WACC Report en

Frontier Economics Ltd, London.
The impact from regulatory regimes on

the WACC
A REPORT FOR RWE GASNET
September 2013

September 2013 | Frontier Economics i

Contents

the WACC
Executive Summary 1
1 Background and scope of the study 7
1.1 Context....................................................................................... 7
1.2 Scope of the study ..................................................................... 7
1.3 Structure of the report ................................................................ 8
2 Regulation of energy network in Czech Republic 9
2.1 Regulation of energy networks 2010 to 2014 .......................... 9
2.2 EROs actions during 3
rd
regulatory period .............................. 10
2.3 EROs action and the regulatory climate .................................. 11
3 Relationship between regulation and risk 13
3.1 Channels for transmitting changes in risk to the WACC .......... 13
3.2 Role of regulation in the cost of financing ................................ 15
3.3 Regulation and risk the view from rating agencies ................ 19
3.4 Key findings Regulation and risk ........................................... 22
4 Regulation and risk selected European countries 23
4.1 UK ............................................................................................ 24
4.2 Germany .................................................................................. 33
4.3 France ...................................................................................... 40
4.4 Key findings Regulation and risk in UK, Germany and France
................................................................................................. 48
5 Regulation and risk Czech Republic 49
5.1 Stability and Predictability of the Regulatory Regime ............... 49
5.2 Cost and Investment Recovery and Revenue Risk ............. 55
5.3 WACC Cost recovery for cost of capital at risk ..................... 61
5.4 Key findings Regulation and Risk for CZ gas distribution
companies ................................................................................ 67
ii Frontier Economics | September 2013

Contents

6 Conclusion 69
7 References 73

September 2013 | Frontier Economics iii

Tables & Figures

the WACC
Figure 1. Channels for transmission of risk changes to the WACC 14
Figure 2. Principal outputs under RIIO GD1 30
Figure 3. Investment indicators 44
Figure 4. Quality of service indicators 45

Table 1. Regulation and Risk and the impact on cost of capital 2
Table 3. Moody's methodology for rating regulated electricity and gas
networks 20
Table 4. Regulatory parameters RIIO-GD1 29
Table 5. WACC parameter UK 32
Table 6. Regulatory parameters Germany 36
Table 7. Cost of equity parameter Germany 38
Table 8. Regulatory parameters France 42
Table 9. WACC parameter France 46
Table 11. Stability and Predictability of Regulatory Regime from 3
rd
to
4
th
regulatory period 55
Table 12. Regulatory components CZ gas distribution companies 56
Table 13. Cost and Investment Recovery and Revenue Risk from
3
rd
to 4
th
Table 14. WACC 3
rd
to 4
th
Table 15. Frontiers assessment Rating factors from 3
rd
to 4
th


September 2013 | Frontier Economics 1

Executive Summary


Executive Summary

Executive Summary
ERO proposes substantial adjustments and changes for 4
th
regulatory
period
The Czech regulator ERO is responsible for the regulation of the electricity and
gas network companies. The current revenues are set according to the decision
on the 3
rd
regulatory period (2010-2014) from December 2009, which was the
result of a consultation process with all relevant stakeholders starting in 2008. In
March 2013 ERO made a first proposal for the regulatory framework of the 4
th

regulatory period including substantial adjustment compared to the previous one,
in particular the reversal of former partially acknowledged asset revaluation and a
shortening of the 3
rd
regulatory period. In August 2013 ERO issued a new
proposal including new regulatory instruments and a reduction in the WACC
compared to the March 2013 document.
RWE Gasnet asked Frontier to compare the regulatory and legal regime and their
main components for European peers with the CZ regime with regard to the risk
profile regulated entities face and to assess the alignment of the proposed WACC
by ERO with the potential increase in risk since the start of the 3
rd
regulatory
period.
Regulatory actions will influence the cost of capital by altering the risks
faced by equity and debt investors
The cost of capital represents the minimum rate of return companies must pay in
order to attract capital from investors. Changes in risk will affect equity investors
and debt investors via different channels. Risk will feed into the
cost of equity via the beta; and
cost of debt via the debt premium.
Regulatory actions and regulatory design will influence the cost of capital by
altering the risks faced by businesses. Credit rating indicators can reflect the
various aspects of the regulatory environment. Moodys covers the regulatory
environment by:
Stability and Predictability of the Regulatory Regime;
Cost and Investment Recovery; and
Revenue Risk.
Regulatory systems can be compared by analysing how they perform against
these indicators and how business risks influence the beta and debt premium.
2 Frontier Economics | September 2013

Executive Summary

Regulation and risk in selected European countries UK, Germany
and France
In order to assess the return/risk profile of the Czech Republic we compared the
regulatory framework with regard to the three Moodys factors covering the
regulatory environment for UK, Germany and France. UK sets the benchmark
(Aaa) for Stability and Predictability of Regulatory Regime. Germany (A) and France
(Aa) get a slight lower rating by Moodys. For Cost and Investment Recovery Moodys
rated the countries in the range of A to Baa, Revenue risk in the range of Aaa to A.
The corresponding beta and debt premium set by the regulatory authorities in
UK, Germany and France are:
asset beta in the range of 0.38 to 0.46;
equity beta in the range of 0.76 to 0.90; as well as
debt premium in the range of 0.60% to 0.90%.
Table 1. Regulation and Risk and the impact on cost of capital
UK
(2013-2021)
Germany
(2013-2017)
France
(2012-2015)
Stability and Predictability of Regulatory Regime Aaa A Aa
Cost and Investment Recovery A Baa A
Revenue Risk Aaa A Aa
Asset beta 0.38 0.39 0.46
Equity beta 0.90 0.79 0.76
Debt premium 0.90% na 0.60%
Source: UK Moodys; Germany and France and Frontier assessment based on Moodys ratings for
HSE Netz (Germany) and TIGF (France)
Deterioration of Stability and Predictability of CZ Regulatory Regime
between 3
rd
and 4
th
regulatory period
First, we compared the regulatory framework of the 3
rd
regulatory period for gas
distribution companies with the draft proposal from ERO for the 4
th
regulatory
period. Based on this comparison, we assess the potential impact on risk faced by
the companies. We also take EROs action during the 3
rd
regulatory period into
account. Second, we compared the new draft proposal from ERO for the 4
th

regulatory period and its corresponding return/risk profile with the relevant
profiles from UK, Germany and France.

Executive Summary

With regard to Stability and Predictability of Regulatory Regime we conclude that
EROs actions may be classified as a
non consistent application of the regulatory framework for the 3
rd

regulatory period; or even a
significant change compared to the 3
rd
regulatory period.
We assess a significant downgrading of Stability and Predictability of Regulatory
Regime in the 4
th
regulatory period.
Cost and Investment Recovery and Revenue Risk also affected by
EROs proposal
There are various factors having a potential adverse direct impact on the Cost and
Investment Recovery and Revenue Risk. The main impact stems from the Network
utilisation factor, where the specification and application is still pending. We note
that the Network utilisation factor depending on its final specification may
induce even a sharp downgrade due to asset stranding and/or high exposure to
volume risk. In addition, the new mechanism for network losses may have an
adverse impact, as well, if ERO is reluctant on increasing network losses. As long
as this is still an unresolved issue we make the assumption that the new
parameter will slightly increase the risk of cost recovery and the revenue risk
resulting in a small downgrade compared to the 3
rd
regulatory period. Finally, the
efficiency assessment of operating expenditure which allows a retrospective
reduction of costs may jeopardize cost recovery, as well.
Cost Recovery for cost of capital at risk in 4
th
regulatory period
In order to assess if the current WACC proposal covers the risks borne by
investors in the Czech gas distribution sector it is necessary to compare the risks
faced by companies between the 3
rd
and 4
th
regulatory period. Applying the logic
of Moodys rating factors, we assess that the risk faced by gas distribution
companies increased between the 3
rd
and 4
th
regulatory period due to
increased uncertainty on the Stability and Predictability of Regulatory regime;
and
new proposed regulatory parameters which are yet unspecified and may
have an adverse effect on Cost and Investment Recovery and Revenue Risk
In addition, we assessed a potential adverse effect on selected Moodys key credit
metrics, Adjusted Interest Coverage Rate and Retained Cash Flow/Capex from the
reversal of asset revaluation.
Hence, in order to allow cost recovery for equity and debt investors the
increased risk should be reflected in the asset (equity) beta and debt
premium.

Executive Summary

Adjustments of beta and debt premium in 4
th
regulatory period to allow
cost recovery
In order to allow cost recovery for the cost of capital the relevant parameters
through which this increased risk flows into the WACC beta and debt premium
should follow the principles outlined below.
Cost of equity The level of the asset (equity) beta from the 3
rd
regulatory
period should serve as the starting point for the 4
th
regulatory period. In
order to allow cost recovery a mark-up on this value covering the increased
risk between the 3
rd
and 4
th
regulatory period should be applied. This implies
an asset (equity) beta in the range of 0.45 to 0.50 (0.69 to 0.77) for the
4
th
regulatory period. Compared with the respective values for UK, Germany
and France and taking into account the higher rating in particular for the
important factor Stability and Predictability of Regulatory Regime in all
three countries this range seems to be a reasonable risk adjusted asset beta
and equity beta (Table 2) taking into account the lower notional gearing
(40%) proposed by ERO compared with UK (65%), Germany (60%) and
France (50%).
Cost of debt The risk faced by debt investors between the 3
rd
and 4
th

regulatory period did not decrease (in contrary the risk increased). This
implies that the implicit debt premium from the 3
rd
regulatory period should
serve as the starting point for the 4
th
regulatory period. However, we further
identified a systematic problem in the way ERO currently determines the
cost of debt. ERO sets the cost of debt based on a short-term interest rate
(1-5years) which is in contrast with the longer term financing and investment
horizon for networks and European regulators best practice (substantially
above 5 years). Hence, the overall level of the regulatory cost of debt
may be substantially below market cost of debt. Hence, the
adjustment of the debt premium should reflect the switch from a short-term
to a longer-term interest rate. This results in a substantial higher debt
premium in the range of 0.70% to 1.30%, which is more in line with the
respective values used in UK and France. In addition, ERO should consider
including cost of raising debt in the debt premium in the range of 0.10% to
0.20%.

Executive Summary

3
rd
reg- period
(2010-2014)
4
th
reg-period
(Aug 2013)
UK
(2013-21)
Germany
(2013-17)
France
(2012-15)
Stability and
Predictability of
Regulatory Regime
Aa A * Ba B* Aaa** A** Aa**
Cost and Investment
Recovery
A* Baa Ba* A** Baa** A**
Revenue Risk Aa* A Baa* Aaa** A** Aa**
adjICR and RCF/Capex Potential
downward
pressure*
- - -
Asset beta 0.40 0.35 0.38 0.39 0.46
Equity beta 0.62 0.54 0.9 0.79 0.76
Debt premium (implicit) 0.31% 0.23% 0.90% na 0.60%
Frontier adjustments 3
rd
reg- period
(2010-2014)
4
th
reg-period
(Aug 2013)

Asset beta
(risk adjusted)
0.45 0.50
Equity beta
(risk adjusted)
0.69 0.77
Debt premium
(longer term interest rate)
0.70% - 1.30% 0.70% - 1.30%
Cost of raising debt 0.10% - 0.20%

Source: Frontier based on Moodys methodology, Moodys
* Assessment by Frontier
** Assessment by Moodys
Regulatory principles guiding the specification of the 4
th
regulatory
period
Provided that ERO still insisted in changing the regulatory framework in the 4
th

regulatory period in particular with regard to the reversal of asset revaluation then
at least ERO should adopt a more refined logic that explicitly considers the
following principles:
Avoidance of retrospective interventions Regulators and regulated
companies play a repeated interaction game, coming together periodically to
agree new cost allowances and incentive mechanisms that will apply for the

Executive Summary

next period. Regulators credibility is therefore key: this also includes that
retrospective interventions shall be avoided.
Specification of regulatory framework The current ERO proposal for
the 4
th
regulatory period introduces various new regulatory changes and
regulatory instruments, e.g. the Network utilisation factor. However, there is
a low degree of specification which hampers companies to assess the specific
impact on their costs and/or revenues. In order to increase predictability for
companies and also investors a detailed description which can be translated
into companies business plans should be provided by ERO as soon as
possible.
Transparent decision rules In order to maximise the regulatory
commitment and stability, ERO should base any new measure announced in
the decision for the 4
th
regulatory period on transparent decisions rules,
which are known to the regulated companies ex ante. This means that the
regulated companies must know in advance, which behaviour will induce
measures by ERO. For example, this refers to the announced audits on the
efficient utilisation of funds from the Network obsolescence factor.


Background and scope of the study

1 Background and scope of the study
1.1 Context
The Czech regulator ERO is responsible for the regulation of the electricity and
gas network companies. The current revenues are set according to the decision
on the 3
rd
regulatory period (2010-2014) from December 2009, which was the
result of a consultation process with all relevant stakeholders starting in 2008. In
March 2013 ERO made a first proposal for the regulatory framework of the 4
th

regulatory period including substantial adjustment compared to the previous one,
in particular the reversal of former partially acknowledged asset revaluation. In
August 2013 ERO issued a new proposal including new regulatory instruments
and a reduction in the WACC compared to the March 2013 document. ERO
stick to the reversal of the asset revaluation, however, it stated that the new
regulatory instruments proposed in August 2013 increase the incentives to invest
and decrease the risk compared to the March 2013 proposal.
1.2 Scope of the study
RWE Gasnet is concerned on the potential impact from the proposed
adjustments on risk and the alignment of the risk with the proposed WACC by
ERO. In addition, RWE Gasnet is concerned on the long-term stability of the
proposed regulatory framework.
RWE Gasnet has asked Frontier to
Benchmark of the WACC parameters for European peers compared to the
CZ figures.
Compare the regulatory and legal regime and their main components for
European peers compared with the CZ regime with regard to the risk profile
regulated entities face in the CZ republic compared to European peers. This
includes e.g.
predictability of the behavior of the regulator;
possibility of legal actions against regulators decisions; as well as
regulatory components and their impact on various risks, e.g. volume
risk, cost risk.
Assess the WACC proposed by ERO in relation to the potential increase in
risk since the start of the 3
rd
regulatory period.

Background and scope of the study

RWE Gasnet provided Frontier with the respective EROs draft proposals for
the 4
th
regulatory period from March 2013 (ERO 2013a) and August 2013 (ERO
2013b).
1.3 Structure of the report
The report is structured as follows:
Section 2 describes the regulatory system for CZ gas distribution companies
and the proposed changes for the 4
th
regulatory period.
Section 3 describes the relationship between regulation and risk and how a
change in the risk may feed into the cost of equity and the cost of debt.
Section 4 describes the relationship between the regulatory framework and
the WACC for three selected European countries, UK, Germany and
France.
Section 5 analysis behaviour of ERO since the start of the consultation
process for the 3
rd
regulatory period and the proposed changes for the 4
th

regulatory period with regard to the implication on the risks faced by the gas
distribution companies. The section analysis to what extent the proposed
WACC in ERO (2013b) aligns with the underlying risk exposure of the
companies.
Section 6 concludes the results.

Regulation of energy network in Czech Republic

2 Regulation of energy network in Czech
Republic
This section describes the Czech regulatory regime until the 3
rd
regulatory period
(2010-2014) and the proposed regulatory framework for the 4
th
regulatory period
(2015-2019) by the Czech regulator, ERO, with regard to asset revaluation.
2.1 Regulation of energy networks 2010 to 2014
The energy networks are regulated using a revenue cap. The regulatory period is
5 years. The Czech revenue cap is a combination of incentive regulation and
cost-plus regulation, where the first applies to operating costs and the latter to
capital costs.
In 2006 there was an one-off revaluation of the assets based on current costs
during the process of unbundling, which resulted in roughly a doubling of the
asset value compared to historic costs (step-up) which had to be reflected in
the accounting books of the company. Already in the 2
nd
regulatory period ERO
started a process of gradual acknowledgement of revaluated depreciation which
was accomplished in the 3
rd
regulatory period.
1
Allowing depreciations based on
revaluated assets at current cost in 2006 was a means of providing cash to the
companies in order to finance necessary investments.
The decision by ERO to acknowledge revaluated depreciation as allowed one was
taken after an intense assessment by the ERO and discussion between ERO and
the regulated companies on their long-term investment plans. For this a period of
15 years was evaluated. The submitted investment plan in 2009 forecasted for the
years 2010 2013 (already) lower investment than depreciation with growing
investments exceeding depreciation after 2014. Other aspect of the ERO strategy
of providing cash to the companies in the regulatory period was slower
depreciation of RAB via deduction of only a share of the allowed depreciation.
This share was determined by a ratio of RAB to the revaluated asset value. ERO
(2009: 16) stated in 2009 that if companies do not reinvest revaluated
depreciation in asset upgrades in a way to preserve their level and the quality of
supply, the Office will introduce a mechanism into regulation, which will ensure
that allowed depreciation is used solely for investment purposes under the
respective licence.

1
Energy Regulatory Office, Final Report of the Energy Regulatory Office on the regulatory methodology for the
third regulatory period, including the key parameters of the regulatory formula and pricing in the electricity and gas
industries, December 2009.


The initial value of the regulatory asset base for the 3
rd
regulatory period (2010-
2014) has been based on the RAB 2009 which was acknowledged in the previous
regulatory period (based more or less on historical costs), which was then
adjusted by an initial revaluation coefficient. This revaluation coefficient was
calculated by dividing the previous RAB 2009 value with the revaluated asset
value in 2009 (comprising the one-off current cost revaluation in 2006 plus new
investments at historical costs between 2007 and 2009). Only, if the asset value at
historic costs is less than 50% of the revalued assets there is a step up of the
assets at historical costs to reach 50% of the revalued assets. In other cases the
initial RAB is set at the residual asset value 2009.
EROs hybrid approach in relation to asset revaluation differs from approaches
used by other European regulators. In countries where revaluation was applied
either based on historic or replacement costs , e.g. Norway, Netherlands,
Finland, Sweden, the revaluated assets were used to calculate depreciation and
also the allowed RAB (and not only to calculate depreciation as in the CZ
republic).
However, EROs objective for asset revaluation seemed to be similar: supporting
a long-term sustainable asset value and signalling investors the long-term stability
of the regulatory system with regard to the regulated asset base.
2.2 EROs actions during 3
rd
regulatory period
We understand that during the 3
rd
regulatory period a new head of ERO was
appointed by the Czech government with effect from August 1
st
, 2011. ERO
fundamentally changed its position in relation to asset revaluation. In 2012 ERO
made the legal assessment that the regulatory decision for the 3
rd
regulatory
period contradicts the Czech energy law, which according to the new
interpretation of ERO grants depreciation only for realized investments and not
on revaluated assets.
2

ERO started actions during the 3
rd
regulatory period to comply with its legal
assessment with the goal to reverse the impact from asset revaluation. This
introduced a substantial discontinuity with the regulatory framework set out in
the 3
rd
regulatory period:

2
Article 19a Energy act: (1) Pi regulaci cen penosu elektiny, pepravy plynu, distribuce
elektiny a distribuce plynu postupuje Energetick regulan ad tak, aby stanoven ceny
pokrvaly eln vynaloen nklady na zajitn spolehlivho, bezpenho a efektivnho vkonu
licencovan innosti, dle odpisy a pimen zisk zajiujc nvratnost realizovanch investic
do zazen sloucch k vkonu licencovan innosti [].



ERO proposed a change in the regulatory formula for the 3
rd
regulatory
period at the end of year 2012. The change was planned to come into force
in 2014, hence, during the 3
rd
regulatory period. ERO proposed the so called
Investment Debt Factor (IDF) which shall be applied for the period 2010-
2025 and would decrease allowed revenues on 2014 by accumulated
differences of investments and depreciation since 1.1.2010. ERO did not
implement this factor, because the Governments Legislative Council
dismissed this new parameter as retroactive and therefore incompatible with
the legislative order.
Instead ERO proposed in March 2013 to shorten the 3
rd
regulatory period
by one year and start with the 4
th
regulatory period as of 1.1.2014 (instead of
1.1.2015). In addition ERO proposed to reverse the revaluation of the assets
(step up) and to base the depreciation on the lower historic book values.
In August 2013 ERO when ERO dismissed its previous March intention to
shorten the 3
rd
regulatory period, they published a new proposal for the 4
th

regulatory period, which included some differences compared to the
regulatory formula for the 3
rd
regulatory period and the ERO proposal from
March 2013. It still includes the reversal of the step up from 2006.
However, it further includes
reduction of the WACC compared to March 2013;
introduction of the Network obsolescence factor, which is yet to be
specified;
introduction of a network utilisation factor, which is yet to be specified;
introduction of the so called investment fund which retrospective
claws back revenues from the companies.
2.3 EROs action and the regulatory climate
We understand that ERO is aware that the CZ gas and electricity network
companies are facing substantial investments in the future. Hence, it is still well
accepted by ERO that the companies need additional financial resources and a
reliable investment climate to implement their ambitious long-term investment
plans. A stable regulatory environment is the key prerequisite that companies can
and will raise capital at reasonable costs.
However, EROs actions during the 3
rd
regulatory period and the draft proposal
for the 4
th
regulatory period issued on August 2013 may have affected the
stability of the investment and regulatory climate for CZ energy network
companies by increasing the uncertainty on regulatory actions, on the future


regulatory framework and the cost of capitals investors demand for providing
equity and debt for investments into energy networks.


Relationship between regulation and risk

3 Relationship between regulation and risk
In this section we explore the links between regulation, risk and return. It
describes the mechanisms through which regulation affects the risk faced by debt
and equity investors and considers the importance of regulation relative to other
risk factors for investors in utilities.
3.1 Channels for transmitting changes in risk to the
WACC
The cost of capital represents the minimum rate of return firms must pay in
order to attract capital from investors. As such, it is recognised widely as the rate
of profit that firms operating in a competitive market could be expected to earn.
The rate of return earned by firms in competitive markets could, in any given
year, deviate from the cost of capital. However, on average, firms in such markets
could be expected to cover their cost of capital.
The cost of capital needs to cover the risks (and opportunity costs) borne by
investors in the business. A return that just covers the cost of capital is therefore
commensurate with a normal economic return. Regulatory allowances of the
cost of capital aim to ensure that the firm can cover its expected financing needs
in order to undertake efficient investments and asset maintenance that sustain the
provision of services.
The cost of capital is typically measured by the Weighted Average Cost of Capital
(WACC). WACC has two basic components:
the cost of equity capital; and
the cost of debt capital.
The cost of equity is the expected rate of return required by investors in equity
that compensates them for the risk they bear, and the opportunities they forgo by
committing funds to the firm. The cost of debt measures the expected cost of
borrowing to the business. The WACC calculation weights these two
components according to the proportion of debt and equity capital within the
businesss financing structure, i.e. its gearing.
Changes in risk can affect equity investors and debt investors via different
channels. In order to understand the full implications of a regulatory change on
the cost of capital, it is necessary to understand the impact on the cost of equity
and the cost of debt separately.
Figure 1 illustrates how a regulatory change could flow through to WACC by
altering a risk parameter within the cost of equity (beta) and/or a risk parameter
within the cost of debt (the debt premium).


Figure 1. Channels for transmission of risk changes to the WACC

Source: Frontier Economics
The cost of equity to be used in the WACC formula is usually estimated using the
Capital Asset Pricing Model (CAPM). The CAPM formula to be applied for this
purpose is:
ost of euity iskfree rate eta uity risk remium
The risk-free rate represents the return on a completely riskless asset and is
generally proxied by the yield on government securities. The equity risk premium
measures the premium (over and above the risk-free rate) that investors might
expect to earn by investing in a fully diversified portfolio of all risky assets in the
economy (i.e. the market).
eta measures the resonsiveness of the comanys euity returns to
changes in overall market returns. It therefore captures the riskiness of the
equity invested in the given company. A change in regulatory circumstances that
alters the risk that equity investors expect to bear will feed through to the cost of
equity by causing the beta to change.
The cost of debt may be represented as follows:
ost of debt iskfree rate ebt remium
The debt premium reflects, among other things, the credit risk of a
comany. Any regulatory change that alters the riskiness of a comanys
debt will do so by altering the debt premium. A companys credit risk
depends, in part, on its capital structure (i.e. gearing level). In general, the higher
Change in risk resulting from a regulatory change
Cost of equity
Change in
beta?
Change in
cost of equity
Yes
Change in Weighted Average Cost of Capital
Change in debt
premium?
Cost of debt / leverage
Yes
Change in
cost of debt or
gearing


the level of gearing, the greater is the credit risk and, therefore, the higher is the
cost of debt.
In practice, a companys debt is observable directly, for example by examining
the yields on bonds issued by the firm. However, a companys cost of equity
cannot be observed in the same way. It needs to be estimated using asset pricing
models such as the CAPM.
3

The foundation of all asset pricing models is the risk-return trade-off, which says
that, all else being equal, the greater the risk borne by investors, the higher the
returns they expect in exchange for supplying capital.
3.2 Role of regulation in the cost of financing
This section considers how regulatory action, and regulatory design, can
influence the cost of capital by altering the risks faced by businesses. In this
regard, there are three distinctions to be made:
Firstly, the system of regulation may, itself, impose a certain risk profile on
companies. Relevant regulatory parameters may be length of regulatory
period, way how costs are determined (backward/forward looking), the
degree of incentives and/or uncertainty of cost recovery in the regulatory
system.
Secondly, regulatory actions, that either increase or lower uncertainty about
how the system of regulation will work in future, can alter the risks faced by
companies. This would include regulatory reform processes in relation to
future price control reviews.
Thirdly, the legal framework has an impact on the risk profile of companies
as it may limit the degree of freedom of regulators behaviours. This includes
how detailed rights and obligations of regulated companies are fixed in
primary and secondary energy legislation. Essential part of this is the appeal
process against regulatory actions which gives the regulated companies the
possibility to challenge regulatory decisions.
3.2.1 The system of regulation can influence risk and the cost of capital
A companys risk profile can be influenced by the nature of the regulatory system
it faces.
4
To help illustrate this concept we discuss the theoretical effect of two

3
Other asset pricing models considered by UK regulators include the Fama-French three-factor
model, and the Dividend Growth Model.
4
See, for example, Parker, D. (2003), Performance, risk and strategy in privatised, regulated
industries: The UKs experience, International Journal of Public Sector Management 16(1), 75 100;
Wright, S., Mason, R., Miles, D. (2003), A study into certain aspects of the cost of capital for


alternative pure systems of regulation rate-of-return and price-cap on
firms cost of capital.
Rate-of-return regulation and price-cap regulation could be viewed as two
extremes of a spectrum of possible regulatory systems. Under pure price-cap
regulation, prices are set for a number of years, based on a forecast of efficient
costs. If a company manages to reduce costs below these forecast levels, it may
keep the profits from doing so for the remainder of the control period.
Therefore, price-cap regulation provides firms with incentives to improve
efficiency.
The efficiency incentives provided by a price-cap system exposes regulated firms
to cost outturns deviating from forecasts. In order to be compensated for this
risk, theoretically investors will demand a higher rate of return, which will be
reflected in a higher cost of capital. We note that empirical evidence may be in
contrast to this theoretical argument. For example, Frontier (2008/2011)
5

compared asset betas for energy network companies grouped in countries with
cost-plus and incentive-based regulation and could not find differences based on
statistical tests. There may be various reasons for this. In principle cost-plus and
incentive regimes applied are not pure systems, e.g. the incentive regimes include
also cost-pass through mechanism. In addition, even if cost-plus regulation is
applied, the companies will be exposed to regulatory scrutiny when setting
reasonable costs.
3.2.2 Regulatory action can alter the risk faced by companies
Apart from the broader regulatory system itself, the actual behaviour of the
regulator within a given system can influence the risks borne by the regulated
firm and investors. There are a number of reasons why regulatory risk can be
correlated with market risk. In periods of unfavourable economic conditions,
regulators might be less inclined to raise allowed rates of return for regulated
firms in order to avoid increasing the burden on consumers.
6
This would cause
regulatory actions to be correlated with general macroeconomic conditions. This

regulated utilities in the U.K., a Smith & Co. Ltd. report to the OFT and U.K. economic regulators.;
Guthrie, G. (2006), Regulating infrastructure: the impact of risk and investment, Journal of Economic
Literature XLIV, 925972.
5
Frontier Economics, Ermittlung des Zuschlages zur Abdeckung netzbetriebsspezifischer Wagnisse im Bereich
Strom und Gas, Report for Bundesnetzagentur, 2008; Frontier Economics, Wissenschaftliches Gutachten
zur Ermittlung des Zuschlages zur Abdeckung netzbetriebsspezifischer unternehmerischer Wagnisse im Bereich Gas,
Report for Bundesnetzagentur, 2011.
6
In fact, an asymmetry may arise because pressure from consumer groups and industrial customers
may make it difficult for regulators to raise prices in bad times, and the regulator could justify
disallowances of price increase.


in turn would mean that the effect of regulatory decisions will be difficult to
diversify, so such changes will affect the cost of capital.
7

In relation to the impact of regulatory actions on company risk, it is useful to
distinguish between two categories for regulatory action.
First, predictable regulatory changes can increase the correlation of the
regulated firm with market risk. This is not necessarily a source of harm for
society. For example, regulatory action that introduces competition into a
sector may increase the risks faced by firms regulated within that sector, but
the change may nevertheless raise overall welfare to society.
Second, regulatory action can create uncertainty about how the system will
work in future. This is potentially more harmful to society. Unpredictable
regulatory conduct can create uncertainty for firms and, ultimately, for
investors. Depending on the source and nature of the uncertainty, this could
raise the firms cost of capital.
Several empirical studies find significant effects of regulation on the regulated
firms cost of capital. Trout (1996)
8
, Archer (1981)
9
and Dubin and Navarro
(1982)
10
compared utilities in different US states, to investigate the effect of
variations in state-level regulations on the cost of capital. All these studies find
that regulatory climate has a significant effect on the cost of capital.
Uncertainty over the future expected behaviour of the regulator can also affect
the cost of capital for the regulated firm. A number of studies have examined the
effect of regulatory uncertainty. Buckland and Fraser (2001) studied the impact of
the 1992 UK general election on the betas of 12 regional electricity companies,
which were privatised in 1990. The Conservative victory at those elections was
one of the more unexpected results during the 20
th
century and in the month
leading up to the election on 10 April, speculation of a Labour victory was
intense. Buckland and Fraser found statistically-significant evidence of the betas
of the Regional Electricity Companies (RECs) rising significantly during this
period, peaking on the day of the election, in anticipation of stricter regulation to
come. This would have had the effect of raising the RECs costs of capital, all
else being equal.

7
Burkhard, p., 2010. Regulatory risk and the cost of capital. Determinants and implications for rate
regulation. Springer Berlin- Heidelberg 2010. Pp. 37.
8
Trout, R., R., 1979. The regulatory factor and electric utility common stock investment values.
Public Utilities Fortnightly, November 22 1979, pp.28-31.
9
Archer, S., H., 1981. The regulatory effects on cost of capital in electric utilities. Public Utilities
Fortnightly, February 26 1989, pp. 36-9.
10
Dubin, J., A., and Navarro, P., 1982. Regulatory climate and the cost of capital. In: regulatory
reform and public utilities, ed. By Michael A. Crew, Boston/Dordrecht/London 1982, 141-66.


3.2.3 Legal certainty, appeal process, regulated companies and regulatory
action
The possibility for regulated companies to legally appeal a regulatory decision,
with which they disagree, may influence the behaviour of regulators in two ways:
Ex ante limitation The threat of a potential legal appeal may force the
regulator to put more emphasis on reasoning its decisions. For example, this
may result in a transparent consultation/decision process, where regulated
companies and/or other stakeholders have the possibility to comment the
regulators proposals.
Ex post limitation In principle the regulatory process is a balancing of
various and sometime conflicting interests. In some cases the regulatory
action may overemphasize one interest or is supposed not compliant with
the law. Hence, the legal appeal institution has the task to decide on the
legitimacy of the regulatory action and will approve or disapprove it ex post.
We note that the degree of the ex ante and ex post limitation depends on various
factors in relation to the legal appeal process:
Rules defining the regulatory framework detailed rules for setting the
regulatory components will more easily allow assessing the compliance
of regulatory decisions with the law.
11

Clear structure of legal appeal institutions allows all stakeholders to know
the respective legal enforcement institution. In addition the legal
character of the regulatory decision should comply with the principle
legal appeal process, e.g. in some countries a regulatory contract may
not fit into legal appeal process; and
Track record of legal appeal institutions the legal appeal institution should
have a track record (credibility) to decide in time and with a balanced
view for all stakeholders. This is important as companies will only use
the costly legal appeal process if they can expect a positive decision
in their case. In particular, the credibility of the legal appeal institution
has an important impact on the ex ante limitation of regulatory actions.
Only if the regulator expects an overruling of her decision, she will take
into account the expected opinion of the legal appeal institution.

11
However, we note that detailed rules may have an adverse effect on risk, as well. This is the case if a
change in the economic environment of regulated companies, e.g. increase in investment need due
to connection of renewables, requires flexible regulatory actions.


3.3 Regulation and risk the view from rating
agencies
The regulation/risk exposure of regulated companies to the capital market can be
reflected by the rating methodologies published by credit rating agencies. The
level of risk embedded in companies regulatory framework plays a crucial role in
these methodologies and differentiates the regulated sector from most other
corporate sectors.
In the following we illustrate Moodys rating methodology for regulated electric
and gas networks
12
, which hinges on four rating factors with different weights on
the final result:
Regulatory environment and asset ownership model, which reflect
the companys expected ability to recover cost in a consistent manner
over time;
Operational characteristics and asset risk, which reflects the
companys capacity to carry out its investment plan;
Stability of business model and financial structure, which capture
the exposure of lenders from the company engaging in new or
unregulated activities; and
Key credit metrics, which account for the financial parameters that
best reflects the likelihood of default.
The four rating factors are further categorised into sub-factors illustrated in
Table 3 again with different weights on the final result.

12
Moodys Investors Service, Rating Methodology Regulated Electric and Gas Networks, 2009. However,
we note that Standard&Poors and Fitch are using similar financial indicators.


Table 3. Moody's methodology for rating regulated electricity and gas networks
Broad Rating Factors Broad Rating
Factor
Weighting
Rating Sub-Factor Sub-
Factor
Weighting
1. Regulatory environment
and asset ownership model
40% Stability and Predictability of
Regulatory Regime
15%
Asset Ownership Model 10%
Cost and Investment Recovery 10%
Revenue Risk 5%
2. Efficiency and execution
risk
10% Cost Efficiency 6%
Scale and Complexity of Capital
Programme
4%
3. Stability of business model
and financial structure
10% Ability and Willingness to Pursue
Opportunistic Corporate Activity
3.33%
Ability and Willingness to Increase
Leverage
3.33%
Targeted Proportion of Operating
Profit Outside Core Regulated
Activities
3.33%
4. Key credit metrics 40% Adjusted ICR (or FFO Interest Cover) 15%
Net Debt/RAV 15%
FFO/Net Debt 5%
RCF/Capex 5%
Source: Moody's
In the following we focus on the sub-factors which correspond to our discussion
on the role of regulation in the cost of financing in Section 3.2.
Stability and Predictability of Regulatory Regime (15%) Reflects the
characteristics of the regulatory environment in which a network operates.
This includes the transparency of the regulatory framework, the regulators
track record for predictability and stability in terms of decisions making and
its independence from politics. In addition this sub-factor takes into account
the overall robustness of institutions and the rule of law in relevant
jurisdiction. Hence, this sub-factor corresponds with the discussion on
regulatory action and risk (Section 3.2.2) and the possibility of the legal
appeal process (Section 3.2.3).


Cost and Investment Recovery (10%) Focuses on the supportiveness of
the regulatory system on cost recovery with regard to operating and capital
expenditures. For example this includes the degree of incentives on costs,
the degree and timing of the cost-pass through mechanism, etc. In other
words, it measures the risk allocation between the company and its
customers. Hence, this sub-factor corresponds with the discussion on the
system of regulation (Section 3.2.1).
Revenue Risk (5%) Refers to the mechanism of revenue generation by
the company, in more detail on the volumes transported by a network as a
driver of potential volatility and uncertainty of future revenues. The
regulatory framework can mitigate this risk e.g. by introducing tariffs based
on capacities (which tend to be more stable) instead of volume or a revenue
cap. Hence, this sub-factor corresponds with the discussion on the system
of regulation (Section 3.2.1).
As the three sub-factors discussed above make up 35% of the overall assessment
the effect on the credit rating by an up-/downgrade will be substantial. In
addition, it is straightforward that the factor Cost and Investment Recovery and
Revenue Risk will affect other rating factors, e.g. Key credit metrics by influencing the
cash flow profile of the regulated companies.


3.4 Key findings Regulation and risk
Changes in risk will affect equity investors and debt investors via
different channels. Risk will feed into the
cost of equity via the beta; and
cost of debt via the debt premium.
Regulatory actions and regulatory design will influence the cost of capital by
altering the risks faced by businesses.
We identified three sources of potential regulatory influence and
categorised them to three Moodys key credit rating indicators reflecting
the regulatory environment:
Stability and Predictability of Regulatory Regime;
Revenue Risk.
Regulatory systems can be compared by analysing how they perform
against these indicators and how this may influence business risks
influence the beta and debt premium.


Regulation and risk selected European
countries

4 Regulation and risk selected European
countries
In the following we describe and analyse selected European countries with regard
to the
Revenue Risk.
In addition we illustrate the allowed cost of capital (WACC) for these countries.
The European countries we selected are:
UK Introduced a new regulatory framework, RIIO
13
, for the electricity and
gas networks. The first application of RIIO for the UK gas distribution
companies came into force on 1 April 2013. The main changes from RIIO
on the companies are the extension of the regulatory period from 5 to 8
years (RIIO-G1 for gas distribution companies is from 1 April 2013 to 31
March 2021) and the strong focus on providing outputs. Hence, UK
provides as an example of a recent regulatory decision applying a new
regulatory framework.
Germany Started the 2
nd
regulatory period for gas distribution companies
with 1 January 2013. As the main principles of the regulatory framework are
set out in law the 2
nd
regulatory period is mainly an extension of the revenue
cap framework from the 1
st
regulatory period. However, with regard to the
cost of capital the regulator decided to deviate from the more mechanistic
approach used in the 1
st
regulatory period to a more flexible one in favour of
the regulated companies. Hence, Germany provides as an example of a
recent regulatory decision, as well.
France Started the 4
th
regulatory period for gas distribution companies
with 1 July 2012. The regulation in France is characterised by a combination
of incentive regulation for operating expenditures and cost-plus regulation
for investments. In addition the regulation includes incentive-based
mechanism for certain output objectives, e.g. promotion of gas use and
quality of service. Hence, France provides as an example of a regulatory
framework compared to UK and Germany with a lower degree of
incentives.

13
RIIO stand for Revenues = Incentives + Innovation + Outputs.

countries

We make the following disclaimer in relation to the below stated Moodys
assessment for gas distribution companies in Germany and France:
France The assessment of Moodys rating is taken out from the rating of
the French gas TSO, TIGF
14
. Although TIGF being a gas TSO we assume a
similar assessment with regard to gas distribution networks, as the same
regulatory principles are applied.
Germany The assessment of Moodys rating is taken from the rating of
HSE Netz AG
15
, which owns and operates gas and electricity distribution
networks. Although HSE Netz AG operates gas and distribution networks
we assume a similar assessment with regard to gas distribution networks
only, as the same regulatory principles are applied for gas and electricity
networks.
4.1 UK
16

4.1.1 Stability and Predictability of Regulatory Regime
Regulation in UK for electricity and gas networks has a track-record of more
than 20 years. The process of price control for a regulatory period is transparent
and lasts between 18 months to 2 years. During this period the regulator, Ofgem,
obtains information from the companies and consults on the methodology that
will be used to set the price control. Ofgem publishes a draft determination,
which is also open to consultation, and then presents the company with a final
determination of the tariff control for the next regulatory period.
When reaching the determination, Ofgem must ensure that it is consistent with
her legal duties. Specifically, the regulator has a primary duty to protect the
interests of consumers and a number of secondary duties including the need to
secure that licence holders are able to finance the activities which are the subject
of obligations imposed
17
.
Once presented with the final determination, a company has a pre-specified
period of time to decide whether to accept Ofgems decision. If the decision is
accepted, the companys licence is modified to reflect the new tariff. If the

14
Moodys, Credit Opinion: TIGF SA, August 2013.
15
Moodys, Credit Opinion: HSE Netz AG, August 2013.
16
We note that this section refers to gas (and electricity) networks regulated by Ofgem. These are the
networks in England, Wales and Scotland. The networks in Northern Ireland are not included as
they are regulated by the Northern Ireland energy regulator (UR).
17
Utilities Act 2000.

countries

decision is not accepted within the specified time period, Ofgem refers the case
to the Competition Commission (the appeals body in UK).
The conditions under which a company can reject the regulators decision and
thereby seek an appeal are laid out in legislation. Formally, the company will
reject the proposed tariff if it is unable to finance the proper carrying out of its
function. That is, the company can reject the decision if it believes that the
revenues allowed by the regulator are not sufficient to cover the costs of
delivering required outputs.
If a company rejects Ofgems proposal the case is referred to the Competition
Commission (CC). The duties of the CC are laid out in the legislation relevant to
the particular sector (The Utilities Act 2000 in the case of energy). In addition,
the companies have the possibility to make a legal appeal to the High Court.
However, since the beginning of regulation no company has rejected Ofgems
proposal. The CC is also responsible for the decisions from the Northern Ireland
energy regulator (UR). There was a recent case where a company rejected the
decision from UR, in which CC analysed the impact from regulatory actions on
risk and the cost of capital (see box below).
In November 2008 Ofgem started its review of the then regulatory approach
(RPI-X@20). The main task was to incentivise networks to support sustainability
objectives and sector decarbonisation, while maintaining high quality of service
and low costs. RPI-X@20 included an extensive consultation and interaction
process with all stakeholders. The goal of this process was increase the
transparency on the objectives of all relevant stakeholders and to include them in
the new approach. In addition, the consultation was meant to specify the new
regulatory measures proposed. The process resulted in the new regulatory
approach RIIO Revenue set with Incentives for delivering Innovation and
Outputs in October 2010. Its key innovation is the central focus on outputs,
not inputs. The principle is simple. Customers care primarily about the end result
and so this is what network operators should be incentivised to provide. In 2013
RIIO was first applied to the gas distribution companies (RIIO-GD1), electricity
and gas transmission companies (RIIO-T1).

countries

Competition Commission Phoenix Natural Gas
In February 2012 Phoenix Natural Gas Limited (PNGL) rejected the price
control proposed by the Northern Ireland energy regulator (UR). UR
subsequently referred the price control to the CC investigate whether the price
control conditions operated against the public interest. The dispute was focussed
on URs proposal to write off approximately 25% of PNGLs regulated asset
base (RAB).
PNGL argued that this proposal was unexpected, unjustified, and contrary to the
principles of incentive regulation, since it retrospectively altered the previously
agreed value of PNGLs asset base. UR argued that it was acting in line with
regulatory practice, and protecting the interests of customers, by removing
unspent allowances from the asset base after 5 years.
The CC
18
found that URs proposal had not been adequately signalled and that
the rationale for it was not sufficiently well communicated or understood.
Changes to the regulatory framework that were enacted in this way would lead to a
perception of regulatory uncertainty, as investors may assume that URs future actions could be
unpredictable.Investors may anticipate that in addition to normal commercial risks there
could be greater uncertainty in the future about the regulatory environment, and thus increased
risks that returns on investment will not be realized in the way or to the extent that is expected.
This is likely adversely to affect investment decisions in the future.
The CC identified the ways in which customers could be harmed by retrospective
interventions in the long-run. It highlighted three possible mechanisms by which
the willingness to invest and the cost of finance could be adversely affected by URs
proposals:
The credit ratings agencies may view the regulatory regime as less favourable and, as
a result, may demand higher credit metrics for a given credit rating, which may lead to a
downgrade of a companys debt. This may have the effect of decreasing the amount of debt
that a company can have in its capital structure and/or increasing the cost of the
companys debt, both of which could lead to an increase in the overall WACC.
Equity investors may consider that the regulatory regime is less attractive,
and as a result may increase the return that they require for investing in a given project.
This may have the effect of increasing the required rate of return.
Finally, a perception of regulatory uncertainty may deter investment if companies
are unable to form judgements or are very uncertain of what the regulatory environment will be
and if, how or when they will receive a return on investments.

18
Competition Commission, Phoenix Natural Gas Limited price determination, November 2012.

countries

Therefore, the CC considered that regulatory uncertainty would affect both the
cost of debt and the cost of equity. It stated that any effects on the cost of equity could
be long-lived because the investment community may be expected to take into account URs
track record over a relatively long time period when investing in infrastructure assets with a
similarly long life. [para 8.94]
The CC did not quantify the scale of the impact of regulatory uncertainty on the
cost of capital. Nevertheless it concluded that it is our judgement that these effects
could be significant. As an illustrative example, applying a 50 basis point uplift to the cost of
capital to NIEs and PNGLs combined RABs of approximately 1.8 billion would equal
9 million a year. This does not take into account any effects on other regulated investments
and on future greenfield investments. [para 8.99]
Moodys assessment Stability and Predictability of Regulatory
Regime with Aaa rating
With regards to Stability and Predictability of Regulatory Regime Moodys uses the UK
regulatory framework as the benchmark and applies an Aaa rating.
In particular Moodys placed special attention to the Ofgem project RPI-X@20
started in 2008, which evaluated Ofgems past regulatory approach for future
application. This process finally resulted in the new RIIO regime.
In October 2010 Moodys raised its concern about Ofgems announcement that
the new regulatory model RIIO is the biggest change to the regulatory
framework for 20 years. Moodys was concerned that the regulators track
record for stability and predictability could be quickly undone.
Moodys welcomes this review and recognises that the challenges facing network companies
are clearly evolving against the backdrop of the changing way in which energy is likely to
be delivered in the future. The current regulatory framework for energy companies was
developed when they were purely infrastructure companies with a somewhat fixed role in
the industry. This is no longer the case and network companies will clearly need to evolve
to meet new technological challenges. However, the UK regulatory framework and, in
particular the RPI-X concept, has been adopted all over the world and is held in high
regard for its predictability, support and good track record. Moodys scores the UK
regulatory framework for the energy sector as one of the most transparent in the world.
Therefore, any material change to the regime could potentially weaken that view until a
good track record of performance has been re-established. We also note that a changing
regulatory framework and new processes may represent a significant management
challenge for companies, particularly in the first few years.
19

19
Moodys (2010: 3).

countries

However, after the first application of RIIO to the UK gas distribution
companies (RIIO-GD1), electricity and gas transmission companies (RIIO-T1)
Moodys notes that
RIIO is more a rebranding of the previous RPI-X regime and represents a natural
evolution in regulation that has continued since the utilities were first privatised.
20

Due to the evolutionary development from RPI-X to RIIO Moodys assessed
that the transition to RIIO for the gas distribution companies has no impact on
the Aaa rating.

20
Moodys (2013: 1).

countries

4.1.2 Regulatory system Cost and Investment Recovery and Revenue
Risk
Table 4. Regulatory parameters RIIO-GD1
Regulatory component Description
Type of regulation Revenue cap regulation
Length of price control 8 years (mid-period review)
Opex Split in to
Controllable costs (subject to efficiency analysis) ;and
Non-controllable costs.
RAB RAB is based on
Asset value of end year of previous period (rolled forward);
Annual net additions to RAB (fixed percentage of Totex)
Cost of capital WACC approach
Real WACC
Depreciation Sum-of-year digits (front loading)
Depreciation based on asset live of 45 years (sum-of-digits)
Investment Business plans serve as basis for RAB growth rate of 1%/a
Efficiency analysis Totex benchmarking based on four models (average efficiency):
Historical Totex;
Forecast Totex;
Historical disaggregated activity level expenditure; and
Forecast disaggregated activity level expenditure.
DSOs have to close 75% of their assessed gap between the cost forecast
and the upper quartile (75%-quartile).
Treatment of network
losses
DSOs are expected to improve gas transport losses over RIIO-GD1 through
rolling incentive mechanism
Companies receive forecast allowance for shrinkage based on actual
volumes and forecasted prices
Ex post alignment between forecast and outturn prices, therefore no
commodity price risk for operators
Incentives Incentive rates in cost allowances
IQI (Information Quality Incentive) provides ex-ante incentives to
submit accurate cost forecasts. Companies receive bonus if
submitted business plan is closely aligned to Ofgems forecast.
Innovation stimulus packages
Source: Frontier

countries

The key element of the new RIIO framework is represented by an output
oriented, instead of in input-oriented, definition of cost-allowances. Under RIIO,
companies are required to submit business plans setting out future investment
plans and define how the set of outputs will be achieved. Those plans serve as
key input in setting the price control elements. Figure 2 shows the principal
outputs under RIIO GD1 which can be allocated to different output categories.
Figure 2. Principal outputs under RIIO GD1

Source: Frontier
The biggest expenditure item under RIIO GD1 is represented by replacement
expenditure
21
(repex) which is an obligation derived from UKs Health&Safety
Executive that requires gas distribution companies to replace iron mains located
within 30 meters of buildings within 30 years (30/30 program).
In order to overcome the inherent principal-agent problem that lies within
business plans as source of information being submitted by regulated companies,
Ofgem introduced mechanisms (Information quality incentive, IQI) that aim at
incentivising the operators to submit accurate plans and reveal their true costs:
Incentive rates for outperformance IQI allows companies to retain part
of cost outperformance during a regulation period. The incentive rate has
been set between 65% and 70%, allowing companies to retain two thirds of
the achieved cost outperformance.

21
Ofgem changed the capitalisation principles for repex and introduced a stepped transition for repex
capitalisation, from 50% capitalisation in 2013-14 to 100% in 2020-21.
Principal outputs in RIIO GD1 (extract)
Percentage of biomethane capacity
connected
15-20% reduction of gas transport
losses
Reduction of carbon footprint
satisfactory survey, complaints metrics,
stakeholder engagement
Connection of 80,000 energy poor
households
Increase public awareness for carbon
monoxide
Maintain connection standards
New connection standards for gas
entry costumers
Reduce safety risks by 40-60%
Compliance with statutory
requirements
Expected number of interruptions
Asset load / Capacity utilisation
Maintaining operation performance
Environ-
ment
Customer
service
Social
obligation
Customer
connection
Safety Reliability

countries

Reward for accuracy in business plans Cost rewards are granted
(penalties charged) of maximal 2.5% of total expenditure for companies that
provide costs forecasts equivalent to Ofgems assessment of efficient costs.
As to provide further incentive to innovate, RIIO GD1 includes an innovation
stimulus package to fund innovation.
Further, the submitted business plans are subject to a comparative efficiency
analysis based on four cost measures of total expenditure, two based on historical
costs and two based on forward looking cost assessment. The average over all
four measures serves as base line cost allowance. Companies will have to close
75% of the assessed gap between their forecast and the efficient costs
22
.
Moodys assessment Cost and Investment Recovery with A rating
and Revenue Risk with Aaa rating
With regards to Cost and Investment Recovery Moodys still applies an A rating on the
gas distribution companies after the first application of RIIO. The main reasons
are:
the extension of the price control period from five to eight years is a key
change of RIIO as there is the potential for companies having to wait
longer for prices to be reset if specific costs increase. However,
Moodys notes that this risk is largely mitigated by the number of
uncertainty mechanisms (such as true-ups and the move to a cost of
debt index) included;
the nature of the allowed expenditure is very much in line with the
existing price control and represents business as usual for the
companies;
the companies will face a similar risk due to cost performance under
RIIO-GD1; as well as
Moodys is of the opinion that the presence of new incentives in
relation to outputs is more than offset by the new uncertainty
mechanisms with regards to costs, hence, making the overall credit risk
balance broadly neutral for RIIO-GD1.
With regards to Revenue Risk Moodys applies an Aaa rating. This is due to the
structure of the tariffs as fixed capacity charges make up a big proportion of the
overall revenue in gas and that the companies are not exposed to volume
risks.

22
Efficient costs are defined as the upper quartile (75%) of efficiency scores.

countries

Moodys rating for Cost and Investment Recovery and Revenue Risk under RIIO
indicates a low risk exposure for gas distribution companies with regard to these
factors which will feed into the overall credit rating assessment.
4.1.3 WACC
Table 5. WACC parameter UK
Parameter Parameter value
Risk-free rate (real) 2.0%
Asset-Beta 0.38
Equity-Beta 0.9
Market risk premium 5.25%
Cost of equity (real, post-tax) 6.7%
Gearing 65.0%
Tax 21.0%
Debt premium 0.9%
Cost of debt (iBoxx 10-year simple trailing
average index) (real, pre-tax)
2.9%
Inflation rate 3.1%
WACC (real, vanilla) 4.2%
Source: Frontier
Ofgem used the Capital Asset Pricing Model (CAPM) including a relative risk
analysis to determine the cost of equity for RIIO-GD1. Compared to the
previous price control regime (gas distribution price review - GDPCR1), Ofgem
decided to lower the equity beta from 1 to 0.9 based on the argument that gas
distribution network operators face lower risks than in GDPCR1. The equity
beta of 0.9 translates into an asset beta of 0.38. Further, Ofgem reduced the real
risk-free rate from 2.5% to 2% and increased the market risk premium from
4.75% by 0.5% pp to 5.25%.
Under the RIIO model Ofgem decided to base the cost of debt on a long-term
trailing average of forward interest rates, and the revenues allowed under the
price control will be adjusted each year for changes in this trailing average.
Ofgem notes that the allowed return on debt in price controls before RIIO has
closely tracked the long-term cost of debt average rather than current rates. This
is a strong indication that long-term averages remain an appropriate basis for
calculating the cost of debt going forward irrespective of current (or indeed

countries

forecast) market rates.
23
Hence, this approach should allow cost recovery for cost
of debt in the long run.
For RIIO-GD1 Ofgem decided to use a trailing 10-year average of two iBoxx
indices for the cost of debt. The respective iBoxx indices are the
iBoxx Non-Financials A 10+
24
This index includes bonds with a an
average remaining time to maturity (weighted by outstanding amount) of
21.6 years for A rated companies.
iBoxx Non-Financials BBB 10+
25
This index includes bond with a an
average remaining time to maturity (weighted by outstanding amount) of
17.2 years for BBB rated companies.
The unweighted average of both indices is then deflated by using a break-even
inflation figure. The break-even inflation figure is derived from the yield from
British Government Securities 10 year real and nominal zero coupons.
26
Ofgem
does not explicitly display the debt premium. However, using the risk-free rate
and the cost of debt implies a debt premium of 0.9 % at the beginning of RIIO-
G1.
4.2 Germany
4.2.1 Stability and Predictability of Regulatory Regime
The regulatory framework for incentive regulation for gas and electricity
networks is set out in the Incentive regulation decree (Anreizregulierungsverordnung
2012, ARegV). In addition the Gas network tariffs decree
(Gasnetzentgeltverordnung, GasNEV) defines how the costs are determined
to set the network tariffs for gas transmission system operators (TSO) and
distribution system operator (DSO) companies. These decrees include e.g.
regulatory formula;
size of productivity factors; or
calculation of allowed depreciation, asset values and cost of equity
and limit the actions from the regulator, Bundesnetzagentur (BNetzA).

23
See Ofgem, RIIO Handbook, 2010.
24
Series reference: DE000A0JY837.
25
Series reference: DE000A0JZAH1.
26
10 year nominal zero coupon, series reference IUDMNZC; 10 year real zero coupon, series
reference IUDMRZC.

countries

In cases where the decree leaves open the explicit details of the design of certain
regulatory parameters, e.g. detailed specification of benchmarking analysis,
detailed calculation of the risk premium (equity beta) for the cost of equity,
BNetzA uses a public consultation process including all relevant stakeholders.
BNetzA sets the allowed costs and the application of the regulatory formula for
each company by an individual decision. This individual decision also includes
the details, e.g. for the specification of the benchmarking analysis the resulting
efficiency score. The companies have the possibility for a legal appeal against this
decision. The legal appeal first goes to
Court of appeal which is Oberlandesgericht Dsseldorf against
decisions from BNetzA; as well as
Supreme court which is the Bundesgerichtshof against decisions from
the court of appeal.
The principle Reformatio in peius applies for decisions at Courts of Appeal.
This means that no appellant can be put in a worse position for filing and appeal.
The judgment of the higher court cannot amend the decision of the lower one in
harm of the defendant or plaintiff who turns to the higher court for a new
decision. Hence, companies cannot loose when appealing a decision.
Companies tend to use their right for legal appeal against decisions from BNetzA
since the start of incentive regulation. In the past the courts of appeals issued
various decisions reflecting an in-depth evaluation of the raised issues from
companies, which were either in favour of the arguments raised by
Companies, e.g. on the application of the industry-wide productivity
factor, indices used for revaluation of the assets; or
BNetzA, e.g. on the level of the cost of equity for the 1
st
regulatory
period.
There were amendments of the ARegV since the beginning of incentive
regulation taking into account the future investment needs in particular of
electricity TSOs. For example, the time lag for including expansion investment in
the allowed revenues during the regulatory period was removed. In addition the
decision of BNetzA on the allowed cost of equity for the 2
nd
regulatory period
also took into account the future investment needs of the energy sector (see
below).

countries

Moodys assessment
27
Stability and Predictability of Regulatory
Regime with A rating
With regards to Stability and Predictability of the Regulatory Regime Moodys considers
the German regulatory framework as modestly riskier in terms of transparency
and predictability than the UK framework used as the benchmark and applies an
A rating to this sub-factor. The reasons are:
Key principles of the incentive-based regulatory framework are
enshrined in law. However, being a relatively new form of regulation
that is still undergoing material changes, the outcome of future
developments is less predictable.
Whilst the experience to date shows that in many cases regulatory
changes have resulted in additional clarity and reduced risk for regulated
companies, Moodys expects to see a longer track record of consistent
application of regulatory principles before aligning the score with those
of more established regimes.

27
The assessment of Moodys rating is taken from the rating of HSE Netz AG , which owns and
operates gas and electricity distribution networks. Although HSE Netz AG operates gas and
distribution networks we assume a similar assessment with regard to gas distribution networks only,
as the same regulatory principles are applied for gas and electricity networks.

countries

Risk

Table 6. Regulatory parameters Germany
Length of price control 5 years (2
nd
regulatory period 2013-2017)
Opex Controllable operating expenditures (e.g. direct manpower costs;
expenditures for goods and services) fixed value from photo year (t-3)
which is adjusted annually by CPI and productivity factor
Uncontrollable operating expenditures (e.g. costs for using transmission
network) cost-pass through either t-2 or t-0
RAB RAB refers only to equity financed part, as cost of debt taken from P&L
account
Distinction into old assets (pre 1.1.2006) and new assets (post 1.1.2006)
Old assets (new assets) are valued at replacement (historic) costs
Cost of capital No WACC approach as cost of debt taken from P&L statement
Cost of equity based on CAPM model
Real (nominal) cost of equity for old assets (new assets)
Depreciation Fixed value from photo year (t-3) which is adjusted annually by CPI and
productivity factor
Old assets equity financed part (capped at 40%) based on replacement
values; debt financed part based on historic values
New assets based on historic values
Investment No forecasts used for regulatory period to assess investment needs during
regulatory period
Expansion investments covered by growth factor based on development of
supply area, peak demand and number of connection points
Efficiency analysis Efficiency analysis on total costs using two benchmarking methodologies
(DEA and SFA)
losses
Costs for network losses are not part of distribution companies revenues.
The costs are covered via purchasing of balancing energy by traders
Incentives Only controllable costs are incentivised, where capital costs are defined as
controllable, as well
Two types of targets are applied cumulatively: (i) Industry-wide productivity
target; and (ii) Company-specific efficiency targets based on efficiency of
each firm
Companies can retain cost savings that go beyond the efficiency targets
Source: Frontier

countries

BNetzA does not use cost forecasts to set the costs operating costs and capital
costs for the following regulatory period. Instead the costs from a photo year
are used. The starting point is the values from P&L statements and balance
sheets from the annual reports of the companies. According to 6 ARegV the
relevant photo year is based on the t-3 costs, where t is the start of the following
regulatory period. For the 2
nd
regulatory period for incentive regulation of gas
DSOs starting at 1 January 2013 this means that the relevant costs for the period
2013-2017 are the accounting data from 2010.
The ARegV defines three categories of costs with different treatment during the
regulatory period:
Non-controllable costs (11 (2) ARegV) defined by an exhaustive list
which are cost-pass through items;
Volatile costs (11 (5) ARegV) defined by an exhaustive list which are
cost-pass through items; and
Controllable costs costs not falling under non-controllable and volatile
costs are by default controllable. This includes operating costs and
capital costs (depreciation and cost of capital). Controllable costs are
adjusted during the regulatory period by inflation and a productivity
factor.
The productivity factor consist of two parts:
Industry-wide productivity target which applies to all companies and
is set at 1.5% for the 2
nd
regulatory period; and
Company-specific efficiency targets based on the efficiency for each
company, which is derived from a total cost benchmarking analysis. The
companies have to reduce all their inefficiencies during 5 years. In order
to dampen the impact from the company specific target a best-of
approach from different benchmarking models and a cap on the
maximum inefficiency is used.
With regard to investments during the regulatory period one has to differentiate
between
Replacement investments the implicit assumption is that the allowed
depreciation in the photo year is sufficient to generate sufficient cash
flows for replacement investments for the coming regulatory period;
and
Extension investments which are covered by the so-called expansion
factor. The expansion factor allows companies further revenues if
their supply task increases during the regulatory period. The increase of
the supply task is reflected by the change in the supply area, peak load
and number of connection points.

countries

The revenue cap places no volume risk on the companies. Hence, the regulatory
formula does not include any measures for network utilisation.
In principle quality regulation may also apply to the gas distribution companies.
However, BNetzA, did not implement quality regulation yet. Hence, there is no
exposure of gas distribution companies on quality.
Moodys assessment
28
Cost and Investment Recovery with Baa
rating and Revenue Risk with A rating
With regards to Cost and Investment Recovery we assume the same Baa rating
Moodys applies to HSE Netz AG, because:
the application of the industry-wide productivity factor and the
company-specific efficiency targets on total costs; and
the limited track record of the application of the tariff formula.
With regards to Revenue Risk we assume the same A rating Moodys applies to
HSE Netz AG, because volume risk is largely mitigated through an adjustment
mechanism, whereby any over- or under-recoveries of revenues are recorded in a
regulatory account and adjusted at the next regulatory period.
4.2.3 WACC
The German regulator BNetzA sets a separate allowance for return on equity and
cost of debt (i.e. there does not exist a WACC approach in Germany). BNetzA
stipulates the parameters that are used to calculate the cost of equity for the 2
nd

regulatory period for gas networks (2013-2017). BNetzA based its decision on a
report from an external expert that examines the costs of equity for gas and
electricity networks in Germany.
29

Table 7. Cost of equity parameter Germany
Risk-free rate (nominal)* 3.8%
Asset-Beta (taken from first regulatory period)** 0.39
Equity-Beta (taken from first regulatory period)** 0.79

28
The assessment of Moodys rating is taken from the rating of HSE Netz AG, which owns and
operates gas and electricity distribution networks. Although HSE Netz AG operates gas and
distribution networks we assume a similar assessment with regard to gas distribution networks only,
as the same regulatory principles are applied for gas and electricity networks.
29
Frontier Economics (2011), Wissenschaftliches Gutachten zur Ermittlung des Zuschlages zur Abdeckung
netzbetriebsspezifischer unternehmerischer Wagnisse im Bereich Gas, Gutachten im Auftrag der BNetzA.

countries

Market risk premium** 4.55%
Equity risk Premium 3.59%
Cost of equity (nominal, pre-tax for new assets)*** 9.05%
Cost of equity (real, pre-tax for old assets)*** 7.14%
Gearing 60%
Tax**** 29.48%
Inflation rate 1.56%
Source: Frontier Economics based on BNetzA (2011)
* Weighted average yield of outstanding Bundesbank bonds of the past ten years.
** BNetzA decided against the CAPM approach and used instead the betas and market risk premium from
the first regulation period. The asset beta/equity beta originally published in its proposal submitted for
consultation for the second regulatory period amounts to 0.32/0.66 and the market risk premium to 4.40%
(corresponding to the average of the recommended range for asset beta provided by Frontier Economics
(2011)).
*** Cost of equity for new installations are nominal pre-tax and for old installations real pre-tax.
**** The tax covers trade tax of 13.65% and corporate tax of 15.825%.
BNetzA lowered the cost of equity compared to the 1
st
regulatory period for gas
networks and justifies this with the general level of interest rates. The parameters
for the cost of equity for the 2
nd
regulatory period are set out in Table 7 below.
The commissioned expert report defined a potential range for the equity beta
(asset beta) of 0.62 and 0.71 (0.30 and 0.35) and a potential range for the market
risk premium of 3.8% and 5.0% (geometric and arithmetic mean). In its decision
BNetzA however decided to deviate from the CAPM approach as applied in the
external expert report and instead adhered to the higher betas and market risk
premium derived in the 1
st
regulatory period. The higher equity beta in the 1
st

regulatory period amounts to 0.79 (which implies an asset beta of 0.39) and the
market risk premium to 4.55%.
BNetzA reasoned the deviation from the CAPM approach by
the exceptional situation on the financial markets and
Germanys specific energy policy change in recent years following the
incident in Fukushima that was also followed by changes in the legal
framework in Germany.
In particular BNetzA emphasises the considerable need for extension and
modernisation of the German distribution grids to enable them to accommodate
a larger amount of renewable energy in line with Germanys revised Renewable
Energy Sources Act (EEG). By deciding against lowering the risk premium

countries

BNetzA aims to provide greater regulatory incentives for essential investments
needed due to the turnaround in German energy policy.
30

4.3 France
4.3.1 Stability and Predictability of the Regulatory Regime
The gas and electricity sector in France is regulated by the Commission de
Rgulation de lEnergie (CRE), under a law of February 2000. As an
administrative authority, the CRE is independent of government. The mission of
CRE is
Guaranteeing the right of access to public electricity grids and natural
gas networks and facilities;
Ensuring the proper functioning and development of electricity and
liquefied natural gas networks and infrastructure;
Ensuring the independence of system operators;
Contributing to building the European Internal Market for electricity
and gas.
The French Energy Code, in force since 1 June 2011, implements the Directive
2009/73/EC into French law. Articles L.452-2 and L.452-3 of the French Energy
Code determine the CREs remit over tariffs. Article L.452-2 states that CRE sets
the methods used to establish the tariffs for use of natural gas networks.
Furthermore, Article L.452-3 states that
The Energy Regulatory Commission considers tariff changes [] with, as appropriate,
amendments to the level and structure of tariffs that it believes justified in light
particularly of an analysis of operators' accounts and foreseeable changes in operating and
investment costs.
CRE first applied a long-term regulatory framework including incentives on gas
distribution companies in 2008. CRE did not change the regulatory framework
for the 2
nd
regulatory period. Although not obliged by law CRE undertakes
extensive consultations on everything it considers doing. Hence, CRE has the
reputation of setting out the rules of the price control clearly and in great detail at
the beginning of each regulatory period.
CRE submits its decisions on tariffs and the reasoning behind them to the
ministries with responsibility for energy and the economy. The ministries have

30
BNetzA explicitly mentions in its decision that it will return to apply CAPM approach in the third
regulation period if conditions for network operates improved by predictability and a more stable
legal framework.

countries

the power to veto within 2 months if they consider that the tariffs are not in line
with current energy policy. In case of no veto the new tariffs and underlying
regulatory framework come into force.
The companies and other stakeholders have the possibility to appeal the decision
from CRE at the Conseil dEtat. We are not aware of an appeal from the gas
sector. However, in 2009 a group of local authorities appealed the tariff decision
for electricity distribution companies. They argued that the tariffs should be
reduced because the capital costs were set too high. The Conseil dEtat overruled
the CRE decision on 28 November 2012, which was replaced retrospectively by
an ex-post cost-plus regime. The consultation for the next regulatory period is
currently under way taking into account the ruling of the Conseil dEtat. Overall,
this shows that the appeals mechanism in France can lead to a price control being
overruled.
Moodys assessment
31
Stability and Predictability of the Regulatory
Regime with Aa rating
With regards to Stability and Predictability of the Regulatory Regime Moodys considers
the French regulatory framework as modestly riskier in terms of transparency and
predictability than the UK framework used as the benchmark and applies an Aa
rating to this sub-factor. The reasons are:
CRE regulator has commitments in terms of stability of the framework,
which in Moody's view reduces the likelihood of any sudden changes to
it.
CREs methodology and models are published and transparent in terms
of capital expenditure and operating expenditures and RAB
remuneration.

31
The assessment of Moodys rating is taken out from the rating of the French gas TSO, TIGF.
Although TIGF being a gas TSO we assume a similar assessment with regard to gas distribution
networks, as the same regulatory principles are applied.

countries

Risk
Table 8. Regulatory parameters France
32

Length of price control 4 years
1
st
regulatory period: 2008-2011
2
nd
regulatory period: 2012-2015 (reviewed 2-yearly)
Opex DSO forecasts operating expenditures, NRA defines OPEX trajectory
based on forecast, annual productivity target and inflation
RAB Initial RAB: Historical assets (before 2003) revaluated using
market-sektor GDP price index and linearly depreciated.
Updated RAB: Assets in operation since 2003 included at their gross
value (excluding third party contributions and subsidies)
Depreciation Assets included in RAB revaluated on 1
st
January using the rate of
inflation; linear-depreciation on basis of their economic lifetime
33

Investment Planned investment included in RAB at forecasted gross value (CRE
fully accepted GrDFs investment forecast)
Efficiency analysis No efficiency analysis is conducted
Treatment of network losses Expenses and Revenue clawback account (CRCP) reimburses
operator for 80%
34
of the differences between
purchasing costs for gas and the balance of supplier
variance account and inter-operator variance account
(GrDF TSO), (calculated ex-post on, based on actual
figures); and
estimated purchasing costs.
In the Event of variation of over 5% between the market price of gas
to cover losses and other discrepancies and the forecasted purchase
price adopted in the tariff, the benchmarking figure will be reviewed..
Incentives Expenses and Revenue clawback account (CRCP) takes account of
variances between actual and forecasted expenses and revenues;
increase/decrease of income to be recovered through tariffs (max.
2%/a)

32
CRE, Deliberation of the French Energy Regulatory Commission of 28 February 2012 forming a decision on the
equalised tariff for use of GrDF public natural gas distribution networks, 2012; CRE, CREs tariff proposal of 28
February 2008 for use of public natural gas distribution networks, 2008.
33
Economic lifespan of assets: Gas pipes and connections 45-50 yrs.; depressurisation stations 40 yrs.;
compression/metering 20 yrs.; other techn. equipment 10 yrs.; buildings 30 yrs.
34
Reduced from 90% in ARTD3 to 80% in ARTD4.

countries

Annual productivity target for operating expenses
Incentive-mechanism on investment (max 2 Mio./a)
Incentive-based quality of service regulation mechanism
Financial incentives to promote usage of gas (i.e. in new house
building)
Source: Frontier
For a period of 4 years, CRE defines tariffs through which GrDF is allowed to
recover its costs. The tariffs are calculated based on forecasted operating and
capital expenses. Opex are annually indexed by inflation and subject to an annual
productivity target
35
. The allowed capital costs consist of depreciation and
financing costs (WACC multiplied with RAB), which are based on the opening
RAB and forecasted investments. The RAB is revaluated annually by inflation.
In the 1
st
regulatory period (ARTD 3) a correction mechanism (Compte de
rgulation des charges et des produits, CRCP) was introduced. This mechanism
adjusts the tariffs to take into account the differences between specific outturn
expenditures (e.g. investments)/revenues and forecasted expenditures/revenues.
The CRCP balance is cleared annually and automatically reduces or increases the
income that is to be recovered through the tariffs (capped at 2%/a + carry-over
in next year).
In addition to annual productivity target for the operating expenditures,
incentives for efficient operation are provided by
the incentive-based cost control for investment;
the incentive-based quality of service regulation; and
the incentive-based mechanisms for promoting the use of gas.
In the following we illustrate these mechanisms.
Incentive-based cost control for investments this instrument was
introduced in the 2
nd
regulatory period and is new and may increase or
decrease the income from tariffs, depending on the positive or negative
difference between the forecasted and outturn investments.
In addition CRE implemented several quantitative indicators to monitor the
investment programme, all of which are reported annually (Figure 3).

35
Fourth regulatory period (ATRD 4): 1,3%.

countries

Figure 3. Investment indicators

Source: Frontier
Incentive-based quality of service regulation CRE implemented an
extensive system of indicators monitoring the quality of service provided by
the gas network. For each indicator, a trajectory is defined that is monitored
on weekly, monthly, quarterly or yearly basis. Indicators being the most
important to the functioning of the market are subject to financial penalties
and incentives, e.g. the proportion of connections established within the
deadline agreed. For this indicator, a basic objective of 82% (85%) of
connections <6-10 m/h (>10m/h) and a target objective of 87% (90%)
was defined. If the operator does not achieve to meet the basic objective, a
penalty of 10,000 per month below the target will become effective. If the
operator meets or exceeds the target objective, a bonus of 10,000 per
month above the target ratio will be credited to the CRCP.
Figure 4 illustrates an extract of the quality of service indicators in place in
ATRD4.
Investment indicators
Length in km of new network
development
Number of biomethane facilities
connection
Number of new delivery points (new or
replaced)
Number of periodic checks and
calibrations of industrial meters
Number of periodic checks and
calibrations of domestic meters
Length in km of network replaced
Length in km of network laid as
restructuring extensions
Facilities moved at third party request
Number of plans geo-referenced over
the year

countries

Figure 4. Quality of service indicators

Source: Frontier
Incentive-based mechanism to promote the use of gas CRE made
provisions of 45 Mio. in the operating expenditure for covering additional
spending from GrDF related to intensifying the use of its network. These
measure aim at promoting the use of gas in the residential and tertiary
and industrial-market. A reference trajectory is defined and monitored at
the end of the regulatory period for:
Residential market: new housing units with gas heating; and
Tertiary and industrial market: sum of total new customers.
If either of the trajectories is not fulfilled at the end of 2015, the mechanisms
induced a penalty payment (max. 30m across the whole regulatory period),
in return, GrDF is allowed to retain any surplus if the trajectories are
reached at lower costs.
Moodys assessment
36
Cost and Investment Recovery with A rating
and Revenue Risk with Aa rating
With regards to Cost and Investment Recovery we assume the same A rating Moodys
applies to TIGF, because:

36
The assessment of Moodys rating is taken out from the rating of the French gas TSO, TIGF.
Although TIGF being a gas TSO we assume a similar assessment with regard to gas distribution
networks, as the same regulatory principles are applied.
Quality of service monitoring indicators (extract)
Number of scheduled appointments
missed by DSO
Start-ups completed within deadline
requested
Shut-downs within deadline requested
Connections completed within deadline
requested
Actually taken half-yearly reading
Quality of reading submitted to TSO
DSOs portal availability rate
Responses to supplier complaints
within 15 days
Responses to supplier complaints
within 30 days
Publication rate of reading on online
portal
Variance from contract scope of
alternative suppliers
Size of imbalance account
Level of corrected meter figures
Atmospheric emissions of GHG

countries

Operating costs and capital costs are set for 4-years, providing a clear
and transparent view on revenue allowance;
Transparent pass-through mechanism for uncontrollable costs;
Reasonably incurred investment is automatically added to RAB;
Factoring in incentives from efficiency targets, new treatment of
investment under-/overspent and quality targets.
With regards to Revenue Risk we assume the same Aa rating Moodys applies to
TIGF, because volume risk is largely mitigated through an adjustment
mechanism, whereby any over- or under-recoveries of revenues are recorded in a
regulatory account and adjusted at the next regulatory period.
4.3.3 WACC
Table 9. WACC parameter France
Risk-free rate (real) 2.2%
Asset-Beta 0.46
Equity-Beta 0.76
Market risk premium 5.0%
Cost of equity (real, pre-tax) 9.2%
Gearing 50.0%
Tax 34.4%
Debt premium 0.60
Cost of debt 2.8%
Inflation rate 2%
WACC (real, pre-tax) 6.0%
Source: Frontier
For each tariff ruling
37
, CRE reassess the various parameters that are used to
calculate the WACC. In addition, CRE commissioned a report from an external

37
CRE, Deliberation of the French Energy Regulatory Commission of 28 February 2012 forming a decision on the
equalised tariff for use of GrDF public natural gas distribution networks, 2012; CRE, CREs tariff proposal of 28
February 2008 for use of public natural gas distribution networks, 2008.

countries

provider that examines the costs of capital for gas and electricity networks in
Europe.
The commissioned report of CRE defined a potential range for the asset beta
between 0.35 and 0.45. In its decision for the fourth regulatory period, CRE set
the asset beta at 0.46, which is lower than the value used in the previous
regulatory period (0.58).
With regard to the debt spread CRE increased the value by +20% to 60%.
Further changes compared to the previous regulatory period are an increased
market risk premium (+0,5pp) and decrease of the real risk-free rate by 0.2 pp
(constant nominal risk-free rate). The debt gearing has been increased from 40%
to 50%.

countries

4.4 Key findings Regulation and risk in UK,
Germany and France
UK (Aaa) sets the benchmark for Stability and Predictability of
Regulatory Regime. Germany (A) and France (Aa) get a slight lower rating
by Moodys. This results in a range of Aaa to A.
The regulatory frameworks result in Cost and Investment Recovery in the
range of A to Baa and Revenue Risk in the range of Aaa to A.
The corresponding beta and debt premium set by the regulatory authorities
in UK, Germany and France are
asset beta in the range of 0.38 to 0.46;
equity beta in the range of 0.76 to 0.90;
debt premium in the range of 0.60% to 0.90%.
UK
(2013-2021)
Germany
(2013-2017)
France
(2012-2015)
Stability and Predictability of Regulatory Regime Aaa A Aa
Cost and Investment Recovery A Baa A
Revenue Risk Aaa A Aa
Asset beta 0.38 0.39 0.46
Equity beta 0.90 0.79 0.76
Debt premium 0.90% na 0.60%
Source: UK Moodys; Germany and France and Frontier assessment based on Moodys ratings for
HSE Netz (Germany) and TIGF (France)


Regulation and risk Czech Republic

5 Regulation and risk Czech Republic
In the following we compare the regulatory framework of the 3
rd
regulatory
period for gas distribution companies with the draft proposal from ERO for the
4
th
regulatory period and the potential impact on risk faced by the companies.
The comparison follows Moodys rating methodology illustrated in Table 3 on
the following factors:
Revenue Risk.
We draw on the arguments for the selected European countries in Section 4 to
draw conclusions on the likely rating impact from EROs proposals and actions
on these three rating factors.
In addition, we assess the potential effect on selected Moodys key credit metrics
from EROs proposed regulatory framework for the 4
th
regulatory period.
Disclaimer We note that the following ratings are based on Frontiers assessment based on
Moodys methodology. Frontiers assessment may be in contrast to Moodys own assessment.
5.1 Stability and Predictability of the Regulatory
Regime
In the following we will discuss the development of the regulatory environment
between the start of the 3
rd
regulatory period and the August 2013 proposal from
ERO for the 4
th
regulatory period.
5.1.1 Frontiers assessment for 3
rd
regulatory period rating between Aa and
A
At the start of the 3
rd
regulatory period in 2010 the Czech regulatory system had a
history since 2002. During this time ERO showed its ability to react on changing
circumstances e.g. due to future investment needs, in a pragmatic way. This eight
year history is comparable with Germany and France, as described in Section 4.
ERO in principle applied the same regulatory framework as in the 2
nd
regulatory
period, stated a predictable 15 year assessment period for the replacement
investment plans of the companies and there was no change in the market model.
The possibility of legal appeal for companies was (and is) restricted in the Czech
Republic. We understand from RWE Gasnet that price decisions are considered
as a legal regulation/enactment as opposed to individual decisions issued by the
competent authorities in individual cases. The conformity of legal
regulations/enactments (either decree as statutory instrument or price decision)


with the constitutional order or a statue may be reviewed by the Constitutional
Court. However, we understand from RWE Gasnet that this procedure is very
complicated and a right of appeal seems to be rather illusionary. This legal appeal
process differs from those in UK, Germany and France. This will not be an issue
if the regulator acts in a predictable way.
With regard to Moodys assessment of Stability and Predictability of Regulatory Regime
we assess a similar rating for the 3
rd
regulatory period as for Germany and France
in the range of A and Aa, with a slight bias to A due to the legal appeal process:
A means that regulation is generally independent and developed
(published methodologies set out principles of risk allocation between
companies and customers and are based on established precedents in
the same jurisdiction)
38
;
Aa means that regulation is independent, reasonably well
established (>10 years of being predictable and stable) and transparent
(published methodologies clearly define risk allocation between
companies and customers and are generally consistently applied)
39
.
th
regulatory period (August 2013 proposal)
downrating to Ba or B
The time period from 2011 until August 2013 was characterised by various
interferences from ERO in the regulatory setting. The main objective of these
actions was to reverse the impact on companies revenues from depreciation
based on revaluated assets, which was introduced for the 3
rd
regulatory period.
ERO reasoned these actions by stating that companies investments were below
allowed depreciation which contradicts the intention of the asset revaluation.
As mentioned in Section 3.2.2 only unpredictable regulatory actions may be
potentially harmful by increasing the uncertainty for companies and, ultimately,
for investors, which feed into higher cost of capital.
40
Hence, in the following we
assess to what extent EROs actions during the 3
rd
regulatory period can be
classified as unpredictable.

38
Moodys (2009: 11).
39
Moodys (2009: 11).
40
There may be arguments that EROs action were predictable, as already outlined in 2009: If
companies do not reinvest revaluated depreciation in asset upgrades in a way to preserve their level
and the quality of supply, the Office will introduce a mechanism into regulation, which will ensure
that allowed depreciation is used solely for investment purposes under the respective licence
(Energy Regulatory Office, Final Report of the Energy Regulatory Office on the regulatory methodology for the
industries, p 16, December 2009.).


Moodys definition of a lower rating than A for Stability and Predictability of
the Regulatory Regime serves as the starting point for this assessment:
Ba means that regulatory framework is defined but not
consistently applied.
41

B means that regulatory framework is unclear, untested or
undergoing significant change, with a history of political
interference.
42

Non consistent application of the regulatory framework for the 3
rd

regulatory period
ERO launched a consultation process for the 3
rd
regulatory period in July 2008.
There were extensive discussions between all relevant stakeholders which
resulted in the decision from ERO in December 2009. Appendix 2
43
of the
decision document included the starting regulatory values for the 3
rd
regulatory
period. In addition, the companies capital expenditures plans (used to calculate
depreciation and the RAB for the period 2010 to 2014) were documented in
Appendix 2. This means, companies could expect that investments in line with
the documented capital expenditures plan will not induce ERO to take any
correcting measures.
End of 2011 ERO informed the regulated companies on its intention to assess
the way how depreciation was calculated for the 3
rd
regulatory period and to
analyse companies investment behaviour. In May 2012 (two years after the start
of the 3
rd
regulatory period) ERO completed the analysis claiming that regulated
companies had not reinvested depreciations (from revaluation) and asked
companies for respective measures. ERO rejected companies measures and
published a proposal to amend the decree on price regulation. This included a
new parameter, the so-called Investment Debt Factor (IDF), in the calculation of
allowed revenues of electricity and gas network companies for the period 2010
2014. However, on 1 October 2012 Governments Legislative Council dismissed
this new parameter as retroactive and therefore incompatible with the legislative
order.
On 27 November 2012 ERO published a draft amendment of the Decree on
Price Regulation proposing a new IDF. In addition, ERO claimed that the
existing decree was not in line with the Energy Act when providing regulated
entities with revaluated depreciations that were not invested back into the

41
Moodys (2009: 11).
42
Moodys (2009: 11).
43
Energy Regulatory Office, Final Report of the Energy Regulatory Office on the regulatory methodology for the
industries, p 68ff, December 2009.


regulated business. Again, the Governments Legislative Council dismissed the
proposal.
On 19 March 2013 ERO published a proposal for the 4
th
regulatory period which
included a shortening of the 3
rd
regulatory period for the gas sector by one year.
This proposal also included the reversal of the revaluation of assets accepted in
the 3
rd
regulatory period. ERO justified its actions with the claimed non-
compliance of regulated gas companies with an alleged obligation of annual
investment into the gas infrastructure that should equal the approved regulatory
depreciations in the given year. On 1 August 2013 ERO published its second
proposal for a methodology of the 4
th
regulatory period that included a
retrospective Investment Debt Fund comparable to the twice dismissed IDF.
In addition ERO tried to force the companies to tender all services including
services provided internally or by group service companies.
Given this history, we conclude that EROs actions can be classified as an
unpredictable non-consistent application of the regulatory framework because
ERO proposed measures to interfere in the 3
rd
regulatory period, e.g.
IDF in November 2012, soon after the start of this period. ERO
neglected the compliance of gas distribution companies with their
planned investments documented in Appendix 2 in ERO (2009). We
understand from RWE Gasnet that the outturn investments for 2010
and 2011 at that time were above the planned investments. Hence,
companies like RWE Gasnet could not expect this interference by
ERO, because they behaved consistent with the regulatory decision for
the 3
rd
regulatory period.
ERO proposed to shorten the 3
rd
regulatory period from 5 to 4 years in
March 2013. Although ERO reversed this proposal again in the August
2013 document, there were 6 months of unclear application of the
current rulings faced by the companies.
Undergoing significant change in the 4
th
regulatory period
In Section 4.1.1 we discussed in relation to the RIIO process in UK that rating
agencies are concerned about significant changes in the regulatory framework
because of the adverse effect on regulators track record for stability and
predictability.
We note that it is common practice by regulatory authorities to adjust and change
regulatory parameters over time. Hence, the important question is if the
proposed changes from ERO for the 4
th
regulatory period can be classified as a
significant change, from which an impact on Stability and Predictability of Regulatory
Regime can be expected.
The main changes proposed for the 4
th
regulatory period are:


Reversal of asset revaluation (both for depreciation and RAB) ERO
reversed the revaluation of assets introduced in the 3
rd
regulatory period
which was meant to mitigate the financing needs due to increasing
investments in the coming 15 years. From the 4
th
regulatory period onwards
the allowed depreciations and the RAB will be derived from a much lower
asset value mainly based on historic costs.
New split of Regulated Asset Base (RAB) into old and new A
The new RAB consists of the investments undertaken from 2007-2013.
The old RAB consists of the difference between the RAB 2009 plus
investments 2010-2013 and the new RAB. Depreciation for the old
RAB is calculated by using a residual lifetime, where we understand from
RWE Gasnet that ERO targets for about 10 years.
Network obsolescence factor ERO introduced this factor in August
2013 (it was not included in the March 2013 document). ERO acknowledges
the need to mitigate the financing needs of the companies due to increasing
investments. We understand that this factor should close the gap between
investments and the lower allowed depreciation in the 4
th
regulatory. The
factor will be determined on the annual replacement needs outlined in ten-
year investment plans submitted by regulated entities. However, ERO has
not fully specified the calculation of the Network obsolescence factor in
detail, yet.
Investment fund ERO introduced this fund in August 2013 (it was not
included in the March 2013 document). The investment fund records the
revenues generated from the Network obsolescence factor not used for
replacement investments. As long as the Investment fund is positive the
company will not be entitled to receive funds from the Network
obsolescence factor. In addition, the initial value of the Investment fund at
the start of the 4
th
regulatory period is based on the difference between
outturn investments and allowed depreciation during the 3
rd
regulatory
period. Hence, the initial funding results from a retrospective interference
into the previous regulatory period.
Efficient network use factor This factor should stimulate the use of
capacity in the distribution system. We understand that the design of this
factor is yet to be decided and the impact on revenues/costs still unclear.
There are various reasons to classify the proposal in August 2013 as a significant
change, because
ERO fundamentally changed its position with regard to asset
revaluation compared to the 3
rd
regulatory period (and actually also the


2
nd
regulatory period) introducing substantial discontinuity between
regulatory periods;
we understand that the legal reasoning for the reversal of the asset
revaluation referring to Art 19a Energy Act is disputable jeopardizing
the stability of the regulatory framework for the 4
th
regulatory period;
the reversal of asset revaluation significantly impacts the allowed
depreciation and the RAB and is the major difference compared to the
3
rd
regulatory period;
ERO seems to be aware of the significant impact and tries to mitigate it
by the Network obsolescence factor, whereas the detailed design is not
clearly outlined in ERO (2013b)
44
;
the initial funding of the Investment fund is based on a retrospective
action, which has no precedent in the CZ regulation. In addition, the
initial funding of the Investment fund by a retrospective action may
jeopardize the legal stability of the 4
th
regulatory period. We understand
that the Governments Legislative Council dismissed a similar parameter
as incompatible with the legislative order. The Constitutional Court may
take a similar stance with regard to the price decision for the 4
th

regulatory period;
the network utilization factor is a new parameter in the regulatory
framework, where the outcome for regulated companies on costs and
revenues is yet unclear but based on the initial description in ERO
(2013b) tends to result in a downside for companies;
the time period to develop and implement these substantial changes and
new regulatory parameters is rather short (from August 2012
Mid/End 2013) compared to the RPI-X@20 process by Ofgem with
extensive consultations and interactions with all relevant stakeholders
lasting more than 5 years (November 2008 to 2013) before the first
application.

44
In addition ERO states that it will evaluate the efficient use of the resources derived from this factor
and may abolish it. However, it is unclear how ERO defines efficient utilization placing further
uncertainty on the long-term stability of this factor.


5.1.3 Conclusion Deterioration of Stability and Predictability of Regulatory
Regime between 3
rd
and 4
th
regulatory period
Table 11. Stability and Predictability of Regulatory Regime from 3
rd
to 4
th
regulatory
period
Factor Weight 3
rd
regulatory
period
4
th
regulatory period
(August 2013)
Stability and Predictability
of Regulatory Regime
15% Aa A Ba B
Source: Frontier based on Moodys methodology
We note that EROs actions may be classified as a
non consistent application of the regulatory framework for the 3
rd

regulatory period; or even a
significant change compared to the 3
rd
regulatory period.
This implies a downgrading on Stability and Predictability of Regulatory Regime from
Aa-A to Ba-B with regard to the 4
th
regulatory period. Given the value of the
weights assigned to this metric, we expect an adverse effect on the overall credit
ratings of the gas distribution companies and hence, an impact on the cost of
capital.
5.2 Cost and Investment Recovery and Revenue
Risk
In the following we will discuss the potential impact on Cost and Investment Recovery
and Revenue Risk between the 3
rd
regulatory period and the August 2009 proposal
for the 4
th
regulatory period (Table 12). When assessing the impact on risk, we
differentiate if the adjustment has a
direct impact on Cost and Investment Recovery and Revenue Risk;
indirect impact on Cost and Investment Recovery by deteriorating key credit
metrics which feed into higher cost of capital.
We refer to Section 5.3 for the discussion on the cost recovery with regard to
the cost of capital.
5.2.1 Frontiers assessment Cost and Investment Recovery and
Revenue Risk with potential for downgrade in 4
th
regulatory period
Table 12 illustrates the main regulatory parameters and the proposed changes
between 3
rd
and 4
th
regulatory period.


Table 12. Regulatory components CZ gas distribution companies
Regulatory
component
3
rd
regulatory period 4
th
regulatory period Impact on rating
Type of regulation Revenue cap regulation (restricted) Revenue
cap regulation
Potential adverse
direct impact
depending on design of
network utilisation factor
Length of price
control
5 years 5 years No impact expected
Opex Average 2007-2008
Annual adjustment by
inflation factor plus
market service index
and efficiency factor
Economically
substantiated costs
Exclusion/decreasing of
profit margins from
intra-group service level
agreements
Adjustment for
extraordinary or non-
standard costs
Possibility to
retroactively decrease
the allowed OPEX basis
based on ERO cost
inspections even during
the period
Potential adverse
direct impact
RAB In principle based on
historic costs with the
partial revaluation step-
up and slower RAB
depreciation
In principle based on
historic costs fully
depreciated by allowed
depreciation including
the Network
obsolescence factor
Claw-back of the former
revaluation step-up
Potential adverse
indirect impact via Key
credit metrics (see
Section 5.2.2)
Depreciation Based on revaluated
assets
Based on non-
revaluated assets and
split between old and
new RAB
Accelerated
depreciation on old
RAB
Network obsolescence
factor included as an
tool for depreciation
enhancement
Investment fund
introduced as an
retroactive measure to
decrease depreciation
until the previous
depreciation to
investment gap is
compensated via new
Potential adverse
indirect impact via Key
credit metrics (see
Section 5.2.2)


investment spendings
Investment Planned investments
rolled into RAB with
later
correction/adjustment to
actuals
Outturn investments
rolled into RAB with t-2
time lag, later
compensation via a
correction factor with a
special interest rate

No impact expected
Efficiency analysis /
Network utilisation
factor
No explicit efficiency
analysis
Possible retrospective
efficiency assessment
of operating
expenditures
Possible efficiency
assessment of network
utilization with possible
ERO intervention to
whole allowed revenue
setting
45

Potential adverse
direct impact
losses
Planned costs and
quantitiy with ex post
correction
Price for losses
determined by tendering
procedure conducted
according to the Public
Procurement Act
Quantity derived from 5
years average for
2014-2016 average
from 2007-2011. For
2017-2018 average
from 2009-2013
No correction ex post
Potential adverse
direct impact
Incentives Cost targets for opex by
X-factor
Cost targets for opex by
X-factor but level not yet
presented

No impact expected
Source: Frontier
The revenue cap applied in the 3
rd
regulatory period can be classified as a
combination of
incentive regulation for operating expenditures;
cost plus regulation for capital costs; as well as
limited volume exposure.

45
Information from RWE Gasnet.


This regulatory approach is comparable to the one for gas distribution companies
in France described in Section 4.3.2 indicating a rating of at least A for Cost and
Investment Recovery and Aa for Revenue Risk.
In the following we discuss the proposed changes between the 3
rd
and 4
th

regulatory period which may have a direct impact on Cost and Investment Recovery
and Revenue Risk:
Network utilisation factor ERO (2013b) is vague on the design and
impact of the network utilisation factor. However, we note that the
specification of this factor may be crucial for companys risk with regard to
volume and stranded investments. For example, if the recovery for
investment costs depends in part on the utilisation of the physical
infrastructure then this will expose the gas distribution company to an
uncontrollable risk, which should be somewhere reflected in the cost of
capital. The same applies if the utilisation factor has an impact on the
volumes used to set tariffs.
Network losses The cost for network losses is a substantial part of
operating expenditures. ERO (2013b) proposed a change in how the costs
for network losses are calculated. The price of gas to cover losses and own
technological consumption will result from tendering procedure conducted
according to the Public Procurement Act. ERO will establish criteria for
candidate eligibility and tender conditions so as to ensure transparency and
will monitor the procedure. We understand that ERO will accept outturn
prices from this tender process as reasonable. However, the detailed
specification from ERO on the tender process is still pending. With regard
to the quantity for losses ERO proposes to use 5-years averages to
determine the reasonable amount. ERO refers for 2014-2016 on the average
from 2007-2011 and then recalculated the quantities for 2017-2018 from the
average for 2009-2013. We understand that ERO will apply the recalculated
quantities for 2017-2018 even if they are higher. In contrast to the 3
rd

regulatory period no ex post correction for network loss price is applied.
Opex assessment ERO proposes efficiency assessments for operating
costs. These assessments can take place when setting allowed costs at the
beginning of the 4
th
regulatory period. In addition, ERO states that such
assessments will also be undertaken during the regulatory period. If ERO
detects inefficiencies, ERO will reduce cost accordingly (and also
retrospectively). In particular, the planned efficiency assessment during the
regulatory period is critical. For example, if companies are on or even below
the ex ante fixed cost path, this does not guarantee cost recovery, because
ERO may assess the cost ex post as inefficient.


We conclude that there are various factors having a potential adverse direct
impact on the Cost and Investment Recovery and Revenue Risk. The main
impact stems from the Network utilisation factor, where the specification and
application is still pending. We note that the Network utilisation factor
depending on its final specification may induce even a sharp downgrade due to
asset stranding and/or high exposure to volume risk. In addition, the new
mechanism for network losses may have an adverse impact, as well, if ERO is
reluctant on increasing network losses. As long as this is still an unresolved issue
we make the assumption that the new parameter will slightly increase the risk of
cost recovery and the revenue risk resulting in a small downgrade compared to
the 3
rd
regulatory period. Finally, the efficiency assessment of operating
expenditure which allows a retrospective reduction of costs may jeopardize cost
recovery.
Table 13. Cost and Investment Recovery and Revenue Risk from 3
rd
to 4
th

regulatory period
Factor Weight 3
rd
regulatory
period
4
th
regulatory period
(August 2013)
Cost and Investment
Recovery
10% A Baa-Ba
Revenue Risk 5% Aa A-Baa
th
regulatory period reversal of asset
valuation puts key credit metrics at risk
Moodys explicitly rewards measures which increase the cash inflow for regulated
companies with a higher credit rating as these measures will have a positive effect
for example on adjusted Interest Coverage Ratio (adjICR) and Retained Cash
Flow/Capex (RCF/Capex). Moodys values the financial flexibility enjoyed by
regulated network companies to fund investment generated by internal cash
flows
46
.
The asset revaluation applied by ERO in the 3
rd
regulatory period provided
regulated companies with higher cash inflow by revaluated depreciation and
incremental cost of capital on the RAB step-up. In addition, the depreciation
rules applied to the RAB indicated a transition phase to increase the RAB to the

46
Such a company would not need to access the markets to raise additional finance and may have a
wider range of options to react to changing regulatory assumptions (e.g. reduction in the cost of
capital allowed). (Moodys, 2009: 19)


revaluated asset figure. Hence, internal cash flow generation should be kept at
constant rates in the long-term.
The proposed reversal of asset revaluation and the calculation of depreciation
based on the lower historic cost value will reduce cash inflows from deprecation
in the 4
th
regulatory period. In addition the reversal of the RAB step-up will
reduce the cash-inflow from the incremental cost of capital on the RAB step-up.
Hence, ceteris paribus this will have an adverse impact on the credit metrics, adjICR
and RCF/Capex.
However, ERO (2013b) explicitly states the objective of securing sufficient
source of liquidity for regulated companies to ensure that they have the capacity
to finance the investments required. As opposed to the proposal in March 2013,
where the reversal of asset revaluation was first proposed, ERO (2013b) includes
some measures to mitigate the cash impact.
ERO (2013b) proposes to split the RAB into an old and new RAB
with different depreciation rules. Depreciation for the old RAB is
based on the residual lifetime of the assets. We understand from RWE
Gasnet that a target value of around 10 years is planned. Hence, there is
a mitigating impact by accelerating depreciation on the old RAB,
which may close or narrow the gap between depreciation before and
after reversal of asset revaluation. We can not assess the size of this
effect. However, we note that accelerated depreciation tends to be a
short term solution to a long term investment problem, as an eroded
old RAB in around 10 years will trigger refinancing risks in the future
and will induce necessary regulatory actions in the near future again. To
say it in other words: ERO does not solve the problem, but only shifts
the problem to the future.
Another proposed instrument by ERO to mitigate the cash impact from
lower depreciation is the Network obsolescence factor. The factor
provides companies with additional cash inflows based on their
replacement needs. However, as mentioned above the detailed
specification is still pending. In addition, the statement from ERO on
the evaluation of the functioning of the Network obsolescence factor
and the possibility to abolish the factor is rather vague. This may
jeopardize the expected positive effect on the planning security for
investments again.
On the other hand, the proposed Investment fund has the potential
when first implemented to partly reverse the cash impact from
accelerated depreciation and the Network obsolescence factor. Hence,
at the beginning of the 4
th
regulatory period companies may be
confronted with a deterioration of cash flows.


We conclude that the impact on Moodys key credit metric like adjICR and
RCF/Capex

depends on the interaction between cash reducing and cash
increasing parameters proposed for the 4
th
regulatory period, where the outcome
is yet unclear. However, we would at least expect a slight downward pressure on
the credits metrics compared to the 3
rd
regulatory period. In addition, the long-
term stability of the proposed regulatory framework may be at risk due to the fast
eroding old RAB from accelerated depreciation resulting in long-term
financing problems.
5.3 WACC Cost recovery for cost of capital at risk
The cost of capital represents the minimum rate of return companies must pay in
order to attract capital from investors. Regulatory allowances of the cost of
capital aim to ensure that the firm can cover its expected financing needs. In this
section we analyse if the current WACC proposal by ERO allows cost recovery
for cost of equity and debt.
In order to assess if the current WACC proposal covers the risks borne by
investors in the Czech gas distribution sector it is necessary to compare the risks
faced by companies between the 3
rd
and 4
th
regulatory period.
In the following we discuss
the WACC applied and proposed by ERO for gas distribution
companies for the 3
rd
and 4
th
regulatory period;
the overall development of risk faced by the companies between the 3
rd

and 4
th
regulatory period; and
the likely impact on the cost of equity and cost of debt.


5.3.1 WACC 3
rd
and 4
th
regulatory period
Table 14. WACC 3
rd
to 4
th
regulatory period
3
rd
regulatory
period (first year)
4
th
regulatory
period (March
2013)
4
th
regulatory
period (August
2013)
Risk-free rate 4.60% 4.49% 4.49%
Asset beta (unlevered) 0.40 0.50 0.35
Equity beta (levered) 0.62 0.674 0.54
Equity Risk Premium 6.40% 6.09% 6.09%
Cost of equity (post
tax)
8.54% 8.59% 7.77%
Debt premium
(implicit)*
0.31% 0.23% 0.23%
Cost of Debt (pre tax) 4.91% 4.72% 4.72%
Gearing 40% 30% 40%
Tax rate 19% 19% 19%
WACC (post-tax) 6.72% 7.16% 6.19%
WACC (pre-tax) 8.29% 8.84% 7.65%
*Debt premium (implicit) ERO determines the cost of debt by referring to a total cost of debt figure. We
calculate the implicit Debt premium by Cost of Debt minus Risk-free rate.
Table 14 illustrates the components of the WACC used in the first year of the 3
rd

regulatory period
47
and EROs proposals for the 4
th
regulatory period.
The WACC proposal of ERO differed between March and August 2013. ERO
argued that the new measures proposed in August 2013, e.g. the Network
obsolescence factor, reduced the risk of the companies compared to March 2013
indicating a reduction in the cost of capital. As a result ERO decreased the
asset beta from 0.50 to 0.35 (which is below the value used in the 3
rd

regulatory period set at 0.40); and

47
The WACC is annually adjusted during the 3
rd
regulatory period with regard to the risk-free rate and
the cost of debt, while the asset beta and gearing is fixed. However, we note that the following
arguments are not affected by this rolling adjustment.


increased the notional debt share from 30% to 40%.
The current WACC proposal is lower than the WACC for the 3
rd
regulatory
period (as opposed to the value in March 2013), as well.
5.3.2 Increase in risk between 3
rd
and 4
th
regulatory period faced by gas
distribution companies
Based on the discussion in Section 5.1 and 5.2 with regard to Moodys rating
factors there are strong indications that the risk faced by gas distribution
companies increased between the 3
rd
and 4
th
regulatory period due to
increased uncertainty on Stability and Predictability of Regulatory Regime; and
new proposed regulatory parameters which are yet unspecified and may
have an adverse effect on Cost and Investment Recovery and Revenue Risk.
In addition, we assessed a potential adverse effect on selected Moodys key credit
metrics, Adjusted Interest Coverage Rate and Retained Cash Flow/Capex.
Table 15. Frontiers assessment Rating factors from 3
rd
to 4
th
regulatory period
Factor Weight 3
rd
regulatory
period
4
th
regulatory period
(August 2013)
Stability and Predictability
of Regulatory Regime
15% Aa A Ba B
Cost and Investment
Recovery
10% A Baa-Ba
Revenue Risk 5% Aa A-Baa
adjICR 15% Potential
downgrading
pressure RCF/Capex 5%
As the factors illustrated in Table 15 sum up to 50% for the relevant factors used
by Moodys a downward impact on the credit rating should be expected feeding
into the
cost of equity by an increase in the beta; and
cost of debt by an increase in the debt premium.


5.3.3 Cost of equity equity (asset) beta from 3
rd
regulatory period plus
mark-up for increased risk
ERO (2013b) does not include a description how the WACC parameters and in
particular the asset beta of 0.35 used to calculate the equity beta of 0.54 are
determined. In the following we rely on the description from March 2013 set out
in ERO (2013a).
ERO proposes to set the WACC parameters in such a way that the WACC is not
affected by the expansionary monetary policy in the years 2010 to 2013. Hence,
ERO specifies the relevant period for setting the parameters, including the asset
beta, with 2005-2009. As opposed to the 3
rd
regulatory period ERO calculated
the asset beta in March 2013 on a peer-group using vertically integrated energy
companies instead of network companies. Due to the higher risk of vertically
integrated companies this results per se in a higher asset beta of 0.5.
Unfortunately, ERO does not explicitly state the asset beta for pure network
companies based on 2005-2009 data.
However, the decision for the 3
rd
regulatory period may serve as an indication for
the respective asset beta for gas network companies for the period 2005-2009.
ERO (2009) used data published by Reuters from December 2008 on 20 month
asset beta for European gas transmission and distribution companies. This
resulted in an average asset beta of 0.37. In addition, ERO compared asset betas
used by European regulators to assess the appropriate level, which resulted in an
average beta for gas distribution companies of 0.39. As a result, ERO set the
asset beta for the gas distribution companies at 0.40 for the 3
rd
regulatory period.
This implies that the asset beta of 0.35 in ERO (2013b) and the resulting equity
beta of 0.54 may be too low because
ERO states that 2005-2009 should be the relevant time period for
setting the WACC parameters. This means that the asset beta used in
the 3
rd
regulatory period may serve as a good indication for the market
circumstances in the time period 2005-2009. The respective asset beta
was 0.40; and
the risk faced by equity investors increased in the last years. This should
impact the beta, at least by the share of the additional risk which is not
diversifiable.
We conclude that the asset beta of 0.40 and the resulting equity beta of 0.62 used
in the 3
rd
regulatory period should be used as starting point for the 4
th
regulatory
period.
In order to allow cost recovery a mark-up on this value covering the increased
risk between the 3
rd
and 4
th
regulatory period should be applied. The upper range
of the beta including the mark-up may be derived from the asset beta from ERO
(2013a). This asset beta of 0.50 was derived from integrated energy companies


reflecting a systematically higher risk than pure network companies. The lower
range may be simply derived from the average of 0.40 and 0.50.
This implies an asset (equity) beta in the range of 0.45 to 0.50 (0.69 to 0.77)
for the 4
th
regulatory period. This reflects the fact that the risk for gas distribution
companies has not decreased since 2010 (in contrast the risk actually increased).
A lower value may put Cost and Investment Recovery for the cost of equity at risk.
5.3.4 Cost of debt short term debt in contrast to long-term commitment for
network investments
ERO does not calculate the cost of debt by using the risk-free rate plus a debt
premium. Instead ERO uses data from the Czech National bank, namely the
interest rates provided to non-financial companies in excess of CZK 30 Mio. and
fixed for one to five years. In the 3
rd
regulatory period ERO adjusted the cost of
debt annually based on the one year average of the respective interest rate. For
the 4
th
regulatory period ERO proposes to fix the cost of debt for the whole
period and the monthly averages in the years 2005 to 2009 will be used.
ERO specifies the relevant period for setting the cost of debt with 2005-2009, as
well. Hence, the market environment relevant for determining the cost of debt
for the 3
rd
and 4
th
regulatory period tends to cover a similar time period. The
(implicit) debt premium decreases from 0.31% to 0.23% in the 4
th
regulatory
period indicating a reduction in the risk faced by debt holders. However, this
contradicts the likely downward pressure on the credit rating due to increasing
risks.
Hence, the same argument as for the beta applies. As the risk for the gas
distribution companies did not decrease the (implicit) debt premium of 0.31%
should be used as a starting point for the debt premium in the 4
th
regulatory
period. In line with the cost of equity a mark-up on the debt premium is
necessary, as well, covering the increased risk between the 3
rd
and 4
th
regulatory
period. In the following we discuss the potential range of this debt premium.
In Section 4.1.3 we discussed that Ofgem is using a total figure for the cost of
debt, as well. However, to reflect the long-term character of investments into
energy networks Ofgem uses two corporate bonds indices with a maturity
exceeding 10 years. Using corporate bonds with a maturity around 10 years is
also in line with the calculation of the debt premium in France. Other European
countries are using similar approaches, e.g. Netherlands, Austria.
For the first year in RIIO-GD1 this implies an implicit debt premium of 0.90%
which is substantially above the implicit value applied (0.31%) and proposed
(0.23%) by ERO. The difference is mainly driven by the unusual application of
short-term interest rates (1-5 years) by ERO when setting the allowed cost of
debt.


Using short-term interest rates to determine the cost of debt seems to be a CZ
specific feature. However, we understand from RWE Gasnet that the application
of the short-term interest rate must be seen in a historic perspective. It was part
of a regulatory package for the 3
rd
regulatory period agreed between ERO and
the companies which included
allowed depreciation based on revaluated assets; and
cost of debt based on short-term interest rates.
However, we note that assuming no regulatory package in place, the cost of
debt should be set based on long-term interest rates in line with European best
practice. Using relevant market data around 2009 allows to proxy an appropriate
cost of debt for the 3
rd
and 4
th
regulatory period based on the respective
risk free rate; plus
debt premium.
OXERA (2011)
48
calculated debt premiums for 2009 in the range of 0.70% to
1.30% based on traded bonds from energy companies with a maturity of around
ten years and a credit rating of or close to A.
Given the risk-free rates applied for the 3
rd
and proposed for the 4
th
regulatory
period, this implies a long-term cost of debt for the
3
rd
regulatory period in the range of 5.30% to 5.90%; as well as
4
th
regulatory period in the range of 5.19% to 5.79%.
We conclude that the way how ERO currently determines the cost of debt based
on a short-term interest rate is in contrast with the long-term investment horizon
for networks and European regulators best practice. Hence, the overall level of
the regulatory cost of debt is below the market cost of debt indicating
a debt premium substantially above the proposed 0.23% in the range of
0.70% to 1.30% in order to allow cost recovery for cost of debt.
In addition, ERO may consider including cost of raising debt in the debt
premium. In particular, if companies can expect increasing need of new debt due
to rising investments in the future. OXERA (2011)
49
showed debt issuance costs
for 2009 in the range of 0.10% to 0.20%.

48
OXERA, Cost of capital for GTS: annual estimates from 2006 onwards, Report prepared for NMa,
May 2011.
49
OXERA, Cost of capital for GTS: annual estimates from 2006 onwards, Report prepared for NMa,
May 2011.


5.4 Key findings Regulation and Risk for CZ gas
distribution companies
EROs actions and the draft regulatory framework from August 2013 may
be classified as a non-consistent application of the regulatory framework
for the 3
rd
regulatory period and significant change compared to the 3
rd

regulatory period.
This in addition with other factors indicates an increase in the risk faced by
gas distribution companies compared to the 3
rd
regulatory period in 2010.
The level for asset (equity) beta and debt premium of the 4
th
regulatory
period should be above the figures used in the 3
rd
regulatory period.
Cost recovery for equity investors in the 4
th
regulatory period implies a
range for the asset (equity) beta of 0.45 to 0.50 (0.69 to 0.77).
Cost recovery for debt investors implies switching to longer term interest
rates in line with European best practice, which results in a substantial
higher debt premium in the range of 0.70% to 1.30% compared to the
proposed premium proposed for the 4
th
regulatory period.
In addition, ERO may consider including cost of raising debt in the debt
premium in the range of 0.10% to 0.20%. In particular, if companies can
expect increasing need of new debt due to rising investments in the future.
Adjusted beta and debt premium are in line with respective values in UK,
Germany and France, which have higher ratings in particular with regard
to Stability and Predictability of Regulatory Regime.


Conclusion

6 Conclusion
Our analysis finds that EROs actions during the 3
rd
regulatory period and the
draft proposal for the 4
th
regulatory period issued on August 2013 has affected
the stability of the investment and regulatory climate for CZ energy network
companies.
We conclude that this resulted in an increase in the risk faced by gas distribution
companies compared to the start of the 3
rd
regulatory period in 2010. In order to
allow cost recovery for the cost of capital the relevant parameters through which
this increased risk flows into the WACC beta and debt premium should
follow the principles outlined below.
Cost of equity The level of the asset (equity) beta from the 3
rd
regulatory
period should serve as the starting point for the 4
th
regulatory period. In
order to allow cost recovery a mark-up on this value covering the increased
risk between the 3
rd
and 4
th
regulatory period should be applied. This implies
an asset (equity) beta in the range of 0.45 to 0.50 (0.69 to 0.77) for the
4
th
regulatory period. Compared with the respective values for UK, Germany
and France and taking into account the higher rating in particular for the
important factor Stability and Predictability of Regulatory Regime in all
three countries this lower bound seems to be a reasonable risk adjusted asset
beta and equity beta (Table 16) taking into account the lower notional
gearing (40%) proposed by ERO compared with UK (65%), Germany
(60%) and France (50%).
Cost of debt The risk faced by debt investors between the 3
rd
and 4
th

regulatory period did not decrease (in contrary the risk increased). This
implies that the implicit debt premium from the 3
rd
regulatory period should
serve as the starting point for the 4
th
regulatory period. However, we further
identified a systematic problem in the way ERO currently determines the
cost of debt. ERO sets the cost of debt based on a short-term interest rate
(1-5years) which is in contrast with the longer term financing and investment
horizon for networks and European regulators best practice (substantially
above 5 years). Hence, the overall level of the regulatory cost of debt
may be substantially below market cost of debt. Hence, the
adjustment of the debt premium should reflect the switch from a short-term
to a longer-term interest rate. This results in a substantial higher debt
premium in the range of 0.70% to 1.30%, which is more in line with the
respective values used in UK and France. In addition, ERO should consider
including cost of raising debt in the debt premium in the range of 0.10% to
0.20% (Table 16).

Conclusion

3
rd
reg- period
(2010-2014)
4
th
reg-period
(Aug 2013)
UK
(2013-21)
Germany
(2013-17)
France
(2012-15)
Stability and
Predictability of
Regulatory Regime
Aa A * Ba B* Aaa** A** Aa**
Cost and Investment
Recovery
A* Baa-Ba* A** Baa** A**
Revenue Risk Aa* A-Baa* Aaa** A** Aa**
adjICR and RCF/Capex Potential
downward
pressure*
- - -
Asset beta 0.40 0.35 0.38 0.39 0.46
Equity beta 0.62 0.54 0.9 0.79 0.76
Debt premium (implicit) 0.31% 0.23% 0.90% na 0.60%
Frontier adjustments 3
rd
reg- period
(2010-2014)
4
th
reg-period
(Aug 2013)

Asset beta
(risk adjusted)
0.45 0.50
Equity beta
(risk adjusted)
0.69 0.77
Debt premium
(longer term interest rate)
0.70% - 1.30% 0.70% - 1.30%
Cost of raising debt 0.10% - 0.20%

Source: Frontier based on Moodys methodology, Moodys
* Assessment by Frontier
** Assessment by Moodys
Provided that ERO still insisted in changing the regulatory framework in the 4
th

regulatory period in particular with regard to the reversal of asset revaluation then
at least ERO should adopt a more refined logic that explicitly considers the
following principles:
Avoidance of retrospective interventions Regulators and regulated
companies play a repeated interaction game, coming together periodically to
agree new cost allowances and incentive mechanisms that will apply for the
next period. But the more scope a regulator gives itself to revisit parameters
and change the rules of the game after the event, the more clouded the
networks effort/reward trade-off becomes, and the more uncertain

Conclusion

investors are of their expected return. Regulators credibility is therefore key:
this also includes that retrospective interventions shall be avoided.
Specification of regulatory framework The current ERO proposal for
the 4
th
regulatory period introduces various new regulatory changes and
regulatory instruments, e.g. the Network utilisation factor. However, there is
a low degree of specification which hampers companies to assess the specific
impact on their costs and/or revenues. In order to increase predictability for
companies and also investors a detailed description which can be translated
into companies business plans should be provided by ERO as soon as
possible.
Transparent decision rules In order to maximise the regulatory
commitment and stability, ERO should base any new measure announced in
the decision for the 4
th
regulatory period on transparent decisions rules,
which are known to the regulated companies ex ante. This means that the
regulated companies must know in advance, which behaviour will induce
measures by ERO. For example, this refers to the announced audits on the
efficient utilisation of funds from the Network obsolescence factor.


References

7 References
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Utilities Fortnightly, February 26 1989, pp. 36-9.
Burkhard, Regulatory risk and the cost of capital. Determinants and implications for
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Competition Commission, Phoenix Natural Gas Limited price determination,
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CRE, CREs tariff proposal of 28 February 2008 for use of public natural gas
distribution networks, 2008.
CRE, Deliberation of the French Energy Regulatory Commission of 28 February 2012
forming a decision on the equalised tariff for use of GrDF public natural gas distribution
networks, 2012.
Dubin, J., A., and Navarro, P., Regulatory climate and the cost of capital In:
regulatory reform and public utilities, ed. By Michael A. Crew,
Boston/Dordrecht/London 1982, 141-66.
ERO (2009), Final Report of the Energy Regulatory Office on the regulatory
methodology for the third regulatory period, including the key parameters of the regulatory
formula and pricing in the electricity and gas industries, p 16, December 2009
ERO (2013a), METODIKA REGULACE IV. REGULANHO OBDOB
PRO ODVTV PLYNRENSTV, March 2013.
ERO (2013b), AKTUALIZOVAN: METODIKA REGULACE IV.
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2013.
Frontier Economics (2008), Ermittlung des Zuschlages zur Abdeckung
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Bundesnetzagentur, 2008.
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Zuschlages zur Abdeckung netzbetriebsspezifischer unternehmerischer Wagnisse im
Bereich Gas, Report for Bundesnetzagentur, 2011.
Gandolfi, Jenkinson and Mayer, 1996. Regulation and the cost of capital, Working
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References

Guthrie, G. (2006), Regulating infrastructure: the impact of risk and
investment, Journal of Economic Literature XLIV, 925972.
Moodys Investors Service, Rating Methodology Regulated Electric and Gas
Networks, 2009.
Moodys (2010), RPI-X@20: A Welcome Review of the UK Regulatory Framework
but a Step Change Could Raise Credit Risk, Special Comment, June 2010.
Moodys (2013), UK Gas Distribution Networks: Transition to RIIO Is Credit
Neutral, Special Comment, August 2013.
Moodys, Credit Opinion: HSE Netz AG, August 2013
Moodys, Credit Opinion: TIGF SA, August 2013.
Ofgem, RIIO Handbook, 2010.
Parker, D. (2003), Performance, risk and strategy in privatised, regulated
industries: The UKs experience, International Journal of Public Sector
Management 16(1), 75 100.
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investment values. Public Utilities Fortnightly, November 22 1979, pp.28-
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Wright, S., Mason, R., Miles, D. (2003), A study into certain aspects of the
cost of capital for regulated utilities in the U.K., a Smith & Co. Ltd. report to
the OFT and U.K. economic regulators.


References

Frontier Economics Limited in Europe is a member of the Frontier Economics network, which
consists of separate companies based in Europe (Brussels, Cologne, London & Madrid) and Australia
(Melbourne & Sydney). The companies are independently owned, and legal commitments entered
into by any one company do not impose any obligations on other companies in the network. All
views expressed in this document are the views of Frontier Economics Limited.

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Frontier Economics Ltd 71 High Holborn London WC1V 6DA
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