNGGTopex(£m)

Difference = ‐6.4%


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Figure2BGTLactualversusallowedcontrollableopex2008/09‐2012/13

Source:EconomicInsightanalysisofMutualEnergydata

Figure3PTLactualversusallowedcontrollableopex2008/09‐2012/13

Source:EconomicInsightanalysisofMutualEnergydata

Again,bothfiguresaresignificantlylowerthanthe10%figureusedintheNIAUR’smidwayscenario.Asnotedpreviouslyinthisreport,therearereasonstothinkthattheBelfastGasTransmissionisaclosercomparatortotheGastotheWestPipelinethanPremierTransmission,indicatingthatitmightbemoreappropriatetorelyonthelowerfigure.

4.3.2. Conclusion on energy industry comparators

Thetablebelowsummarisestherecentactualmarketevidenceofcontrollableoperatingexpenditurevariabilityfromtheenergysectorcomparators.

£6.24 £6.18

£0.00

£1.00

£2.00

£3.00

£4.00

£5.00

£6.00

£7.00

Allowedcontrollableopex(total)between2008/09and2012/13

Actualcontrollableopex(total)between2008/09and2012/13

AllowedandactualcontrollableBGTLopex(£m

)Difference = ‐0.9%

£19.4£18.2

£0.0

£5.0

£10.0

£15.0

£20.0

£25.0

Allowedcontrollableopex(total)between2008/09and2012/13

Actualcontrollableopex(total)between2008/09and2012/13

AllowedandactualcontrollablePTLopex(£m

)



16

Table5Summaryofenergysectorcomparators

Source Actual/Allowed%

BGE(NI) ‐4.1%(5years,2007/08‐2011/12)

NGGT ‐6.4%(4years,2007/08‐2010/11)

BelfastGasTransmission ‐0.9%(5years,2008/09‐2012/13)

PremierTransmission ‐6.2%(5years,2008/09‐2012/13)


Thetableshowsthat:

noneofthe‘projects’exhibitvariabilityoftheNIAUR’sproposedmidwayestimateof+/‐10%;

alloftheprojectarebelow+/‐7%;and twooftheprojectsarebelowthecurrentlowestimateof+/‐5%.

Therefore,thisevidencesuggeststhatthecurrentmidwayestimateof+/‐10%istoohigh.Theactualmarketevidencesuggeststhatvariabilityinexcessof+/‐7%isunlikely,andsomaybeamoreappropriate‘upper‐bound’estimate.Moreover,asnotedabove,Ofgem’sscenario‐basedanalysessuggestthatthecontrollableoperatingcostvariabilityforgastransmissionislowerthanforelectricitytransmission,andsoafigurelowerthantheaverage10%wouldalsobeappropriateonthisbasis.

4.3.3. Water industry comparators

InourviewthewaterindustryisahelpfulcomparatortoconsiderwithregardtothepotentialscopeofopexriskwithintheWACCinrelationtotheGastotheWestPipeline.Inparticular,wenotethattheImrecon/ECAreportforOfgem(which,asnotedabove,isakeysourcefortheNIAUR’sownassessmentofopexvariability)specificallymakesreferencetothewatersector,statingthatit:“isgenerallythoughttohaveasimilarriskprofiletoenergynetworks.”10Wefurthernotethat:(i)OfwatplacedweightonenergyretailermarginswhendeterminingappropriateallowednetretailmarginsinthewatersectorforPR14;and(ii)whendetermininganappropriaterangeforthereturnonregulatoryequity(RORE),whichishighlypertinenttotheissuesunderconsiderationhere,OfwatexplicitlyexaminedRORErangesforgasdistribution,notingthat:“wewouldexpecttoseeaconsistencyintheoverallrangeforROREforregulatedutilitieswithcomparablereturns.”11

Indeed,wenotethat(similartogastransmission)thewaterindustryischaracterisedby:

ahighlevelofcapitalintensity(i.e.alowrelativeamountofopex); stableandrelativelypredictabledemand;and apredictableandstableregulatoryregime.

Forthisreasonwehavecomparedallowedopex(assetduringpricecontrols)withactualcompanyopexovertimeforthewaterindustry.OurstartpointwastoexaminethedifferencebetweenactualandallowedopexforNorthernIrelandWater(NIW),asthefactthatitsoperatingareaisNorthernIrelandislikelytofurtherimprovecomparability.

10 ‘RIIO Reviews: Financeability study.’ Imrecon and ECA report submitted to Ofgem (November 2012). Page 4.

11 ‘Setting price controls for 2015‐20 – risk and reward guidance.’ Ofwat (2013). Page 47.


17

4.3.3.1. Northern Ireland Water

TheNIAURpublishesinformationonNIW’sactualandallowedopexinitsCostandPerformancereports.Inparticular,fortheperiod2010‐13,theNIAURsetoutitsassessmentoftheextenttowhichNIWhasgenuinelyoutperformeditsopextargetsforreasonsofefficiency(ratherthansay,bydeferringprojects).Inourviewthisisahighlyrelevantmeasure,asweareseekingtoidentifytheextenttowhichcontrollableopexcouldvaryfromthatoriginallyassumedbytheregulator(asultimately,thisistherisktowhichequityisgenuinelyexposed).UsingthedatapublishedbytheNIAURwethereforecalculatedthevariationinopexarisingfromoutperformanceasapercentageofallowedopexineachyear,asshowninthefollowingtable.

Table6NorthernIrelandWaterallowedandactualopex

Calculationstep 2010‐11 2011‐12 2012‐13 Total

Allowedopex‐PC10FDTarget(£m)

£220.4 £215.1 £207.2 £642.7

NIWtotalopexunderspend(£m) ‐£17.1 ‐£25.0 ‐£15.5 ‐£57.6

NIAUR'sassessmentofunderspendduetooutperformance(£m)

‐£6.1 ‐£6.9 ‐£6.5 ‐£19.5

Allowedopexadjustedforoutperformance(£m)

£209.4 £197.0 £198.2 £604.6

NIWactualopexspend(£m) £203.3 £190.1 £191.7 £585.1

Opexvariancefromoutperformance(%)

‐2.9% ‐3.5% ‐3.3% ‐3.2%

Source:NIAUR12

OuranalysisshowsthatthetotalopexvarianceforNIW(arisingfromoutperformance)was‐3.2%overthethreeyearsto2012/13.Overthisperiod,opexvariancefromoutperformancewasnomorethan‐3.5%inanyindividualyear.

4.3.3.2. England and Wales Water and Sewerage Companies

Inadditiontotheabove,weexaminedtheopexvarianceofwaterandseweragecompanies(WASCs)inEnglandandWales,whicharesubjecttoarevenuebasedpricecontrolmodel,asperNIW.Specifically,we:

» ExaminedtheaverageannualallowedopexsetbyOfwat(theregulator)atthelastpricereview(PR09).13

» ObtaineddataonWASCactualopexineachofthethreeyearssincethecontrolperiodstarted(2010/11,2011/12and2012/13)–asreportedintheirregulatoryaccounts.14

12 ‘Cost and Performance Report For NI Water ‐ PC10.’ NIAUR (2013). Tables 2.2 and 2.3

13 As reported in: ‘Ofwat PR09 Final Determination.’ See Table 37: Operating expenditure by company (annual average post‐efficiency). Ofwat has advised us that the data is in 2007/08 prices and so the reported allowed opex of £3,323m as published has been inflated by RPI in each subsequent year and then averaged (giving £3,664m).

14 Actual WASC opex figures are taken from ‘operating cost analysis’ tables as reported in the notes to company’s regulatory accounts. These provide a breakdown of opex by area. Ofwat advised us that both third party services costs and retail costs


18

» Then,finally,wecalculatedthe%differencebetweenactualandallowedopexfortheindustryasawholeacrossthethreeyearstodate,asshowninthechartbelow.

Figure4WASCactualversusallowedopexoverPR09

Source:EconomicInsightanalysisofOfwatdataandWASCregulatoryaccounts15

Ouranalysisshowsthatacrosstheindustry,actualopexhasvariedby‐2.3%relativetoallowedopexoverthepricecontrolperiodtodate.Regardingthemethodologywehaveemployedtocalculatethisvariance,therearethreeimportantpointstohighlight:

» First,wethinkthatitisappropriatetolookatthevarianceoverthethreeyearscombined,asequityholderswouldgenerallytendtothinkabouttherisktoreturnsfromtheperspectiveofapricecontrolperiod(i.e.thefactthatopexorequityreturnscouldvarybemoreorlessthanthisinanygivenyearisnotparticularlyinformativeoftheactualrisktowhichequityholdersareexposed).

» Second,wethinkthatitisappropriatetolookatthevariancefortheindustryasawholeovertime(ratherthanindividualcompanies),ascapitalisreadilysubstitutableacrossindividualcompanieswithintheindustryand,assuch,theriskprofileacrosscompaniesisunlikelytovaryinanymeaningfulway.WenotethatthiswasOfwat’srationale(consistentwithadvicefromPwC)forretainingasinglenotionalindustryWACCfortheforthcomingPR14pricecontrol.16Notwithstandingthispoint,ouranalysisalsoshowsthat8ofthe10WASCsincludedinouranalysishadavarianceoflessthan+/‐3%andonlyonehadavarianceofgreaterthan+/‐10%.

» Third,becausetheavailabledatadoesnotallowustospecificallyisolatevarianceincontrollableopexinrelationtoWASCsinEnglandandWales,theopexvariancefactor

are included in the allowed opex figures above, and so we have also included these in our actuals (noting that Ofwat’s total allowed opex at the start of PR09 would have included retail costs, even though the requirement to report them separately only came into effect during the price control period). WASCs included in the analysis were: Anglian Water, Dwy Cymru, Northumbrian Water, Severn Trent, South West Water, Southern Water, Thames Water, United Utilities, Wessex Water and Yorkshire Water.

15 Analysis is in nominal outturn prices.

16 See: ‘Cost of capital for PR14: Methodological considerations.’ PwC report for Ofwat (July 2013).

£3,664£3,581

£0

£500

£1,000

£1,500

£2,000

£2,500

£3,000

£3,500

AllowedaverageannualopexarPR09(£m)

Actualaverageannualopex(£m)

AllowedandactualW

ASCopex(£m)



19

wehavecalculatedmayover‐statethetrueopexvolatilityrisktowhichequityholdersareexposed(thisisthecasesolongasonesupposesthatitistheuncontrollableelementofopexthatismostsubjecttovolatilityrisk,whichweconsidertobelikelyinmostinstances).

Insummary,ouranalysisofopexvariabilityinthewatersectorsuggestsarangeofbetween+/‐2.3%to+/‐3.2%.

4.3.4. Airport and rail comparators

Thissectionbrieflysetsoutadditionalevidencefromotherregulatedsectors,namelyHeathrowandGatwickairports(whicharesubjecttopricecontrolsbytheCivilAviationAuthority)andNetworkRail(whichissubjecttopricecontrolsbytheOfficeofRailRegulation).Asnotedabove,weconsiderthesesectorstobelesscomparablethanthegasandwatersectors,andsoattachlessweighttotheminourconclusions.

4.3.4.1. Airports

ThetablebelowshowstheactualandallowedoperatingexpenditureofHeathrowandGatwickairportsbetween2008/09and2012/13.

Table7ComparisonofHeathrowandGatwickairports’allowedandactualopex

£m2011/12prices 08/09 09/10 10/11 11/12 12/13 Total

Heathrowallowed 968 952 956 962 969 4,807

Heathrowactual 1,071 1,052 996 1,001 997 5,117

Difference% 6.4%

Gatwickallowed 315 313 314 315 312 1,569

Gatwickactual 312 319 281 281 285 1,478

Difference ‐5.8%

Source:EconomicInsightanalysisofCAAdata,

Thetableshowsthat:

forHeathrow,actualoperatingexpenditurewashigherthanallowedoperatingexpenditureby6.4%;and

forGatwick,actualoperatingexpenditurewaslowerthanallowedoperatingexpenditureby‐5.8%.

Again,bothfiguresaresignificantlylowerthanthe10%figureusedintheNIAUR’smidwayscenario.

4.3.4.2. Rail

NetworkRail’sregulatoryaccountsshowthatitsactualcontrollableoperatingexpenditurebetween2009/10andbetween2011/12was£2,887manditsallowedcontrollableoperatingexpenditurewas£2,581–adifferenceof11.5%.17

Wenotethatpartofthereasonforthisrelativelyhighdifference,whichisclosertotheNIAUR’smidwayestimate,maybecausedbytheshorttimeperiodoverwhichthe

17 ‘Network Rail Infrastructure Limited Regulatory Financial Statements’, (2012), Statement 7a.


20

differenceiscalculated.Wehavethereforecheckedthedifferenceforentiretyofthepreviouspricecontrol,runningfrom2004/05to2008/09.18Thedatashowsthat:

thegapbetweenactualandallowedoperatingexpenditure(controllableanduncontrollable)wasmuchlowerat+1.2%;and

accordingtoNetworkRail“TheACR2003splitsoperatingexpenditureintocontrollableandnon‐controllablecostsanditisthelatterthathasexceededthedeterminationacrossthecontrolperiod.”19

4.3.4.3. Conclusion on airport and rail comparators

Althoughweconsidertheaboveairportandrailregulatedsectorstobelesscomparablethanenergyandwater,thisevidenceisalsoconsistentwiththeviewthatafigureof+/‐10%istoohighforamidwayestimate.

4.4. Our conclusions regarding the variability of controllable opex

Basedontheaboveanalysis,thefigurebelowsummarisestheactualmarketdataoncontrollableoperatingcostvariability.Therangeisbetween0.9%and11.5%.

Figure5SummaryofcomparatorevidenceonopexvariancerelativetoNIAURrange


Onthebasisofthisdataweconsiderthat:

» Anappropriatelowestimateofvariabilitywouldbearound+/‐3%.ThisisbasedonthefactthattheaverageopexvariabilityofBGE(NI),NIW,BGTLandE&WWASCstogetherisjustunderthislevel.

» Asuitablemidwayorcentralestimateofvariabilitywouldbearound+/‐6%.Thisisbasedonthefactthatmostcomparatorshaveoperatingcostvariabilityatorbelowthislevel(anditisalsomidwaybetweentheminimumandmaximumestimatesof0.9%and11.5%).

» Themaximumestimateshouldbe+/‐7%.ThisisbasedonthefactthatallbutNetworkRailarebelowthislevel–andthatNetworkRailfiguremay:(a)notbeasgoodacomparatorastheothers;and(b)mayexhibitalowerlevelofvariabilityoveralongertimeperiod.

18 ‘Network Rail Infrastructure Limited Regulatory Financial Statements’, (2009)

19 ‘Network Rail Infrastructure Limited Regulatory Financial Statements’, (2009), page 4.

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%NIAUR Low NIAUR Mid NIAUR High

BGTL, 0.9%

NIW, 3.2%

BGE (NI) 4.1%

NR, 11.5%

E&W WASCs, 2.3%

Gatwick, 5.8%

PTL, 6.2%

NGGT, 6.4%

Heathrow, 6.4% Blue cross = Stronger comparatorOrange cross = Weaker comparator

Yellow shading = Our proposed range


21

Finally,wenotethattheNIAUR’s‘high’estimateisinconsistentwiththeevidenceandshouldbedisregarded.Thatis,thehighestimatesuggeststhatthatitismorelikelythannot(specificallya56.5%chance)thatopexvariabilitywouldbegreaterthan7%.


22

5. Conclusions Theevidenceandanalysissetoutabovesuggeststhemoreappropriatealternativeassumptionsforthelevelandvariabilityofcontrollableopexare:

£1.0mand3%inthelowscenario; £1.2mand6%inthemediumscenario;and £1.4mand7%inthehighscenario.

Thetablebelowshowstherevisedpre‐taxWACCadjustmentfactorsusingthesealternativeassumptionsandthesamecalculationmethodologyastheNIAUR.Itshowsthatthepre‐taxWACCadjustmentfactorsrangebetween0.04%and0.14%.

Table8Revisedpre‐taxriskadjustmentfactorswithalternativeassumptions

Assumptions Low(3%) Medium(6%) High(7%)

Low(£1.0m) 0.04% 0.09% 0.10%

Medium(£1.2m) 0.05% 0.11% 0.12%

High(£1.4m) 0.06% 0.12% 0.14%


Ourviewisthattheappropriatemidwayorcentralestimatetouseis0.11%,whichishalfofthecurrentmidwayorcentralestimateof0.22%.Alternatively,thedataismoresupportiveoftheNIAUR’s‘low’estimateof0.09%thanitisofitscentralestimateof0.22%,andwithoutfurtheranalysis,werecommendthatthisisused.Finally,thetableshownoverleafprovidesfulldetailsofthecalculationstepsusedtoderivetheaboveadjustmentfactors.


23

Table9CalculationstepsforWACCadjustmentfactor

Calculationstep Lowcase Mediumcase Highcase

Controllableopex(£m) £1.000 £1.200 £1.400

Variation(%) 3.00% 6.00% 7.00%

Variationvalue(£m) £0.030 £0.072 £0.098

Expectedequityreturn(£m)

£0.818 £1.818 £2.818

Min(£m) £0.788 £1.746 £2.720

Max(£m) £0.848 £1.890 £2.916

MinRORE(%) 6.55% 14.51% 22.61%

MaxRORE(%) 7.05% 15.71% 24.24%

Spread(%) 0.50% 1.20% 1.63%

Standarddeviations 1.65 1.65 1.65

SDEquity 0.15% 0.36% 0.49%

SDMarket 8.50% 8.50% 8.50%

Equitybeta 0.02 0.04 0.06

ERP(%) 5.30% 5.30% 5.30%

ECA(%) 0.09% 0.23% 0.31%

Gearing(%) 62.50% 62.50% 62.50%

WACCAdj 0.04% 0.08% 0.12%

WACCAdj‐pre‐tax 0.04% 0.11% 0.14%Source:EconomicInsightanalysis

Economic Insight WACCadjustmentfortheGastotheWestPipeline privilegedandconfidential

24

Further information

EconomicInsightLimited88WoodStreetLondonEC2V7RS

www.economic‐insight.com

EconomicInsightLtdisregisteredinEnglandNo.760829.

Whilsteveryefforthasbeenmadetoensuretheaccuracyofthematerialandanalysiscontainedinthisdocument,theCompanyacceptsnoliabilityforanyactiontakenonthebasisofitscontents.EconomicInsightisnotlicensedintheconductofinvestmentbusinessasdefinedintheFinancialServicesandMarketsAct2000.

Anyindividualorfirmconsideringaspecificinvestmentshouldconsulttheirownbrokerorotherinvestmentadviser.TheCompanyacceptsnoliabilityforanyspecificinvestmentdecision,whichmustbeattheinvestor’sownrisk.

©EconomicInsight,2013.Allrightsreserved.Otherthanthequotationofshortpassagesforthepurposesofcriticismorreview,nopartofthisdocumentmaybeusedorreproducedwithoutexpresspermission.

© Economic Insight Ltd 2014

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