Investor Guide

UK Regulated Infrastructure
An Investor Guide
December 2014
UK Regulators Network
Prepared by:
AVIATION ENERGY RAIL TELECOMS WATER

CONTENTS
FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . .......................................................... 3
EXECUTIVE SUMMARY . . . . . . . . . . . . .......................................................... 5

1 Introduction . . . . . . . . . . . . . . . . . . . . . .......................................................... 9
2 Market overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2. 1 Characteristics of UK regulated infrastructure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2 Sector overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2. 1 Aviation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2.2 Energy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2.3 Rail.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.2.4 Telecommunications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2.5 Water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.3 Private sector investment and delivery. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.4 Significant opportunities for investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4. 1 Current issues and trends: priorities and pipeline. . . . . . . . . . . . . . . . . . . . . . . . . 25
2.5 Investment entry and exit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.5. 1 Routes to investment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.5.2 Exiting the market and consolidation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3 Regulatory framework. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3. 1 Laws, licences and regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
3.1. 1 Government policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.1.2 Legislation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.1.3 Regulation and regulatory independence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.1.4 Concurrent powers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2 Companies and investors’ rights and obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2.1 Conditions of the licence.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.2.2 licence obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.2.3 Investor rights and expectations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4 Regulatory practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4. 1 Objectives and principles of UK economic regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4.1. 1 Consumer protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4.1.2 Key features of UK economic regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4.1.3 Incentives-based regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
4.1.4 Principles of returns of and on invested capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.2 Regulated cash flows and revenue building blocks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
4.3 Sector-specific regulations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.4 Aviation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.4. 1 Industry structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4.4.2 Legislation, regulation and licences. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
4.4.3 Regulation in practice and risk & reward. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
4.5 Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.5.3 Regulation in practice and risk & reward. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.6 Rail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
4.7 Telecommunications. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.8 Water . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5 Frequently asked questions. . . . . .......................................................... 61
FURTHER INFORMATION
Links to further information. . . . . . . . . . ......................................................... 65
GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
UK regulated infrastructure industries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Notice: about this guide.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
EXECUTIVE SUMMARY 5
1. Introduction 9
2. Market overview 13
3. Regulatory framework 29
4. Regulatory practice 39
5. Frequently asked questions 61
FURTHER INFORMATION 65
GLOSSARY 67
CAA’s economic regulation work is focused on improving choice

and value for aviation consumers now and in the future by
promoting competitive markets, contributing to consumers’ ability
to make informed decisions and protecting them where appropriate.
Ofgem is committed to making a positive difference for energy

consumers by ensuring Britain’s wholesale and retail energy
markets are competitive and by regulating the natural monopolies
that exist in distribution and transmission networks.
ORR’s role is to ensure the rail network operates safely, reliably

and provides value for taxpayers and customers.
Ofcom is committed to a thriving communications sector where

companies can compete fairly and businesses and customers
benefit from the choice of a broad range of services.
Ofwat’s job is to make sure that water companies provide

consumers with a good quality service at a fair price.
The Utility Regulator is responsible for regulating the electricity,

gas, water and sewerage industries in Northern Ireland,
promoting the short- and long-term interests of consumers.
2 UK REGULATED UTILITIES | AN INVESTOR

INFRASTRUCTURE GUIDE
| AN INVESTOR GUIDE
FOREWORD
For over 25 years, regulated utilities in the UK have attracted investment from
around the world to build and maintain our essential infrastructure and to ensure the
provision of vital services. The role of independent economic regulation, designed
to protect the interests of consumers whilst providing a clear and transparent
regulatory framework for investments, has been key to that success.
Utility sectors in the UK, supported by our standard-setting regulatory regimes,

have been viewed as models for other countries. But they are subject to changing
requirements with an evolving economic and social context and significant levels of
new investment required. The financial landscape is also evolving, with a more diverse and widely spread
investor base interested in investing in the UK.
In 2014, the economic regulators in the UK came together to form the UK Regulators Network (UKRN). It
comprises, amongst others, economic regulators for the energy, water and wastewater, aviation, rail and
telecommunications sectors. Its objectives include the maintenance of a positive environment for continued
investment, which across these sectors is expected to exceed £100 billion in the next five years alone.
The UKRN decided that one of its first activities in coming together should be to maximise transparency of
how these regulated sectors operate and summarise the range of information that might be relevant to both
new and existing investors in considering and managing investments. We therefore commissioned this
independent investor guide to regulated infrastructure.
Through the eyes of expert, independent advisers, this guide is intended to provide an easily accessible,
high-level overview of regulated utilities’ infrastructure in the UK, the key characteristics common across
sectors, and the main elements of associated economic regulation, as applied by sector regulators, that
are of interest to investors. The guide also sets out the ways in which investors may ordinarily access the
sectors as well as presenting some of their key rights and obligations.
The guide is not a statement of regulatory policy current or future and is not intended to provide a
comprehensive description of all forms of regulation or to cover all segments of the regulated infrastructure
sector – it is an introduction with suggestions for further reading. Since regulated utilities differ from each
other across sectors, sometimes in a material way, this guide makes certain simplifications about the
details of the regulatory regime in each case to achieve greater transparency. In particular, it is mostly
focussed on investments in infrastructure subject to economic regulation. There is substantial variation
between sectors in the extent to which infrastructure is subject to economic regulation: in some sectors
where there is a high degree of competition large parts of infrastructure investment are unregulated.
As part of an ongoing process of engaging with investors and looking at key cross-regulatory aspects, our
wider UKRN work programme will also be looking at cost of capital. This work will consider the potential
for, and approaches to, a common framework across sectors.
We recognise that the views of regulators and investors will not always be aligned, particularly during the
challenges brought by economic and financial downturn. However, this in itself reinforces the importance
of an independent and transparent overview of how UK regulated sectors work in general, the fundamental
principles underpinning market regimes in these sectors and how regulators seek to deliver positive
outcomes for consumers.
We hope you find this investment guide to be a valuable reference document. Regulation in the UK has an
enviable track record that has delivered significant benefits for consumers, but we know that it must remain
attractive to secure the investment required to meet our infrastructure needs, and consumers’ expectations
on quality and value for money. We believe that engaging fully and openly with investors will maintain a
positive climate for investment and help ensure we deliver best-value outcomes for UK consumers.
Richard Price, Chair UK Regulators Network
UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 3

ABOUT UKRN
The UK’s economic regulators have joined together in the UK Regulators

Network (UKRN) to ensure effective cooperation between sectors. UKRN
will strengthen work across sectors without cutting across the independence
or specific goals of each regulator. It will explain and take account of the
differences between sectors, while maximising coherence and shared
approaches in the interests of consumers and the economy.
ABOUT THE AUTHORS
KPMG LLP is a leading provider of professional services including advisory,

audit and tax consulting services across a range of clients and industries.
KPMG’s specialists in regulated infrastructure provide advice to investors,
companies and the public sector on financial, regulatory, operational and
economic issues, including competition, corporate finance, modelling, and
regulatory strategy advice.
EXECUTIVE SUMMARY
This concise Investor Guide to UK
Regulated Infrastructure aims to help potential
and existing investors understand, at a high level,
the nature of the assets and activities involved, how
the market and regulatory regimes are set up and
how they function in practice, based on underlying
economic principles, market observations
and their track record to date.
6 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
EXECUTIVE SUMMARY
Open and mature private market companies), fixed income securities, Incentives for outperformance and
for essential public services primary market offerings and financing efficiency, risks and rewards shared
The wave of privatisations in the 1980s of specific project developments. These with customers
and 1990s in the UK brought to the multiple options for entry and exposure At its core, the UK regulatory model for
market for the first time a new asset to the sectors are matched by the wide assets and services is an incentives-
class – regulated infrastructure companies variety of financial structures adopted in based regime, designed to promote
providing essential public services across the market, which is enabled by an active efficient performance while improving
a range of sectors, including energy, and liquid secondary market. customer service quality levels. Most
water and wastewater, aviation, rail infrastructure regulation contains
and telecommunications. Since then, Regulation driven by consistent transparent mechanisms to encourage
the companies, markets and regulatory application of core principles efficiency of investment and delivery with
regimes in these sectors have developed Developments in technology, society additional, well-defined rewards for strong
into the mature environment of UK and business requirements have driven performance and penalties for failure to
regulated infrastructure, with exposure a continuous evolution in regulated meet the required standards. If companies
to these assets keenly sought by both infrastructure, but the core principles outperform the targets set up front, they
domestic and international investors. of successful regulation in the sectors are allowed to keep some gains from
have remained the same. Central to this outperformance alongside sharing
Significant opportunities for these principles and the successes of UK them with customers. Regulators aim to
investment regulated infrastructure to date is fulfilling allocate risk to companies where they and
There has been a very significant inflow the objective of protecting customers their investors are best placed to manage
of private capital into the UK regulated through the application of regulation based that risk; this helps to provide the right
infrastructure sectors since privatisation on underlying values of transparency, incentives for efficient risk mitigation and
of almost half a trillion pounds, which independence and commerciality, which risk management.
allowed the large capital expenditure are designed to ensure efficient and
needed to renew and enhance assets and targeted regulation. There is recognition Transparent rules and extensive
improve services to customers. There is, that companies and investors should be engagement
however, a need for significant further able to recover their efficient costs and UK regulation is based on public
investment to ensure that the continued earn a reasonable return on the capital consultations prior to decisions.
supply of these services remains fit for employed, commensurate with the risks Interested parties can assess details
purpose, both now and in the future, faced when operating an efficient, well- of regulators’ approaches and can
and that policy objectives are met. The run company. respond to consultations and/or take
National Infrastructure Plan estimates part in stakeholder workshops to discuss
that more than £100 billion of investment Independence and oversight their views with the relevant regulator.
is required in the next five years alone Regulators in the UK are independent, Companies have recourse to a well-
across five infrastructure sectors subject non-political bodies, with significant defined appeals process in the event
to economic regulation, and that this sector expertise and specific regulatory of disagreement, which can include
investment need is expected to continue objectives in each sector. They have the reviews by both the judicial system and by
in the following decades. power, typically bestowed on them by independent competition authorities.
legislation, to control prices and corporate
Multiple routes to market available activities in order to protect consumers, This guide includes:
to investors prevent operators from exploiting §§ An overview of regulated
This demand for capital supported by market power and remedying other infrastructure markets in the UK
innovation and best-in-class management market failures. Their role is to simulate
competitive market conditions (where §§ Explanation of the legal aspects of the
presents a major business opportunity
necessary and appropriate) and enable regulatory framework and how they
and an investment requirement, which
efficient private delivery and investment operate in practice
is not time bound and can be fulfilled
through a number of channels. The ‘routes in these sectors, free from day-to-day §§ Drivers of investment needs in each of
to market’ include equity investment political interference. the five sectors
and ownership (in both private and listed

IN THIS SECTION
§§ What is the scope and remit of this

investor guide?
§§ What are the document’s

objectives, coverage and
limitations?
INTRODUCTION
EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
1. Introduction
The UK Regulators Network (UKRN) is committed to improving understanding of UK regulated

infrastructure and the environment for investment in the UK market to meet the expectations of
consumers. In this context, UKRN has commissioned KPMG to prepare this independent ‘Investor
Guide’ to help investors to navigate these sectors. The preparation of this guide comes against
a background of a large and growing investment pipeline, new opportunities for innovation, new
channels and types of financing as well as continued evolution of the regulatory environment with
the opening of some new segments of the regulated value chain to new entrants and competition.
This guide is intended to provide a high-level overview of regulated infrastructure

in the UK as well as a summary of the key information for those interested
in the operation of and investment in these sectors.
The guide is aimed principally at those who are relatively new to the sectors, but should be also of
interest to those already involved in different aspects of regulated infrastructure and want to learn
more about this market. Investors and analysts should find the guide particularly useful, but it is
designed to be accessible to any other party with a general interest in UK regulated infrastructure.
This document is not an investment prospectus, but is intended to help interested parties
understand the nature of the sectors as well as the principles and basic structures of economic
regulation applied to UK regulated infrastructure. The guide can be also used as a starting point for
exploring different market and regulatory regimes in more detail.
The regulated infrastructure covered in this guide includes the relevant segments of the aviation,
energy, rail, telecommunications, water, and wastewater sectors. It covers, therefore, sectors
regulated by the Civil Aviation Authority (CAA1), the Office of Gas and Electricity Markets (Ofgem 2),
the Office of Rail Regulation (ORR 3 ), the Office of Communications (Ofcom 4 ) and the Water
Services Regulation Authority (Ofwat 5 ). It is also relevant to the work of the Northern Ireland
Authority for Utility Regulation (NIAUR 6 ) and Water Industry Commission for Scotland (WICS7).
This guide focuses on the key parts of the value chain that are subject to economic regulation, i.e.
where operator charges or revenues are subject to approval by an independent regulatory authority.
In practice, this implies a focus on networks and other traditional, infrastructure-heavy parts of the
value chain, where, currently, normal market forces and competition tend to be either absent or
insufficient for ensuring efficient economic outcomes, and only covers the remainder of the value
chain at a high level. For some sectors, such as telecoms, greater parts of the value chain are open
to competition, which may mean that this only represents a part of the overall market and hence
only some investment needs and opportunities.
The guide is not a statement of policy or regulatory objectives and should not be relied upon as
a statement of future regulation or potential future evolution of these sectors—investors need to
form their own view of future risks and potential returns. It also does not replace other initiatives
carried out by regulators, companies and other stakeholders to enhance understanding of particular
sectors, but is intended to complement them. The guide does not discuss all forms of regulation
and in some places the presentation simplifies the actual situation to ensure greater accessibility.
This document is part of the wider programme of work being carried out by UKRN, which also
includes work on the cost of capital.
1 5
http://www.caa.co.uk/ http://www.ofwat.gov.uk/
2 6
https://www.ofgem.gov.uk/ http://www.uregni.gov.uk/
3 7
http://orr.gov.uk/ http://www.watercommission.co.uk/
4
http://www.ofcom.org.uk/

IN THIS SECTION
§§ What are the key characteristics

of UK regulated infrastructure?
§§ How is each sector structured

and which sub-sectors are
subject to economic regulation?
§§ What is the role of the private

sector in delivering these
services?
§§ What are the investment

opportunities and how can you
enter/exit the market?
MARKET OVERVIEW
EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
2. Market overview
to consumers. This infrastructure and payback periods on these investments

Regulated infrastructure networks often span national or regional are also long and require stable regimes,
geographies. regulatory frameworks or contracts that
Regulated infrastructure in the
investors can rely upon to be able to
UK is largely privately owned and After a long period of underinvestment,
recover efficient investments many years
has attracted significant amounts the public entities that operated the
after they originally committed their capital.
of private capital over the past 25 infrastructure necessary for providing
years. Broadly speaking, twice as essential services were privatised in the Network infrastructure, which represents
much capital has been invested UK. This predominantly took place during a significant part of economically
as has been paid back to investors the 1980s and 1990s, with the aim of regulated infrastructure, tends to exhibit
to date and significant amounts bringing in the necessary capital to renew economies of scale due to its sheer size
have been reinvested, resulting in and enhance existing assets, build new and the nature of the underlying assets.
a fundamental transformation of assets, improve efficiency of operations There is also no economic case for
the regulated infrastructure sector and provide better service, and better duplication of most of these networks
assets and operations. value to customers. because widespread infrastructure is
prohibitively expensive to recreate and
There is also a significant requirement
Common characteristics of because it might lead to significant,
for further investment in UK
regulated infrastructure sectors inefficient overcapacity. This means
regulated infrastructure, which relies
These now privatised and regulated that direct, head-to-head competition
on the private sector to finance and
businesses differ somewhat across ‘in the market’ between different
deliver this investment. Over £100
sectors, but have many common infrastructure providers is often not
billion is estimated to be required
characteristics, such as their provision of feasible or economically desirable. These
over the next five years alone 8
across the five regulated sectors, essential services or large asset bases, infrastructure assets are often referred to
which creates a major opportunity which cannot be easily or efficiently as ‘natural monopolies’.
for investors. Sizeable investments replicated. Some of these characteristics
make them particularly attractive for Business characteristics and their
are also required in those same
investment, but also create the need societal role creates a case for
sectors in infrastructure that is not
for economic regulation to remedy regulation
subject to economic regulation.
potential market failures associated with Infrastructure services, in general, are
their market power or other industry also characterised by a high public
characteristics that can give rise to impact of failure, for example, in terms
2.1 inefficient market outcomes. of service disruptions. This means
Characteristics of UK regulated that their operational robustness and
infrastructure The essential nature of network
resilience are critical from the public
Economies and societies rely on infrastructure means that, in general,
interest perspective, and there is a case
a number of essential services in demand for utilities infrastructure
for regulatory and policy intervention
order to function. Although many services is relatively stable over time and
to ensure continuity of supply in all
of these services, such as energy, that the price elasticity of demand (i.e.
circumstances.
communications and transport, can be how demand changes with price) tends
provided to customers via a competitive to be low (though there are exceptions to Economic regulation is intended to
market (e.g. by competing energy supply this, for example in the aviation sector). protect consumers from the adverse
companies), the companies providing effects of companies having significant
There is also continuous need for
these services themselves rely on unique market power. Such regulation aims
large-scale investments over long time
and extensive infrastructure including, to simulate market outcomes while,
horizons due to long, effective economic
in particular, networks or other large at the same time, ensuring conditions
lives of the underlying assets such
physical assets, to deliver their services for private sector provision, such as
as pipes or runways. This means that
an adequate return on investment
8
National Infrastructure Plan (2014) and National Infrastructure Pipeline (2014), see https://www.gov.uk/government/collections/national-infrastructure-plan

Figure 1: Which sectors are subject to economic regulation?
KEY
Heathrow &
Gatwick Non-regulated Air traffic
AVIATION Airports airports control Airlines
Subject
to economic
regulation
ELECTRICITY Regulatory
oversight
Generation Transmission Distribution Retail and/or state
intervention
Not subject
to economic
regulation
GAS
Production and
importation & Transmission Distribution Retail
shipping
Regional
National rail Train Rolling and local rail
RAIL infrastructure operators stock infrastructure
Copper and Wholesale Mobile network

TELECOMS fibre access national network Retail operators
WATER
Sources
(abstraction) Treatment Distribution Retail*
WASTEWATER
Sludge
Sewage Sewage treatment
collection treatment & disposal Retail*
Source: KPMG analysis * Retail competition is being introduced for water and wastewater

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
2. Market overview (continued)
for efficient companies. Economic by policy to give it a greater role in 2.2

regulation is distinct from health and these sectors. There is likely to be a Sector overview
safety, environmental and other types fine balance, however, in some market Infrastructure represents a rich and
of regulation to which all infrastructure segments between the benefits of complex marketplace combining
activities are subject. 9 competition and the costs of introducing competitive, regulated and state-owned
complex market rules to enable a genuine segments of the value chain across the
While the precise form of economic
marketplace to emerge. There are clear economically regulated sectors. These
regulation varies by sector, the general
limits to this for parts of the value chain sectors are diverse in nature and, in each
approach has been to link prices to the
where it is not possible to introduce case, have a number of distinct sub-
required returns on investments made at
competitive market forces, i.e. the core sectors with different business and market
a market cost of capital, commensurate
‘pipes and wires’ network infrastructure, characteristics. All sectors and almost
with the risks involved, while at the same
constituting the bulk of asset bases. In all sub-sectors within them are open to
time incentivising progressively more
these segments, where the infrastructure private investment in different forms.
efficient operations.
has inherent monopoly characteristics,
The aim of regulation is also to ensure economic regulation will have to continue The structure of regulated industries and
necessary service quality levels to to be employed. the organisation of economic regulation
facilitate the appropriate level of also vary across the UK. In the case
investment required to secure supply and Regulatory framework for of telecoms, the industry structure is
to ensure that prices to customers do not investments UK wide. In other sectors, different
include abnormal returns to private arrangements may apply for England,
The approach to the economic regulation
sector providers. Scotland, Wales or Northern Ireland.
of infrastructure adopted to date has
For example, in the case of water and
been such that returns on private
Introduction of competition and wastewater, the arrangements for
investments in networks largely depend
deregulation Scotland and Northern Ireland differ
on the size and efficiency of these
from those for England and Wales with
The scope of economic regulation in investments. Returns are typically
different sector regulators. In general,
the infrastructure sector has evolved calculated on the basis of the regulated
however, similar regulatory principles
over time as market development and asset base (RAB), which records these
and practices apply across geographies,
technology have made the introduction of investments, plus an allowance for other
even where precise regimes structures
competition ‘for the market’ or even ‘in costs, to determine allowed revenues
and institutions are slightly different. This
the market’ feasible in some segments and prices.
is supported by the presence of UK-
of the value chain. For example, two of
Economic regulation creates scope wide appeal bodies, i.e. the Competition
the four originally designated airports
for returns to investors to vary and Markets Authority (CMA 12) and the
have now been deregulated and there is
somewhat depending on operating cost Competition Appeals Tribunal (CAT13 ).
competition for some energy network
performance, achievement of agreed
assets (e.g. Offshore Transmission Figure 1 on the previous page provides a
outputs and performance against
Owners).10 Technology and regulation high level overview of the infrastructure
regulatory incentive schemes, which
have helped facilitate the liberalisation value chain in each of the five sectors
are often geared to improving outcomes
of telecoms and competition is now covered in this guide (it excludes
for customers. Over time, economic
gradually being introduced to some corporate supply chains). The activities
regulators have become increasingly
extent into other sectors, e.g. water retail subject to economic regulation are
keen to make use of such incentives to
services.11 highlighted, and it is these activities that
ensure better outcomes for consumers
form the primary focus of this guide.
This trend is likely to continue and and enable the best companies to
economic regulation is likely to evolve as outperform and demonstrate the In some parts of the value chains, a
competition might become feasible in potential for improvement to others. degree of competition has been
other parts of the value chain supported introduced, as shown above. However,
9
S ome sector regulators are also the health, safety and environmental regulators for their respective sectors. The primary regulatory body for health and safety in the UK is the Health & Safety Executive,
see http://www.hse.gov.uk/ for more information.
10
See https://www.ofgem.gov.uk/publications-and-updates/offshore-transmission-investor-perspective-update-report for more information on the OFTO regime.
11
For more information on water market reforms and the introduction of retail competition, visit http://www.open-water.org.uk/
12
See https://www.gov.uk/government/organisations/competition-and-markets-authority
13
See http://www.catribunal.org.uk/

many of these competitive activities Manchester Airports Group (MAG) owns NATS Services limited (a wholly owned
remain under regulatory oversight or are Manchester, Stansted, East Midlands non-regulated subsidiary), airports self-
subject to a degree of regulatory and Bournemouth airports. Heathrow, supplying and other third party operators.
intervention to ensure ongoing consumer Gatwick and Stansted airports, along NATS Services limited is by far the
protection and efficient operation of the with four others in the UK, were owned largest provider in terms of air transport
industry given the essential nature of by BAA plc between 1987 and July movements controlled and value.
utilities infrastructure services. A table 2006. In March 2009, the Competition
Airlines and providers of ground
listing the main entities that provide Commission’s (CC) BAA Airports Market
handling services at airports are not
regulated infrastructure services in the Investigation found that BAA’s common
subject to price regulation and are free to
UK is provided at the end of this report. ownership of airports in the South East of
determine the price and quality offering
England and in lowland Scotland caused
to consumers in order to meet their own
2.2.1 Aviation an adverse effect on competition.15 As
individual business objectives.
a result, BAA (now Heathrow Airport
Holdings) sold Gatwick airport to GIP in
2009, Edinburgh airport to GIP in 2012 2.2.2 Energy
and Stansted airport to MAG in 2013.
There is a need for new runway

capacity in the South-East of England
and the Government has appointed an
independent Airports Commission to
determine the best option to meet this
requirement.16 There is an expectation
that between £7.4-18.6 billion will be
required to deliver this investment
The Civil Aviation Authority (CAA) is the
according to the Airports Commission
independent aviation regulator in the UK, The energy sector is regulated by the Gas
draft findings.
with responsibility for economic and Electricity Markets Authority
regulation, airspace policy, safety The provision of en route Air Navigation (GEMA), which was established by
regulation and consumer protection. The Services (ANS) in UK airspace is the section 1 of the Utilities Act 2000. GEMA
CAA is responsible for the economic responsibility of NATS En Route Plc is supported by Ofgem, the Office of Gas
regulation of Airport Operators and Air (NERL). NERL is part of NATS (Holdings) and Electricity Markets, in delivering its
Navigation Service Providers (ANSPs). Plc (NATS), which is a public private duties. Ofgem was formed by the merger
partnership. The Government holds 49 of the Office of Electricity Regulation
The vast majority of airports in the UK
percent and a golden share, 5 percent (Offer) and Office of Gas Supply (Ofgas)
are not subject to economic regulation.
is held by the NATS staff and 4 percent in 2000.
Only two of around 60 airports in the UK
by LHR Airports Limited (formerly
are regulated in that sense via a licence. Electricity transmission assets in Great
BAA), while the remaining 42 percent
Most of the airports are also privately Britain are currently owned by three
is controlled by the Airlines Group. In
owned and some are part owned by the monopoly transmission operators (TOs),
2014, USS Sherwood Ltd purchased
local authorities.14 although Ofgem has recently reiterated
49.9 percent of the Airlines Group, and
a desire to introduce competition into
While there are many airports that are the remainder is held by a number of
the provision of new assets, which
individually owned, there are also now different airlines.
might create an opportunity for new
several airport operator groups in the
The provision of terminal air navigation market entrants. National Grid Electricity
UK. For instance, Global Infrastructure
services (TANS) is undertaken by a Transmission (NGET) plc, a subsidiary of
Partners (GIP) own Gatwick, London
range of providers including NATS via National Grid, is by far the largest of the
City and Edinburgh airports, while
14
In 2010, the OFT published a detailed database of the ownership and control structures of large infrastructure operators in the UK, including airports, see http://webarchive.nationalarchives.gov.uk/20140402142426/http://
www.oft.gov.uk/shared_oft/market-studies/ownership-control-mapping/OFT1290.pdf
15
F or more information on CAA airport market power assessments, see http://www.caa.co.uk/default.aspx?catid=78&pagetype=90&pageid=12275
16
F or more information on the Airport Commission and new UK runway developments, see https://www.gov.uk/government/organisations/airports-commission

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
existing monopolies, covering England but this will continue to grow over the price for making capacity available. The
and Wales. Scottish Power Transmission next decade in line with the expansion of EMR mechanisms represent competition
owns the network in Southern Scotland offshore wind generation. for the market in that operators bid
and Scottish Hydro Electric Transmission for the contracts, but ensure that they
There are also four electricity
owns the network in Northern Scotland are less exposed to changes in market
interconnectors and three gas
and the Scottish Islands. National Grid prices. EMR has been designed and
interconnectors that connect Great
also performs the system operator role introduced by the Government. 21
Britain to international markets,
on behalf of the Scottish networks to
facilitating cross-border trading and The Northern Ireland Authority for Utility
enable effective management of a single
the creation of an EU Single Electricity Regulation (NIAUR) is responsible for
British electricity network.
Market19 . The interconnector market is regulating the energy (electricity and
Gas transmission assets in Great Britain also subject to ongoing expansion. gas) industries in Northern Ireland. The
are all owned and operated by National wholesale electricity market on the island
Electricity generation is a competitive
Grid Gas, a subsidiary of National Grid. of Ireland is regulated by the Single
activity, as is gas production and
Electricity Market Committee, which
Energy distribution assets in Great shipping. In principle, the energy
is also a statutory committee of both
Britain currently consist of 14 regional prices that generators and wholesalers
NIAUR and the Commission for Energy
electricity distribution networks can charge are not determined by the
Regulation in the Republic of Ireland.
(owned by six companies) and eight regulator but by the market, although
gas distribution networks (owned by there is also significant government
four companies) as well as a number intervention in the market both through 2.2.3 Rail
of smaller independent distribution the unbundling requirements of the EU
network operators and independent gas Third Energy Package and incentives for
transporters. The energy distribution certain generation technologies.
companies are a mixture of privately-held
Supply businesses, including retail
companies and subsidiaries of
activities, are competitive in both gas
listed companies.
and electricity and thus are not price-
The onshore energy network businesses regulated, though extensive standards
in the UK are regulated under the RIIO of conduct are in place for these sub-
(Revenue = Incentives + Innovation + sectors. Ofgem recently referred the
The economics of rail means that it
Outputs) framework (see section 4.4 for energy retail market to a review by
stands out from other economically
details17), and their revenue is received by the CMA.
regulated UK infrastructure as being the
charging users for access to the network
The Energy Act 2013 introduced only one to receive significant
(i.e. generators and suppliers).
measures for Electricity Market Reform government subsidy rather than relying
The Offshore Transmission Owner (EMR) 20 in England, Wales and Scotland. on customers to pay directly for all its
(OFTO) regime regulates the high- The Contracts for Difference (CfDs) costs and services.
voltage electricity transmission cables mechanism allows participating operators
The rail sector is regulated by the
connecting offshore wind farms to the of certain low-carbon generation
Office of Rail Regulation (ORR), but
onshore network. The ownership of the technologies to achieve a fixed, long-
the Government is a direct and active
transmission assets is separated from term power price, as they obtain the
stakeholder with extensive involvement
ownership of the wind farms, in line difference between the market price and
in setting detailed policy and strategic
with EU unbundling requirements, and the contracted and indexed strike price.
direction. In rail, the Government
taken on by OFTOs through a process EMR is also introducing a mechanism
directly specifies and funds many of the
of competitive tendering. There are for operators of conventional electricity
investments in the rail infrastructure.
currently around ten OFTOs in the UK18 generators to receive a long-term fixed
17
More information on the RIIO model can be found on Ofgem’s website at https://www.ofgem.gov.uk/network-regulation-%E2%80%93-riio-model
18
See https://www.ofgem.gov.uk/publications-and-updates/offshore-transmission-investor-perspective-update-report for more information on the OFTO regime.
19
More information on electricity interconnection in GB can be found at https://www.ofgem.gov.uk/electricity/transmission-networks/electricity-interconnectors, and at https://www.ofgem.gov.uk/gas/transmission-networks/
gas-interconnectors for gas interconnectors.
20
F urther information on the Energy Act 2013 can be found at https://www.gov.uk/government/collections/energy-act
21
F urther information on EMR and the associated policy mechanisms can be found at https://www.gov.uk/government/policies/maintaining-uk-energy-security--2/supporting-pages/electricity-market-reform

The market composition of the rail sector number of other stations are both
2.2.4 Telecommunications
is complex and involves a number of public owned and operated by TOCs.
and private entities. Overall, there are
§§ As well as the national rail
four key elements to the GB rail sector:
infrastructure, there are also High
§§ The public transport authorities Speed and international rail
(Department for Transport, Transport infrastructures, i.e. the High Speed
Scotland and some metropolitan 1 (HS1) rail infrastructure 22 and
authorities such as Transport for the Channel Tunnel infrastructure
London), which specify, let and connecting Britain to the European
manage operating contracts and continent.
provide a significant proportion of the
Network Rail’s assets do not include There are effectively two types of network:
funding for infrastructure maintenance
the tracks and stations of the London §§ Core network, consisting of very
and enhancement to Network Rail.
Underground network, which are owned high capacity fibre cables (or other
§§ Privately owned and operated Train by London Underground Limited, a high-speed links such as microwave
Operating Companies (TOCs) and subsidiary of the Transport for London, backhaul for mobile towers) that
Freight Operating Companies or the HS1 line between King’s Cross connect exchanges, masts or network
(FOCs). TOCs operate under Franchise St. Pancras and the Channel Tunnel, aggregation points; and
or Concession Agreements let by and the Channel Tunnel itself, which are
the authorities mentioned above. both privately operated under long-term §§ Consumer-facing ‘last mile’
The concessions are typically concession agreements by High Speed 1 networks, which can consist of
competitively tendered every 7 to 15 Limited and Eurotunnel, respectively. copper, fibre and co-axial (cable)
years. Service levels are determined networks or mobile masts.
It is possible to trade in Network Rail’s
during the franchising competitions
existing debt issued prior to 1 September Core networks
and around half of fares are regulated
2014, which is underwritten by a
by the Government. FOCs are wholly There are a number of significant
Government guarantee. It is not possible,
commercial with competition in the network providers in each of the fixed
however, to invest in Network Rail equity
rail market and with other modes. and mobile market segment, though the
or new debt. Going forward, all Network
distinction between the two segments
§§ Unregulated and privately-owned and Rail new debt will be borrowed directly
has been reducing due to the evolution
financed rolling-stock companies from the Government.
of fixed-mobile convergence. This effect
(ROSCOs), which lease rolling stock
Network Rail has also begun a process is driven, in part, by the delivery of data
to the TOCs and are supported by
of decentralisation and regionalisation, and broadband services over multiple and
several financial investors.
where some assets, such as competing network platforms, but there
§§ The regulated national rail infrastructure related to certain routes, is still an important distinction between
infrastructure, owned and operated are managed separately and more closely fixed and mobile and this is likely to
by Network Rail, a government with the train operating companies and persist for at least the next few years.
body originally created as a company other stakeholders. This might result in a The services provided by competing
limited by a guarantee following the different structure or management model core network operators range from fixed
restructuring of its private sector of rail infrastructure in the future, which and mobile voice services to households
predecessor, Railtrack, in 2002. could open additional opportunities for and businesses, over conventional
investment. and new technologies, to provision of
Most stations on the national rail
broadband via a range of methods, to
network are owned by Network Rail
high bandwidth data services delivered to
but operated by TOCs. There are
the business market.
some exceptions to this. The major
London terminals and some other In both the fixed and mobile market
major stations are both owned and segments there are a number of
operated by Network Rail and a limited companies that own a core network.
22
S ee http://www.highspeed1.com for more information

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
In the fixed line segment, there are that are downstream of it). The prices In addition, Openreach manages the
numerous network companies that can it can charge for most forms of access “last mile” access to higher bandwidth
provide both long distance and local to its network fall within the scope of networks exclusively operating over
services, within and between the larger economic regulation. In addition, BT fibre, notably those running Ethernet-
cities and conurbations. The extent of has given a series of legally binding based data services that provided high
coverage and technology choices are ‘Undertakings’ that commit BT and band width point to point services for
determined by commercial considerations Openreach to selling the main products businesses, or that supplement other
and all companies can supplement their and services to other communications operators’ core networks. These
network capabilities with access to BT’s providers on the same terms as to services, up to and including 1Gbit/s
core network where necessary. BT’s own lines of business. In order to services are also provided on regulated
deliver these Undertakings, Openreach terms to other operators.
The fixed segment is still dominated by is functionally and operationally separate §§ Mobile networks refer to the masts
BT at both the “core network” and “last from the rest of BT Group. and associated infrastructure used
mile” levels and hence BT generally has
to provide cellular network coverage.
to provide such access on an equivalent The basis for much of the retail
This infrastructure includes backhaul,
basis, i.e. the terms on which such competition in fixed telecoms and
the core network required by mobile
access is given have to be the same for broadband for consumers is provided
network operators (MNOs) to
other service providers as for BT Retail, by Local Loop Unbundling (LLU), which
transport information (voice or data)
BT’s downstream division. In the core allows companies other than BT to install
around.
network area, services are provided their telecoms equipment in the local BT
by BT to other operators either on the exchange. These companies can then
There are four mobile networks in the
basis of specific network components offer their own direct phone or broadband
UK, each of which owns and manages
where other operators may not possess services to consumers. Communications
network infrastructure, and each of
network, or fully operational services that providers, who use BT’s copper network
which now provides a 4G mobile data
are priced on wholesale terms. to provide telephone and broadband
service the roll out of which also requires
services to homes and businesses,
There are also a number of specialist significant investment. In addition, there
are required to pay Openreach a fee to
providers of network services, such are operators of virtual mobile networks
access the network for the provision of
as those that provide high quality that buy in network service from other
various wholesale telecoms services. The
connectivity and bandwidth between operators. Mobile telecoms account for
wholesale charge for such services is
mobile masts, media centres and the majority of connections in the UK.
regulated by Ofcom where BT has been
broadcasting masts. found to have significant market power in §§ Retail services – Retail in the
the delivery of these services. telecommunications industry
Last mile networks are providers of voice, data and/
In and around the city of Kingston upon or television services to retail
In the ‘last mile’ segment, the largest
Hull in East Yorkshire, KCOM plc owns consumers. The combination of core
operator is Openreach, a division of BT
and operates the last mile infrastructure and last mile networks, either owned
Group, the UK’s Universal Service Provider.
for historical reasons and is economically or bought in on regulated terms, is
Despite the continuing dominance of
regulated in ways analogous to the used by all operators to provide retail
Openreach, about half UK homes have
regime applied to Openreach. communications services. There
the option of an alternative supplier of
is extensive competition for retail
last mile access, using cable network Openreach’s fibre last-mile network, services in fixed and mobile.
technology to provide voice, broadband, which mainly runs to BT’s street cabinets
TV and mobile services. This alternative from its exchanges, can deliver high- Mobile networks and retail
cable network is not subject to specific speed internet broadband services, and telecommunications services include
economic regulatory control by Ofcom. access to this network is not currently elements of telecommunications
subject to price regulation in the same infrastructure but differ in their
Openreach is subject to detailed
way as LLU. However, it is subject to a investment profile from traditional
regulation of the way it provides
number of non-price restrictions that are regulated infrastructure sectors, so
telecoms retailers access to the last mile
designed to ensure fair access. are not discussed here in detail but
network (including all of BT’s divisions

mentioned for completeness, given competition is to be introduced in 2.3
their substantial role in the overall England in 2017 for non-household Private sector investment
telecommunications industry. customers, which means that business, and delivery
charity, and public sector customers will In the UK, most regulated infrastructure
2.2.5 Water & wastewater be able to choose their water retailer. assets are owned by private companies.
Retail competition for non-household Therefore, responsibility for the supply of
customers is already in place in Scotland. services (including operations and capital
As the competitive retail market has investment) generally sits with these
developed, the Scottish water regulator private companies. This is distinct from
(Water Industry Commission for Scotland the public ownership and concession
or ‘WICS’) has gradually reduced models that are common in other
economic regulation of Scottish Water’s jurisdictions, under which ownership of
retail business but retains control over assets remains in the public sector with
certain areas such as licensing, setting some private companies operating under
default tariffs and default levels of time-bound concessions.
service. Economic regulation remains in The UK ownership model arguably offers
Water and wastewater services in place for the asset-intensive network and greater transparency, but also greater
England and Wales are currently mainly upstream activities. control to the private sector, and hence
delivered by 18 regional monopolies.
If England follows the same pattern as ensures provision of long-term, private
There are also a number of other
in Scotland, 5 percent of revenues could capital. However, there are still some
providers (new appointees and water
be subject to competition in the retail entities, such as the water companies
supply licensees) at specific sites, but
market. To facilitate this, Ofwat will set in Scotland and Northern Ireland and
they represent a negligible proportion of
separate price controls for wholesale Network Rail, which are publically-owned.
the total supply.
water, wholesale wastewater, household Figure 2 on the following page
The companies vary significantly in retail and non-household retail in the demonstrates the significant and
size: 10 larger companies supply both PR14 price review that will cover the growing private investment in UK
water and sewerage services (WaSCs) period 2015-20. regulated infrastructure over the past
and eight smaller ones supply water
Much of the asset-heavy wholesale five years. This is the investment made
only (WoCs), although some of the
network, which represents by far the by the companies subject to economic
largest WoCs are almost the size of the
greatest part of the value chain, will regulation discussed in this guide and
small WaSCs. All these companies are
remain a regulated monopoly activity. not the total investment in these sectors,
fully privatised, some listed and some
However, following the Water Act which can be significantly higher. This
privately held, and one company is
2014, 24 Ofwat and other stakeholders in is particularly true for sectors such as
owned by a not-for-profit company (Dwr
the sector are considering how market telecoms, where only a small part of the
Cymru or Welsh Water). A single state-
mechanisms can play a greater part in value chain constitutes infrastructure that
owned company supplies both water
upstream activities, particularly in respect is subject to traditional price regulation.
and wastewater services in Scotland
(Scottish Water). 23 to water trading. Since the vast majority of infrastructure
In Northern Ireland, water and in the UK was privatised 20 or 30 years
The market for retail water and
wastewater services are provided by ago, the private ownership model of
wastewater services in England and
Northern Ireland Water which is regulated operations and associated economic
Wales is largely not competitive at
by the Northern Ireland Authority for regulation has a level of maturity,
the moment, i.e. all customers within
Utility Regulation (NIAUR). stability and track record rarely seen
a specific geographical location are
in other jurisdictions. The provision of
supplied by the incumbent supplier,
essential services by privately owned
which is also the owner of the local
and regulated companies is generally
network. However, water retail
accepted by the public at large, with
23
A n overview of licenced water and wastewater companies can be found on Ofwat’s website at http://www.ofwat.gov.uk/industrystructure/licences/
24
F or details of the Water Act 2014, see http://services.parliament.uk/bills/2013-14/water.html

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
Figure 2: Capital expenditure in GB on infrastructure subject to economic regulation (2010-14)
£10,000
millions
£9,000
£8,000
£7,000 AVIATION ENERGY RAIL TELECOMS WATER
£6,000
£5,000
£4,000
£3,000
£2,000
£1,000
£0
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
2010
2011
2012
2013
2014
5 year
£7,000 £41,000 £18,000 £25,000 £5,000 £19,000
totals
Electricity Gas
Source: Company regulatory accounts and financial statements. Estimates used where data was unavailable.
the debate focused more on the nature ensure effective cost benchmarking for have enabled significant capital raising at
and results of regulation rather than the regulatory purposes. low prices compared with other sectors
concept of private ownership itself. of the economy. This is evident, for
Other corporate structures in regulated
example, from the amount of debt capital
The structure of regulated infrastructure infrastructure have resulted from
invested in UK regulated infrastructure
in the UK has been largely stable with changes post-privatisation initiated by
since privatisation, in absolute terms and
limited changes over time. Some of the private sector. This includes, for
relative to equity, which includes the
these changes have resulted from example, consolidation in electricity
period of the financial crisis.
regulatory intervention, as in the case of distribution networks, although the
the break-up of BAA following a market networks under common ownership still The quantum of fixed income securities
investigation, or the separation of energy operate under separate licences with issued by UK regulated infrastructure
transmission from generation, which separate regulatory accounts. Further companies over the past decade per
followed the adoption of EU directives. 25 structural changes in these sectors could sector is shown in Figure 3 opposite.
occur in the future, although in case Since regulated companies have ongoing
Some structural change, such as
of consolidation regulators are likely to investment commitments, they are
potential sector consolidation in the water
seek to ensure sharing of potential cost required continuously to tap capital
sector, which might have been otherwise
savings and synergies with consumers. markets for new funding or refinancing.
expected, has not occurred to date on
Figure 3 opposite illustrates this point
a large scale due to specific statutory While market structures and regulatory
and that they have been able to do
barriers – in this case the existence of practices have evolved over time,
continuously over the past decade.
the water-specific merger regime and the inherent stability of the market
arguments around keeping a sufficient arrangements and the overall regime to Confidence in UK regulated infrastructure
number of independent companies to date, as well as the low risk nature of the is further evidenced by the appetite
underlying business activities themselves, displayed by investors to enter the
25
Notably, the Third Energy Package. For more information, see http://ec.europa.eu/energy/gas_electricity/legislation/third_legislative_package_en.htm

market, which has been consistently Long asset lives, real returns where the capital and operational expenditure spent
strong following the initial tranche of inflation component is capitalised rather to ensure efficiency.
primary market offerings. This has than recovered immediately, and the
Energy is one of the UK’s priority
resulted in a large volume of transactions consistent need for partial reinvestment
investment areas given the importance of
on the secondary market. of capital in the business have all meant
energy security and the need to respond
that, to some extent, private owners rely
Figure 4 on the following page shows to climate change. The ageing state of UK
on the secondary market for recovery of
the number of transactions per year. This energy plants is also driving a significant
invested capital in the short to medium
underscores the secondary market’s need for investment in the sector. The
term. An active and vibrant secondary
liquidity and desirability of these assets to electricity sector, in particular, has a large
market for regulated assets is therefore
investors from across the world. investment pipeline, with increasing
an important part of the overall business
renewable energy generation capacity
The total value of transactions in case for investment in regulated
being developed, new generation
regulated infrastructure has fluctuated infrastructure utilities.
connections and reinforcement of the
year by year, but there has been an
onshore transmission and distribution
overall upward trend over the past 2.4
network being required.
decade. There has been a steady flow Significant opportunities for
of transactions in water and energy investment Offshore transmission is also a
reflecting a large number of entities There is a significant pipeline of future key growth area driven by ongoing
supplemented by more occasional trades investments required in UK infrastructure investment in offshore wind generation
in rail and aviation assets. In the telecoms creating major opportunities for private and a need for increased interconnection
sector, Openreach has remained a part debt, equity capital and private sector capacity between British and neighbouring
of the BT Group, but there has been delivery. Across regulated infrastructure electricity markets. Significant investment
significant corporate activity in the wider sectors, there is a recognised investment is also required to reinforce the network
telecommunications market including, in requirement not only to maintain and for electrification of transport.
particular, in mobile telecommunications, replace existing infrastructure, but also to
There are also significant investment
which is not included in the summary upgrade and build new facilities, while at
needs in water to ensure sector resilience
data presented in figure 4. the same time optimising the balance of
Figure 3: Fixed income securities issued by regulated infrastructure companies (2004-2014)
£18,000
millions
£16,000
£14,000
£12,000
£10,000
£8,000
£6,000
£4,000
£2,000
£0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Capital IQ, KPMG analysis. Note: excludes Artesian debt.
KEY Aviation Energy Rail Telecoms Water

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
Figure 4: Transactions in selected regulated infrastructure sectors – total number of transactions by year26
12
transactions
10
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Capital IQ, ThomsonOne, MergerMarket and regulator websites, KPMG analysis
KEY Aviation Energy Water
and future supply in the presence of illustrated in Figure 5 opposite. The pipeline of investments includes projects
climate change. While over £100 billion middle chart shows the total estimated that are still in the planning stage, such
has been spent in the water sector on spending, with a breakdown of spending as Crossrail 2 29 , as well as projects
upgrading existing infrastructure, there by regulated infrastructure companies that are now procuring financing and
is a need for large new assets such as in each sector and spending on new entering delivery stage such as Thames
Thames Tideway Tunnel and increasing projects. The circle on the left breaks Tideway Tunnel. This is reflected in the
water storage capacity and resilience down company spending by sub-sector, National Infrastructure Plan published
schemes to ensure future supply. 27 and the circle on the right breaks down by the Government, which captures
new project spending by type of project. current investments but not all future
In rail, the High Speed 2 (HS2)
opportunities that are yet to be converted
programme will practically double the In practice, the requirement for some
into viable business projects. 30
Government’s annual spending on rail of this spend will depend on policy
infrastructure. 28 In telecoms, a number of priorities, affordability, market signals and
2.4.1
providers have been rolling out superfast public needs (for example, requests for
Current issues and trends: priorities
broadband and mobile network operators electricity transmission from generator and pipeline
are rolling out 4G, while in aviation connections). However, for much of
The five sectors have different
there is a need for a new runway in the regulated infrastructure, investments are
investment cycles, but all have
South East of England as well as airport relatively certain, for example upgrades
continuous requirements for investment
capacity expansion and other airport to energy and water networks or
in the future reflecting the general
investment. electrification of rail routes, because they
growth trend of the GB economy. This
are essential to securing future supply.
The estimated total spending on investment will come to market in three
regulated infrastructure to 2020 is The projects accounted for in Figure 5 are forms: (1) investments by incumbent
at various stages of development. The
26
T his data only includes transactions in the regulated infrastructure sectors, and does not capture significant additional market activity in the non-regulated subsectors of the telecoms and airports industries, which are
not subject to economic regulation.
27
For more information on Thames Tideway Tunnel, see http://www.thamestidewaytunnel.co.uk/
28
For more information on HS2, see http://www.hs2.org.uk/
29
F or more information on Crossrail 2, see http://crossrail2.co.uk/
30
F or more information on UK infrastructure projects, visit KPMG’s Interactive Infrastructure portal at http://www.kpmg.com/uk/en/industry/buildingandconstruction/pages/interactive-infrastructure.aspx

regulated infrastructure service §§ In electricity transmission, §§ In gas networks, approximately £6
providers; (2) infrastructure investment approximately £10 billion of billion is required to reinforce the
opportunities that are competitively investment is required in the network as sources of gas change
tendered (including primary market transmission networks between 2015- as well as to continue replacing old
opportunities), which could be provided 2020 both to replace ageing lines cast iron gas mains with plastic over
by regulated incumbents or third parties; and also to connect new sources of 2015-2020.
and (3) stand alone, developer-led projects. generation, particularly renewables.
§§ In water and wastewater,
Some of this investment is to facilitate
companies expect to make
1. Investments by incumbent the connection of offshore wind farms.
investments of more than £22 billion
regulated infrastructure service
providers §§ In electricity distribution, over 2015-20 to upgrade and enhance
investment is required to roll out infrastructure and improve future
The National Infrastructure Plan, company
smart grids, reinforce the networks resilience.
business plans, regulatory determinations
to support increased renewable
and other publications outline specific §§ In the rail sector, over £20 billion
generation and enable future
investment needs in each sector. The is required to upgrade stations and
electrification of transport and replace
following estimates for future investment tracks, and construct new tracks and
old infrastructure. Approximately £11
requirements have been sourced from the tunnels over 2015-2020.
billion of investment is potentially
National Infrastructure Plan except where
required over 2015-2020. §§ In aviation, approximately £4 billion
otherwise specified.
of investment is required to upgrade
Figure 5: Planned capital expenditure in regulated infrastructure sectors (2015-2020)
COMPANY SPENDING VS. NEW PROJECTS
ENERGY
RAIL £27,100m
£22,700m
WATER
PROJECTS
£22,100m
Water only companies £31,500m
£1,600m Superfast
Other digital broadband
communications Gas transmission
£900m
£3,600m £800m
NATS Thames TidewayTunnel

Airports AVIATION
£600m £2,700m
£3,300m £4,000m
Network Rail TELECOMS
Gas £22,700m £3,600m High Speed
Interconnectors
distribution Rail
£6,000m
£11,600m
£4,800m
COMPANY
EXPENDITURE PROJECTS
Electricity
distribution OFTOs
£11,400m £5,000m
Water and sewerage
companies
Electricity transmission £20,500m Crossrail
£10,100m £5,300m
Source: National Infrastructure Pipeline, Ofgem, KPMG analysis. Note: 2012/13 prices.

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
the existing infrastructure at Heathrow 2. Competitively tendered phase to Birmingham completed in 2026.
and Gatwick over 2015-2020, in infrastructure investment A future government may choose to
addition to an estimated £7.4-18.6 opportunities (including recover part of the estimated total project
billion required for new runway primary market) cost of around £50 billion through private
capacity and associated terminal and OFTOs – The licences to design, build, investment, as happened with High-
other infrastructure. 31 own and operate OFTOs are awarded Speed 1 through the competitive letting
via a competitive tendering process of an operating concession in 2010.
§§ In fixed-line telecommunications,
approximately £4.5 billion could be run by Ofgem. OFTOs receive an
availability-based revenue stream over 3. S tand alone, developer-led
required to complete the roll-out of
the useful economic life of the asset. projects
superfast broadband and other general
digital communication investment over Nearly £2 billion pounds have been These opportunities can include either
2015-2020. invested in OFTOs since the regime’s merchant or regulated projects, but
commencement 34 and approximately tend not to include large network-based
Contestability £5 billion of investment is potentially assets. Examples include electricity and
required over 2015-2020. Ofgem has gas interconnectors and LNG importation
Most of the infrastructure providers also recently reiterated its intention to terminals, for which the degree of regulatory
mentioned in this guide operate deliver greater competition in the delivery oversight will vary depending on the
in licensed, localised monopolies, of new onshore electricity transmission, exact nature of the project and sector.
which means that investment which may lead to opportunities similar to
within a given area, which could In particular, there is a need for additional
OFTOs in this space.
be nation-wide, typically comes electricity interconnection between
under the remit of the incumbent Thames Tideway Tunnel (TTT) – This the UK and other markets, to allow the
operator. 32 Increasingly, however, is a project to construct the 25km, 7m trading of energy between jurisdictions.
some discrete projects are being diameter wastewater tunnel running Approximately £6 billion of investment
put out to tender and opened through central London under the river is potentially required over 2015-2020 to
to other providers. Examples of Thames planned by Thames Water. A increase interconnection capacity of GB
this include OFTOs and Thames new bespoke special projects regime and the UK with multiple projects under
Tideway Tunnel. In aviation, there has been developed for TTT, which will consideration linking the UK to other
is effective competition between see the ownership, construction and jurisdictions. 35
different airport operators to secure final development to be carried out by a
new company following a competitive 2.5
a recommendation from the Airports
tender process. Total costs for the project Investment entry and exit
Commission for new runway
capacity. In energy networks, Ofgem are currently estimated to be around £4
2.5.1
is also considering how feasible it billion, and construction is expected to
Routes to investment
might be to introduce competition commence in 2016 and finish around
2023. The same regime with tailored There are multiple investment routes to
for some new assets of the onshore
treatment could be applied to other major enter into the UK regulated infrastructure
networks as part of its ITPR project
water projects in the future. sectors. Debt and equity markets are open
(Integrated Transmission Planning
to participation, though both are not always
and Regulation). 33 High Speed 2 – A second UK high- available for every project or asset class.
speed rail line is planned to link London
to the Midlands and Northern England. There has been a growing share of debt
The project is managed by a company participation in the overall financing mix
established and guaranteed by the of regulated infrastructure as the actual
Government, and is due to become financial structures have caught up with
operational in two phases, with the first the higher achievable debt capacities
31
T he interim report from the Airports Commission into airport capacity and connectivity in the UK can be found at https://www.gov.uk/government/publications/airports-commission-interim-report
32
T he telecoms sector does not have an incumbent operator.
33
F or more information on Ofgem’s ITPR project, see https://www.ofgem.gov.uk/electricity/transmission-networks/integrated-transmission-planning-and-regulation
34
O fgem 2014 estimates
35
O fgem 2014 estimates.

given the nature of regulated assets, and manage. Regulatory intervention in offered solely pre-construction. There
the need for investment and the large relation to financing is therefore limited are also projects being offered while
free cash flows available to support it. to setting the allowed rate of return, still in development. As a result, there
However, not all regulated infrastructure ensuring financeability under a notional are projects that should fit with differing
utilities have adopted high leverage, with financial structure assumed reasonable investment styles and risk appetites.
a number of publicly listed companies by the regulator, and monitoring In the future, competitive tendering for
retaining lower gearing; many companies investment grade requirements to limit new infrastructure might be more widely
also pay high distributions to meet the likelihood and potential costs of a adopted, opening up new opportunities
investors’ appetite for strong dividend company entering financial distress. for direct investments.
flow given the nature of the assets.
On the equity side there are also a
Public debt capital markets are used to 2.5.2
number of investment channels. In the
access investment grade bond financing Exiting the market and
secondary markets, shares in publically consolidation
in a relatively liquid market.
listed companies are freely traded and are
The regulatory regimes allow for the
Structured finance solutions are very liquid. Additionally, many companies
repayment of invested capital through
also commonly used to tap different operating in these sectors are privately
allowed depreciation, but due to the long
investor groups and market segments owned. Stakes in these businesses can
economic lives of the assets, capitalisation
and to maximise leverage. Corporate be negotiated, as can full acquisitions.
of the inflation component of the return
securitisations in the form of Whole In both listed and private companies the
and significant reinvestment needs, this
Business Securitisations (WBS), popular level of control purchased can be flexible
route is primarily attractive to long term
in the water sector, have become more from small minority to full control.
investors such as pension funds.
widely spread combining low cost of debt
In the primary markets, there are also
financing and high leverage by ensuring In the short term, exit from the market is
parts of the infrastructure sector,
tight cash management and limiting to some extent dependent on the entry
currently in public hands, that could
managerial discretion through a range route. Freely traded bonds or shares can
potentially be privatised in the future.
of covenants. These typically include clearly be sold on in the same markets.
Projects are also put out to tender
establishment of a financial ‘ring-fence’ Exit from privately held companies or
periodically either by the relevant
around the licenced business which projects acquired through the primary
regulator or through another mechanism.
corresponds to the regulatory ring- market is generally possible through
This includes development of the new
fencing provisions such that revenues active secondary markets, though the
markets to bid for CfDs and at capacity
and assets of regulated activities are exact nature of the process will vary from
auctions under EMR. The standalone
clearly separated from those for non- case to case and can include tenders or
projects tend to be either significant
regulated activities (ring-fencing is privately negotiated sales.
one-off developments, such as Thames
discussed in more detail in the next
Tideway Tunnel, or in market segments Market structures in regulated
section).
where there is a regular pipeline of new infrastructure vary from a very high
Some hybrid securities have also been projects, such as for offshore electricity degree of concentration, as in the case
issued in the sector in the past. There is transmission tendering or electricity of rail, to fragmentation along horizontal
also a significant amount of bank financing generation capacity auctions. The (water) or vertical (energy) lines. There
supplementing publicly issued debt, which projects tend to go through a competitive has been some consolidation in energy
can offer companies bespoke solutions selection process, focused heavily, networks to date, but it has been limited
and additional financial flexibility. though not solely, on costs. in the water sector to the smaller
companies. The break-up of BAA has
With the exception of Network Rail, The point in the project lifecycle at
meant a greater fragmentation and
none of the regulated infrastructure which these projects are offered to
diversification of the airports market
debt is guaranteed by the Government tender varies. Some projects, such as
than was previously the case. In general,
and regulators have consistently taken OFTOs, can be offered both pre- and
market structures in these sectors evolve
the view that financial structures and post-construction, whereas others,
over time albeit slowly.
risks are for private owners to assume such as Thames Tideway Tunnel, are

IN THIS SECTION
§§ How is the sector regulated and

what is the overall legal and
governance structure?
§§ What entities/documents/
processes are involved in the
regulatory framework?
§§ What rights/obligations do
investors have?
REGULATORY FRAMEWORK
EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
3. Regulatory framework
Figure 6: Regulatory framework overview: key structures and duties
LEGISLATION POLICY REGULATION SERVICE PROVISION

REGULATOR
INDEPENDENCE
PARLIAMENT GOVERNMENT REGULATOR COMPANY INVESTORS
HOUSE Sets Define regulatory

Raise capital
OF COMMONS strategic policy policy & objectives
Grants authority
HOUSE Policy
OF LORDS statements Business Provide
Licences(1)
operations capital
Draft legislation Regulatory Provide

Enact legislation (“bills”) Governance
reviews services
Monitoring Payments
Primary
Primary Secondary Transactions
& enforcement for services
legislation legislation
EU DEVOLVED
(LEGISLATION) CMA & CAT CUSTOMERS STAKEHOLDERS
GOVERNMENTS
Source: KPMG analysis

* Licence grant not applicable in the telecoms sector, where operators are granted a ‘General Authorisation’ (see section 3.2.1).
KEY
ENTITY
3.1 Figure 6 above presents a simplified

Laws, licences and regulations overview of the key entities, interactions Action or duty
There are several levels of governance and activities constituting the

and regulation over regulated overall market regime for regulated
Document
infrastructure companies, with the infrastructure, with their respective
authority and duties divided amongst powers and responsibilities.
a number of entities. One of the key The Government prepares draft
features of the overall regime is the legislation proposals (‘bills’) and defines
separation and independence of the the overall policy for each industry.
processes and institutions involved in Based on these proposals, Parliament
legislation, policy and regulation, which enacts primary legislation where sector-
ensures the clear division of roles and specific or general Acts of Parliament
enhances transparency. define market regimes and delegate
powers and authority. These Acts confer
powers on ministers to provide details

of implementation through secondary regulators have concurrent powers
The working dynamics legislation and set more detailed policy with competition authorities to apply
direction. Legislation also defines powers competition law in these sectors.
of market regimes and
and responsibilities of independent Regulators set detailed regulatory
regulatory frameworks
regulators who grant and enforce objectives and methodologies as well
vary across industries, licences, which in turn define regulated as implement and enforce regulations.
but share common companies’ rights and obligations. Regulatory decisions can be appealed to
themes. competition market authorities.
Like any other sector in the economy,
regulated infrastructure companies are Subsequent discussion explains how the
also subject to general competition law different entities and duties interact in
at the UK and EU levels 36 and sector more detail.
The Government has a number of roles in cases, the market regime embodied
relation to regulated infrastructure: in the legislation may enable the
Government to give individual
§§ The Government is responsible for
regulators specific policy guidance
developing the overall market regime,
or set direction, for instance on
including the general regulatory
environmental matters.
framework that applies to each
3.1.1
industry. In doing so, it considers §§ More generally, the Government may
Government policy
public objectives and, effectively, set wider public policy, for instance in
defines the overall market structure, relation to climate change or airport
regulatory duties and enforcement location, which effectively creates
powers that it believes are required to parameters within which regulators
meet public policy objectives. must work. It also provides ‘steers’
via white papers and strategic policy
§§ The government policy is reviewed
statements which set out priorities for
by Parliament, which is responsible
the industry.
for enacting it as legislation. 37 Such
legislation is passed infrequently and §§ Investments in infrastructure, like all
so the resulting framework can be other investment in other sectors of
expected to endure for many years. In the economy, are also affected by
contrast to other sectors with limited the Government’s general economic
state intervention, this effectively and social policies and the market
implies development of a ‘market by principles embodied in the relevant
design’ rather than just by free market legislative framework. Government’s
forces. broader policies, such as those for
taxation, employment and other
§§ The Government also has wider,
areas, directly affect infrastructure
national policy and European
companies as they do the rest of the
legislation responsibilities, which
economy.
include areas of key importance for
regulated infrastructure. In certain
36
As per the Competition Act 1998, see http://www.legislation.gov.uk/ukpga/1998/41/contents
37
For more information on the process for enacting bills into legislation, see http://www.parliament.uk/business/bills-and-legislation

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
3. Regulatory framework (continued)
The legislative framework in a given Secondary legislation could include

sector is built on the basis of a main regulations or a licence, and guidance
Parliamentary Act, which can be revised published to clarify aspects of the legal or
to address developments in the industry technical framework. This is interpreted
and is supplemented by secondary and implemented by independent
legislation. regulatory bodies that work within
3.1.2 their mandates specified by legislation
The Houses of Parliament (the UK
Legislation and operate independently of the
House of Commons and House of Lords)
Government.
alongside the devolved legislatures
in their respective jurisdictions, are Legislation establishes the overall market
responsible for reviewing draft legislation framework as well as regulators’ powers
(‘Bills’), proposed by the Government, for and statutory duties. These duties
Legislation plays a central
enactment into law. Legislation passed include, for example, a duty to ensure
role in the formulation by Parliament can take the form of an the provision of regulated services by
of the market regime for ‘Act of Parliament’, and in the regulated the relevant operators and to protect
regulated infrastructure. It sectors is often referred to as primary consumers, often through promoting
endows sector regulators legislation or statute. competition. In doing so, the regulators
with the power to issue are typically required to ensure that
The main Act typically specifies the
licences, to introduce operators are able to make a return
overall market regime and long term policy
and enforce specific such that they can finance their ongoing
objectives. It can set the overall structure
operations and new investments.
regulations, and to ensure for the industry, define access to the
compliance, which could market, extent of competition, conditions Finally, the main Act typically includes
include taking legal action for the provision of the services, as well provisions for the review of the
as the rights of consumers or users of regulator’s decisions and practices.
and imposing fines across
the services. The main Act also forms the
a sector.
basis for the enactment of secondary or
‘enabling’ legislation.
This legislative remit enables regulatory regulatory predictability and credibility

bodies to conduct themselves should provide a degree of assurance to
independently of the Government. They investors in long-lived assets.
recruit and manage their own staff,
Regulatory independence, however, is
and are able to develop sector-specific
exercised within a number of parameters
expertise. The aim is to enable regulators
and constraints, which serve to ensure that
3.1.3 to take well-informed decisions free
economic regulators are both accountable
Regulatory independence from day to day political control and
for their decisions and take appropriate
according to long term objectives
account of broader policy development.
embodied in legislation. This provides
investors in regulated infrastructure The most important parameters are
with a number of advantages: expert those contained in the relevant legislation
analysis and decision making; a longer itself. The general duties of the economic
term approach to regulatory policy; and regulator are typically set out in primary
processes that are distinct from political legislation. For example, all sector
timetables and pressures. The resulting regulators covered have some form of

duty to protect consumers and promote ensures that a reasonable return can
competition (depending on the nature be earned by investors on a forward- Economic regulation of
of the sector). A key point for investors looking basis. infrastructure companies
is that most regulators also have a duty is undertaken by
Several EU directives, including the original
to ensure that regulated companies can regulatory bodies, a
directives that drove the liberalisation of the
finance their operations. Even when
main regulated infrastructure markets to different regulator for
that duty is not present, for instance in
competition, require the establishment of each sector, each of
telecoms, the economic regulator sets
independent sector regulators in different which is governed by
the pricing framework in a way that
markets. They supported the development an independent board.
of a single EU internal market for different
Each board’s task is to
Sector regulators in the services and are still important and
influential today in many respects, including
conduct the regulatory
UK now have a long-
in the interpretation of the national legislation functions according to the
standing track-record
that the UK regulators are empowered legislation passed
of setting independent
to apply and enforce. This includes EU by Parliament.
price controls without
legislation that regulates areas associated
government intervention, with the provision of regulated infrastructure
except in limited and pre- services such as environmental is ‘unbundled’ from ownership of
defined circumstances protection or technical standards. transmission and distribution assets 40 ,
the EU Telecoms Framework Directives 41,
where Government
Examples of relevant EU legislation which drives much of the regulation in
exercises their specific shaping up the industries and market the telecommunications sector, or the EU
powers under the regimes include the Third Energy Single European Sky programme
legislation. Package, which stipulates that ownership in aviation. 42
of generation assets or retail operations
Regulatory accountability and Judicial Review
There are a number of mechanisms CMA. The most frequent such decisions the competition laws can be appealed
whereby regulators are accountable are those that concern the periodic to CAT, whereas price review decisions
for their decisions. They are expected changes in licence conditions relating to of sector regulators are appealed to the
to act in a transparent and predictable price and service (price controls). CMA. Right of appeal to these bodies
way, providing all stakeholders with provides a degree of protection for
The CMA and CAT are expert
timely opportunities to comment on the companies and investors from arbitrary
professional bodies with the experience
development of regulatory thinking and or mistaken regulatory decisions
and power to amend or overturn
a reasoned basis for decisions. Failures and is a key element of regulatory
regulatory decisions. They are
in such processes are potentially accountability.
independent from central government,
reviewable by the courts through a legal
which is an important safeguard against Regulators are also accountable to
process known as Judicial Review. 38
their decisions being vulnerable to Parliament and may be interrogated by
The merits of regulatory decisions, lobbying by special interest groups. 39 Select Committees about any aspect of
which result in amendments to existing their remit.
Generally speaking, decisions by sector
licences, can be appealed to the CAT or
regulators and the CMA made under
38
More information on the Judicial Review process can be found at http://www.judiciary.gov.uk/you-and-the-judiciary/judicial-review
39
For more information on the duties of the CMA, see https://www.gov.uk/government/organisations/competition-and-markets-authority see http://www.catribunal.org.uk/
40
For more information, see http://ec.europa.eu/energy/gas_electricity/legislation/third_legislative_package_en.htm
41
For information on the UK’s transposition of EU telecoms directives, see http://stakeholders.ofcom.org.uk/international/telecoms/framework-review
42
For information on the Single European Sky programme see http://ec.europa.eu/transport/modes/air/single_european_sky/

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
A number of regulators have a specific In March 2014, the CMA published

role in promoting or facilitating guidance on the concurrent application of
competition within their sectors and have competition law to regulated industries. 44
the power to apply the Competition Act This guidance sets out how concurrency
1998 (CA98) concurrently with the CMA will work in practice, including the
and alongside the competition primacy workings of the UKCN (UK Competition
3.1.4 duty placed on regulators through the Network) and the principles for case
Concurrent powers Enterprise and Regulatory Reform Act handling, complaints and information
2013. 43 This means that sector regulators sharing. An annual concurrency report
have the authority to enforce competition is to be published by the CMA giving
legislation within their sectors, thereby an assessment of the way concurrency
allowing the integrated use of sector arrangements have worked in the
regulation and competition law and the previous year.
application of sector regulators’ industry
expertise and ongoing surveillance to
competition cases.
3.2
Companies’ and investors’ rights
and obligations Special administration and the provider of last resort arrangements
Regulated infrastructure companies The regulators have set out requirements the continuous provision of related
usually operate under the basis of a under certain licence conditions to reduce service to customers.
licence, which is awarded by the regulator. the risk of financial failure of licensed
There are some exceptions to this, e.g. Special administration enables the
companies providing essential public
in the telecoms sector. The licence is a appointment of an administrator of
services. These requirements include
legally binding document, which sets out the licensed company in the event of
the need to maintain an investment grade
undertakers’ rights and obligations with financial distress, insolvency or other
credit rating and ring-fencing the activities
regard to providing services and charging specific circumstances. The powers are
of the licensed company (see p. 37
users. It is effectively a form of a contract governed by the relevant Acts setting
for more information on ring-fencing).
governing companies’ activities in a out the regulators’ powers and duties.
However, financial and operational shocks
regulated setting. The special administrator would oversee
could still arise that cause financial distress
the operation of the licenced entity while
to a licenced entity.
In most cases, the licence defines the it was transferred to new ownership and
required service levels and the means Where licenced entities do get into the governing Acts make provisions that
of providing services to consumers. It financial distress, regulators have differ from and take precedence over the
also effectively determines a company’s additional powers, which can include usual laws governing insolvency. This is
market condition given that no one else enforcement action or re-opening of a to enable continued provision of services to
can provide the same services without price control settlement with the aim of customers while financial and/or ownership
a licence. The licence also establishes mitigating the financial distress when restructuring takes place. Financial
the basis for calculating the operator’s it is in customers’ interests. Ultimately, distress or insolvency of regulated
allowed revenue in line with regulatory some regulators also have the power utilities is rare, and special administration
determinations. In some sectors, the to instigate special administration and powers have been used only occasionally,
licence itself includes the price or some regulators can also appoint a but they exist as a backstop to protect the
revenue limits set by the regulator as provider of last resort in order to ensure interests of customers.
amended at the time of the review.
43
duty is imposed on each sector regulator to consider whether a more appropriate way of proceeding would be under the Competition Act before using its sector-specific powers. Details of the Enterprise and Regulatory
A
Reform Act 2013 can be found at http://www.legislation.gov.uk/ukpga/2013/24/contents/enacted. Details of the Competition Act 1998 can be found at http://www.legislation.gov.uk/ukpga/1998/41/contents
44
The CMA’s guidance document can be found at https://www.gov.uk/government/publications/guidance-on-concurrent-application-of-competition-law-to-regulated-industries

and standards to ensure that they are ‘fit Stakes in these privately
and proper’, relating, for example, to their
held companies can and
ability to finance the licensed activity.
Such standards are set out by the
do change hands on
regulator before a licence is granted and the secondary market.
continue to apply afterwards. As a result, This demonstrates that,
3.2.1 in extreme circumstances the license can while the content of the
Conditions of the licence be revoked. licence (and performance
Licences generally provide a company Subject to the tests mentioned above, against it) is always
with the right to carry out regulated the ownership of the company holding carefully controlled by the
activities within a given sector in a the licence can change hands and a regulators, ownership of
specific geography. They typically allow variety of different ownership forms the licence itself is only
the company to own, construct and are possible. For example, some water lightly regulated.
maintain assets to provide a service to companies are still quoted on the London
its customers and sets out the charging Stock Exchange following a stock market
methodology and prices that it may flotation at privatisation, while most are
In other sectors licences are set
charge for doing so. now privately held. Several companies
geographically. Water companies, for
The licence sets out the scope of the are 100 percent owned by overseas
example, have a licence that grants
services that must be provided, gives industrial corporations and some are
the operator a geographic monopoly
the holder necessary rights to be able owned by financial investors, either 100
for providing the services, although
to provide them, identifies when the percent by a single owner or by multiple
the retail market for non-household
licence applies, sets any limitations on owners. Financial owners can be pension
customers is opening to competition in
ownership or transfer of ownership and funds, infrastructure funds and sovereign
April 2017. In other sectors, the licences
any geographic restrictions that apply wealth funds. 45
do not explicitly grant the operator the
to the operations (as well as any other Licences for regulated airports have only right to provide services on a geographic
applicable restrictions). been introduced recently. Furthermore, basis, but the scope for competitors to
The licence is normally held by a public Ofcom, the telecommunications enter the market might be otherwise
limited company (plc) or other limited regulator, does not issue any licences. limited. In some sectors, licences might
liability company. That company is then Operators in telecoms are instead subject also constrain the extent of competitive
the entity that owns the regulated assets to a ‘General Authorisation’ regime, set market entry. This gives more visibility
and receives the associated revenues. out in the primary legislation. 46 However, about the nature of potential competition
Licences can also be held by a subsidiary this General Authorisation is subject in the sector.
of holding companies rather than the to a set of ‘General Conditions’. These
listed plc or ultimate parent company or conditions apply to all persons providing
equity investor. Licences themselves electronic communications networks and
tend not to be time bound in the UK, but services. Individual providers may be
clauses are usually updated periodically, subject to additional conditions, such as
particularly in line with price control SMP conditions (imposed as a result of
periods. a finding of Significant Market Power by
the regulator), access related conditions
In general, there are no restrictions on or conditions imposed as a consequence
who can own a licence. However, the of a provider being designated as a
owner may have to meet certain tests universal service provider.
45
Further information on ownership structures in the water and wastewater sector can be found on Ofwat’s website at http://www.ofwat.gov.uk/industrystructure/ownership/
46
Further information on the General Authorisation Regime can be found at http://stakeholders.ofcom.org.uk/telecoms/ga-scheme/

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
Licences set out obligations on the Regulators are given powers by the
company, which it must adhere to. licence to enforce such conditions, and
These may include minimum standards they have powers to impose sanctions
of service, quality of outputs, activities such as fines and enforcement orders.
within the regulatory ‘ring fence’ and the Since regulated companies will, by
implications of failing to deliver these definition, either be monopolies or
3.2.2 obligations. There are also obligations in possess significant market power, and
Licences obligations regard to regulatory reporting, which will since regulators have a duty to protect
be likely to include preparing regulatory consumers of the service, penalties for
accounts and other compliance non-compliance with the licence can be
statements at least annually. significant.
An important aspect of infrastructure Regulated companies must also comply

utilities regulation is the regulatory ‘ring- with general competition law, notably the
fence’ around the licenced business such Competition Act 1998, EU articles 101
that assets and revenues of regulated and 102 47, and the Enterprise Act 2002. 48
activities are clearly separated from those
of non-regulated activities.
Investors have certain rights that protect appropriate explanation and justification.
their interests. The property rights and In response to the consultation, all
contracts can be enforced in courts interested parties, including the regulated
and the UK legal regimes are generally company, can make representations
viewed as one of the most established, that need to be considered. Decisions,
independent and transparent in the reasoning and evidence supporting them
3.2.3 world. English law is often used as the are made public.
Investor rights and expectations preferred jurisdiction for commercial
transactions more generally. Companies also have rights to appeal
important regulatory decisions, such
Sector regulation is also based on a set of as price controls, ‘on merit’ (with some
fundamental principles, which underpin exceptions). This means that they can
regulators’ obligations and define argue to an independent body that the
regulatory best practice. These principles regulator is in error and has incorrectly
were identified by the Better Regulation interpreted the facts of a case or
Task Force and together with general has taken inappropriate action under
market practices are discussed in more its duties. Regulated infrastructure
detail in section 4. companies generally appeal in the first
instance to the CMA whereas decisions
One of these principles, which is of under the competition powers are
paramount importance to investors, is appealed to the CAT. The right to appeal
transparency—the basis for regulations is an important safeguard for investors
has to be explained and decisions taken and is usually, though not always, set out
only after public consultation, including in the licence.
47
etails of EU articles 101-106 can be found at http://ec.europa.eu/competition/antitrust/legislation/articles.html
D
48
Details of the Enterprise Act 2002 can be found at http://www.legislation.gov.uk/ukpga/2002/40/contents

Ring-fencing
Ring-fencing of regulated activities is a cannot be transferred out, nor can non- the investments they pay for, and not to
key feature of the regulatory regime. It is regulated assets and activities typically be allow the regulated activities to confer
a set of provisions which seek to protect transferred in without regulator’s consent. a competitive advantage to the non-
consumers from being exposed to risks, regulated activities. The regulatory ring
Regulatory ring-fencing aims to ensure
including financial risks, associated fence often corresponds to the financial
that there is no cross-subsidy from
with activities that are carried out by ring-fence, which controls cash flows,
regulated to unregulated activities so that
other, unregulated activities and entities assets and activities of regulated entities
companies’ other market activities do not
within the same corporate group as the and their parent companies from the
draw undue advantage from the regulated
parent of the infrastructure provider. financing and control perspectives.
company’s market power. This is also
The regulated entity is required to be
designed to protect the licensed activities
separate and distinct from other entities
should the parent company or any of its
within the corporate group with no cross-
other subsidiaries become distressed,
subsidisation. The licensed activities
to ensure that customers benefit from
and assets sit within the ring fence and

IN THIS SECTION
§§ What are the key principles

and objectives of infrastructure
regulation in the UK?
§§ What are the key costs/revenues

and how does cash flow?
§§ How are the key economic

regulation principles applied in
each sector?
REGULATORY PRACTICE
EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
4. Regulatory practice
The long track-record of applying they underpin investors’ confidence RAB-based approach used to set prices
economic regulation to infrastructure in regulation and, ultimately, in the for regulated infrastructure. This includes
sectors in the UK has resulted in a set infrastructure sectors at large. the basic building-blocks process used
of high level principles of regulatory for setting allowed revenues and prices.
Regulatory methodologies and price
practice, which have been generally This generic, high level model can then be
reviews are applied in practice based on
followed since privatisation. Some of broken down into its key constituent parts
the high level principles mentioned above
these principles are explicitly stated but to explain some of the main differences
and discussed in more detail below. The
many are also effectively implied by the across sectors and what these differences
most prevalent, but not exclusive, form of
way in which sector regulators have mean for companies and investors in
infrastructure regulation can be illustrated
approached the price and output setting terms of risks and returns.
using a simple, generic version of the
process. They are important because
Figure 8: Selected principles of regulatory practice
Transparency Independence Commerciality
Predictable Return of efficiently

methodologies Statutory independence invested capital
Regulatory bodies are granted Capital that is efficiently
Regulators publish
statutory authority and are invested and employed in the
regulatory methodologies
separate from Government. business can be recouped by
in advance of applying them
and consult on them. investors over the course of
the economic asset lives.
Recognition
Clear engagement process Right to appeal of required returns
Consultations allow for feedback Companies may appeal regulatory Regulators allow companies
and challenge to regulatory decisions to competition and investors a reasonable return
approaches. Regulators’ authorities. on investment, commensurate
analysis is available and verifiable.
with the risks taken.
Evidence-based decision- Long-term visibility

making supported by Adaptability Stable, multi-year settlement
economic analysis Regulators are able to tailor periods with no sudden,
Regulators explain their their approach to market radical changes provide
rationale and publish relevant circumstances and decisions companies and investors with
evidence to support their decisions. may be company-specific. the ability to look ahead.

4.1 §§ Cost efficiency: Regulators challenge that regulators’ decisions should be
Objectives and principles of UK companies to reduce their overall explained and verifiable.
economic regulation costs of service, both operational
§§ Consistency: The Government rules
and capital, often through efficiency
4.1.1 and standards must be implemented
targets and incentives, with the overall
Consumer protection fairly and consistently. This underpins
objective of ensuring that consumers
continuity and sets limits on regulatory
The primary role of the regulator is to receive value for money for the prices
discretion.
protect consumers, who in the absence that regulated infrastructure service
of regulation would bear the costs of providers are allowed to charge. §§ Transparency: Regulators should be
market failure, e.g. from excessive open and keep regulations simple
prices or from underinvestment. This §§ Quality of outputs: Regulators
and transparent. This means that
role can take a number of forms, which determine the overall quality and
regulations must be well understood
vary depending on the nature of the robustness of the infrastructure that
and clearly explained.
market failure that the regulator has to companies own and use to deliver
services to consumers to ensure that §§ Targeting: Regulation should be
remedy and hence the type of regulation
it is fit for purpose and affordable. In focused on market failure and
applied in a given market. For most
some sectors this may also relate to minimise side effects. This is
regulators, this includes the promotion
security of supply. particularly important because it aims
of competition, but competition might
to limit extending regulation to areas
not be possible or effective in all markets §§ Conduct regulation: Relevant
where it is unnecessary or too broad
where companies have significant legislation and regulation set out the
compared with the market failure it is
market power. standards of conduct that govern
trying to address.
In the parts of the value chain where how companies should behave and
the standards of service consumers The Legislative and Regulatory Reform
effective competition is possible,
should expect. Act of 2006 was passed to establish
regulators try to ensure that markets
statutory principles of good regulation
are least distorted and as competitive
4.1.2 based on the above principles. This Act
as possible. Where there is a need for
Key features of UK economic obliges regulatory authorities to have
regulation, this should aim to be least
regulation regard to the above principles and a
burdensome to avoid additional costs
UK regulatory practice is based on a regulatory code of practice. 50
and distortions. This may mean that,
for example, some parts of the value set of fundamental principles, which
A wider set of behaviours or principles of
chain are deregulated or that smaller underpin regulators’ obligations and
regulatory practice can be also identified,
companies are not burdened with the define regulatory best practice. In
which has emerged over the long track
same level of regulation as larger ones. particular, five such principles were
record of applying economic regulation
identified by the Better Regulation Task
since privatisation. These more granular
For regulation of natural monopolies, Force in 1997 as the basis for regulatory
principles are effectively implied by the
where effective competition might be conduct that is fit for purpose. 49
way in which sector regulators have
limited to the supply chain, the regulator’s These include:
approached the price and output setting
duty of consumer protection
§§ Proportionality: This means that process for regulated companies and
is typically discharged through a
regulators should only intervene when are consistent with the five principles
number of channels related to different
necessary and that this intervention listed above.
companies’ activities, to simulate market
pressures and ensure economically should be proportional and limited to
These principles include, inter
efficient outcomes. Examples of these the problem identified in the market.
alia, predictability, transparency,
channels and corresponding regulatory §§ Accountability: Regulators should be engagement, independence, right to
tools include: able to justify decisions and be subject appeal, commerciality, and evidence-
to scrutiny. In practice, this means based decision-making supported by
49
ore detail on the five principles devised by the Better Regulation Task Force can be found at http://webarchive.nationalarchives.gov.uk/20100407162704/http:/archive.cabinetoffice.gov.uk/brc/upload/assets/www.brc.gov.
M
uk/principlesleaflet.pdf
50
Details of the Legislative and Regulatory Reform Act 2006 can be found at http://www.legislation.gov.uk/ukpga/2006/51/contents

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
4. Regulatory practice (continued)
appropriate economic and financial regulatory methodologies based on them, the required return on capital, should
analysis. This, in turn, implies it is considered one of the most mature be reflected at any particular point in
consideration by regulators of the markets for regulated infrastructure. time. This means that, from the investor
terms on which the private sector perspective, there is always an element
Although there is no binding commitment
would commit capital while ensuring no of underlying risk.
by regulators for any particular form
abnormal returns.
of regulation or regulatory practice to
4.1.3
These wider principles that can be continue in the future, the generally
Incentives-based regulation
observed in regulatory practice are not consistent application of these principles
all hard coded or legally binding, but have over the past 20 years has distinguished A key feature of economic regulation
been generally followed by UK regulators the UK as a leader in terms of visibility, of utilities infrastructure in the UK is
since privatisation. This consistency transparency and consistency in applying the presence of financial incentive
in the approach to regulation plays regulation. Its continuation is likely mechanisms, the aim of which is
the crucial role in establishing investor to be critical to ensure private sector to encourage companies to adopt
confidence and underpin the successes participation and hence give customers behaviours that maximise benefits
of regulated sectors in attracting private the benefits of private ownership and to consumers.
capital and delivering strong outputs management in the future. It is also intended to help promote
for consumers. symmetry of information, i.e. to
While these high level principles have
Many of these principles have now been been generally followed by regulators, it incentivise companies accurately to
adopted in other jurisdictions. However, should be also recognised that regulatory communicate costs to regulators.
since the UK has played a central role in practice differs by sector and over The way this works in practice is that
the development and first application of time. There is also no uniform view as if, for example, companies outperform
these principles as well as of the detailed to how some of these principles, e.g. their underlying cost targets used to set
Figure 9: R
ecovery of asset costs plus an allowed return under the generic revenue ‘building blocks’ model
Total
return
Investors earn a return to compensate
for present value of capital plus the risk
they take in investing Return
Depreciation
Investors recover original investment
over lifetime of the asset
Return
Investment Original
in year 0 investment
Return Depreciation
Return Depreciation
Depreciation
y0 y1 y2 y3 yx
Asset life
Source: KPMG analysis

Figure 10: R
eal weighted average costs of capital (excluding tax allowance) and notional gearing levels set
at the most recent price determination for the aviation, energy, rail and water sectors
6%
percent
4.90%
5% 4.66%
4.55% 4.38% 4.31%
4.24%
4% 3.76% 3.70%
55:45
3% 60:40 60:40
63:38 63:38
65:35
65:35 63:38
2%
1%
0%
Electricity Gas Gas Gatwick Heathrow Network rail Electricity Wholesale water
transmission distribution transmission airport airport 2014 distribution and wastewater
2013 2013 2013 2014 2014 2015 2015
(draft)
effective from (year)
Source: Regulatory publications, KPMG analysis
Note: Cost of capital determinations for RIIO price controls for energy networks are based on an indexed cost of debt, which
changes over time. The numbers presented above are based on the value of the index at the time of the final determination. Some KEY Debt Equity
RIIO price controls also include different cost of capital determinations for slow track and fast track companies—the results for
slow track companies are presented above. For water and wastewater the presented number is based on Wholesale Water and
Wastewater only (excluding Retail) at the time of the Draft Determination.
regulated revenues and prices, they can bearing those risks that they are best and Safety Executive (HSE) determined
keep at least some of the gains from placed to manage. In practice, not every that all cast iron gas mains close to
outperformance. There may be also time possibility can be accounted for. For domestic properties should be replaced
limits on this retention and typically there example, in the energy sector, the Health with plastic over a 30 year period, which
are mechanisms in place to share gains was allowed for in the costs of the
with consumers. This information can relevant regulated companies.
also be used to benchmark costs Some risks may be shared
To ensure full transparency, under
across companies. between companies
best regulatory practice, all regulatory
Alongside economic regulators, other and consumers, for mechanisms to be implemented are
agencies are responsible for approving example via the so-called communicated and consulted with
companies’ specific competencies ‘uncertainty mechanisms’ companies in advance. The UK regulators
required to undertake their duties, where certain outcomes also tend to avoid clawing-back gains
for example, health and safety and of the regulatory review retrospectively and changing rules
environmental standards. In some cases, are subject to future ex post because it may be seen as
the economic regulators are also the weakening incentives for enhancing
market developments.
safety regulators. The cost of meeting efficiency and performance. This
these requirements may be taken into
Companies may also be approach has been supported and
account by the economic regulator in able to earn additional reflected by the competition authorities’
setting price limits. revenue for improving decisions in the course of appeals of
service standards through regulatory decisions.
In general, it should be clear which risks
are to be borne by the company and incentive mechanisms. Regulators conduct public consultations
which by consumers, with companies prior to making their decisions. The

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
approaches and evidence supporting expenditure funded by investors. This remuneration of the inflation component
regulatory determinations are made is not the only possible approach but is of the total return is delayed compared
available for public analysis. Interested most common. with the real component.
parties can assess a regulator’s approach
What this means for regulated The allowed returns presented in Figure
and respond to consultations and/or take
infrastructure is that the regime allows 9 are post-tax, ‘vanilla’ returns, i.e. they
part in stakeholder workshops to discuss
for the efficient capital spent during that exclude an allowance for tax, which the
their views with the regulator. The
period to be recovered over time and a company is assumed to have to pay on
regulatory process and approach, therefore,
return earned on the capital employed its returns to equity only and which is
tends to be open and transparent.
during the period. This is illustrated in estimated separately and included into
Figure 9 on page 42. the total allowed revenues. The allowed
4.1.4
‘vanilla’ WACC means that there is no
Principles of returns of and on The amount of capital invested in the
invested capital additional revenue allowance for the
business might be set explicitly or
hypothetical tax payments on debt
Most regulators have a duty to ensure as a proportion of the total allowed
that can then be saved using debt tax
efficient companies can finance their expenditure (totex, which combines
shields, unless there is a difference
licensed activities. This duty tends to capital and operational expenditure as
between actual gearing and one used for
be discharged through the allowance explained further below) that should
estimating the tax allowance.
for a return of and a return on efficiently be capitalised rather than charged to
invested capital alongside the recovery of consumers in a given year. While it is most common, the generic
efficiently incurred costs from end users approach described above is not
The capital invested in the business is
(as opposed to taxpayers). universal, with other forms of price
typically remunerated at the allowed rate
regulation such as, for example,
This approach implies there should be of return. This reflects acknowledgment
allowance for average cost plus a margin,
no ‘revenue gap’ between efficiently of the fact that capital comes at a price
applied in some segments of the value
incurred costs and the allowed and requires a return, which is recognised
chain in certain sectors. The specific
revenue (which is not the case in all by all regulators.
approach to the calculation of allowed
other jurisdictions where similar type
This rate of return is typically set as a revenues varies across regimes and is
of regulation is applied). 51 However,
constant for a regulatory period, although discussed in more detail in sections 4.3
timing differences and adjustments
in some cases recently (e.g. in energy to 4.7.
through regulatory mechanisms linked
networks) regulators have introduced
to performance as well as discrepancies Cost recovery
annual cost of capital indexation, which
between projections and outturn
updates some components of the cost From the regulatory perspective, in order
inflation, or other economic factors, mean
of capital (the allowed cost of debt in to determine prices, companies must
that they would not necessarily equalise
this case) annually over the course of estimate their future costs at the start
at all times.
the regulatory period. Figure 10 sets out of each regulatory period and calculate
For the avoidance of doubt, the rest of this the current allowed real rates of return the revenue they will require during that
section describes a generalised model and on capital and notional gearing levels for period to recover their costs. In simple
not all facets of which apply to all sectors. each of the sector regimes. terms, using an estimate for demand
This is particularly the case for telecoms. volumes (e.g. energy consumption,
The rates of return are calculated in
real terms, but investors are allowed a number of passengers, etc.), the
Allowed returns company is then able to calculate the
nominal return. The inflation component
Typically, the calculation of returns of the total return is typically estimated required price per unit.
on the capital employed over a given and recovered separately by applying This approach means that at the
period is based on the returns on net inflation adjustment to the asset base. beginning of each regulatory period
capital at the beginning of the period It is usually recovered through the the regulated companies submit their
adjusted periodically downwards for allowed depreciation, i.e. the capital business and financial plans to the
allowed depreciation (which is recovered repayment part of the total allowed regulator, which then assesses the
through prices) and upwards by capital revenues. In practice, this means that the proposals provided by the company,
51
Rail is the exception to this general rule, as the costs are not fully recovered from end users, but are partly subsidised by the State. This is discussed further in section 4.3.3.

in conjunction with its own evidence approach is based on a revenue regulated activities including asset
and analysis, in order to determine the cap rather than a price cap. construction, asset maintenance and
allowed price or revenue levels. This means that the regulated operating costs; and
infrastructure company does not
The concept of allowed costs is a – A return on asset value: to
bear volumetric risk. If volumes are
key element of regulated revenues remunerate investors for providing
lower or higher than forecast and
and price limits. Regulators pay close the capital to construct the assets.
revenues are therefore over or under
attention to the costs projected by each
recovered, these are “trued-up” §§ Costs: It is generally recognised that
regulated company. The approach to the
in subsequent years to recover or efficiently incurred costs should be
regulatory cost assessment varies across
repay the difference, though as part recovered. Allowed costs that can
regimes, but regulators generally use a
of their determinations regulators be recovered from consumers are
range of benchmarking and ‘yard-stick’
may consider the extent to which determined by regulators using a
assessments, comparing company
companies should bear the risk combination of benchmarks from other
business plans against one another (with
associated with inaccurate volume companies in the sector and from other
companies both inside and outside of
forecasts. sectors. Operating cost allowances are
the sector), over time and across sectors
based on an expectation of efficiency
to test companies’ projections against Revenues are collected from
savings each year. The depreciation
benchmarks. They also use independent consumers typically through a
allowance is normally based on
third party estimates and analysis while combination of a fixed and volumetric
economic asset lives.
companies submit their own evidence and charge. Consumers can be end users
justification to support their projections. such as residential bill payers or Some regulators are moving away
The analysis and determinations are industrial and commercial customers. from the distinction between
generally evidence-based. capital expenditure and operational
In most sectors, all revenues
expenditure, focusing instead on
In determining allowed costs that come from these charges. For
total costs (totex) and allocating a
can be recovered from customers, example, there is generally very little
fixed percentage of this spend to be
regulators take into account year-on- government subsidisation, and the
capitalised in the asset base, with the
year efficiencies that companies are ‘user pays’ principle is adopted in
remainder being treated as an in
assumed to be able to achieve. In line most of the sectors in the UK.
year allowance.
with the principles of incentive regulation,
Historically, some regulators have
if companies are able to outperform Cost allowances typically include a
used the ‘RPI-X’ approach to revenue
assumed efficiencies, they keep at least forward-looking view of the effect of
setting, whereby revenues are linked
some of the difference. inflation, and some regulators break
to RPI inflation, less the expected
down costs into separate buckets and
These are the central features of savings from efficiency gains.
provide a different inflation assumption
many regulatory regimes for regulated
§§ Building-blocks: To determine the level for different cost elements.
infrastructure and are particularly
of allowed revenues that the regulated
important for attracting long-term Cost allowances also typically include
company can earn, regulators consider
investors, who are willing to put capital at an efficiency assumption, such that
projected costs for the regulated
risk over the lifetime of the assets. companies are incentivised to reduce
company over the coming regulatory
costs to at least this level. Companies
period. The costs are known as
4.2 are generally able to retain at least a
the ‘building-blocks’ of the allowed
Regulated cash flows and revenue proportion of any gains beyond this
building blocks revenue and include:
assumed efficiency level.
This section provides a simplified, high – Depreciation: the recovery of capital
§§ Returns: There is a recognition that
level illustration of how the allowed investment spread over the lifetime
companies and investors need to earn
revenue for a generic regulated of the assets;
a reasonable return on their capital
infrastructure company is built up.
–A
n operational allowance: to for operating a well-run company,
§§ Revenues: Typically, the regulatory fund the costs of carrying out the i.e. a return that reflects the risk they

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
are bearing. There is potential for 4.3 airport, while about 75 percent of the
out- and under-performance through Sector-specific regulations UK population can reach three or more
cost savings, normally operational, airports within two hours’ drive time. 54
The generic cash flow model described
but sometimes also on efficient
above varies in certain respects This availability and proximity of multiple
capital expenditure. Outturn profits
between different sectors and even airports for large parts of the population
can also be increased or decreased
sub-sectors. Revenue building-blocks might be taken to imply a high degree
through incentive mechanisms. In
and risk mechanisms will differ on the of choice for airport users and hence
most cases, customers also share the
basis of sector-specific circumstances, effective competition without the need
benefits and risks of out- and under-
for example whether there are separate for economic regulation. However, in
performance. There is also recognition
wholesale and retail markets, or the practice, not all airports offer the same
that shareholders expect dividends to
extent to which the infrastructure is services and some services require scale
be paid from the allowed returns.
vulnerable to service disruptions. The or other business characteristics to be
§§ Interest: There is a recognition of the following sections revisit the generic cash economically viable. These services can
importance of ensuring companies flow model in relation to each regulated include long-haul travel, connectivity
can support future investment needs, infrastructure sector and explain the key (including whether the airport acts as a
and therefore that companies should differences between each regime in hub) and a choice of destinations, and
maintain an investment-grade credit- terms of structure, regulatory approach tend to be concentrated in a smaller
rating and be financeable. The cost and risk and reward in more detail. number of relatively large airports. Thus,
of capital allowance is based on an concentration and specialisation can give
While the fine details of each cash flow
assumption that the company is rise to market power and consequently
model will vary depending on the sector,
efficient and maintains an investment the need for regulation.
the objective of this section is to highlight
grade credit rating on the basis of an
the key considerations and distinctions The location of airports relative to
assumed notional capital structure,
rather than exhaustively describe all population centres and the quality of
which should be clearly achievable in
elements of regulation. the surface access, particularly around
the current market conditions.
London, can also affect airports’ market
§§ Tax: It is recognised that companies position. However, the aviation sector
4.4 Aviation
have to recover from consumers the is dynamic and the use of airport
amounts of tax they have to pay to the 4.4.1 infrastructure can change over time,
state. Tax allowances are generally Industry structure as evidenced by the rise of the low
calculated either to approximate the cost carrier airline model, global airline
actual tax costs or on a notional basis Airports and the air traffic control system alliances, or new international routes
through an uplift to the allowed return. constitute the infrastructure-heavy parts and hubs. It is this tension between
of the aviation sector, which is, in some certain monopoly characteristics on
§§ Reinvestment: There is a general parts, subject to economic regulation. the one hand, and the choice available
expectation that a combination of
The UK has a large number of airports to consumers on the other hand,
retained earnings and new capital will
that are used for operating commercial which is one of the key distinguishing
be used by companies to fund new
passenger flights relative to its features of airports compared with other
investments. In order to ensure that
population. 52 As a result, in certain infrastructure sectors.
companies can raise new capital and
hence fund new capital expenditure geographical areas, many airports are in
there is a requirement on most relatively close proximity to each other
companies to maintain a secure and a high proportion of the population
investment grade credit rating. in that area can reach at least one major
airport within a reasonable time. 53 About
70 percent of the UK population are
within one hour’s reach of at least one
52
Statistics on UK airports can be found on the CAA’s website at http://www.caa.co.uk/default.aspx?catid=80&pagetype=88&pageid=3&sglid=3
53
A major airport is defined as one with more than one million passengers per year.
54
CAA estimate, see http://www.caa.co.uk/docs/5/20110905%20Market%20Context-FINAL.pdf for more information.

Figure 11: Airport money/service flow
Air traffic
control
Airlines
Airport
Cash flow
KEY
Service flow
Passengers
4.4.2 The framework for licensing and Following the new market structure, the
Legislation, regulation and licences regulating airport services has recently CAA undertook market power tests of
Regulatory framework for airports been reviewed and a number of Heathrow, Gatwick and Stansted airports
amendments enacted. In particular, and concluded that Heathrow and Gatwick
The regulatory framework for UK airports
The Civil Aviation Act 2012 set out a met the market power tests. 58 The
is set out primarily in the Civil Aviation
new system of airport regulation. This CAA found that Stansted should not be
Act 2012. 55 Any airport with over five
in turn meant that the CAA’s economic subject to economic regulation from 2014
million passengers per annum is also
regulation powers for the non-designated onwards, i.e. charges at Stansted Airport
subject to regulation via the Airport
airports in England, Scotland and Wales for passenger and cargo traffic are no
Charges Directive 2009/12/EC, which
under the previous 1986 Act ceased from longer determined by the regulator.
was transposed into UK law as the
6 April 2013 and its powers under the
Airport Charging Regulation 2011. 56 This Licences
1986 Act for the designated airports of
sets out rules with regards to the setting The introduction of licences for
Heathrow, Gatwick and Stansted ceased
of charges for airport infrastructure and is designated (i.e. regulated) airports was a
from 1 April 2014.
designed to ensure a consistent approach significant feature of the 2012 legislation,
to charging across the single market. Under the Civil Aviation Act 2012, giving CAA a powerful regulatory tool
The CAA also has regulation powers decisions are taken by the CAA against that also enabled greater flexibility in
under the Airports (Ground-handling) specified criteria to ensure that airports the approach to economic regulation.
Regulations 199757, which implemented are only subject to economic regulation Previously, airports constituted the
the Ground-handling Directive 1996/67/ where certain criteria are met, including only regulated infrastructure sector
EC on access to the ground handling criteria around market power and that the where licences did not apply and the
market at EU airports. benefits of regulation outweigh the costs. market regime was based on primary
legislation. The introduction of licences
55
Details of the Act can be found at http://www.legislation.gov.uk/ukpga/2012/19/contents/enacted
56
Information on the Airport Charges Regulations 2011 can be found on the CAA’s website at http://www.caa.co.uk/default.aspx?catid=5&pageid=14467
57
See http://www.caa.co.uk/default.aspx??catid=78&pagetype=90&pageid=69 for more information.
58
Sections 5 to 8 of the Civil Aviation Act 2012

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
brought the sector more closely in line 4.4.3 Paris-Orly and Brussels Airport. The
with other regulated industries. Under Regulation in practice and risk CAA looked at this issue in detail as
new legislation CAA was able to adopt & reward part of the Q4 price control review and
a more appropriate regulatory regime The key features of the economic found in favour of maintaining a single till
for Gatwick, where, instead of the regulation of airports that make it distinct approach, on the grounds that a single
CAA imposing a price cap, the airport from the other UK regulated sectors till recognises the demand and revenue
undertakes certain commitments and include: complementarities between aeronautical
prices are monitored against a ‘fair price’, and non-aeronautical services, and is
with the intention that the CAA will §§ Airports undertaking both competitive more similar to what emerges from the
intervene if required. The effect is that, and commercial non-core activities as natural working of competition at non-
in general terms, the regime still protects well as core aeronautical services; regulated airports. 61
consumers, but offers some additional §§ Traditionally a price cap regime rather 4.4.3.2
flexibility in detail. than a revenue cap, i.e. demand risk is Price cap versus revenue cap
Air navigation services borne by the airport; and
Most UK regulatory settlements are
The provision of en route Air Navigation §§ An increased role for airport users. ‘revenue caps’ rather than ‘price caps’.
Services (ANS) in UK airspace has been That is, an overall level of revenue is
4.4.3.1
subject to economic regulation, including determined and divided by forecast
Single till regulation
fixed control period price controls, volume / passenger levels to determine
since the privatisation of National Air Under the ‘single till’ principle, the full a user charge. Should actual volumes
Traffic Services in 2001. These services range of airport activities (aeronautical not match forecast levels, there is a
are provided by NATS En Route plc and commercial) are taken into provision for adjustments to be made to
(NERL) under a licence issued by the consideration to determine the level subsequent revenues. Under a price cap,
Government under the Transport Act of airport charges. By contrast, only there is no such provision for a correcting
2000, which gives effect to economic aeronautical activities are taken into factor and revenues move up or down
regulation. 59 consideration under the dual till principle. with volumes , as mentioned in section
This means that the single till deducts 4.2. Conceptually, the key difference
The licence is monitored and enforced non-regulated net revenues from the total between the two models is the level
by the CAA as the economic regulator. regulated revenue requirement whereas of volume or demand risk to which the
Economic regulation of ANS in UK the dual till separates the regulated and regulated company is exposed. Under
and Europe has become increasingly non-regulated businesses and sets a a revenue cap the company faces little
governed by EU legislation under the price cap for the regulated business demand risk due to the correcting catch
Single European Sky (SES) Performance without consideration for the non- up factor, whereas under a price cap the
Scheme 60 , which is the EU-led initiative regulated business. company does face demand risk.
to improve the performance of ANS.
Terminal air navigation services are also The issue of single till regulation is keenly Consistent with the partial competition
subject to the SES performance scheme. debated wherever economic regulation of that exists in the airport sector, the
However, they are currently exempt airports is in place and is not universally CAA implements a price cap for the
from domestic licence based regulation applied. Single till is the more common designated airports, exposing airports to
under Air Traffic Service (Exemption) regulatory approach globally, however the demand risk. 62 This additional level of
Order 2011 (SI 2011/425) until at least 31 and notable dual till examples include risk is reflected elsewhere in the regularly
December 2019. Schipol Airport (Amsterdam) and Sydney model, namely in the allowed cost of
Airport, and there are examples of equity feeding into the allowed WACC.
emerging hybrid approaches including
59
Information on NERL’s licence to provide regulated en route ANS can be found on CAA’s website at http://www.caa.co.uk/default.aspx?catid=5&pagetype=90&pageid=585
60
Further information available at https://www.eurocontrol.int/articles/performance-scheme-single-european-sky
61
C AA further concluded that the incentives acting upon the airport were generally more focussed on positive consumer aeronautical outcomes in the areas of investment, operating efficiency and service standards and
that prices could be expected to be lower under a single till.
62
W hile there is no explicit passenger volume correction factor in the airport revenue model there is a passenger mix correction factor to protect airports from airline decisions outside the airport’s control.

4.4.3.3 disagreement between the airport and its There is a diverse range of companies
Single European Sky Performance Plan airlines around key inputs into the CAA involved in upstream activities (i.e. gas
The SES Performance Scheme for determination. wholesale and electricity generation),
Air Navigation Services (ANS) aims to which are responsible for the wholesale
CE is not intended to displace the CAA
improve the performance of European of energy through markets or through
but does allow the regulator to step
ANS by establishing targets at the EU- bilateral contract arrangements. Many
back from the process. Where the CAA
level and committing Member States of the companies present are major
believes airport / airline agreed outcomes
to adopt consistent targets at the local international corporations with multiple
are in the best interest of passengers, it
(national or Functional Airspace Block investments in the UK, others are
takes more of an oversight role. Notable
(FAB) level. The Scheme was introduced independent power producers. In GB, the
elements of CE include:
through amendment to the SES high- tariffs paid by consumers for electricity
level legislation (SES II), supplemented §§ It is a multilateral approach intended to and gas are not subject to price regulation,
through the adoption of a Performance apply with an independent facilitator; but are determined by the market.
Regulation and amendment to the §§ It is not a series of bilateral The infrastructure-heavy part of the
Common Charging Regulation in 2010. 63 commercial agreements; and value chain consists of a number of gas
The EC appointed Eurocontrol to act as and electricity network businesses.
§§ Discussions should include issues
an independent Performance Review The gas transmission network is
beyond the regulatory building-blocks,
Body (PRB) and to advise it on the owned by National Grid, and the gas
including strategic context
development and implementation of distribution networks are owned and
and affordability.
the Scheme. 64 There are four Key operated by a number of gas distribution
Performance Areas (KPAs): safety; the Aside from constructive engagement, network companies (GDNs), which are
environment; capacity (delay); and cost- the increased role of users in setting licensed to deliver the services over
efficiency. Reference Period 1 (RP1, outcomes is also evidenced in bilateral specified geographical areas. Electricity
2012-2014) of the Performance Scheme contracts that have played a key role, transmission and distribution are also
focuses on the en route environment particularly at Gatwick. undertaken on a regional basis. Electricity
only and sets EU-wide targets for the distribution companies are known as
environment, capacity and cost-efficiency distribution network operators (DNOs).
KPAs, with national/FAB targets 4.5 Energy
In recent years, there has been a
only required for the latter two - the 4.5.1 growth in smaller companies with
environment target will be addressed at Industry structure network licences for providing particular
the network level for RP1. small regions (for example industrial
The gas and electricity sectors in Great
4.4.3.4 Britain are characterised by a number of developments) with gas and electricity
Constructive engagement private sector companies providing the distribution services. The providers of
services of generation, transmission and such services are known as independent
A key feature of the application of the
distribution (i.e. network services) and gas transporters (IGTs) in gas, and
regulatory model in airports is the degree
retailing (i.e. supply and sales of energy independent distribution network
of airport/airline engagement in shaping
to end users. Private sector ownership operators (IDNOs) in electricity. 65
and informing the outcome of the price
control reviews. This is referred to as in the sector is largely the result of a
privatisation process that took place more 4.5.2
‘constructive engagement’ (CE) in the
than 20 years ago and had been followed
Legislation, regulation and licences
airports context. CE was first introduced
as part of the previous Q5 price control by extensive corporate activity, including The main body with responsibility for
and was extended for the current Q6 multiple changes of ownership and regulation of the energy sector in GB is
control. The output of CE is intended to some consolidation. Ofgem. Ofgem is the Office of Gas and
be a clear statement of agreement and Electricity Markets.
63
F urther information on the CAA’s implementation of the SES Performance Scheme for ANS can be found at http://www.caa.co.uk/default.aspx?pageid=11579
64
F urther information regarding Eurocontrol’s role in the Single European Sky initiative can be found on the Eurocontrol website at https://www.eurocontrol.int/single-sky
65
S ee Ofgem’s website for more information on IGTs at https://www.ofgem.gov.uk/gas/distribution-networks/connections-and-competition/independent-gas-transporters, and https://www.ofgem.gov.uk/electricity/
distribution-networks/connections-and-competition/independent-distribution-network-operators for more information on IDNOs.

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
Figure 12: Energy money/service flow
Suppliers Gas
producers
Generator
Transmission
&
Transmission distribution
&
distribution
Consumer
Cash flow
KEY
Service flow
Ofgem is governed by the Gas and market participant is involved in gas or the fair treatment of customers by the
Electricity Markets Authority (GEMA). electricity, and which part of the value energy retailers through the promotion of
The Authority determines strategy, sets chain they are involved in (for example, standards of conduct in how the supply
policy priorities and makes decisions there are separate electricity generation, companies interact with customers.
on a wide range of regulatory matters, transmission, distribution and retail
In 2014, following a market assessment,
including price controls and enforcement. licences). The ability of a participant to be
a report by Ofgem and OFT deemed that
The Authority’s powers are mainly awarded multiple licences is also subject
competition was not working as well
provided for in legislation including the to EU ownership unbundling requirements,
as it should for consumers. As a result,
Gas Act 1986, the Electricity Act 1989, whereby holdings in generation and retail
Ofgem referred the energy market to
the Utilities Act 2000, the Competition assets must be separated from those in
the CMA for market investigation. The
Act 1998, the Enterprise Act 2002 and transmission assets.
focus of the CMA’s market enquiry is
the Energy Act 2004, the Energy Act
Outside of the regulated network on retail and wholesale parts of the
2008 and the Energy Act 2010. They also
businesses, Ofgem has market oversight value chain rather than networks but the
arise directly from EC legislation. 66
and investigative powers to monitor the outcome of the investigation is likely to
Ofgem is responsible for issuing competitiveness of the wholesale and have implications for the entire sector.
licences to operators in the sector. retail energy markets. In recent years, The CMA is expected to publish its final
There is a range of licences Ofgem the energy regulator has introduced decisions by the end of 2015.
awards depending upon whether the multiple licence modifications to promote
66
F or more information on the role of GEMA, see https://www.ofgem.gov.uk/about-us/who-we-are/gas-and-electricity-markets-authority. Further detail on the powers and duties of GEMA can be found at https://www.ofgem.
gov.uk/publications-and-updates/powers-and-duties-gema

4.5.3 regulatory scrutiny and is put in the fast- mechanism, with the Caithness Moray
Regulation in practice and track to finalise their price controls and transmission project in Scotland being
risk & reward receive a number of incentive benefits. one recent example. 67
The gas and electricity transmission §§ A greater role for customers in As well as regulating the incumbent
and distribution licensees are regulated setting targets: Customers have network companies via the RIIO
under Ofgem’s RIIO model (Revenues = been more involved in the business framework, Ofgem also oversees
Incentives, Innovation and Outputs), planning process as regulated regulation of OFTOs and interconnectors.
which has been introduced recently and companies have been responsible For OFTOs, the competitive tender
is now applied to the regulation of all for extensive customer consultation process sees bidders compete for a
energy networks. on their business plans and price regulated availability-based revenue
At the core of the RIIO model are the review submissions. Where the stream over the life of the asset. 68 For
general principles of efficient cost regulator has seen a clear case made interconnectors, Ofgem has introduced
recovery, incentives and return of and on for expenditure in a business plan a “Cap and Floor” regime for new
efficiently invested capital, as described that is both efficient and required interconnector projects, whereby
in Section 4.2. However, there are by customers, these costs should developers’ revenue is governed by
also other features of the RIIO model generally be included in the resulting a cap and floor on returns (such that
that provide companies with additional regulatory allowance. returns below the floor are topped up by
incentives. In particular, key aspects of consumers, and returns above the cap
§§ Outputs: RIIO price controls also
the RIIO model include: are clawed back). 69
specify a set of outputs the company
§§ Longer regulatory periods than in must deliver over the eight-year There is a number of variations to
other price controls in regulated period. Outputs tend to take the form the application of the core industry
sectors and what was formerly the of service delivery commitments, for regulation model, given the nature of
case in the energy sector – RIIO price example around the level and duration the businesses involved in the supply
settlements are in place for an eight- of customer outages on the networks of energy in GB. The variations in these
year period. This offers companies or secondary outputs around asset regulatory models tend to be more in the
with significant programmes of condition levels. details of the application of those models
investment in networks greater rather than in terms of core principles of
§§ Incentives: Incentives are typically
visibility and time to plan, procure and cost recovery and allowing an efficient
based on delivering outperformance
deliver major projects. operator to make a fair return.
on agreed targets, whether in terms
§§ Fast tracking through the regulatory of cost reduction or enhanced quality In Northern Ireland, the energy
process: At the time of the price for customers. Many of the incentives network companies are regulated
setting process, companies are include upsides and downsides. by the Northern Ireland Authority for
required to prepare business plans to Well-run companies have the potential Utility Regulation (NIAUR). NIAUR
justify the prices they would charge to enhance returns by delivering on also directly regulates end prices for
customers for the forthcoming incentives. If companies do not deliver domestic and small business consumers
regulatory period. As an incentive the agreed outputs, outturn returns in both electricity and gas sectors by
for companies to produce high may be lower than expected. setting a Maximum Retail Price for the
quality business plans as inputs into dominant supply companies (former
As part of RIIO, Ofgem has put in place
the regulatory process, Ofgem has incumbent monopolies), whilst at the
mechanisms to allow transmission
created the fast tracking regulatory same time opening supply markets
network owners to bring forward large
approach: If Ofgem assesses a up to competitive pressures from new
investment where the cost of the
given business plan to be of high entrants. This then allows other retail
projects was not included the price
quality based on its initial review, companies to compete below the
control settlement. This is known as
the company is subject to no further regulated maximum.70
the Strategic Wider Works (or SWW)
67
F urther information on Strategic Wider Works can be found at https://www.ofgem.gov.uk/electricity/transmission-networks/critical-investments/strategic-wider-works
68
For more information on the regulation of investment in OFTOs, see https://www.ofgem.gov.uk/publications-and-updates/offshore-transmission-investor-perspective-update-report.
69
Further information on electricity interconnectors and Ofgem’s cap and floor regime can be found at https://www.ofgem.gov.uk/electricity/transmission-networks/electricity-interconnectors
70
Further information on NIAUR’s electricity price controls for Northern Ireland can be found at http://www.uregni.gov.uk/retail/price_controls/

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
Figure 13: Rail money/service flow
HM treasury/
taxpayer
Train
operating
Passengers companies
Network rail
RosCo
Cash flow
KEY
Service flow
UK’s national public sector debt.72 The typically leased by TOCs from privately-
4.6 Rail Government has expressed interest in owned rolling stock leasing companies
developing opportunities for greater (ROSCOs).
4.6.1 private investment in the rail sector. It
Industry structure 4.6.2
is currently uncertain whether or when
The industry involves a vertically this might result in greater opportunities Legislation, regulation and licensing
separated structure between for other parties to develop/own/operate Key legislation governing the GB rail
infrastructure and train operation. sections of the heavy rail infrastructure. sector includes the Railways Act 199373 ,
Network Rail (NR) is, with limited This objective has been achieved recently which provided the powers under which
exceptions, the owner and operator of for HS1, which is private operated under the network was initially privatised
GB heavy rail infrastructure, i.e. track and a 30-year concession agreement let in and regulated. NR operates under a
signalling and some large stations.71 2010, and HS2 may make also make use Network Licence, granted by the Office
NR was previously a Private Company of private funding in the future. of Rail Regulation (ORR). This sets out
Limited by Guarantee (CLG) but, as Private train and freight operating a range of duties, obligations, rights and
of 1 September 2014, is a central companies (TOCs and FOCs respectively) restrictions to which NR is subject. TOCs
government body in the public sector, are responsible for operating passenger are also subject to a licensing regime
with all of its debt consolidated in the and freight services. Rolling stock is permitting them to operate services,
71
S1 is a notable exception to this.
H
72
F urther information regarding Network Rail’s reclassification is available at http://www.networkrail.co.uk/supplying-us/reclassification-as-a-public-sector-body/
73
Details of the Railways Act 1993 can be found at http://www.legislation.gov.uk/ukpga/1993/43/contents

but are not subject to full economic Government pays a limited subsidy in HS1 Ltd, ORR oversees the company’s
regulation like Network Rail. respect of certain types of freight. performance and efficiency. ORR
approves all new framework agreements
§§ Network infrastructure: As the
4.6.3 as well as revisions to existing framework
monopoly owner and operator of most
Regulation in practice and risk & agreements (i.e. track access contracts,
of the GB heavy rail infrastructure, NR reward covering the reservation of capacity for
is subject to regulation by the ORR.
more than one timetable period of six
NR is regulated under a Regulatory Network Rail
months). ORR also ensures that HS1 Ltd
Asset Base (RAB) structure, similar NR receives around two-thirds of its is provided with incentives to reduce the
to other regulated infrastructure annual income from the Government cost of allowing access to the network
sectors, on a five-year cycle. Each by way of a direct grant, with most of through periodic charge reviews. The first
regulatory cycle involves the ORR its remaining income made up from of such reviews has been completed and
determining NR’s regulated income regulated Track Access Charges and covers the period from 1 April 2015 to 31
for the forthcoming period (referred a variety of commercial sources of March 2020 (Control Period 2 or CP2).75
to as a “Control Period” (CP)), based income. NR’s overall income requirement
on a range of factors, including high is determined by the regulator during The regulatory approach for the
level outputs and funding specified the 5-yearly Periodic Review, which anticipated High Speed 2 project is not
by the DfT and Transport Scotland as sets Track Access Charges (and other yet confirmed, but it is possible that the
appropriate. charges) and determines the outputs and regulatory framework will include aspects
efficiency that NR is expected to deliver.74 of both the regimes applied to Network
§§ Train Operating Companies: The GB
Rail and to HS1.
rail franchising market is competitive A further significant source of funding
and TOCs compete in the open market has historically been NR’s ability to raise Channel Tunnel
to win franchises awarded by DfT and debt capital from private markets under
Transport Scotland and concessions The UK-France Channel Tunnel is
the benefit of a guarantee from the
let by TfL. Each franchise is typically operated under a 99-year concession
Government. In 2014, the Government
for a duration of between seven and agreement, awarded to Eurotunnel (the
decided to provide an equivalent funding
15 years. Although TOCs are not trading name of two private companies)
facility to NR directly. Around £30 billion
subject to full economic regulation and expiring in 2086. The infrastructure
of privately held debt was in issuance at
akin to Network Rail, they are subject is regulated for safety and efficiency by
that point, but this is unlikely to be rolled
to regulation in a number of other a bi-national body, the Channel Tunnel
over when it reaches term.
ways. They operate under contractual Intergovernmental Commission (IGC),
terms specified in their franchise The bulk of NR’s income is fixed with which includes members from both
or concession agreement, and they limited exposure to demand risk. the UK and France. From April 2015,
require a licence to operate services Because this creates only limited responsibility for regulating efficiency will
which is issued and enforced by commercial incentives for the company, transfer to the national regulators jointly.76
the ORR. ORR monitors and regulates NR’s
performance to ensure that it is delivering Train Operators
§§ Freight Operating Companies: FOCs the services that it has been funded to Private companies can provide passenger
are wholly private companies, and are provide to its customers, including the rail services in the UK either through
not subject to a government tendering TOCs and FOCs. winning a franchise or concession to
process and also are not held
run passenger services or by becoming
harmless by the Government for the High Speed 1 (HS1) Ltd an open access operator that applies
financial consequences of five-yearly
HS1 Ltd has a 30 year concession to to run new services directly. GB TOCs
track access charge reviews. They
operate and manage the railway between are typically owned either by privately-
require a licence to operate, which is
St Pancras and the Channel Tunnel. As owned transport groups or by non-UK
issued and enforced by the ORR. The
the economic and safety regulator for state-owned transport groups that have
74
F urther information on ORR’s regulation of Track Access Charges can be found at http://orr.gov.uk/what-and-how-we-regulate/track-access
75
F urther information on HS1’s concession agreement can be found at http://www.highspeed1.com/regulatory/concession-agreement/
76
F urther information on Eurotunnel’s concession agreement can be found at http://www.channeltunneligc.co.uk/Essential-texts,24.html?lang=en

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
entered the GB market. TOCs bid for franchise services are non-commercial
the right to operate passenger services (i.e. revenues do not cover costs), 4.7 Telecommunications
on certain routes, with the relevant TOCs receive subsidy payments from
public authority specifying particular DfT. Where revenues exceed costs, 4.7.1
requirements for each franchise or TOCs pay Franchise Premiums to DfT. Industry structure
concession. This can include minimum Furthermore, the industry performance The UK telecoms market is characterised
service levels on particular routes and regime between TOCs and NR includes by a number of large, often overlapping,
franchise tenure. Track, signalling and mechanisms designed to protect TOCs private service providers as well as
station infrastructure remains under the from the revenue and cost impacts of smaller operators offering niche services.
ownership, operation and maintenance of network change and disruption.
§§ BT owns a nationwide fibre core
Network Rail. TOCs operate all stations
network and last-mile network,
except for around 20 key hub stations Freight operating companies
allowing it to offer a range of fixed line
in major cities. TOCs are granted track A small number of privately owned voice, broadband and TV services to
access rights by the regulator in return for companies operate in the fully businesses and consumers, as well as
fixed and variable track access payments competitive rail freight industry. Freight a range of wholesale services to other
to Network Rail.77 Operating Companies (FOCs) are not telecoms providers.
Generally, DfT is responsible for subject to economic regulation by the
ORR, but do operate under certain §§ Virgin Media owns a cable network
specifying and letting contracts to TOCs
licence conditions determined by the that covers approximately 50 percent
to run franchised passenger services in
regulator, and are subject to regulated of UK households, offering fixed line
England and Wales (and long-distance
Track Access Charges set in the periodic voice, broadband and TV services.
services that also serve Scottish cities).
review of Network Rail. FOCs operate It competes with BT in the areas it
The Scottish government is responsible
outside of a formal franchise regime covers.
for franchising services within Scotland
(ScotRail) and for the sleeper services and are therefore exposed to changes §§ Sky and TalkTalk offer retail fixed
between London and Scotland. ORR in charging, and risks associated with line, broadband and TV services,
works with TOCs to ensure that Network capital investments.78 using a mix of their own network
Rail operates the infrastructure and plan infrastructure and BT’s network.
the future development of the network ROSCOs
§§ There are numerous fixed network
in a way that meets their reasonable ROSCOs were established during the
operators such as colt, at&t, Level (3),
requirements. privatisation of the UK rail sector to
verizon, SSE and others that operate
finance, maintain and renew rolling stock
TOCs are not capital intensive fixed network, data and IT platforms.
under long-term lease arrangements
enterprises, as they do not own They provide a wide range of services
with TOCs. ROSCOs are not subject
infrastructure or rolling stock, with to businesses including, voice and
to economic regulation, but rolling
income from passenger fares and related data, connectivity, mobility, data
stock is licenced by the regulator for
commercial activities. Although certain hosting and warehousing, network
technical and safety purposes. As leases
fares are regulated by the Government, security, cloud computing and others.
are not necessarily aligned with TOC
TOCs have freedom to set other
franchise terms, the DfT provides certain §§ In mobile telecommunications,
fares on a commercial basis. Recent
guarantees to ROSCOs to limit risks from there are four large mobile network
developments in DfT’s franchising policy
franchise change.79 operators (“MNOs”), which own
have been designed to limit TOCs’
network infrastructure (and sometime
exposure to revenue risk. Operating
share parts of those networks
costs tend to be relatively stable, and
with other MNOs) and provide
TOCs are usually held harmless by DfT
retail services to households and
for variations in Track Access Charges
businesses. Each of the 4 main
determined by the regulator. Where
77
list of TOCs can be found on ORR’s website at http://orr.gov.uk/about-orr/who-we-work-with/industry-organisations/train-operator-companies
A
78
A list of FOCs can be found on ORR’s website at http://orr.gov.uk/about-orr/who-we-work-with/industry-organisations/freight-operator-companies
79
A list of ROSCOs can be found on ORR’s website at http://orr.gov.uk/about-orr/who-we-work-with/industry-organisations/rolling-stock-companies

Figure 14: Telecoms money/service flow
Retail
Core
network
Last mile
Consumers
Cash flow
KEY
Service flow
network operators now offers a 4G approach to regulation of telecoms competition. This leads to focus on
mobile service. There is also a range networks. Ofcom’s duties are set out in driving competition rather than on the
of mobile virtual network operators the Communications Act 2003. 80 financial sustainability of the network
(“MVNO”s), which purchase network operators. Ofcom is required to have
A significant proportion of the
access on a wholesale basis regard to the desirability of promoting
Communications Act 2003 consists of
from MNOs. competition in relevant markets; the
the transposition of the EU Regulatory
desirability of encouraging investment
§§ At the retail level there is considerable Framework for communications into
and innovation in relevant markets; and
convergence of services being UK law. The Framework is made up
the need to encourage the availability of
offered, with numerous companies of 5 Directives and 2 Regulations that
high speed data services throughout
providing a package of fixed and cover areas such has Access, Universal
the UK.
mobile voice, broadband, TV and Service, Electronic Privacy etc. The
data services to households and overall aim of the Framework is for The telecommunications sector also
businesses. European consumers to be able to differs from other sectors in that the
benefit from increased choice thanks to requirement to apply for a licence
4.7.2 low prices, high quality and innovative has been replaced by the general
Legislation, regulation and licences services. authorisations regime, which has general
The telecoms regulatory model is conditions that apply to all operators and
Ofcom’s primary duty is to further the
different from that of other infrastructure specific conditions that apply to only
interests of citizens and consumers,
regulators, which stems primarily from some operators.
where possible by promoting
the different duties that govern Ofcom’s
80
Details of the Act can be found at http://www.legislation.gov.uk/ukpga/2003/21/contents

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
4.7.3 two broad categories – “traditional where Ofcom has identified one or more
Regulation in practice and interface” and “alternative interface”. companies to possess SMP. The price
risk & reward Traditional leased lines are delivered control can set for a service or group of
Ofcom is required to review over older technology and deliver services with the market definition and
certain specified markets in the data services of up to 155Mbit/s. will be reviewed and a regular cycle.
telecommunication sector on a 3 year Alternative interfaces are IP or
Although Ofcom does not have a
cycle, as set out by the European Ethernet-Based services, and are
statutory duty to ensure companies can
Commission. Where a market has been available on regulated terms at
finance their functions, its long-standing
reviewed by Ofcom and an operator in bandwidths of up to 1Gigabit/s.
practice when setting price controls has
the relevant market has been deemed §§ Mobile and fixed call termination, i.e. always been to identify a fair level or
to have significant market power (SMP), for mobile and fixed calls terminating return on capital, set in advance using
Ofcom has to consider remedies. These on someone else’s network, the market principles, and then not to adjust
can be far-reaching and include charge perception is that competitive forces this allowed return once set. This is
controls, non-discrimination obligations, do not bring prices down, hence the illustrated by a number of concepts that it
cost-orientation obligations, ex-ante regulator has intervened to set price brings to bear when considering market
margin squeeze tests, etc. ceilings. MNO terminating rates reviews and charge controls:
Many areas that Ofcom reviews are and, increasingly, certain wholesale
§§ ‘Fair bet’ concept – investors are to
deemed to be competitive and so there and retail charges associated with
be afforded the opportunity (but not
are relatively few in which operators are international “roaming” are set
a guarantee) to make a reasonable
deemed to have SMP. Among the larger through formal regulatory intervention
return on any network investments.
ones are the following: by Ofcom. Certain fixed voice
What this means in practice is that
services, notably call termination
§§ Fixed access connections, i.e. the the network operator will bear some
and call origination, continue to
last mile infrastructure, which is still of the risks of underperformance if it
be price regulated by Ofcom (with
predominantly owned by BT with performs inefficiently or irrationally.
rates determined by the European
limited competition, and hence BT is Commission). §§ No retrospection – once a charge
deemed to have SMP. This is remedied control has been set, there is no
through local loop unbundling, where Ofcom has a general preference for
scenario under which the regulated
equal access charges are levied on all regulation at the wholesale level, which
entity can ‘claw back’ any costs or
retailers for use of the assets (this is then often precludes the need for
revenues, for example if the market
similar to KCOM in Hull). Fixed access regulation at the retail level. Ofcom’s
volumes are lower than expected. This
connections can be provided over predecessor, Oftel, began removing
means that once a charge control has
copper or fibre and can deliver voice retail regulation many years ago and
been set, the execution risk lies solely
and broadband services. Unbundled Ofcom has continued in a similar vein.
with the SMP operator.
loops (LLU) are becoming the main The approach to wholesale regulation
method of providing competing voice is set out in Ofcom’s market review Ofcom generally does not set controls or
and broad band services, with more process. Where a provider is deemed apply regulation at the retail level, so the
than 95% of UK premises connected to to have SMP, and it is assumed that balance of risks and potential returns is
a BT exchange where unbundling can greater competition could improve the set by competition in the market.
take place. Fixed voice and ISDN lines market environment (and provide better
are also provided on regulated terms to outcomes for consumers), wholesale
any qualifying telecoms operator. regulation may be viewed as a relatively
low-cost, efficient way of introducing
§§ Leased lines, i.e. private dedicated, greater competition at the retail level.
often high-speed, lines leased from
a network operator. BT is deemed The most common tool Ofcom uses to
to have SMP in a number of the manage the balance of risk and reward
designated markets, as is KCOM in is the price control. Price controls are
Hull. Leased lines are categorised into developed as remedies for markets

These companies are generally the result modifications to the 1989 Act, the 2003
4.8 Water of competition for the market in water Water Act and the 2014 Water Act, 81
and take wholesale supplies from the which facilitates the introduction of
4.8.1 incumbent monopolies. retail competition for non-household
Industry structure customers in the water sector in England.
Water companies own the assets
In England and Wales, there are 10 large
outright. In Scotland and Northern Ireland The 2014 Water Act allows for the
regional water and sewerage companies
there are state-owned companies that introduction of retail competition in
(sometimes known collectively as
provide water and wastewater services. the non-household market so that all
WaSCs) that are privately owned. There
Water and wastewater services in business, charity and public sector
are also eight regional companies that
Scotland are regulated by the Water customers will be able to choose their
provide water only (WOCs) though this
Industry Commission for Scotland retail supplier. The company providing
may change as new appointees are able
(WICS), and by NIAUR in Northern the network and associated services
to enter the market subject to meeting
Ireland. will in general be subject to the same
certain criteria. Customers of these WOC
regulatory principles as applied currently.
companies will have water provided by
4.8.2 Implementation work is underway, and
one company and sewerage provided
Legislation, regulation and licensing the market is due to be fully open for
by another. Each is governed by its own
Key pieces of legislation impacting the competition in April 2017. The Act also
licence, which are broadly similar but
regulation of the sector are the Water Act enabled the future introduction of more
not identical.
1989 which brought about privatisation competition in the network and water
In addition, there are a number of new and the creation of Ofwat, the 1991 resources parts of the value chain. 82
appointees and water supply licensees Water Industry Act which made some
that are much smaller but still regulated.
Figure 15: Water money/service flow
Cash flow
KEY
Service flow
Retail
Water Wastewater
companies companies
Consumers
81
ore information on the Water Act 2014 and its role in water market reform can be found at https://www.gov.uk/government/policies/reforming-the-water-industry-to-increase-competition-and-protect-the-environment/
M
supporting-pages/reform-of-the-water-market-the-new-water-bill
82
F urther information on the Water Act 2014 can be found at https://www.gov.uk/government/policies/reforming-the-water-industry-to-increase-competition-and-protect-the-environment

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
4.8.3 can provide rewards or penalties refer to a return on capital. Ofwat

Regulation in practice and directly through revenue changes, to acknowledges that a return on RCV
risk & reward incentivise high quality delivery of the is a critical part of the regulatory
Water and wastewater price controls services that are most highly valued regime for the wholesale network and
are currently re-set on 5 year cycles. by customers. is central to the companies’ ability
Both revenue and the RCV have to attract the additional investment
§§ Approaches to ensuring the
historically been indexed by RPI, capital they continue to need. Ofwat
appropriate maintenance of long
with price limits being set to provide has maintained a consistent approach
lived water assets: The water sector
incentives for efficient operation and for to RCV at each successive price
regime includes specific approaches
outperformance of the price control. review and many investors now use
to monitoring asset health and
RCV as a proxy for the market value of
The PR14 price controls are set largely performance and enabling companies
the regulated businesses and in some
on the basis of total revenue allowance, to recover through regulated
cases companies have chosen to
so do not only set limits for charges revenue the efficient costs of asset
incorporate it in debt covenants.
(this is a change from the earlier price maintenance.
controls). A total revenue control reduces The regulatory mechanism contains
§§ Total expenditure approaches: Ofwat
the exposure of the company to the risk provisions for price controls to be re-
has also moved from assessing the
of unanticipated changes in volume. The opened in a few defined circumstances
efficiency of operating and capital
price control formula is expressed as RPI and at these reviews the regulator can
expenditure separately to considering
± K with K representing the target for reset parts of the regulatory package
overall total expenditure or ‘totex’. Each
efficiency and any other net cost changes. subject to strong evidence and meeting
company must now choose an amount
materiality thresholds (normally 10% of
There some specific aspects of the of expenditure to be charged as an
turnover). For less material problems where
water regulatory regime that impact the expense (the ‘Pay As You Go’ ratio or
a reopener is not required, there have been
regulatory risk profile: PAYG), with the remainder being added
mechanisms to allow for unanticipated
to the RCV. Companies can also choose
§§ Separation of price controls for changes in cost due to new environmental
a depreciation rate for expenditure
wholesale and retail: Ofwat has or legal obligations to be logged and funded
previously added to the RCV.
introduced a number of important at the next price review.
changes in the price review beginning Since these parameters have
Company business plans, and the
in 2015, including the setting of consequences for cash flow,
regulators’ determinations, reflect the
four binding separate price controls: companies have been asked to use
outcomes that customer engagement
wholesale water, wholesale this flexibility to ensure that they
has revealed what the company’s
wastewater, household retail and non- can meet the required credit metrics
customers need, want and can afford.
household retail, with an expectation in the next control period, although
They are reflected in performance
of deregulating non-household retail. ratings agencies’ treatment of these
commitments that apply across the
mechanisms is not yet confirmed.
§§ Outcomes focused approach: control period.
Incentives are now much more Companies can also use these levers
During price reviews, Ofwat undertakes
closely associated with outcomes to manage their bill profiles over time,
a risk-based assessment of company
and companies are encouraged to taking account of their customers
business plans. Companies that
deliver the outcomes that customers views on bill profiles.
perform well against criteria including
need, want and can afford, including §§ Consistent use of the Regulatory engagement with customers, delivery of
those in relation to the environment. Capital Value (RCV) as a basis for outcomes, efficient costs, the balance
For example, compliance with setting the returns for the water of risk and reward and affordability and
improvements required as part of companies: The RCV is not identified financeability may qualify for ‘enhanced
the EC Water Framework Directive. 83 in either the water law or the licences, status’. Enhanced companies can gain
Ofwat has created new Outcome but the statutory duties on Ofwat financial, procedural and reputational
Delivery Incentives (ODIs), which
83
F urther information on the Water Framework Directive can be found on the European Commission’s website at http://ec.europa.eu/environment/water/water-framework/index_en.html

benefits. Enhanced companies
can benefit from an initial financial
reward. They also receive procedural
benefits from receiving an early draft
determination, and reputational benefits
from being ranked more highly than
their peers.
Ofwat also uses a ‘menus’ approach

to determining the available cost
performance incentives. The incentives
menu allows companies to choose
the sharing factor that applies to their
totex costs – the extent of sharing
costs’ under- and over-performance
with customers is set in advance by
this choice. The aim of these incentives
is to promote accurate forecasts from
companies in their plans and to provide
greater incentives for companies to
out-perform their targets for efficient
delivery of outcomes. The combined
effect of these two approaches could
result in more differentiation between the
financial outcomes for higher- and lower
performing companies.

IN THIS SECTION
§§ What happens to regulated

company revenues if electricity or
gas prices increase dramatically?
§§ This question answered and more…
FREQUENTLY ASKED QUESTIONS

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
5. Frequently asked questions
What happens to regulated What level of control do companies Is it possible to own companies
company revenues if wholesale have over their capital structures? across sectors and/or deliver on a
electricity or gas prices increase Most regulators calculate returns based multi-utility basis?
significantly? on a notional capital structure, but it It is possible to own companies across
Commodity risk sits with the retail and is the responsibility of the company multiple regulated sectors, for example
generation businesses not the networks. management to finance the company energy networks and water companies.
To the extent that prices affect demand, as they see fit. Investors bear the risk However, following the implementation
the energy network companies in Great associated with this decision for the of the EU Third Energy Package, there are
Britain are generally regulated on a actual cost of capital compared with limitations on fully vertically integrated
revenue basis and bear no direct volume the allowed return. There are, however, energy companies in terms of ownership
risk so any changes in demand should some regulatory requirements in relation of both a transmission company and a
have no direct bearing on the revenues to financial structures that companies generation or retail company. Companies
they are able to collect, although there must adhere to, for example around that operate on a cross-sector basis
might be differences in timing as to when maintaining an investment grade credit would still require the relevant licences
the revenue is collected. rating and a ring fence around for each sector in which they operate
regulated assets. and would be subject to the regulatory
Are there restrictions on foreign regime in each sector, including the
ownership of UK infrastructure? How does the approach in the UK relevant ring-fence arrangements.
To own and operate regulated differ from approaches in other
infrastructure, most companies require a countries? To what extent can regulation
licence. There are no restrictions on who The UK was a pioneer of independent change? Who can change it
can hold a licence other than meeting economic regulation following and how?
certain ‘fit and proper’ requirements privatisation of utilities networks in the UK experience to date has been
principally relating to a company’s ability 1980s and 1990s. While the regulatory that the fundamental principles of
to finance its regulated activities, but also regimes in the UK have evolved since economic regulation endure and in this
sometimes relating to security of supply. they were first developed, many other way regulators provide stability and
jurisdictions with privatised infrastructure predictability for investors. However,
How are revenues affected sectors have looked to the UK as an within these broad principles, regulatory
by inflation? example of best practice. Therefore, approaches evolve over time and the
For most price-regulated companies, utilities regulation in the UK shares many method for calculating allowed revenues
revenues are proportional to the size of characteristics with other jurisdictions can, in principle, change subject to
the regulatory asset base and typically while at the same time being the leading, the regulatory remit. During the price
linked to an index. This means that mature market in terms of the tenor of control period, regulation is set and
companies are allowed to recover a real the regimes. generally not open to change except
rate of return plus inflation, although in special circumstances. Changes in
there is also an efficiency assumption Is it possible to build new merchant regulation are generally brought about
and other factors that can affect the infrastructure in the UK? through new price controls. The process
income. Cost recovery allowances are It is generally difficult to build merchant for this is through proposals set out
often tied to inflation assumptions and assets for large networks or similar by the regulators followed by a public
real price effects, which means that asset-heavy infrastructure. Merchant consultation. Where regulatory changes
general inflation levels are adjusted for projects are possible in the telecoms require licence modifications companies
changes in cost-specific prices. sector, as well as in other sub-sectors have the option to accept the regulator’s
of the wider infrastructure market such proposals or appeal them. Similarly,
as energy generation, LNG terminals, where regulatory changes are given
interconnectors, metering services etc. effect in price controls, companies have
the option to accept them as part of the
control or refer them to an appeals body.

To what extent can government Are the regulated infrastructure
policy/legislation change and how sectors open to new market
can this impact companies? entrants outside of the primary
The Government can change policy at market?
various junctures but primary legislation Yes. For example, most of the telecoms
can only be changed following acts sector is open to new entrants. New
of Parliament. Changes in legislation independent gas transporters and
can, but do not automatically affect distribution network operators are able
companies during price control periods, to enter the energy market. Similarly in
i.e. once the regulation is set for control water, there are new appointees and new
period (e.g. five years), it is generally not entrants to provide retail services.
open to change (except in specific pre-
agreed circumstances). Are there any opportunities for
concessions?
How do I know what costs will Assets are generally owned and operated
be deemed “efficient” by the by private companies meaning there
regulator? are few concessions. There are some
Regulators typically publish and consult exceptions such as HS1 in the rail sector.
on their cost assessment processes
and provide examples of costs that will
be considered efficient. For instances
where regulators find proposed costs
to be inefficient, companies should be
given an opportunity to provide further
justification of such costs and many cost
assessments are completed ex ante, i.e.
the companies are given a view prior to
incurring the costs what will be allowed
to be recovered.
Could sectors subject to economic

regulation become subject to
competition?
Regulatory authorities seek to introduce
competition in the market (direct
competition) and for the market (e.g. for
a licence to operate certain services)
in particular sub-sectors, where
feasible, and where public benefits of
its introduction exceed costs. There is
a general recognition that competition
is beneficial to consumers but it
needs to be compatible with sector
characteristics to ensure that provision
of services is viable in a competitive
market. Changes to regulatory regimes,
including introducing competition, involve
extensive prior public consultation.

FURTHER INFORMATION
EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
FURTHER INFORMATION
Regulator Link
Further information on CAA’s regulation of UK airports can be found at:

http://www.caa.co.uk/
Further information on ORR’s regulation of Network Rail can be found at:

http://orr.gov.uk/
Further information on Ofcom’s work in the Telecoms sector can be found at:
http://stakeholders.ofcom.org.uk/telecoms/
Further information on Ofgem’s regulation of gas and electricity networks (RIIO) can be found at:
https://www.ofgem.gov.uk/
Further information on the Utility Regulator’s regulation of utility companies in Northern Ireland
can be found at: http://www.uregni.gov.uk/
Further information on Ofwat’s regulation of the water and wastewater sector can be found at:
http://www.ofwat.gov.uk/
Further information on WICS’ regulation of the water sector in Scotland can be found at:
http://www.watercommission.co.uk

GLOSSARY

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
GLOSSARY
Term Description
CAA Civil Aviation Authority, regulator for airports and aviation sector. As Heathrow and
Gatwick airport are deemed to have significant market power, CAA regulates the prices
these airports can charge
Capacity mechanism A policy mechanism that forms part of the Government’s package of Electricity Market
Reforms (EMR). The mechanism will allow providers of electricity capacity (mostly gas-
fired generation) to receive a long-term fixed price for providing such capacity
CAT Competition Appeals Tribunal (see section 3.1)
CC Competition Commission, former appeals authority whose responsibilities now fall within
those of the CMA
CfD Contracts for Difference, a policy mechanism that forms part of the Government’s
package of Electricity Market Reforms (EMR). The mechanism will allow developers of
renewable energy generation
CMA Competition and Markets Authority (see section 3.1)
Concurrent powers The sectoral regulators have the power to enforce certain articles of EU and UK
competition law ‘concurrently’ with the CMA. The extent of concurrent powers differs by
regulator (see section 3.1.4)
CP1 – CP5 Control periods, ORR’s regulatory price control periods (applied to Network Rail)
Demand risk / volume risk The exposure of a company to the difference between actual demand for products/
services being higher or lower than anticipated
DfT Department for Transport, the government department for policy development in regards
to the transport sector (including rail) in England and Wales
DNO Distribution network operators, used to refer to owner-operators of electricity distribution

networks
EMR Electricity Market Reforms, the Government’s package of policies for reforming the
electricity sector
EU European Union
Ex-ante Based on forecast rather than actual amounts. In price controls, allowances are set ‘ex-
ante’ if they are determined at the beginning of the control period
Ex-post Based on actual rather than forecast amounts. In price controls, allowances are set ‘ex-
post’ if they are based on actual outturn results
Fast track Some regulators have developed a ‘fast track’ mechanism to incentivise companies to
produce higher quality business plans as inputs to the regulatory process. See section
4.3.2.3
Financeability The ability for efficient companies to secure affordable and competitive financing and
service its liabilities. Most regulators have either the objective or duty of ensuring that
companies are financeable, often with reference to minimum credit ratings

Term Description
FOC Freight-operating company, a company that uses the rail network to transport goods (as
opposed to passengers)
GB Great Britain, includes England, Scotland and Wales
GDN Gas distribution network, used to refer to owner-operators of gas distribution networks
HS1, HS2 High-speed rail network, HS1 is already in operation and HS2 is in planning
HSE Health and Safety Executive, the regulator of health and safety standards in Great Britain
IDNO Independent distribution network owner, smaller companies with network licences for
providing small areas with energy distribution services
Incentive mechanism A regulatory mechanism that allows companies to enhance their allowed returns by
achieving certain specified outputs or additional efficiencies
Interconnector A transmission asset that connects the domestic energy market (either electricity or gas)
to a second international energy market, allowing for cross-border energy trading and
‘market coupling’
JR Judicial Review (see section 3.1.3)
K factor In energy, a correction mechanism in revenue building-block formulas to account for over-
or under-recovery of revenues in prior years. In water, an uplift in revenues for quality
improvements
Last mile The local access network or ‘local loop’, made up of copper and fibre connections between
telephone exchanges and homes and businesses. It mainly is owned and operated in the UK
by Openreach (part of BT Group)—see also Local Loop Unbundling (LLU)
LLU Local Loop Unbundling (LLU), the process where the incumbent operator (Openreach)
makes its local network or ‘last mile’ available to other companies. Operators are then
able to upgrade individual lines to offer services directly to customers
LNG Liquefied natural gas
Merchant A merchant service provider is one that is not economically regulated, and therefore
whose prices and revenues are determined by the market, as opposed to an economic
regulator
MNO Mobile network operator, owners of the mobile network infrastructure and providers of
retail services
National Infrastructure Plan The National Infrastructure Plan sets out the challenges facing UK infrastructure and the
Government’s strategy for meeting the infrastructure needs of the UK economy. The
plan contains major commitments for investment in important infrastructure projects
and explains how the Government is attracting new private sector investment. Further
information on the National Infrastructure Plan can be found at:
https://www.gov.uk/government/collections/national-infrastructure-plan

EXECUTIVE SUMMARY 5
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GLOSSARY 67
GLOSSARY (CONTINUED)
Term Description
NIAUR Northern Ireland Authority for Utility Regulation (NIAUR), regulator of energy and water
utilities in Northern Ireland most usually referred to as the Utility Regulator
NR Network Rail, the owner and operator of the national rail network
Ofcom Office of Communications, regulator for the telecommunications sector
Ofgem Office of Gas and Electricity Markets, regulator for the electricity and gas sectors
OFT Office of Fair Trading, former consumer protection body whose responsibilities now fall
within those of the CMA
Oftel Former regulator of the telecommunications sector, predecessor to Ofcom
OFTO Offshore Transmission Owner, the regime governing the offshore transmission assets
connecting offshore generation to the onshore network (run by Ofgem).
Ofwat Water Services Regulation Authority, regulator for the water sector in England and Wales
ORR Office of Rail Regulation, regulator for Britain’s railways
PR94 – PR14 Price reviews, Ofwat’s regulatory price control periods for the water sector
Price cap A form of regulation that limits the prices that can be charged on a volumetric basis.
Companies regulated on a price cap basis might be therefore exposed to demand risk as
prices are set based on forecast volumes and shortfalls are not necessarily adjusted or
‘trued up’ in following periods
Primary legislation Legislation passed by Parliament; an ‘Act of Parliament’ or ‘Statute’
Q1 – Q6 Quinquennial reviews, CAA’s regulatory price control periods for regulated airports
RAB, RAV or RCV Regulated Asset Base, also referred to as Regulated Asset Value (RAV) or Regulated
Capital Value (RCV). Although definitions may vary between users, the terms are often
used interchangeably. The RAB is a regulatory concept used to calculate the allowed
revenue
Reopener A mechanism for adjusting or recalculating a regulatory settlement in light of a change

in circumstances. For example, some regulatory regimes have reopeners to update the
allowance for tax or other uncontrollable costs. In water also known as an IDOK, Interim
Determination of K
Revenue cap A form of regulation that limits the revenues that companies can accrue over a certain
period of time. In some sectors, companies regulated on a revenue cap basis are not
exposed to demand risk as shortfalls in forecast revenue are adjusted or ‘trued up’ in
subsequent periods
MVNO Mobile virtual network operator, providers of mobile retail services who do not own/
operate mobile infrastructure but rather purchase wholesale network capacity from MNOs
RIIO “Revenue = Incentives + Innovation + Outputs”, Ofgem’s framework for setting price
controls for energy network companies

Term Description
ROSCO Rolling stock company, a company that owns vehicles that move on railways and leases
them to Train-Operating Companies (TOCs) and Freight-Operating Companies (FOCs)
RPI Retail Price Index, a measure of inflation rates
RPI – X A regulatory price control approach, whereby revenues are linked to RPI inflation, less
the expected savings from efficiency gains. In the UK, ‘RPI – X’ has broadly been used
to refer to the revenue cap approach used in several regulated infrastructure sectors.
Although some regulators have moved to more sophisticated approaches to revenue
setting, most revenues derived from RAB are still linked to an inflation index
Rural broadband The connection of homes and businesses in rural or hard-to-reach areas to high-speed
internet
Secondary legislation In the UK, secondary legislation refers to legislation or directives passed by an entity other
than the Houses of Parliament. Sometimes referred to as ‘enabling’ legislation, secondary
legislation often provides details of the implementation of primary legislation or clarifies
particular aspects that do not require the full Parliamentary process
Single vs. dual till Refers to the price control approach for regulated airports. The single till approach
considers both aeronautical activities and other commercial activities in setting price caps,
as opposed to the dual till approach, which only considers aeronautical activities
SMP Significant Market Power, a set of conditions that may apply to providers of network
services where they are deemed to have significant power in a particular market
TfL Transport for London; the local government organisation responsible for most aspects of
London's transport system
Third Energy Package An EU legislative package aimed at enhancing the markets for electricity and gas in the
EU. A key aspect of the third package is the unbundling of ownership of energy generation
and retail from energy transmission and distribution
TO / TAO Transmission owner, the owner of the transmission system assets, also referred to as
transmission asset owner (TAO)
TOC Train-operating companies (TOCs) that run rail passenger services, leasing and managing
stations from Network Rail. TOCs directly face consumers and apply for franchises from
the Department for Transport to run specific routes. They often lease trains from the
rolling stock companies (ROSCOs)
Totex Total expenditure, including opex and capex
Transport Scotland The national transport agency for Scotland
True-up An adjustment to revenues to account for a cost or revenue stream in a previous period
being higher or lower than the allowance or forecast
TSO / SO Transmission system operator, the operator of the transmission system (e.g. system
balancing services, ancillary services etc.), also referred to as system operator (SO)

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
GLOSSARY (CONTINUED)
Term Description
TTT Thames Tideway Tunnel, a large infrastructure project by Thames Water. It is intended
to improve the capacity of London’s sewerage system and reduce the number sewage
overflows into the River Thames
UK United Kingdom of Great Britain and Northern Ireland; includes England, Scotland, Wales
and Northern Ireland
Uncertainty mechanisms A mechanism that accounts for uncertainties in the companies costs/revenues, for
example via pain/gain sharing between companies and consumers or re-openers for
specific items
User-pays A principle for recovering the costs of delivering essential services, whereby the end
users (i.e. consumers and businesses) pay for services as opposed to tax-payers via
government subsidy
WACC Weighted average cost of capital typically estimated as a sum of company’s cost of equity
and cost of debt weighted by gearing. Most regulators determine a WACC allowance for
regulated companies, which is updated periodically. The WACC is a component of the
allowed revenue or price calculation and is not a profit cap, i.e. actual returns on capital
may be higher or lower than the allowed WACC, e.g. due to outperformance of regulatory
assumptions and incentive mechanisms
WaSC Water and sewerage company
WBS Whole business securitisation is a type of a financial structuring often adopted by

regulated utilities with extensive covenants and structuring applied to the entire company
resulting effectively in a ring fence around the WBS entity
WICS Water Industry Commission for Scotland, regulator for the water sector in Scotland
WoC Water only company

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67
UK REGULATED INFRASTRUCTURE INDUSTRIES
UK infrastructure is a very broad and diverse sector. This guide

focuses predominantly on economically-regulated infrastructure
in the energy, water and wastewater, telecoms, rail and
aviation sectors, as well as referencing other types of market
participants in those sectors. Companies that operate in the
industries referenced in this guide include those outlined below.
Ownership structures are shown as an indication only, as many
companies are held in complex structures that do not fit easily
into a single category, such as those held by a consortium of
companies, the majority of which are ultimately listed.

List of significant regulated infrastructure companies
Sector Subsector Company Ownership structure
AVIATION Airports Heathrow Airport ltd Private
Gatwick Airport ltd Private
Air navigations service provider NATS Holdings ltd Public-private partnership
ENERGY Electricity distribution Electricity North West ltd Private
Northern Powergrid (Northeast) ltd Private
Northern Powergrid (Yorkshire) plc Private
Scottish Hydro-Electric Power Distribution ltd Subsidiary of listed company
Southern Electric Power Distribution plc Subsidiary of listed company
SP Distribution plc Private with listed parent
SP Manweb plc Private with listed parent
London Power Networks plc Private
South Eastern Power Networks plc Private
Eastern Power Networks plc Private
Western Power Distribution (East Midlands) plc Private with listed parent
Western Power Distribution (West Midlands) plc Private with listed parent
Western Power Distribution (South West) plc Private with listed parent
Western Power Distribution (South Wales) plc Private with listed parent
Northern Ireland Electricity ltd Private
Independent distribution network owners (IDNOs) Various
Electricity transmission National Grid Electricity Transmission plc Subsidiary of listed company
Scottish Hydro Electric Transmission ltd Subsidiary of listed company
Scottish Power Transmission ltd Private with listed parent
Northern Ireland Electricity ltd Private
Gas distribution National Grid Gas plc Subsidiary of listed company
Northern Gas Networks ltd Private
Wales & West Utilities ltd Private
Scotia Gas Networks ltd Subsidiary of listed company
Phoenix Natural Gas ltd Private
Firmus Energy (supply) ltd Private
Independent gas transporters (IGTs) Various
Gas transmission National Grid Gas plc Subsidiary of listed company
Offshore transmission Various Various forms of private ownership
Electricity interconnectors Various Various forms of private ownership
Gas interconnectors Various Various forms of private ownership
RAIL Rail infrastructure Network Rail ltd Publically owned
Crossrail ltd Publically owned
HS1 ltd Private concession
TELECOMS Fixed-line Openreach Subsidiary of listed company
KCOM Group plc Listed company
BT Wholesale ltd Subsidiary of listed company
Mobile Vodafone ltd Subsidiary of listed company
Telefónica UK ltd Subsidiary of listed company
EE ltd Private with listed parent
Hutchison 3G UK ltd Private
WATER Water and sewerage Albion Water ltd Private
Anglian Water Services ltd Private
Dwr Cymru Cyfyngedig ltd (Welsh Water) Company limited by guarantee
Northumbrian Water ltd Private
Severn Trent Water ltd Subsidiary of listed company
Southern Water Services ltd Private
South West Water ltd Subsidiary of listed company
Thames Water ltd Private
United Utilities Group plc Listed company
Wessex Water ltd Private
Yorkshire Water Services ltd Private
Scottish Water Publically owned
Northern Ireland Water ltd Publically owned
Water only Affinity Water ltd Private
Bristol Water plc Private
Cholderton and District Water Company Private
Dee Valley Water plc Subsidiary of listed company
Portsmouth Water ltd Private
Sembcorp Bournemouth Water ltd Private with listed parent
South East Water ltd Private
South Staffordshire Water plc Private with listed parent
Sutton and East Surrey Water services ltd Private with listed parent

KPMG NOTICE: ABOUT THIS GUIDE
This Guide has been prepared on behalf of UKRN on the basis set out in our contract with Ofgem
(“the Client”) dated 21 July 2014. Nothing in this Guide constitutes a valuation or legal advice.
Any party other than the Client that chooses to rely on this Guide (or any part of it) does so at its
own risk. To the fullest extent permitted by law, KPMG LLP does not assume any responsibility and
will not accept any liability, including any liability arising from fault or negligence, for any loss arising
from the use of this document or its contents or otherwise in connection with it to any party other
than the Client.
In preparing the Guide, the primary source has been publically available information. Details of
principal sources are set out within the document and we have satisfied ourselves, so far as
possible, that the information presented in the Guide is consistent with other information which
was made available to us in the course of our work in accordance with the terms of our Services
Contract. We have not, however, sought to establish the reliability of those sources by reference to
other evidence. In addition, references to draft financial information relate to indicative information
that has been prepared solely for illustrative purposes only. Our work was completed on 5 December
2014 and we have not undertaken to update the document for events or circumstances arising
after that date.

EXECUTIVE SUMMARY 5
1. Introduction 9
GLOSSARY 67

CONTACT INFORMATION
Will Hayter Dr Matt Firla-Cuchra

Director UK Regulators Network Partner, Power & Utilities,
E william.hayter@ofcom.org.uk and Project Lead
T +44 (0) 20 7694 5308
Steve Beel E matt.cuchra@kpmg.co.uk
Project Director, Cross-sector
Infrastructure Tony Rocker
E stephen.beel@ofgem.gov.uk Partner and Global Head of
Infrastructure Investment
T +44 (0) 20 7311 6369
E antony.rocker@kpmg.co.uk

Investor Guide

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UK Regulated Infrastructure

AVIATION ENERGY RAIL TELECOMS WATER

EXECUTIVE SUMMARY . . . . . . . . . . . . .......................................................... 5

CAA’s economic regulation work is focused on improving choice

Ofgem is committed to making a positive difference for energy

ORR’s role is to ensure the rail network operates safely, reliably

Ofcom is committed to a thriving communications sector where

Ofwat’s job is to make sure that water companies provide

The Utility Regulator is responsible for regulating the electricity,

2 UK REGULATED UTILITIES | AN INVESTOR

Utility sectors in the UK, supported by our standard-setting regulatory regimes,

Richard Price, Chair UK Regulators Network

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 3

The UK’s economic regulators have joined together in the UK Regulators

ABOUT THE AUTHORS

KPMG LLP is a leading provider of professional services including advisory,

6 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 7

§§ What is the scope and remit of this

§§ What are the document’s

The UK Regulators Network (UKRN) is committed to improving understanding of UK regulated

This guide is intended to provide a high-level overview of regulated infrastructure

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 11

§§ What are the key characteristics

§§ How is each sector structured

§§ What is the role of the private

§§ What are the investment

to consumers. This infrastructure and payback periods on these investments

14 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

Copper and Wholesale Mobile network

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 15

2. Market overview (continued)

for efficient companies. Economic by policy to give it a greater role in 2.2

16 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

There is a need for new runway

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 17

2. Market overview (continued)

18 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 19

2. Market overview (continued)

20 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 21

2. Market overview (continued)

Figure 2: Capital expenditure in GB on infrastructure subject to economic regulation (2010-14)

£7,000 AVIATION ENERGY RAIL TELECOMS WATER

22 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

Figure 3: Fixed income securities issued by regulated infrastructure companies (2004-2014)

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 23

2. Market overview (continued)

24 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

Figure 5: Planned capital expenditure in regulated infrastructure sectors (2015-2020)

COMPANY SPENDING VS. NEW PROJECTS

NATS Thames TidewayTunnel

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 25

2. Market overview (continued)

26 UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE

UK REGULATED INFRASTRUCTURE | AN INVESTOR GUIDE 27

§§ How is the sector regulated and

Figure 6: Regulatory framework overview: key structures and duties

LEGISLATION POLICY REGULATION SERVICE PROVISION

PARLIAMENT GOVERNMENT REGULATOR COMPANY INVESTORS

HOUSE Sets Define regulatory

Draft legislation Regulatory Provide

Source: KPMG analysis