Return on invested capital decision
Reactions and perspective
In several energy supply industry sectors, profits are allowed only as a reasonable return on invested capital subject to regulatory control. This applies, for example, to the electricity distribution, gas distribution and heating supply sectors.
The Danish Energy Regulatory Authority (DERA) is in the process of establishing new methods and principles for determining a reasonable return on invested capital across the different sectors.
Since 2011, DERA has made several decisions concerning prices and reasonable return on invested capital within a number of sectors (eg, gas distribution, heating supply and upstream gas transportation from the North Sea). Further, an expert report with recommendations regarding the determination of a reasonable return on invested capital in the electricity distribution sector was published in 2016. These recommendations have been used by DERA as a basis for setting out new principles for the allowed return in other sectors.
A heating supply company may include a return on invested capital in its prices only with prior approval from DERA. At present, DERA is processing approximately 60 applications from heating supply companies for approval of return on invested capital covering 2003 to 2017. The applicants include heating producers, heating transmission companies and heating distribution companies (ie, district heating companies).
In connection with a recent decision in a leading case concerning the district heating company EnergiGruppen Jylland Varme A/S (EGJ), DERA issued statements setting out the general method that it intends to use when determining the size of reasonable return for heating supply companies.
The method may influence other energy supply sectors, where profits are subject to regulatory control by DERA.
The method is based on a weighed average cost of capital (WACC) model supplemented by criteria clarifying the risk profile of the individual company and securing the protection of consumers against unreasonable prices.
The WACC model is used to calculate upper and lower limits for a reasonable interest rate on equity and debt for each year. For 2017, the lower and upper limits are set at 2.39% and 6.39 % for equity and 0.6% and 0.86% for debt, respectively. These upper and lower limits are then used to calculate a range for the amount of a reasonable return for the individual company based on its capital structure.
DERA decides the final amount within the range based on an overall assessment using several criteria to clarify the company's risk profile, including:
- whether the company's capital structure is over 70% debt financed;
- whether the company delivers to end users;
- whether the company's supply of heat is subject to competition and, if so, what the competition climate is like;
- how the company is ranked in DERA's price statistics;
- for heating production companies:
- whether the company can use one or more types of fuel; and
- whether the company is a waste incineration plant subject to a price cap;
- for heating distribution companies:
- the number of customers connected to the grid;
- the concentration of heat supply;
- the concentration of business users; and
- whether end users are subject to a legal obligation to become or remain connected to the grid; and
- for heat transmission companies:
- the number of district heating companies connected as producers and purchasers; and
- the concentration of heating supply.
DERA may apply other criteria deemed relevant to the individual case. It is unclear how DERA intends to weigh the criteria against each other when assessing the reasonable return.
Return on invested capital decision
In the EGJ case, DERA decided on the reasonable return of EGJ's invested capital for 2011 to 2017. In 2012 DERA had approved EGJ's return for 2003 to 2010 using a different WACC model.
DERA concluded that EGJ's invested capital could be estimated at Dkr612 million. By using the new WACC model and criteria, DERA found that a reasonable return on the invested capital for 2011 to 2017 could not exceed Dkr119 million.
However, it was concluded that administrative law prevented DERA from using the new WACC model for the years before 2017. The new model could be used for 2017 because in 2016 DERA had issued a statement that it expected to change its practice to EGJ and other companies that had applied for approval of return on invested capital.
Based on the old WACC model, DERA found a reasonable return on the invested capital to be Dkr144 million for 2011 to 2015 and Dkr15 million for 2016. For 2017, a reasonable return was set at Dkr13 million using the new WACC model.
In total, EGJ received approval to include Dkr172 million in its consumer prices as a reasonable return on the invested capital for 2011 to 2017.
The decision and new principles that DERA applied have received mixed reactions. The Danish Energy Association has expressed concern that the low rate of return applied by DERA makes it unattractive to invest capital in the heating industry. Calculations from the association indicate a general level of return on invested capital of 1.4% to 2.9% when using DERA's new method. The association argues that this results in returns lower than those which apply to electricity distribution, which is already approximately only half of what is allowed in neighbouring countries.
Conversely, other critics fear that the decisions will lead to increasing consumer prices due to a change in the general practice where many heating supply companies have not previously included a return on invested capital in prices.
Following the abovementioned decisions, the government and several political parties have announced a review of the regulation with the aim of stopping or limiting the possibility of claiming a return on invested capital in future prices. However, such initiatives will meet legal obstacles due to basic principles of protection of legitimate expectations and property.
For further information on this topic please contact Nicolaj Kleist at Bruun & Hjejle by telephone (+45 33 34 50 00) or email ([email protected]). The Bruun & Hjejle website can be accessed at www.bruunhjejle.com.