BEFORE THE COMPETITION AND MARKETS AUTHORITY IN THE MATTER OF AN APPEAL UNDER SECTION 11C OF THE ELECTRICITY ACT 1989 AND SECTION 23B OF THE GAS ACT 1986 BETWEEN: (1) CADENT GAS LIMITED (2) NATIONAL GRID ELECTRICITY TRANSMISSION PLC (3) NATIONAL GRID GAS PLC (4) NORTHERN GAS NETWORKS LIMITED (5) SOUTHERN GAS NETWORKS PLC AND SCOTLAND GAS NETWORKS PLC (6) SCOTTISH HYDRO ELECTRIC TRANSMISSION PLC (7) SP TRANSMISSION PLC (8) WALES & WEST UTILITIES LIMITED APPELLANTS - AND – THE GAS AND ELECTRICITY MARKETS AUTHORITY RESPONDENT RIIO-2 PRICE CONTROL: RESPONSE TO APPEALS ON FINANCE ISSUES AND TNUOS RIIO-2 Price Control: Response to Appeals on Finance Issues and TNUoS A. INTRODUCTION & SUMMARY ............................................................................................................. 3 B. GEMA’S DECISION-MAKING PROCESS ............................................................................................. 6 C. LEGAL FRAMEWORK ............................................................................................................................. 7 GEMA’S STATUTORY DUTIES ............................................................................................................................. 7 STATUTORY GROUNDS OF APPEAL .................................................................................................................... 10 STANDARD OF REVIEW AND REGULATORY DISCRETION .................................................................................... 11 MATERIALITY ................................................................................................................................................... 17 D. ALLOWED RETURN ON EQUITY ....................................................................................................... 18 E. COST OF EQUITY, AIMING UP AND SUFFICIENCY OF RETURN ............................................. 19 RISK-FREE RATE ............................................................................................................................................... 20 TMR ................................................................................................................................................................. 28 EQUITY BETA .................................................................................................................................................... 37 CROSS-CHECKS ................................................................................................................................................. 48 AIMING-UP ........................................................................................................................................................ 66 CONCLUSIONS - OVERALL SUFFICIENCY OF RETURN (INCLUDING EQUITY FINANCEABILITY) ............................. 74 F. EXPECTED OUTPERFORMANCE ....................................................................................................... 75 INTRODUCTION AND OVERVIEW ........................................................................................................................ 75 BACKGROUND AND GEMA’S DECISION ............................................................................................................ 76 RESPONSE TO GROUNDS OF APPEAL ................................................................................................................. 80 CONCLUSION ON EXPECTED OUTPERFORMANCE ............................................................................................... 95 G. COST OF DEBT ........................................................................................................................................ 95 INTRODUCTION AND OVERVIEW ........................................................................................................................ 95 BACKGROUND AND GEMA’S DECISION ............................................................................................................ 96 GEMA’S STATUTORY DUTIES ........................................................................................................................... 98 SECTOR AVERAGE DEBT ALLOWANCE ............................................................................................................. 106 FAILURE TO TAKE INTO ACCOUNT DERIVATIVES ............................................................................................. 112 CONCLUSION ON COST OF DEBT ..................................................................................................................... 114 H. TAX CLAWBACK .................................................................................................................................. 114 INTRODUCTION AND OVERVIEW ...................................................................................................................... 114 THE TAX CLAWBACK MECHANISM ................................................................................................................. 115 THE TREATMENT OF INTEREST PAYMENTS ON DERIVATIVE INSTRUMENTS ...................................................... 115 GEMA’S CORE OBJECTION TO WWU’S SIXTH GROUND OF APPEAL .............................................................. 117 WWU’S COMPLAINT OF BREACH OF A LEGITIMATE EXPECTATION/ABSENCE OF CONSULTATION .................... 118 THE ALLEGED LACK OF LOGICAL COHERENCE IN GEMA’S POSITION ON INTEREST ON DERIVATIVES ............. 119 CONCLUSION ON TAX CLAWBACK .................................................................................................................. 119 I. TNUOS ...................................................................................................................................................... 120 INTRODUCTION AND SUMMARY ...................................................................................................................... 120 SUB-GROUND ONE: ALLEGED DISCONNECT BETWEEN RISK AND RESPONSIBILITY .......................................... 121 SUB-GROUND TWO: ALLEGED ABSENCE OF COMPENSATION FOR THE COSTS ASSOCIATED WITH THE CASH FLOW TIMING RISK .................................................................................................................................................... 125 SUB-GROUND THREE: ALLEGED RISK OF SSEN TRANSMISSION FAILING TO MEET STANDARD CONDITION B7 OF ITS LICENCE ..................................................................................................................................................... 126 SUB-GROUND FOUR: AN ALLEGED ABSENCE OF EVIDENCE TO DEMONSTRATE THE BASIS FOR GEMA’S DECISION ......................................................................................................................................................... 126 SUB-GROUND FIVE: ALLEGED FAILURE TO CONDUCT AN IMPACT ASSESSMENT ............................................. 128 SUB-GROUND SIX: ALLEGED FAILURE TO CONSULT ....................................................................................... 131 J. CONCLUSION ........................................................................................................................................ 134 2 RIIO-2 Price Control: Response to Appeals on Finance Issues and TNUoS A. INTRODUCTION & SUMMARY 1. This is the response of the Gas and Electricity Markets Authority (“GEMA”) to the Appellants’ appeals on finance issues and transmission network use of system charges (“TNUoS”). GEMA will file separate submissions on the balance of the appeal grounds. 2. Where GEMA does not expressly respond to a particular paragraph of any Notice of Appeal, it should not be taken to be accepting the relevant submission. 3. The Appellants sought permission to appeal pursuant to s.23B(3) GA86 and s.11C(3) EA89 in respect of modifications to licences made by GEMA by a decision dated 3 February 2021 under s.23 GA86 and s.11A EA89 (the “Licence Modifications”). The Licence Modifications give effect to GEMA’s price control determinations under the new price control regime known as RIIO-2. Permission to appeal was granted by the CMA on 31 March 2021 in respect of all grounds. 4. GEMA’s decision-making in respect of the RIIO-2 price controls has involved a complex assessment by GEMA based on substantial data, comprehensive expert analysis, extensive consultation over almost four years, and the careful balancing of regulatory objectives. The Licence Modifications are the product of that work, and of the interaction of a broad range of factors considered by GEMA in accordance with its statutory duties. GEMA is confident that the process it has followed has delivered a result that is well-founded and consistent with its principal objective of protecting the interests of existing and future consumers and its wider duties. 5. An overarching account of the decisions, including: the regulatory context, Ofgem’s assessment of RIIO-1 and strategy for RIIO-2; the interlinkages that GEMA considered in the round; and the extensive consultation and stakeholder engagement undertaken before GEMA made its final determinations, is set out in the witness statement of Akshay Kaul, which the CMA is invited to read. As indicated in earlier correspondence with the CMA and the parties, GEMA proposes that submissions on remedies should be made following Provisional Determinations (should such submissions be needed). The CMA has confirmed in correspondence that (i) it will take interlinkages into account;1 and (ii) “the appropriate time to consider submissions on remedies is after