eirgrid: the rab-wacc approach and alternatives · eirgrid: the rab-wacc approach and alternatives...

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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.

http://stakeholders.ofcom.org.uk/binaries/consultations/review-of-regulatory-conditions/statement/statement.pdf


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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.


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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)


Ireland 2012-2017

Bord Gáis

Network

(Interconnec

tors)


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


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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.


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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


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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

http://stakeholders.ofcom.org.uk/binaries/consultations/securing-the-postal-service/annexes/financeability.pdf


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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.


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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


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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.


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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.


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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


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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


£ % 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


£ % 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”.


- 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.


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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%


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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.

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