Oxera is advising National Grid Electricity System Operator (ESO) on the calibration of financial price control parameters in line with the risks faced by the company in the RIIO-2 period.

Ofgem is currently establishing a new regulatory regime for National Grid ESO following the legal separation of the company from the electricity transmission business of National Grid in April 2019. National Grid ESO is responsible for providing the following three specific functions within the energy value chain.

• Balancing services. National Grid ESO is responsible for generation dispatch to meet demand and to balance the system in real time.
• Market and industry services. National Grid ESO performs a range of activities to support the wider system and industry, such as long-term network planning and administering industry codes and standards.
• Industry revenue management. National Grid ESO is responsible for collecting, managing and distributing over £4bn of network charges annually (i.e. TNUoS, BSUoS and Connections charges).

Some characteristics of the business activities of the company that affect its risk profile are that (i) National Grid ESO is a relatively asset-light business; (ii) National Grid ESO’s activities are of systemic importance within the energy value chain; and (iii) notwithstanding its core operational function of balancing the grid, National Grid ESO performs some activities with distinctly differing risk—for example, it is responsible for collecting, managing and distributing network charges that are multiples of its own asset value.

Ofgem has proposed to use a RAV-WACC¹ model for setting the allowed revenues for National Grid ESO in RIIO-2. We have assessed whether this approach implies sufficient financial returns for the asset-light company, by (i) considering the evidence on an appropriate cost of equity allowance, taking account of National Grid ESO’s specific functions; (ii) assessing whether an additional allowance for the industry revenue management function is required; and (iii) cross-checking the individual financing parameters relative to the overall benchmark profitability of the company.

Our analysis suggests that National Grid ESO’s asset-light business model does not allow for sufficient returns solely on the basis of a RAV-WACC allowance. An appropriately calibrated WACC allowance should be complemented by an allowance for the industry revenue management function that has little RAV value attributable to it, to ensure that National Grid ESO has sufficient cash flow and profit adequacy to absorb the risks that it is likely to be exposed to in RIIO-2.

¹ RAV refers to regulated asset value; WACC refers to weighted average cost of capital.