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EirGrid: The RAB-WACC
Approach and Alternatives
January 2015
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Contents
1 EirGrid: The RAB-WACC Approach and Alternatives ....................................................................................... 1
1.1 Introduction ........................................................................................................................................................... 1
1.2 The alleged problem with using a traditional approach to financeability for EirGrid ........................... 2
1.3 Assessment of KPMG’s arguments ................................................................................................................... 2
1.4 Conclusion .............................................................................................................................................................. 7
1.5 Options for way forward .................................................................................................................................... 7
2 Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors ............................ 10
2.1 KPMG’s proposals regarding EirGrid’s margin ............................................................................................ 10
2.2 Margins adopted in other sectors subject to price regulation ................................................................. 10
EirGrid: The RAB-WACC Approach and Alternatives
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1 EirGrid: The RAB-WACC Approach
and Alternatives
1.1 Introduction
The standard approach to economic regulation builds up the cost stack of companies including operating
expenditure, depreciation costs, incentive payments and the allowed return (WACC) on the value of the
regulatory asset base (RAB). In the context of regulation attempting to mimic the prices that would prevail
in a competitive or contestable market (the standard thought experiment in economic regulation), allowing
a WACC on the RAB (which we shall hereafter refer to as the RAB-WACC approach) can be thought of as
reflecting two types of economic costs:
a. If firms rented machines or other capital equipment instead of purchasing it, they would incur operating
expenses that would enter into the price control calculation. But if, instead, they purchase such
machinery they incur no such operating expenses. One function of the RAB-WACC approach is to cover
such an implicit shadow rental cost of capital equipment.
b. In competitive markets, enterpreneurs (owners of firms) make what are termed “normal profits”. Such
normal profits are considered a business cost in economic theory. Another function of the RAB-WACC
approach is to provide an allowance, over-and-above the shadow rental cost, that covers that normal
profits business cost.
The RAB-WACC approach can also be thought of from a financial (as opposed to cost) perspective, as
creating balanced incentives to invest — not so high as to incentivise inefficiently high investment or allowing
excess profits; not so low as to discourage investment down to levels that imply customers do not receive
efficiently high quality goods and services.
The RAB-WACC approach is not, however, the only mechanism regulatory authorities deploy to reflect
these costs and achieve these objectives. Another type of approach involves, instead of a rate of return on
a RAB, the setting of a margin over other allowed costs. That is, for example, the approach taken by Ofwat
and WICS to retail activities in the UK water sector and in a number of contexts in the UK energy sector,
as per the table below. It is also an approach adopted by Ofcom to the regulation of certain postal service
activities.1
Table 1.1 UK retail energy margin regulatory precedents
Regulator Year Margin as a per cent
of turnover
Offer 1994 1.0%
Monopolies and Mergers Commission 1995 0.5%
Ofgem 1998 1.5%
Utility Regulator (Northern Ireland) 2011 1.7%
Source: First Economics; Water UK; Utility Regulator.
This note considers how appropriate or otherwise it is to apply a RAB-WACC approach to EirGrid and
whether, if a RAB-WACC approach is not appropriate, some form of margin might be superior. In doing so,
1 http://stakeholders.ofcom.org.uk/binaries/consultations/review-of-regulatory-conditions/statement/statement.pdf
See especially 5.47ff.
EirGrid: The RAB-WACC Approach and Alternatives
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we take, examine and respond to a number of arguments put forward by KPMG in a presentation to CER
dated 3 October 2014 and as submitted by EirGrid as part of its submissions on PR4.
In this particular report we do not consider the question of what margin would be appropriate, if a margin-
based approach is adopted. We therefore do not respond to the specific KPMG/EirGrid proposals on the
nature and level of margin. Our focus here is upon the issues that a RAB-WACC approach brings for a
company with EirGrid’s structure and whether a margin-based approach might be superior. However, for
reference at the end of this document we set out, as an appendix, the margins adopted in various regulated
sectors in the UK and the mechanisms by which they are applied.
1.2 The alleged problem with using a traditional approach to financeability for
EirGrid
KPMG argues that EirGrid is different from traditional utilities because it offers high potential benefits to
society, has high systematic risks and has a high level of societal responsibility / dependence. KPMG argues
that it would be inappropriate to apply a traditional financial capital maintenance regime based on a
RAB/WACC building block approach to EirGrid for the reasons outlined below. When considering the
theoretical arguments as to whether a RAB/WACC or a margins approach is appropriate, it is important to
bear in mind that EirGrid has in the past been regulated on RAB/WACC basis, and has remained financeable.
Thus, either approach could be viable in practice.
EirGrid is the operator rather than owner of the electricity transmission system in Ireland.
EirGrid is relatively ‘asset light’, with the RAB representing a small proportion of total assets.
EirGrid spends a high proportion of expenditure on ‘intangible assets’.
A high proportion of EirGrid’s capital is required for working capital and as a contingency buffer against
volatility.
EirGrid’s asset values are low relative to turnover (€30m to €300m) and relative to operating costs
(€45m).
The economic asset lives are relatively short.
EirGrid faces high pass through costs.
EirGrid therefore has high operational gearing and greater exposure to market risk and cash flow
volatility.
Most of EirGrid’s value and risk arise from its intangible assets – remunerating only the risk associated
with tangible assets would not be sufficient
Using a traditional (RAB/WACC) approach would not provide a reward to the investment in ‘intangible
assets’ and would not be a good indicator of the company’s financeability.
Fluctuating cash-flows mean that Rating agencies would be more cautious in EirGrid’s ability to service
its debt at a notional gearing level of 55 per cent.
As a result EirGrid may not be financeable or attractive to investors under a traditional utility model
approach.
1.3 Assessment of KPMG’s arguments
It is not clear that arguments put forward by KPMG to suggest that EirGrid is different to traditional utilities
(e.g. because it offers high potential benefits to society, has high systematic risks and has a high level of societal
responsibility / dependence) are either qualitatively different from the position of other regulated utilities
providing infrastructure or network services to consumers, or that they provide a clear rationale for a
different approach to regulation. Further, as set out below, if it were possible to establish a RAB that fully
captured the value of EirGrid’s business, the EirGrid WACC would be as estimated in the Cost of Capital
report that accompanies this report. We discuss below some more specific points raised by KPMG.
EirGrid: The RAB-WACC Approach and Alternatives
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1.3.1 Difference between EirGrid’s financial ratios and those of other regulated entities
Taking traditional measures of capital employed, Table 1.2 shows that EirGrid has very significantly lower
Return on Capital to Operating Expenditure and Return on Capital to Total Revenue ratios than a wide range
of utility operators in Ireland, the UK and Australia, which supports KPMG’s arguments that EirGrid’s financial
ratios are different from more traditional utility operators.
Table 1.2: Return on Capital Ratios for a range of companies
Country Regulatory
period Company Sector
Return
on
capital /
Opex
Multiple
of
EirGrid
Return
on
capital /
Total
allowed
revenue
Multiple
of
EirGrid
Ireland 2011-2015 EirGrid Electricity (TSO) 0.011 0.011
Ireland 2011-2015 ESB
Network Electricity (TAO) 1.827 166 0.496 45
Australia 2014-2019 ActewAGL Electricity
(distribution) 0.993 90 0.389 35
Australia 2014-2019 ActewAGL Electricity
(transmission) 1.154 105 0.432 39
UK 2016-2023
UK Power
Network
(South East)
Electricity
(distribution) 0.56 51 0.168 15
UK 2016-2023
London
Power
Networks
Electricity
(distribution) 0.403 37 0.143 13
UK 2016-2023
Scottish
Hydro
Electric
Power
Distribution
Electricity
(distribution) 0.379 34 0.142 13
UK 2013-2021
SP
Transmission
s
Electricity
(transmission) 1.786 162 0.285 26
Ireland 2012-2017
Bord Gáis
Network
(Onshore)
Gas (transmission) 1.277 116 0.435 40
Ireland 2012-2017
Bord Gáis
Network
(Inch)
Gas (transmission) 0.491 45 0.243 22
Ireland 2012-2017
Bord Gáis
Network
(Interconnec
tors)
Gas (transmission) 3.523 320 0.729 66
UK 2014-2021
Wales and
West Gas
Distribution
Network
Gas (distribution) 0.414 38 0.201 18
UK 2014-2021
Northern
Gas
Distribution
Network
Gas (distribution) 0.444 40 0.203 18
Australia 2011-2016 NT Gas Gas (transmission) 0.637 58 0.337 31
UK 2015-2020 Affinity
Water Water 0.213 19 0.143 13
EirGrid: The RAB-WACC Approach and Alternatives
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Country Regulatory
period Company Sector
Return
on
capital /
Opex
Multiple
of
EirGrid
Return
on
capital /
Total
allowed
revenue
Multiple
of
EirGrid
UK 2015-2020 Yorkshire
Water Water 0.436 40 0.34 31
UK 2015-2020 Dee Valley
Water Water 0.256 23 0.14 13
UK 2015-2023 NI Water Water 0.573 52 0.213 19
UK 2014-2019 Heathrow Airport 0.777 71 0.318 29
* The figures for Bord Gáis Network are the ratios of revenue to reimburse changes in RAB to operating cost / total allowed revenue.
Note: The ratios are calculated using total values for the entire regulatory period.
Considering other “asset light” companies that offer services over networks, but do not own the underlying
infrastructure, such companies need to build integrated activities that maximise the value from using the
network. These include transport businesses, logistics or distribution companies and outsourcing support
providers such as Serco.
In Figure 1.1: Return on Sales (EBIT margin %) 2008-2011 (or year specified)
Note: *EirGrid’s net income margin was obtained from Bloomberg data for 2012. **KPMG’s financeability report for EirGrid was used in order to
obtain the 8-12% range of expected EBIT margin for a Baa credit rating. ***This is KPMG’s EBIT margin conclusion.
Source: Based on Bloomberg data, KPMG analysis
Figure 1.2 to Error! Reference source not found. we illustrate that the logistics and freight forwarding
businesses show very high returns on tangible capital and equity – reflecting the economics of the businesses,
with the true enterprise value including considerable intangible elements or being constructed through
operating costs rather than capital investment. Measured in terms of tangible assets, the returns on those
tangible assets are higher than the cost of capital for a traditional regulated utility. At the same time EBIT
margins for most businesses have been in the 5-10 per cent range with high sales margins.
EirGrid: The RAB-WACC Approach and Alternatives
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Figure 1.1: Return on Sales (EBIT margin %) 2008-2011 (or year specified)
Note: *EirGrid’s net income margin was obtained from Bloomberg data for 2012. **KPMG’s financeability report for EirGrid was used in order to
obtain the 8-12% range of expected EBIT margin for a Baa credit rating. ***This is KPMG’s EBIT margin conclusion.
Source: Based on Bloomberg data, KPMG analysis
Figure 1.2: Return on Equity (%) 2007-2011
Source: Based on Bloomberg data.
40.30
46.93
19.15
19.26
6.20
11.26
12.52
6.19
1.53
9.78
8.17
16.46
7.45
24.09
58.91
6.13
37.73
20.49
15.17
19.03
11.14
0.00 10.00 20.00 30.00 40.00 50.00 60.00
BELGACOM SA
KPN (KONIN) NV
ENIRO AB
SEAT PAGINE
YELL GROUP PLC
PAGESJA LINES GRP
SERCO GROUP
DSV A/S
YAMATO HOLDINGS
K & S CORP LTD
MAINFREIGHT LTD
BOLLORE
TOLL HLDGS LTD
DEUTSCHE LUFT-RG
KUONI REUSEN-REG
FIRSTGROUP PLC
NATL EXPRESS GRP
Post average
SINGAPORE POST
FEDEX CORP
UNITED PARCEL-B
UK MAIL GROUP PL
OESTERREICH.POST
POSTNL NV
DEUTSCHE POST-RG
EirGrid: The RAB-WACC Approach and Alternatives
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Figure 1.3: Return on Capital Employed (%) 2008-2011
Source: Based on Bloomberg data.
An assessment by CEPA2 in Oct 2011 for Ofcom found that:
Post and logistics companies tend to have high returns relative to equity and total capital. These return
ratios are much higher than the cost of capital for a conventional regulated utility which are more asset-
heavy and capital intensive.
Postal firms have a return on sales of 5-10 per cent EBIT to revenue, while logistics or outsourcing firms
are in the range 3-6 per cent.
Infrastructure and utility businesses typically trade on high EV/EBITDA multiples of 8.0-10.0 or more,
where long term earnings are secure and volatility of earnings is low. In comparison, most logistics
companies, which may be more likely to resemble EirGrid’s business, trade at low multiples of 4.0-6.0x.
Market to asset ratios of tangible asset companies tend to be high at 2-4x compared to low asset
companies (1-2x), as EirGrid is (with respect to tangible assets).
1.3.2 Proposals for Incentivising EirGrid
KPMG also argues that EirGrid needs to be properly incentivised to bring innovative solutions and reduce
customer costs. A proper incentive regime is a sensible element of a regulatory framework, but this is
generally a separate element of the design of a company’s regulatory framework from the financeability
regime. In the case of the regulation of EirGrid, the two can be considered to be separate (to the extent
that design of incentives does not affect EirGrid’s exposure to systematic risk). An efficient incentive regime
for example could be two-sided/symmetric payment (rewarding good performance and penalising poor
performance around historic or expected benchmarks). This could be designed to be revenue neutral in
expectation and therefore not require additional financing or impact on the financing settlement.
2 http://stakeholders.ofcom.org.uk/binaries/consultations/securing-the-postal-service/annexes/financeability.pdf.
45.84
37.8
10.54
60.83
84.9
23.1
6.08
11.68
15.28
34.63
8.09
3.64
4.97
6.28
40.32
15.94
31.04
20.82
31.23
5.39
16.18
22.51
19.16
29.13
22.16
0 10 20 30 40 50 60 70 80 90 100
BELGACOM SA
KPN (KONIN NV)
ENIRO AB
SEAT PAGINE
YELL GROUP PLC
PAGESIA LINES GRP
SERCO GROUP
DSV A/S
YAMATO HOLDINGS
K & S CORP LTD
MAINFREIGHT LTD
BOLLORE
TOLL HLDGS LTD
INTL CONS AIRLIN
AIR FRANCE - KLM
DEUTSCHE LUFT-RG
KUONI REISEN-REG
FIRSTGROUP PLC
NATL EXPRESS GRP
Post average
SINGAPORE POST
FEDEX CORP
UNITED PARCEL B
UK MAIL GROUP PL
OESTEREICH POST
POSTNL NV
DEUTSCHE POST-RG
EirGrid: The RAB-WACC Approach and Alternatives
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There is an argument that if an incentive regime adds significant additional financial risk (due to the potential
size and volatility of penalties) then this could require additional funding.3 In most regulated utility incentive
regimes however, payments are capped at a small percentage of the operator’s turnover or they are unlikely
to ever give rise to payments that are significant relative to turnover CER has consistently considered the
impact on financial risk when designing the incentive regime for Irish regulated companies.
It should be noted that using a RAB based approach (based on fixed assets) as a primary metric to set
revenues runs the risk of giving an incentive to invest in tangible assets and may not be consistent with
minimising costs (both in the short and long term) in an industry when outputs can be delivered either
through expenditure on tangible or intangible assets.
1.4 Conclusion
Our interpretation of the evidence presented here is not that EirGrid should be expected to have a higher
WACC than other regulated utilities. Neither are we convinced by the KPMG/EirGrid arguments that
EirGrid presents some special systemic risk, adds unique value or requires particular incentives beyond those
provided to other regulated entities in the standard price control approach. If the EirGrid enterprise value
were specified correctly, the EirGrid WACC would be as estimated in the Cost of Capital report that
accompanies this document. The problem, as we see is, is that the EirGrid RAB, as it is currently calculated,
is unlikely to be an adequate representation of EirGrid’s true enterprise value, and so a RAB-WACC approach
may not be the most applicable approach.
1.5 Options for way forward
We offer the following options to the CER as ways forward, including discussing pros and cons for each
option.
1.5.1 Maintain the status quo
EirGrid has continued to operate through PR3 under the existing price control regime, even under extremely
challenging macroeconomic conditions. Whatever weaknesses there are in the current regime have not, in
any very clear and identifiable way, led to significant disruptions to the services EirGrid provides. It would
therefore be an option simply to continue with the current regime.
1.5.2 Maintain the current regulatory structure but treat EirGrid as a business with higher
operational gearing than ESBN and adjust its beta accordingly
As noted in the main WACC paper, our analysis suggests that EirGrid and ESBN are subject to sufficiently
similar drivers of demand and cost risk that, other things being equal, their asset betas would be more or
less the same if that asset beta were applied to a correct estimate of their relevant regulatory enterprise
value. However, the main WACC paper also noted that, even when underlying demand and cost risk is
similar, if firms choose business models involving materially different levels of operational gearing, there will
be an associated difference in the asset beta. It would be possible to obtain data from EirGrid and ESBN that
would allow for an estimate of the difference in operational gearing and use that to convert the EirGrid asset
beta.
This approach would have the advantage of retaining much of the form and analytical structure of the current
price control. It would however face the drawback that that adjusted WACC for EirGrid would then be
3 For example Railtrack’s performance regime paid out over £600m in delay-based penalties to train operators
following the Hatfield crash in 2000 which was the immediate reason for Railtrack’s financial insolvency.
EirGrid: The RAB-WACC Approach and Alternatives
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applied to a RAB that we do not consider provides an accurate view as to EirGrid’s relevant regulatory
enterprise value and as such we would be ill-placed to comment on how appropriate the aggregate return
(WACC x RAB) that this calculation produced would be.
This approach could be regarded as a pragmatic intermediate option between the status quo and the more
elaborate (and possibly disproportionate) alternatives discussed below. It might for that reason be regarded
as an attractive transitional option, should the CER choose to proceed to one of the other options at a future
price control but stick with something closer to the current structure for PR4.
1.5.3 Integrate the EirGrid TSO business with other assets, for the purposes of price
regulation
There are at least two candidates for assets with which the EirGrid TSO business could be integrated. First,
the integration of the TSO business with TAO assets may be the preferred approach in some jurisdictions.
However this is not currently an option in Ireland given the separation arrangements as certified by the
European Commission in 2013.
An alternative might be to integrate the EirGrid TSO business with other EirGrid activities, such as its
interconnector.
Each of these options would have significant broader implications for the ways EirGrid is regulated, that go
beyond the scope of our analysis here. Furthermore, it could be questioned whether such changes would
really be proportionate to the challenge presented by EirGrid’s RAB being a poor indicator of its regulatory
enterprise value.
1.5.4 Recalculate the RAB to more adequately capture the full enterprise value
Under this option, one might imagine identifying some correction to EirGrid’s RAB to more adequately
capture the full enterprise value. That is not, however, straightforward. Notionally “asset-lite” businesses
are likely to have considerable assets that are not fixed capital assets of the sort that RAB analysis usually
focuses upon. But the great advantage of fixed assets is that, if markets for their production are sufficiently
competitive, they usually can have a cost and value that is not purely determined within the regulated market
but is, instead, a reflection of competition to provide capital goods more generally.
By contrast, many less tangible assets may only have a value in the market in question. But then their value
is, by definition, dependent upon the pricing decisions of regulatory authorities. So, for example, for
concreteness let us suppose a regulated company had invested in developing a very detailed awareness of
consumer needs in a regulated sector. Such knowledge may have no value outside that sector. Within the
sector it has value in the company’s ability to deal with and sell products to its actual and potential consumers.
But the price at which it will be able to sell to those consumers is capped by the regulator. The higher the
cap, the higher the value. So if the regulator used the value of such knowledge in determining allowed returns
in the process of setting prices, then the higher it set prices, the higher the value would be and so the higher
the allowed return and so the higher the prices would be. And the same would apply if the regulator set a
low value. In this way there would be no objective truth of the correct price to cap at — price regulation
would become circular.
There would also be some complexity concerning the question of whether certain costs generating intangibles
might not already have entered into the price control as allowable Opex, such that assigning them now into
the RAB would involve double counting, with consumers paying for those costs twice.
It might be possible to identify a set of allowable costs for EirGrid that would enter, on a cost basis, into a
revised RAB. These costs would not be traditional investment in fixed assets but would, instead, need to
take account of the nature of EirGrid’s business and of the relevant intangible assets it involves. We suspect
EirGrid: The RAB-WACC Approach and Alternatives
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that such an exercise might be feasible but doubt that the cost and resources it would entail would be
proportionate in this case, given the low contribution that Capex makes to EirGrid’s charges, and that EirGrid
charges make to final consumer energy costs in Ireland.
1.5.5 Apply a margin approach to EirGrid
As set out in the Appendix, the main alternative to RAB-WACC adopted in regulated sectors in recent years
has been the use of some form of margin. The margin-based approach has many significant drawbacks,
perhaps the most important of which is that, as yet, there is no well-established method for assessing the
correct margin nor, in particular, any good mechanism whereby, ex post, a regulatory decision on margins
could be deemed to be in error. It is also by no means clear that margins should be expected, even in theory,
to be stable or driven by real factors to the same extent as is, for example, the cost of capital. The use of
margins should therefore typically be regarded as a pragmatic second-best in situations where it is infeasible
or disproportionate to adopt a more robust approach.
However, where no other option is feasible or where the prices involved are a sufficiently small proportion
of overall consumer costs that the simplicity of the margin approach is a strong factor in its favour, margins
are regarded as a viable alternative.
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
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2 Appendix: EirGrid Proposals and
Margins Adopted in Other Price-
Regulated Sectors
2.1 KPMG’s proposals regarding EirGrid’s margin
KPMG argue that rather than using a RAB/WACC approach, financeability tests should focus on equity
financeability through measures of profitability such as EBIT with debt financeability test supplementary to
ensure the ability to provide sufficient working capital and finance tangible assets. They argue that it is in
consumers’ interests to maintain low financial risk and ensure financial stability and that the higher risks borne
by EirGrid warrant a stable investment grade higher than the ratings of traditional utilities. They suggest that
to do this, EirGrid financial position should be consistent with a single A credit rating, which would be
consistent with an EBIT margin of 12-16 per cent and a return on assets of 10-13 per cent.
KPMG compare operational capital approaches with those based on financial capital (ROE, ROCE, RORE and
ROIC) and conclude that operational capital is more appropriate for an asset-lite company as it captures the
relevant risks and activities. They then compare the different operational capital approaches (operating
margin, EBITDA margin and EBIT margin) and recommend EBIT margin since it focuses on bottom line
profitability net of other pass through costs.
If we believed we had an adequate measure of the enterprise value of EirGrid, it would be possible to consider
what EirGrid’s proposals would map to in terms of a WACC. However, as noted in the main section here,
our conclusion is that EirGrid’s RAB is unlikely to be an adequate measure of its enterprise value.4 Neither
is it straightforward to consider how to estimate such a value without being subject to regulatory circularity.
We observe that in our main document we argue that the correct credit rating for EirGrid is comfortable
investment grade, not single A. Hence, even if one adopted the same broad approach as KPMG (e.g. the use
of an EBIT margin and the same comparators), since the target credit rating is lower the result would be a
lower margin.
2.2 Margins adopted in other sectors subject to price regulation
For reference, we next report the margins adopted in other sectors subject to price regulation. We note
that these are, by and large, consumer-facing retail operations. That is clearly a potentially significant
difference from the nature of EirGrid’s business.
2.2.1 Scottish retail water
For the 2006-2010 price control, the Water Industry Commission for Scotland (WICS) spun off Scottish
Water’s retail water and wastewater services into a separate company, Business Stream. As part of the
separation, assets attributable to the Scottish Water’s retail business were transferred to Business Stream.
4 Though it is worth noting that a RAB/WACC approach has not led to financeability problems in previous control
periods.
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 11 -
WICS analysed the new Business Stream’s capital base in order to assess the required rate of return from a
WACC perspective.5
WICS determined the allowed gross margin by analysing Business Stream’s costs, including costs of financing
its assets and working capital. At the end of March 2005, Scottish’s Water’s entire business had £2,847.9
million in fixed assets and £193.3 million in working capital.6 Of this, £5.1 million of fixed assets and
£86.8million of working capital was transferred to Business Stream upon separation. This was financed with
a combination of debt and equity for a total of £91.9 million in capital for retail services. WICS, on the advice
of Ernst and Young, determined the cost of equity to be 12 per cent and the cost of debt to be Libor (assumed
to be 5 per cent) plus 0.6 per cent. This gives a pre-tax WACC of 7.2 per cent.
WICS forecasted that Business Stream would require an average gross retail margin of 10.6 per cent over
the price control period.7 The costs and revenues that fed into the WICS decision are shown in the table
below.
Table 2.1: Income statement forecasts from 2005 Business Stream decision
Income Statement Item (£m) 2006/7 2007/8 2008/9 2009/10
Total Retail Revenue 331.9 335.9 343.9 350.5
Wholesale Costs 297.9 300.4 306.2 313.1
Gross Margin 34.0 35.5 37.7 37.4
Operating Costs 20.5 21.1 23.6 24.1
Depreciation 2.4 3.4 3.0 2.5
Financing 8.8 8.7 8.8 8.8
Taxation 2.3 2.4 2.2 2.0
Source: Water Industry Commission for Scotland.
One candidate approach is to calculate retail margins on an EBIT basis (i.e. EBIT/turnover).8 Then, the allowed
margin covers interest and taxation costs.9 These are shown in the table below as a proportion of allowed
retail revenue.
Table 2.2: Margin to cover financing and taxation expenses from 2005 Business Stream decision
2006/7 2007/8 2008/9 2009/10
Retail Revenue (£m) 331.9 335.9 343.9 350.5
Financing (£m) 8.8 8.7 8.8 8.8
Taxation (£m) 2.3 2.4 2.2 2
Financing + Taxation (£m) 11.1 11.1 11 10.8
Margin 3.3% 3.3% 3.2% 3.1%
Source: Water Industry Commission for Scotland and Europe Economics calculations.
5 Water Industry Commission for Scotland (2005) “The strategic review of charges 2006-10: the final determination”,
p367-369. 6 Scottish Water (2005) “Annual reports and accounts: 2004/2005”, p49. 7 Water Industry Commission for Scotland (2005) “The strategic review of charges 2006-10: the final determination”,
p369. 8 Ofwat (2013) “Setting price controls for 2015-20 – final methodology and expectations for companies’ business
plans”, p133. 9 “Financing” costs may include both the costs of debt and equity. Interest paid on debt is included in EBIT but equity
financing costs, such as dividends, are not. As a result, the financing costs in our calculations may be higher than
interest costs and the calculated margins higher than margins derived using interest-only financing costs.
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 12 -
2.2.2 UK energy retailers
Energy retailers are asset-lite utilities that operate in a regulated market. As part of the Retail Market Review,
Ofgem produces a weekly Supply Market Indicators for the retail electricity and gas supply industry in GB.
Their analysis rests on an indicative level of consumption for an average customer10 and assumptions about
costs and hedging strategies on the supply side. They present results for a dual fuel standard tariff as well as
separate results for the electricity and gas businesses. Their net retail margin is presented as the average
annual net margin a supplier could expect to earn per customer. As the margin observed in any given month
may be rather volatile, owing to changes in commodity inputs and wholesale costs, Ofgem presents a rolling
average net margin per customer. The rolling average net margin is assessed on a 13-month basis that
includes the current month, the previous six months, and the future six months. Any hedging is assumed to
be done over an 18-month forward-looking period.
As shown in the tables below, margins are calculated on the basis of the customer bill. Where the full selling
price of electricity and/or gas provision is the final customer bill, the margins are on a revenue basis. Gross
margins are less wholesale costs and VAT and other costs, together representing cost of goods sold. Net
margin on is equal to gross margin less non-input operating costs (e.g. customer billing, collection of bad
debts, complaint reception, etc.). The net margin, then, is on an EBITDA basis.
The Ofgem margins, assessed on an EBITDA basis (i.e. EBITDA/turnover), are likely to be higher than the
EBIT-based margins since they are assessed before depreciation and amortisation costs. On the other hand
the difference between EBIT- and EBITDA-based margins might not be large, since in asset-lite business,
depreciation and amortisations expenses are likely to be a very small fraction of overall operating cost.
Table 2.3: Ofgem's net retail margin calculations: electricity and gas
12 months from: Jun-09 Jun-10 Jun-11 Jun-12 Jun-13
£ % of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue
Customer Bill 1150 100% 1105 100% 1170 100% 1310 100% 1420 100%
Wholesale Costs 655 57.0% 485 43.9% 570 48.7% 635 48.5% 640 45.1%
VAT and Other
Costs 400 34.8% 435 39.4% 480 41.0% 525 40.1% 560 39.4%
Gross Margin 95 8.3% 185 16.7% 125 10.7% 150 11.5% 220 15.5%
Operating Costs 130 11.3% 130 11.8% 130 11.1% 130 9.9% 130 9.2%
Net Margin -30 -2.6% 55 5.0% -10 -0.9% 20 1.5% 90 6.3%
Rolling net margin -5 -0.4% 55 5.0% 45 3.8% 45 3.4% 100 7.0%
Source: Ofgem.
For a dual fuel bill, Ofgem estimates that firms are currently earning about 6.3 per cent on an average retail
customer. Over a rolling 13-month window, the net retail margin is expected to be around 7.0 per cent.11
Thus, in June, suppliers of electricity and gas were earning around 6.3 to 7.0 per cent net retail margin. This
is an increase on both net and rolling net margins realised in the same month over the past four years. This
10 Prices and costs are calculated at an average consumption per annum of 4MWh of electricity and 16.9MWh of gas
and are held constant over time in the analysis in order to maintain comparability between years. Price changes
from Big 6 suppliers are factored into the customer bill. 11 The rolling average figure takes the average net margin figure over a thirteen month period. For any given month,
the rolling average figure is calculated based on the average of the previous six months, the current month and the
following six months. If calculating the rolling average for January 2011, this is based on the average of July 2010 to
July 2011 inclusive. In Ofgem’s view, the advantage of this method is that it reflects general trends in the net margin,
but smoothes out volatile fluctuations in the figure that can be seen when looking at a data for a specific date.
https://www.ofgem.gov.uk/ofgem-publications/39781/smrmethodology.pdf
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 13 -
has been due primarily to a fall in wholesale costs and VAT and other costs, with some increase in margin
coming from lower operating costs since 2012.
Table 2.4: Ofgem's net retail margin calculations: electricity only
12 months from: Jun-09 Jun-10 Jun-11 Jun-12 Jun-13
£ % of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue
Customer Bill 510 100% 505 100% 535 100% 580 100% 630 100%
Wholesale Costs 270 52.9% 205 40.6% 225 42.1% 240 41.4% 235 37.3%
VAT and Other
Costs 185 36.3% 210 41.6% 225 42.1% 255 44.0% 280 44.4%
Gross Margin 60 11.8% 90 17.8% 85 15.9% 85 14.7% 115 18.3%
Operating Costs 65 12.7% 65 12.9% 65 12.1% 65 11.2% 65 10.3%
Net Margin -5 -1.0% 25 5.0% 20 3.7% 20 3.4% 50 7.9%
Rolling net margin 10 2.0% 25 5.0% 35 6.5% 30 5.2% 50 7.9%
Source: Ofgem.
In the electricity supply market, net margins and rolling net margins have both increased since 2009.
Electricity-only suppliers expect to make around 7.9 per cent net margin on retail customers over the year
June 2013-2014, according to Ofgem’s analysis. The increase in net margins has been primarily a function of
lower wholesale costs, while operating costs (as a per cent of revenues) have fallen to a lesser degree. Over
the period since 2009, this amounts to an average net margin of 3.8 per cent.
Table 2.5: Ofgem's net retail margin calculations: gas only
12 months from: Jun-09 Jun-10 Jun-11 Jun-12 Jun-13
£ % of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue £
% of
Revenue
Customer Bill 665 100.0% 620 100.0% 665 100.0% 775 100.0% 830 100.0%
Wholesale Costs 385 57.9% 280 45.2% 345 51.9% 395 51.0% 405 48.8%
VAT and Other
Costs 215 32.3% 230 37.1% 255 38.3% 270 34.8% 285 34.3%
Gross Margin 65 9.8% 110 17.7% 65 9.8% 110 14.2% 140 16.9%
Operating Costs 65 9.8% 65 10.5% 65 9.8% 65 8.4% 65 7.8%
Net Margin 0 0% 45 7.3% 0 0% 45 5.8% 75 9.0%
Rolling net
margin 15 2.3% 50 8.1% 45 6.8% 55 7.1% 85 10.2%
Source: Ofgem.
For gas-only suppliers, margins on both a single-month and 13-month rolling basis have moved upward.
Ofgem believes that suppliers in this market can expect to earn between 9 and 10.2 per cent on their retail
services over the coming year. Gross margins have benefitted from lower wholesale costs. Lower operating
costs have boosted net margins.
Single-month and rolling net retail margins are consistently higher for electricity- and gas-only customers than
for dual fuel customers. Dual fuel suppliers are likely to realise economies of scope in supplying energy
services, which is then passed onto customers.12 We note that although suppliers usually offer tariff discounts
if customers elect to use a dual fuel rather than single-supply service, Ofgem does not factor these into their
12 This may not be the case in the water market. Research from United Utilities finds that retail opex per unique
customer is higher for WsSCs than WoCs. See: United Utilities (2013) “United Utilities Group PLC: retail household
average cost to serve”.
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 14 -
calculations. Therefore, any discounting effect is absent in the above tables. Over the period from 2009, net
margins averaged 4.4 per cent. Here, it is worth noting the inherent difference in the GB energy supply
market that is open to competition, compared EirGrid which is a state backed monopoly with statutory
responsibilities to customers.
Average net margins from these businesses are summarised in the table below.
Table 2.6: Average net margins for energy retail, 2009-2013
Supply Business Average Margin 2009-2013
Dual Fuel 1.9
Electricity 3.8
Gas 4.4 Source: Ofgem and Europe Economics calculations.
2.2.3 GB Rail operators
In Great Britain, the rail infrastructure is maintained by Network Rail, which is a natural monopoly. As such,
Network Rail is regulated by a WACC approach by the Office of Rail Regulation. By contrast, rail service
providers operate services upon winning a competitive tendering process. Rail franchises are asset-lite —
indeed, in many cases the franchisees even lease the train carriages — that can be thought of as “purchasing
wholesale” access to rail infrastructure. In this sense, rail franchisees are similar to retail water and water
and sewerage providers. A key difference, however, is that rail industry faces competition from alternative
forms of transport, while water retailers face little to no competition from alternative forms of water supply.
Table 2.7 Operating profit margins for UK rail providers, 2013-2009
2013 2012 2011 2010 2009
Stagecoach Group 2.4% 4.5% 4.4% 2.9%
First Group 1.4% 3.9% 2.3% 3.8% 3.5%
Arriva1 1.4%
Go-Ahead Group 1.9% 2.5% 1.4% 3.0%
National Express 4.6% 6.1% 5.3% 1.0%
Average 3.2% 3.8% 3.7% 2.4%
Note: UK rail revenues and profits only; 1: Arriva merged with Deutsche Bahn in 2010 and Deutsche Bahn’s financials do not list a UK rail segment.
Source: Company financial accounts.
A sample of operating profit margins (i.e. EBIT/revenue) for UK rail franchises is provided in Table 2.7.
Average operating margins for UK rail franchises ranged between 2.4 per cent and 3.8 per cent. The highest
observed operating margin was National Express’ margin of 6.1 per cent in 2011, while the same company
registered the lowest margin in the sample at 1.0 per cent in 2009. An average margin around 3 per cent is
in line with profit margin estimates from the rail operator industry group, the Association of Train Operating
Companies.
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 15 -
Figure 2.1 Analysis of average rail operator allocation of revenues
Source: Association of Train Operating Companies.
2.2.4 UK postal services
Royal Mail was previously regulated by Postcomm based on price controls. The regulatory power was
transferred to Ofcom in 2011. In response to the significant challenges faced by Royal Mail13, Ofcom has
removed price control and moved towards margin-based regulation. The new approach is driven by three
overarching factors: the need for the provision of universal postal services to be financially sustainable; the
need to create a reasonable commercial rate of return for the provider, Royal Mail; and the need for sustained
efficiency and the incentives that underpin this.
Ofcom develop an indicative range for what would constitute a reasonable level of return for the provision
of the universal service, bearing in mind the level of risk within the business. In establishing an appropriate
range Ofcom considered different financeability measures and the returns of comparators in other European
markets. The indicative EBIT margin ranges for these different approaches are shown below.
Table 8: Indicated EBIT constructed using different measures
EBIT Measures EBIT Margin Range (%)
Low High
EBIT margin – Comparators (inter-
quartile range)
5.6 7.7
Return on capital – Infrastructure 4.4 5.8
EBIT margin – Rating agencies
(investment grade used in post)
8.0 12.0
Ofcom analysis of Royal Mail
comparator calculation – 2005 to
2013E
8 11
Return on capital – Logistics 6.5 7.3
13 Ofcom (2012) – Securing the Universal Postal Service (Decision on the new regulatory framework) – This
includes 25% reduction in UK market volumes, people moving towards cheaper products, limited flexibility
of Royal Mail to reduce cost to recoup the lost due to volume.
Network Rail
48%
Staff
17%
Maintenance
17%
Leasing Trains
11%
Fuel
4%
Profit
3%
Appendix: EirGrid Proposals and Margins Adopted in Other Price-Regulated Sectors
- 16 -
EBIT Measures EBIT Margin Range (%)
Low High
Return on fixed assets – Rating
agencies
6 8
EBIT margin – Rating agencies
(investment grade used in post for
higher risk business)
12 16
Source: Ofcom (2012) “Securing the Universal Postal Service”
With respect to the EBIT measures above, given Royal Mail’s operating costs significantly exceed the value
of its tangible assets, return on sales is seen as a better measure than return on capital. In this regard, an
EBIT operating margin is a suitable proxy for operating cash generation. Of the estimates above, those which
provide the highest results are least consistent with the aim of providing a return for Royal Mail to achieve
financial sustainability. Hence, Ofcom proposed an EBIT margin range of 5% to 10% for the next regulatory
period.