National Grid plc (NG) Earnings Call Transcript & Summary

Good morning, everybody, and welcome to our call to discuss Ofgem -- our response to Ofgem's draft determinations. Apologies for the slight delay, a slight IT hitch. Hopefully, that's been resolved now. So I'm Nick Ashworth and I head up Investor Relations here at National Grid. Thank you for joining us remotely and I hope everyone is safe and well. As always, I would like to draw your attention to the cautionary statement that you will find at the front of our presentation. And if you have any questions after the presentation, the IR team will be available by phone to help. Before I hand over to our CEO, I just want to run through some quick housekeeping. The call is being recorded, so it can be uploaded to our website, along with a copy of the slides. And at the end of the presentation, there will be an opportunity for Q&A. [Operator Instructions] And so with that, I'd like to hand you over to our CEO, John Pettigrew. John?

Thank you, Nick, and good morning, everyone. Welcome to the call this morning, where we'll spend a few minutes discussing our response to Ofgem's draft determinations, and then as Nick said, we'll open up for questions. With me on the call, as always, I have Andy Agg, our CFO. So as you would have seen, we've now submitted our response to the RIIO-2 draft determinations that Ofgem published in July. The executive summaries for both our electricity and gas transmission businesses have been made public, and for those that have not seen them, they're now on our electricity and gas transmission websites. The documents for the electricity system operator can also be found on its website. As we said in the RNS back in July, we're extremely disappointed with Ofgem's draft determinations as they stand. Our business plans were submitted last December, following the widest consultation we've ever done with our stakeholders and in line with Ofgem's wishes. We proposed GBP 10 billion of totex across electricity and gas to maintain system reliability and accelerate net 0 ambitions, all whilst lowering bills to consumers in real time, in real terms. Our stakeholders strongly supported our plans. For example, 87% of consumers agreed that our approach to net 0 was the right one. As such, we've been working with Ofgem, and we'll continue to do so, to ensure feedback from our customers, stakeholders and independent user groups is taken on board and fully considered. So today, we're setting out our concerns and the remedies we're proposing. We see 3 material and lasting implications if there are no changes by December with the final determinations: First, reduction to the reliability and resilience of our U.K. energy networks; second, jeopardizing the pace of progress to a net 0 energy system; and third, erosion of regulatory stability and investor confidence in the sector. As part of our consultation response, we provide comprehensive evidence that underlines each of these concerns. In addition, we've also been proactive and have proposed remedies to address each of them for both electricity and gas transmission. Our response also covers the electricity system operator and provides evidence to support the investment it requires to step up and be the agile consumer-focused operator that stakeholders tell us they wanted to be. So first, if I turn to reliability on our networks. As a recap on the electricity side, our business plans proposed to invest GBP 3.3 billion on the health of our electricity assets over the 5-year period given the large part of our network was built in the 1960s and '70s. However, Ofgem have proposed to disallow 80% of this investment, which will increase the risk profile of our networks and could give rise to increased reliability events. To put this into context, we'll be delivering 6,791 fewer replacement and refurbishment interventions or a 60% reduction of the 11,000, we believe are necessary to maintain the reliability and hold risk of the system at current levels. Large projects, such as the Sheffield ring main refurbishment, would be postponed. This goes against what our stakeholders have asked us. As the response today shows, this would lead to a rise of 24% in risk levels over 10 years on our electricity network. On the gas side, there is a similar story. With the lower proposed asset health spend, to a 19% increase risk of our gas assets over the next decade. Through this process, Ofgem has referenced that we haven't provided sufficient evidence in our business plans to enable them to allow more of our totex submission. I want to be clear that we disagree. And I believe that our final business plan submissions met the requirements of Ofgem's business plan guidance, which is why we also strongly disagree with the business plan parlances that Ofgem is proposing to levy. However, it is clear that Ofgem is asking for evidence above and beyond its guidance to justify the investments in our plans, and we, therefore, continue to submit more evidence throughout the consultation period. Secondly, the draft determinations, as they stand, will jeopardize the U.K.'s transition to net 0 and National Grid's ability to deliver on the green recovery. For example, the government has ambitious goals in the next decade from the number of EVs on the road to the large increase in new offshore wind generation and promoting hydrogen pilots with the aim of creating a successful hydrogen economy. But the uncertainty mechanisms that Ofgem is proposing, that in theory could unlock greater levels of infrastructure spend as becomes visible through the period, is inflexible. There are bureaucratic hurdles that have been put in place, both electricity and gas, that could add at least 12 to 24 months delays to projects, particularly for electricity. It will slow down, and in some cases, deter investment. For example, on the electricity side, an automatic funding mechanism for connection projects has been proposed that only funds around 30% of the costs, which is a disincentive to connect new customers. The proposed mechanism for future investment levels could also lead to uncertainty around charging. For example, on the gas side, based on our current predictions of projects and the uncertainty mechanism, customers would face a 40% increase in bills in the last year of the price control. This goes against the stability of charges that customers tell us is vital for them to run their businesses efficiently. We would, therefore, like to see corrections to Ofgem's analysis for new connections funding rates. But more widely, we would like to see greater certainty of the approach to large anticipatory investments to be able to start work in RIIO-2 as well as automatic mechanisms to fund smaller projects. Finally, we believe the draft determinations, if made final, will erode regulatory stability and investor confidence. For example, the current draft includes proposals to reopen and claw back over GBP 500 million of fixed incentivized allowances from RIIO-1 where no mechanism exists to do so. It includes a baseline return that is below returns for comparable companies across Europe at a time when competition for green capital has never been higher. It has included unjustified business plan penalties for both electricity and gas transmission, even though we show we've met the minimum requirements for the business plan submissions. It rejects incentives supporting net 0 that are supported by stakeholders, resulting in a negligible incentive package and risk reward heavily skewed to the downside. The plans also deliver a weakening of financial resilience, which is made worse when adding in the gap between spend and revenue being proposed through uncertainty mechanisms. Andy will now spend a few minutes talking through the details around these points before I talk about next steps and close for Q&A. Andy.

Thank you, John, and good morning, everybody. All along, we've recognized that changes to the financial framework are required in RIIO-2 to improve stakeholder legitimacy. We agree that it's appropriate that returns are lower in RIIO-2 than they were in RIIO-1. However, we've said all along that the overall financial package will be a key consideration. And currently, we don't see that the financial package set out in the draft determination is the solution. We have concerns with individual elements as well as the package overall. And in particular, I want to highlight 3 main areas of concern: inadequate allowed equity returns, real challenges in achieving those returns and an overall weakening of financial resilience. Now if I take these in turn. At 3.95%, the proposed allowed equity return at a 60% gearing level is below U.K. water as well as many comparable European regulatory regimes. And more broadly, the draft determination offers limited rewards to drive better performance and service levels for both our customers and consumers. At a time when competition for green capital is growing across markets, we don't believe this is the right time for Ofgem to be proposing such low returns. In particular, we provide further evidence in our submission to show that Ofgem's proposed low returns range comes primarily from 3 areas in how it has determined this range. One is the reduction to TMR, which we show has been calculated using a flawed inflation backcast data set. We're obviously aware that the approach to TMR is currently under review by the CMA in relation to PR19. We continue to press Ofgem to remove the outperformance wedge, which we see as unjustified, particularly given backing evidence from Ofgem that contains multiple errors. We also continue to provide new evidence as to why Ofgem's calculation of beta is too low and why the risk profile for transmission is not the same as for water. Ofgem's own data in the draft determination shows that the National Grid plc beta has been 5% to 12% higher than water using all estimation techniques and averaging periods for the last 10 years. Ofgem also states that it sees U.S. energy betas lower than U.K. water or energy, but it doesn't adjust for this impact for our U.K. businesses. Their own consultants recognize that there are reasons why energy is higher risk than water, given more complex capital programs and the inherent uncertainty arising from the energy transition. We believe we've submitted enough evidence to Ofgem to justify a more balanced appraisal of the allowed equity return and the removal of the floored outperformance wedge. Secondly, whilst we believe allowed returns are inadequate relative to the risk we undertake and compared to comparable industries elsewhere, we're also concerned with the ability to achieve these baseline returns. Incentive arrangements are of very low value and, coupled with the cumulative impact of excessive efficiencies, clawbacks, penalties and the outperformance wedge, we would likely start the RIIO-2 period with a substantial gap to the allowed return. On incentives, the draft determination proposes a package for electricity transmission that is skewed towards penalties and exposed clawback and away from incentives to deliver for consumers. This matters for consumers because it strongly encourages to focus on low-risk, cautious investments to avoid penalties and discourages us from innovating and seeking new efficiencies given we would not be rewarded for the risk we will be taking. The chart shows the incentives for our transmission businesses compared with water and gas distribution. Not only is energy incentivized much less than water, but electricity transmission is incentivized less than either gas transmission or gas distribution. In fact, we see 6x more downside risk than upside opportunity in the proposed arrangements. Consequently, the skewing of incentives towards penalties, together with Ofgem's steep efficiency challenges, means that it will be very difficult for electricity transmission and gas transmission to meet the allowed return. The chart on this slide shows what our achieved equity return could look like at the start of the period if we do not deliver any cost savings. For electricity, the business plan penalty, coupled with the RIIO-1 clawback, steep efficiency challenges and the outperformance wedge, could see our achieved equity return as low as 1.3% under the proposed arrangements. On the gas side, whilst not as severe, we would still only be expecting to earn an equity return of 2.7% without any savings from today. Our response shows why we believe the efficiency challenge is too excessive. Firstly, there are errors in the proposals around the assessment of network CapEx costs which has led to some costs being seen as inefficient. Secondly, Ofgem has scaled down indirect operating costs with a proposed reduction of CapEx, although not all of these indirect costs flex with Capex. We provided evidence to show why both these buckets of costs should be allowed. So to be clear, these are not the returns we expect to earn. We will continue to work hard to deliver on our cost efficiency program, where we already include a 1.1% annual productivity growth target in our business plans, which is almost 3x the current U.K. trend for productivity. From the business plan penalty, we believe we've met the requirements Ofgem set out, and we provide the evidence in our response that will hopefully see this removed, and we will continue to argue for the removal of any RIIO-1 clawback and the negative precedence that this would set. We would therefore expect to be able to deliver higher returns than this. We will continue to push Ofgem to adjust the risk/reward of the overall package to drive service improvements and reduce costs to the benefit of current and future consumers by ensuring appropriate incentivization. Now turning to financial resilience. We remain concerned with a number of areas, such as the methodologies underpinning the financeability ratio calculations, which are inconsistent with those employed by rating agencies. For example, Ofgem based their financeability assessment on revenues which include an assumed earned incentive performance and exclude the business plan incentive penalty, resulting in Ofgem's approach understating the financeability challenge implied by the draft determination. Secondly, the financeability assessment does not adequately stress test whether the RIIO-2 framework can support net 0 investment levels. And thirdly, Ofgem fails to identify or assess the financeability impact of the cash flow risk arising due to the time delay between spend and revenue recovery, given the current proposed uncertainty mechanism framework. We're, therefore, urging Ofgem to undertake a financeability assessment factoring in the expected delays between spend and revenue, given the current proposed framework, provide additional ex ante allowances for uncertainty mechanism expenditure and apply forecasting of outputs for allowances subject to reopeners; and for our electricity transmission business to define a deliverable contestable framework for the RIIO-2 time frame and appropriately assess the totex that could come from this in the financeability and replace return assessments. There is much more detail on all of these areas across our summary documents now on our website. And our submissions have, of course, included the evidence to support all of our proposed remedies. With that, I'll hand back to John.

Okay. Thank you, Andy. So let me be clear, we view the current draft determinations from Ofgem as unacceptable. It will increase the risk profile of our networks that will jeopardize the U.K.'s transition to net 0 with the low returns on offer that will dampen incentives and innovation and limit our ability to help with a green recovery. And of course, the option for the Board of going to the CMA remains should the final determination not provide an appropriate financial framework. Andy and I have laid out the reasons for our concerns today and our response to Ofgem's consultation provides further detail. Nevertheless, we believe we can still reach an outcome in December that addresses these issues. From now until the final determination, we will continue our dialogue with all levels of Ofgem. We already have a schedule of meetings agreed over the next 2 months, including the open hearing that will take place in October. We will continue to provide greater levels of data and information. On this point, we've already submitted a further 118 supplementary evidence reports for electricity transmission. We've tested this evidence with an independent expert engineering organization, and we're confident that Ofgem has the evidence it needs to make a substantial increase in allowances with the final determination. We will continue to work with all our stakeholders to ensure their priorities for RIIO-2 are adhered by Ofgem. Again, on this point, we've commissioned an independent expert organization, also used by Ofgem, to test consumer preferences in light of current economic circumstances. The results of this research are included in our response and clearly and consistently show consumers' preference for investment in reliability in net 0 above short-term bill impacts. Our focus will be to close the investment gap, enabling us to maintain the network reliability that our stakeholders have asked for, whilst agreeing a framework that sensibly delivers the investment for net 0 and a green recovery in a timely manner. Returns will be lower in RIIO-2, but a financial frame work that incentivizes investment and allows for innovation will be key to deliver the networks we require in the coming years whilst protecting consumers. So thank you for listening. We'll now open up the lines for questions.

[Operator Instructions] So the first question is coming to me on the private chat is from Mark Freshney at Crédit Suisse. So he's got 2 questions. Would National Grid Board be willing to go down to Ba1, BBB+ at the U.K. opcos with Moody's and S&P? And does the company need a disposal plan or dividend cut with the RIIO-2 price control as the draft currently stands?

So why don't I take the dividend, and then, Andy, if you could pick up the credit issue. Thank you, Mark. I mean, with regards to dividend, as you know, our dividend policy was reaffirmed by the Board a couple of months ago when we did our results. And as part of that, we acknowledge and recognize the importance of sustainable dividends to our investors. We also, as you know, set out that we review the dividend with our Board on a regular basis and consider aspects such as business performance as well as it's underpinned by sensible regulatory outcomes. So at this stage, this is a Draft Determination. What we set out today is what we believe are the remedies to get to a final determination that makes sense and that will continue to be our focus over the next 3 months.

Yes. And Mark, in terms of the rating question, some will have seen that over the last few weeks, 2 of our rating agencies, Moody's and S&P, have come out with announcements linked to the draft determination, reflecting the proposals put us across the group, effectively, on negative outlook. I think if you dig into the draft determination and certainly our response, we think it's important, as I said in my presentation this morning, that in terms of the financeability assessment, that it takes into account all of the different aspects, both of the package, the proposed levels of totex and also the increases potentially required for net 0. And that those be taken into account in terms of achieving Ofgem's own obligations and what they've set out in their own determination of seeking to retain the BBB+ credit rating at the notional company level. We've clearly been able to then achieve a minus at the opco level previously, and we look to continue to drive our own performance, but for the moment, the focus is on ensuring that the package supports that notional company rating as Ofgem set out.

Thanks, Andy. I think, Deepa, has got her hand up. So Deepa, do you want to ask a question?

Yes. Can you hear me?

Yes, we can.

Yes. So it's very clear that you've laid out that one of the options, if the ultimate outcome is not sensible, would be to go to the CMA. But I think my second question was, well that's always an option, is how do you think about capital allocation? So you obviously do have the choice to invest in the U.S., you have the unregulated business, which, of course, now you started looking at renewables in the U.S., for instance. So there is an option to spend more CapEx elsewhere. There's obviously an option to look at dividend policy, buybacks, et cetera. So I just wondered if you could comment on capital allocation if there's no improvement. And secondly, just looking at how things stand out for gas transmission and RIIO-1, where the ultimate allowances that you were given were lower than what you think was prudent to maintain the safety and reliability of the system. Is there a risk that if Ofgem does not change significantly, that we will see an overspend in ET just because you're being a rightful corporate citizen and doing what's right for the U.K. consumer, but maybe at the cost of returns to your shareholders? Those are my questions.

Thanks, Deepa. I'm going to take the second, and Andy is going to talk about capital allocation. Well I think in terms of where we're at, at this point, I mean what we said I think very clearly today is that we don't believe the draft determination will enable us to be able to deliver what our stakeholders and customers are asking us. Putting it in very simple terms, based on the asset health investment that we've set out for the 5-year period, which is about GBP 3.3 billion, Ofgem's draft determination is suggesting GBP 0.7 billion, of which GBP 0.6 billion of it is for the London Power Tunnel. So you've got, basically, GBP 20 million per annum for the next 5 years for the rest of the country. So that is why we have set out quite clearly that, that would result in an increase in risk, both on our electricity and transmission networks. What we've been doing through this consultation process, and to be fair to Ofgem, they have suggested that's what we should do, is to provide additional information to give them the confidence that these investments are needed. And that's exactly what we've been doing, in my reference to the 118 individual engineering reports, is just a vast quantity of data to justify these investments. And to give you a sense of it, we've now provided, my team told me, 22,000 pages of information to Ofgem to support the investment. So at this stage, we're not at a point where we're looking at whether the allowances cover what we need to do in terms of our mandated spend, but more, we're focusing on making sure that the asset health investments that we make are allowed for in the final determination.

Yes. And Deepa, on the first point about capital allocation, I think just to clarify, also. It hopefully goes without saying that under any set amount, we would absolutely meet our license obligations across all of our U.K. businesses and the same with our U.S. regulated businesses as well. That said, you're absolutely right that we have very attractive opportunities to invest incremental capital. Our U.S. business is growing very strongly, and there are clear drivers, as we've said on previous presentations, across all of our U.S. businesses for growth and where we can see returns significantly above what's been proposed today. And obviously, then in our National Grid Ventures business, again, we have both on renewables, as you mentioned, the interconnector investment that we continue to roll out. So yes, absolutely, we have different opportunities to deploy capital. But at the moment, just to reiterate what we've said a few times is, our focus at the moment is on working with Ofgem to improve what's on the table as we work towards final determinations.

Thanks, Deepa. I think Martin from Investec has got a question. Martin, can you hear us?

Yes. Yes, I can. Can you hear me?

Yes.