Price Review Submission

Transcription

1 Price Review Submission covering period 2016 to 2020 (PR4) Distribution System Operator (DSO) PR4 Overview (DF01) Status: Submitted to CER Date: 21/11/2014 Public Submission Document

2 Table of Contents TABLE OF CONTENTS DSO Executive Summary DSO Introduction DSO PR4 Economic Environment ESRI s Medium Term Review New Connections Load Forecasting Inflation Affordability WACC & Financeability WACC Financeability DSO Capital Expenditure Programme Transmission Smart Metering Prioritisation of Distribution Capex New Business Generator Connections Line Diversions Reinforcement Non Load Related Network Expenditure Non Network Electric Vehicles (EVs) & North Atlantic Green Zone Project (NAGZ) Operating Expenditure Operation & Maintenance Costs Asset Management Metering Customer Services Provision of Data 37 1

3 Table of Contents 7.6. Telecoms Sustainability and R&D Rates Other Efficiencies Benchmarking Pension Recovery Asset Life Distribution Transmission Climate Adaptation Incentives Customer Safety & Resourcing Safety Strategy Work Practices Resourcing DSO Conclusion 55 DSO Appendix 56 2

4 1. DSO Executive Summary ESB Networks Objectives & Economic Outlook Despite the significant challenges that faced ESB Networks (ESB Networks) over the PR3 period of 2011 to 2015 due to the severe economic downturn, the business successfully and substantially delivered on its licence obligations and key objectives over the period. Critically, affordability and customer service targets will be maintained as compared to what was anticipated when the determination was set. This was partially achieved by prioritising and deferring delivery of elements of the PR3 infrastructure investment programme. As a result ESB Networks is now well placed to continue to deliver successfully into the period 2016 to 2020 (PR4). ESB Networks high level objectives for PR4 are to : Continue to deliver a safe and reliable electricity distribution network for our customers and the economy through delivering key electricity infrastructure. This includes investing to enable renewables integration onto the network facilitating the achievement of the Irish Government RES-E target of 40% of energy consumed in the electricity sector coming from renewable sources Ensure safety of staff and the public Continue to provide excellent customer service and have due regard to customer affordability Lead the development of the Smart Grids /Networks sector in the Republic of Ireland Drive efficiencies within ESB Networks to create customer and shareholder benefit. In contrast to PR3, the economic outlook for the PR4 period is positive. It is anticipated that the economy will return to a reasonable rate of growth driving an increase in new connections and electricity demand. Delivery of Networks Objectives In PR4: ESB Networks is proposing a distribution capital expenditure programme of 1.8bn for the PR4 period which ESB Networks believes is the minimum expenditure required to support the delivery of a safe and reliable distribution system for our customers and the economy. In developing the final programme, ESB Networks was very conscious of the affordability impact on our customers. The PR4 plan is broadly in line with expenditure in the PR3 period with the exception of asset replacement and reinforcement expenditure which was controlled carefully in PR3, resulting in deferral of a large portion of required investment as set out in the historic submissions on Reinforcement and Asset Replacement. The base case submission does not include Smart Metering as the final investment decision has not yet been taken. However, further development and project costs necessary to take the project to the next major milestone in 2017 are included. ESB Networks is proposing to progress developments in the smart environment and to implement smart grid technologies and practices as the cornerstone of the networks business into the future. ESB Networks is committed to maintaining excellent customer service. ESB Networks is targeting:»» maintaining strong customer satisfaction with service levels at 78%»» Maintaining strong customer satisfaction within the National Customer Care Centre. To meet customers needs to engage in more online and via social media, ESB Networks is proposing to put in place a new website to offer additional online services and a dedicated team to deliver services via a range of social media»» Maintaining the reliability of electricity supply for our customers at 2009 levels. This will deliver a 60% improvement in the reliability of customers supply as measured by Customer Minutes Lost between 2001 and

5 1. DSO Executive Summary»» Providing critical market services to electricity suppliers in line with service level agreements in areas including customer switching, meter reading, revenue protection services and providing Pay As You Go Meters for electricity customers in financial hardship. ESB Networks is fully committed to ensuring the health and safety of our staff, contractors, and the public. There have been 4 work based fatalities in our business in the last 4 years. In response ESB Networks has put in place a strategy to improve safety with the objective of ensuring that we are incident free. Implementation of this safety strategy has the potential to be disruptive to the delivery of our work programme. CER s support in the delivery of our strategy will enable us to move forward effectively. An allowance of 1.5bn in Distribution Opex costs is sought which is 0.4bn greater than the PR3 allowance. In ESB Networks view, the maintenance allowance in PR3 was too low particularly with regard to the timber cutting allowance. ESB Networks spent more on maintaining network assets than was allowed despite, in the HV stations area, work completed being less than required and what industry norms would demand. ESB Networks is seeking a higher maintenance allowance in PR4 to ensure assets are appropriately maintained to deliver a safe and reliable distribution system for our customers. Other increases relate to rates increases, increased metering costs associated with the provision of PAYG meters to customers in hardship and increased revenue protection service requirements, improvements in customer service and costs associated with complying with increased safety and environmental legislation and safety related enhancements to work delivery structures safety management systems as well as training and competency assurance. Financeability Maintaining Networks financial strength is critical to enable ESB Networks to ensure continued, efficient and competitive access to funding markets to enable it to fund the electricity infrastructure and activities necessary to deliver its licence obligations and objectives and to earn an acceptable commercial return for ESB and its shareholders. The following is ESB Networks proposal in relation to some of the main items which significantly contribute to ESB Networks financeability: ESB Networks is proposing a reduction in the Weighted Average Cost of Capital from 5.2% to 4.98% for the PR4 period on the basis that this is an appropriate return to enable ESB Networks to efficiently and competitively finance its activities. ESB Networks considers that this reduction in the cost of capital is justified by precedent and a broad assessment of the evidence. A reduction of WACC from 5.2% to 4.98% reflects market improvements but retains a long-term focus in mind for PR4 and reflects the considerable risk and uncertainty that still remains for the Irish economy in the medium term. This longer term focus is consistent with various regulatory decisions in the UK within the past five years. It also recognises that the Irish sovereign debt crisis has had a material effect on the cost at which ESB Networks was able to issue debt which will have an overhang effect over PR4. ESB Networks is seeking to recover the ESB Networks element ( 462m)of the contribution payable by ESB to the ESB Defined Benefit Pension deficit as an additional opex allowance for recovery via regulated charges. Regulatory precedent followed by the CER and many other regulators including Ofgem, Utility Regulator, CAR, CAA, etc. is to allow recovery of deficit funding as incurred, i.e. in the period to 2018, and this indeed is our advisor s (Oxera) recommendation. However, in the interest of managing price, ESB Networks is proposing recovery over a 13 year period. ESB Networks considers the pension agreement as a key achievement in the PR3 period that protects the customer into the future by reducing the risk profile of the scheme. ESB Networks has considered whether the 45 and 50 years asset lives for distribution assets and transmission 4

6 1. DSO Executive Summary assets is appropriate (transmission included in this document for completeness). Whilst ESB Networks considers that there are strong arguments for seeking recovery of distribution assets over a shorter timeframe, due to affordability concerns, ESB is making no request in this area. However, a core part of the submission is that ESB Networks is seeking recovery on transmission assets over a 45 year life in line with UK DNOs. As CER is aware in the context of Financeability, Free Funds from Operations (FFO) / net debt is the key metric used by Standard & Poor s in its credit rating for ESB and as a result ESB Networks. In arriving at an appropriate PR4 revenue proposal, ESB Networks has carefully considered all aspects of the business - the appropriate WACC, an appropriate period for pension recovery and asset lives as well as the opex and capex programme. ESB Networks is strongly of the view that the level of revenue required to enable it to competitively and efficiently finance a sustainable networks business should deliver an FFO/net debt target of 15% in line with UK DNOs. Customer Affordability ESB Networks however is acutely aware of the economic pressures customers are under right now and has given significant consideration to affordability in developing this proposal. ESB Networks final proposal is set to deliver a flat DUoS price over the 5 year PR4 period. To deliver this end result, ESB Networks has had to accept a trade off between financeability of the business and customer affordability. Whilst ESB Networks considers that delivery of a 15% FFO/net debt is necessary to competitively and efficiently finance the business, ESB Networks accepts that in the interest of affordability, that this target should not be achieved in this regulatory period. ESB Networks proposal will deliver an FFO/net debt of 13.4% (12.5% excluding pension). The resulting PR4 proposition, from a credit rating metrics perspective places ESB Networks towards the lower end of the range for an A rated company. ESB Networks is strongly of the view that an FFO/debt level of 13.4% (12.5% excluding pension) is absolutely critical to enable the business to secure competitive and efficient financing on an ongoing basis, to facilitate the delivery of key infrastructure investment and delivery of our regulatory obligations for the benefit of our customers and the economy. As ESB Networks does not believe that this will be sustainable into the future, ESB Networks would welcome the opportunity to re-consider the higher target in PR5. As noted above, ESB Networks tempered its pension deficit contribution recovery request, asset life consideration and financeability target as a result of price pressures facing our customers. ESB Networks proposal will facilitate holding DUoS prices at current levels in real terms over the five year PR4 period 2016 to 2020 (i.e. enable no DUoS price increase in real terms over PR4). Summary In summary, Networks considers that this proposal for the PR4 period is appropriately balanced to ensure ESB Networks can continue to deliver on its licence obligations to provide a safe and reliable distribution system for our customers and the economy during PR4, whilst maintaining excellent customer service at an affordable price. 5

7 2. DSO Introduction Despite the challenges over the PR3 period, ESB Networks (ESB Networks) successfully and substantially delivered on its licence obligations and objectives during PR3. Critically, affordability and customer service targets will be maintained in line with anticipated performance when the determination was set. As a result ESB Networks is well placed to continue to deliver successfully into PR4. ESB Networks High Level Objectives for PR4 are to : Continue to deliver a safe and reliable electricity distribution network for our customers and the economy through delivering key electricity infrastructure. This includes investing to enable renewables-integration into the network to facilitate the achievement of the Irish Government RES-E target of 40% of energy consumed in the electricity sector coming from renewable sources Ensure safety of staff and the public Continue to provide excellent customer service and have due regard to customer affordability Lead the development of the Smart Grids /Networks sector in the Republic of Ireland Drive efficiencies within ESB Networks to create customer and shareholder benefit. ESB Networks is committed to bringing Ireland s electricity networks to a world-class standard while also ensuring that the networks can support Ireland s stretching renewables and sustainability targets. Smart metering, intelligent networks and increased electrification, including electrification of transport and heat, will all play key roles in a very different energy infrastructure of the future. ESB Networks will play a central role in the successful delivery of this infrastructure. The base case submission does not include smart metering as the final investment decision has not yet been taken. However, for completeness, ESB Networks provides sensitivities on all key metrics that reflect the investment proceeding in line with the Smart Metering Cost Benefit Analysis (CBA). ESB Networks are acutely conscious of the enormous global and national challenge, in terms of environmental and energy sustainability. The strategies and targets emerging to address climate change in terms of CO2 reduction, renewable energy and energy efficiency are stretching. Energy networks, and electricity networks in particular, will be at the heart of their delivery. ESB Networks will play a key enabling role in the integration and penetration of renewable energy sources, deployment of distributed generation, the roll-out of demand side management (DSM) programmes and transport electrification. Over the next five to ten years ESB Networks will need to develop the network to be smarter, more accessible, more flexible and more efficient, while all the time operating them cost-effectively, reliably and safely. Whilst all efforts have ben made to keep capital investment levels at an affordable level, the capital investment required in PR4 is still significant. Good financial performance, while not the only measure of success, is critical to ESB Networks future as a business. ESB Networks has a mandate to earn appropriate commercial returns for ESB and its shareholders, while meeting the challenges of regulation and meeting responsibilities to customers, the electricity market, and the wider national economy and society. To be financially successful in the longer term, ESB Networks must continue to improve business performance in the form of increasingly efficient delivery of services to customers. This will ensure that the rising debt levels facing the business can be supported and customer costs minimised. In that context, ESB Networks objectives for PR4 are : Hold DUoS charges at 2015 levels in real terms over the five year period of PR4 while continuing to develop and maintain a safe and reliable network for our customers and the economy Increased safety levels for members of the public and employees Address deficiencies such as plant overloading, non-compliance with voltage standards and breaches of safety standards (short circuit deficiencies) 6

8 2. DSO Introduction Replace aging and defective assets that are reaching, or have passed the end of their useful technical life To maintain and improve network continuity performance and safety To integrate new technologies and systems which reduce the lifetime cost of assets, and allow for performance improvement in an informed and effective manner To maintain excellent customer service cost-effectively delivered across the Customer Service spectrum The connection of a predicted additional 108,000 new customers as required Achievement of national renewable energy targets by the connection of significant amounts of renewable generation capacity to the distribution system within the gate processing system To enable an improvement in national energy efficiency through the roll out of a smart metering project subject to CER decision to proceed and through ongoing efficiency and loss reduction measures on the network To implement smart grid technologies and practices as the cornerstone of the networks business into the future. This document sets out the key facets of ESB Networks proposal. 1. DSO PR4 Economic Environment ESRI in their Medium Term review consider three possible scenarios or paths for the economy because of the uncertainty about the future - Recovery, Delayed Adjustment and Stagnation. ESB Networks has taken the Recovery Scenario as a base assumption in developing the PR4 proposal ESRI s Medium Term Review DSO PR4 Economic Environment ESRI in their Medium Term review consider three possible scenarios or paths for the economy because of the uncertainty about the future - Recovery, Delayed Adjustment and Stagnation. ESB Networks has taken the Recovery Scenario as a base assumption in developing the PR4 proposal. 2. DSO PR4 Economic Environment ESRI in their Medium Term review consider three possible scenarios or paths for the economy because of the uncertainty about the future - Recovery, Delayed Adjustment and Stagnation. ESB Networks has taken the Recovery Scenario as a base assumption in developing the PR4 proposal ESRI s Medium Term Review ESRI sets out the scenario as follows: (see following page) 7

9 3. DSO PR4 Economic Environment ESRI in their Medium Term review consider three possible scenarios or paths for the economy because of the uncertainty about the future - Recovery, Delayed Adjustment and Stagnation. ESB Networks has taken the Recovery Scenario as a base assumption in developing the PR4 proposal. 3.1 ESRI s Medium Term Review ESRI sets out the scenario as follows: In the Recovery scenario, the EU economy is assumed to return to a reasonable rate of growth over the rest of the decade. It is also assumed that the continuing problems in the Irish financial sector are tackled effectively. Under these circumstances, the export sector of the economy would see its markets grow, resulting in increases in output and employment. In turn, growth in foreign demand would help produce a turnaround in domestic demand. As firms increase their sales and their profitability they would need to invest to continue growing. With rising real personal incomes and growth in employment, consumption would also begin growing again. Demographic pressures would mean that more dwellings would need to be built later in the decade and a recovery in household circumstances would suggest that this investment could in theory, be financed. Overall, this scenario would see growth in GNP of around 3.5 per cent a year in the second half of the decade (Table 1). While the economy would not be likely to reach full employment by 2020, the level of unemployment could be more than halved to around 6 per cent. Finally, the Irish growth model remains vulnerable to shocks from outside Ireland. As a result, it will be important that the driving force behind the export sector moves gradually away from businesses that are dependent on the low corporate tax regime to businesses that rely on other aspects of Ireland s competitive advantage. ESRI Summary table: Recovery Scenario GDP, % GNP, % General Govt. Deficit, % of GDP Unemployment Rate, % of Labour Force Figure 1: ESRI Summary Table 3.2 New Connections For 2016 to 2020, the anticipated volume of new connections is expected to grow gradually from the dip of the previous five years ( ) to the levels as predicted in the table below based on increases in population, declining emigration and government support in financing programmes for the construction of social and affordable housing units G1 - New housing Schemes 7,000 8,500 9,500 11,500 G2 - Non-scheme Houses 5,500 6,000 6,500 7,000 G3 - Commercial/ Industrial Supplies 4,500 4,500 5,000 5,500 17,000 19,000 21,000 24,000 Figure 2 - Forecasted New Connections 8

10 3.3 Load Forecasting Methodology The essence of load forecasting is to examine the current trends driving growth in demand for electricity, to identify the key factors involved, to determine how these factors are likely to change over the forecast period and to quantify the impact of such changes. The fundamental methodology therefore is to obtain as complete and accurate a description of the existing load composition and behaviour as possible. With this it is possible to identify the key factors driving growth at present and in the immediate past and then to project load growth based on the expected behaviour of these factors over the time period of interest. Key load information includes the following: Sales by customer type (Domestic, Commercial / Institutional and Industrial) Customer numbers by type including some breakdown of residential customers by level of consumption Load composition - some forms of electricity use can have significant growth potential in an expanding economy, e.g. air conditioning, while others are subject to reducing demand due to technology / efficiency improvements, e.g. lighting fluorescents, compact fluorescents (CFLs), etc Economic performance - mainly measured by Gross Domestic Product (GDP) and its composition across the major sectors of the economy. Inflation is also relevant and is measured to Consumer Price Index (CPI) Electricity price / tariff data is needed to assess the impact of price changes on consumption Population data - information is needed on population growth and major population movements, e.g. from rural to urban locations Technology - changes in end use applications and appliances. For example more widespread use of air conditioners could increase demand significantly, while the use of more energy efficient motors, lighting, etc. can reduce demand Weather - changes in average seasonal temperatures. Analysis & Results Following analysis of all constituents above, the following trends were noted: System demand has started to show signs of recovery Average consumption per customer on residential side has been broadly unchanged through the recession; reduction in demand driven instead by the reduction in the number of houses Economic growth (GDP ) returning from 2012 onwards Housing construction continued to fall through 2013 but this trend is expected to reverse over time with a forecast of annual new connections of 27,000 in

11 3.3 Load Forecasting The overall forecast based on this analysis is that distribution sales are anticipated to gradually increase over the PR4 period. This is exhibited in the graph below: 35,000 30,000 25,000 20,000 15,000 10,000 5, Figure 3: Distribution Sales Forecast Adjustments 110kV Network 38kV Tailed 38kV Looped MV LV MD LV Non MD Public Light, Misc. Rural Domestic Urban Domestic The overall impact is a 25% increase in sales between 2015 and It should be noted that a significant portion of this increase is driven by the major new loads forecast (but not confirmed) to connect over the period. Excluding these loads, the normalised cumulative growth over the period is closer to 10%. 3.4 Inflation In PR1 (2001 to 2005) and PR2 (2006 to 2010) the CER used CPI as the index to inflate revenue. During the PR3 review process the issue arose as to whether CPI or HICP would be more appropriate to use. This was mostly driven by the fact that CPI (which includes mortgage interest and house prices) was more volatile during a period with exceptional economic conditions. As a result, CER moved to using HICP for PR3. Low inflation is a significant risk to ESB Networks due to the fact that revenues are indexed. Added to this is the fact that debt bears a fixed interest rate which further increases downside risk. Prolonged low inflation can ultimately impact cashflow and hence credit ratings. Moody s in particular have highlighted low inflation as a particular risk to ESB Networks. In its commentary Low Inflation is Credit Negative but Exposure Varies by Regulatory Framework issued in April 2014, it states that regulated energy network issuers in France, Ireland, Italy and the Netherlands are most affected by low inflation because their asset base will fall in value, increasing leverage. The report goes on to say that the mechanism for allowing revenue becomes very significant in low inflation environments because of the risk of fixed debt payments and fixed staff costs for entities that earn a real return. Regulated entities subject to a nominal return are much more protected because the allowed regulatory return and the value of the RAB will stay at the same level, thus protecting cash flows and debt serviceability. ESB Networks is therefore very exposed from a credit rating / financeability perspective by virtue of the fact of having a real WACC and fixed debt servicing costs. For this reason ESB Networks propose reverting to CPI as the indexation factor for PR4. This is consistent with RIIO-ED1 which continued the use of RPI by Ofgem. ESB Networks is using the following indexation assumption in projecting revenues for the PR4 period Annual CPI Rate 1.50% 1.50% 1.50% 1.50% 1.50% Cumulative CPI Rate Figure 4: CPI Assumption table 10

12 4. Affordability Affordability has been a key consideration for ESB Networks in the PR3 mid term WAAC review and in developing its PR4 proposal. Key areas of focus have been: Prioritisation of infrastructure investment expenditure for the PR4 period. This is covered further in Section 6 of this submission A proposed WACC reduction for the period from 5.2% to 4.98% Efficiency savings of 1% per annum of non-controllable opex are taken into account within the numbers i.e. 5% cumulative over PR4 Instead of seeking pension deficit recovery over the period as regulatory precedent would indicate, ESB Networks is seeking recovery over 13 years Although ESB Networks considers that ESB Networks, as with comparable DNOs, should deliver an FFO/net debt performance of 15%, ESB Networks accepts that there is a trade off with customer affordability and than that, in this context, it is not possible in this price review period and is seeking more a moderate revenue stream Although ESB Networks considers that ESB Networks should be recovering investment on distribution asset over a shorter lifetime than the UK DNOs, ESB Networks is seeking no change in this respect. The Average Unit Price (AUP) impact of ESB Networks PR4 submission is as set out below: Parameter Base Case Smart Metering Sensitivity DUoS Revenue 3.5bn 3.7bn AUP % increase 0% 8.8% Impact of DUoS on end user 0% 2.1% Figure 5: Average Unit Price (AUP) impact of ESB Networks PR4 submission See further detail on DUoS revenue and AUP in Appendix 1. ESB Networks proposal will facilitate holding DUoS prices at current levels in real terms over the five year PR4 period 2016 to 2020 (i.e. enable no DUOS price increase in real terms over PR4). ESB Networks considers that this price review proposal delivers excellent value to the customer at a time when affordability is an issue. 11

13 5. WACC & Financeability 5.1 WACC Recent European regulatory precedent has seen a decline in allowed returns for regulated utilities. This is concerning as Eurelectric research shows that lower returns result in lower investment. ESB Networks believes that it is critical that the business earns an adequate return over the PR4 period to ensure that revenues are maintained at a level that will attract debt investment. Both the distribution and transmission systems are in need of significant investment over the period ESB Networks has engaged Frontier Economics (Frontier) to carry out an independent assessment of the appropriate level of allowed WACC for PR4 to enable ESB Networks to efficiently and competitively finance its activities. On Frontier s advice ESB Networks is proposing a reduction in the Weighted Average Cost of Capital from 5.2% to 4.98% for the PR4 period on the basis that that this is an appropriate return to enable ESB Networks to efficiently and competitively finance its activities. The WACC components for the 4.98% proposal are summarised in the following table: Mid-Term Review Estimate for ESB Networks PR4 Gearing 55% 55% Risk-free rate 2% 2% Debt premium 2.2% 1.75% Cost of debt 4.2% 3.75% ERP 5% 4.6% Asset beta Equity beta Cost of equity (post-tax) 5.35% 5.68% Corporate tax 12.5% 12.5% Cost of equity (pre-tax) 6.1% 6.49% WACC (pre-tax) 5.05% (5.2% with aiming up) 4.98% Figure 6: Weighted Average Cost of Capital Components ESB Networks considers that a reduction in the cost of capital is justified by precedent and a broad assessment of the evidence. The reduction proposed reflects market improvements but does not, in determination of appropriate WACC parameters, follow that market to the all time low levels evidenced right now. It is important to have a long-term focus in mind for PR4 and as a result we consider that the CER should take a cautious approach in any downward adjustment as considerable risk and uncertainty still remains for the Irish economy in the medium term. This longer term focus is consistent with various regulatory decisions in the UK within the past five years. It also recognises that the Irish sovereign debt crisis has had a material effect on the cost at which ESB Networks was able to issue debt which will have an overhang effect over PR4. ESB Networks believes that this balance will provide important clarity and consistency to debt investors at a time when economic conditions remain weak and future prospects remain uncertain across the Eurozone. This may be expected to increase investor confidence and ultimately lower the cost of capital in future to the benefit of customers. 12

14 5.2 Financeability CER has an obligation to ensure that ESB Networks is capable of financing its operations. The CER has interpreted this clause such that the obligation is to ensure that an efficient licence holder is capable of financing its activities. Rationale for Targeting a Strong, Investment-Grade Credit Rating It is imperative that ESB Networks achieves a strong, investment-credit rating to ensure continued access to funding markets. The reasoning behind this is as follows: a) ESB Networks has significant funding requirements as it is consistently in a cash-negative situation due to its long term electricity infrastructure investment programme. The business has larger capex programmes than most peers relative to size of company which is currently predominantly driven by transmission spend. In addition, approx. 2.5bn of ESB debt is maturing during the PR4 period. b) As a state-owned entity, ESB is entirely dependent on debt markets for funding. If markets are not available to raise cash, without action, available funds would run out and capex would have to be constrained (as in 2011). c) ESB (and by extension, ESB Networks) competes for capital from the same investor pool as its UK and European peers. The majority of ESB Networks peers are rated at BBB+/Baa and above, however for a number of reasons ESB could be perceived as a more risky credit. These reasons are as follows: ESB Networks is inextricably linked to the Irish economy both by virtue of being state-owned and because of the geographic focus of the business. During the recent economic crisis ESB s rating (and ESB Networks rating were it rated) was constrained by the Irish sovereign credit rating and financial markets were effectively closed to ESB at this time. Although this risk has receded somewhat over the last 18 months, it is still a consideration for investors, who see Irish credits as more risky than UK peer credits, for example. The majority of ESB Networks peers have access to equity, either through being listed companies or through shareholders which are willing to commit capital. The ability to raise equity, or to retain cash within the business through reducing dividends allows companies to maintain credit quality, however these options are not open to ESB. In investors eyes, therefore, there are fewer sources of funds open to ESB to service debt. ESB therefore needs to be perceived as a stronger credit than its listed peers in order to offset this risk. d) ESB Networks advisors have indicated that a strong investment grade rating is essential to refinance maturing debt and to raise funding for additional capital expenditure at optimal rates. Bond yields have been volatile over the years of the financial crisis and investors will expect to see certainty on credit ratings over the medium term prior to committing to purchasing long-dated bonds. Higher interest costs, shorter maturities and onerous financial covenants could result if a lower credit rating is received. Appropriate Target Credit Rating Metrics for ESB Networks ESB Networks has carefully considered financeabiity and has determined that the appropriate rating for a stand alone networks company situated in Ireland would be an A- /A3 rating from S&P and Moodys respectively to ensure Financeability on an ongoing basis. This rating is required to protect ESB Networks against the Irish sovereign credit risk premium and ensure consistent access to funding throughout PR4. In the context of Financeability, Free Funds from Operations (FFO) / net debt is the key metric used by Standard & Poor s in its credit rating for ESB and as a result ESB Networks. Having considered all of the evidence, ESB Networks believes that an appropriate FFO/Net debt target for ESB Networks for PR4 is 15%. This level of performance is in line with the UK DNOs (rated BBB+ / Baa) and ensures that ESB Networks can maintain a level of headroom over the target that Standard & Poors sets for an A rated entity (13%). This headroom is consistent with all UK DNOs and Rating agency practice. 13

15 5.2 Financeability Having considered the still relatively low levels of growth anticipated over PR4 and having due regard for customer affordability, ESB Networks considers that this is this FFO/Debt target of 15% should not be achieved in this regulatory period. The overall proposal will deliver an FFO/net debt of 13.4% (12.5% excluding pension). The resulting PR4 proposition, from a metrics position places ESB Networks towards the lower end of the range for an A rated company. As ESB Networks does not believe that this will be sustainable into the future, ESB Networks would welcome the opportunity to re-consider the higher target in PR5. The key credit rating metrics resulting from ESB Networks proposal are as follows: PR4 Submission Sensitivity with Smart Metering FFO/debt 12.5% 12.3% FFO/Interest 3.2%X 3.2% Net Debt/RAV 52.7% 54.2% Figure 7: Key credit rating metrics resulting from ESB Networks proposal ESB Networks is strongly of the view that for PR4 this 13.4% (12.5% excluding pension) FFO/debt level is the minimum performance required that will enable the business to secure financing competitively and efficiently to facilitate the delivery of key infrastructure investment and ESB Networks regulatory obligations in PR4. Further detail on this area is set out in a separate submission, DF57 WACC & Financeability. 14

16 6. DSO Capital Expenditure Programme ESB Networks is proposing a capital spend for PR4 that is broadly in line with PR3 with the exception of asset replacement. The following summarises ESB Networks planned capital expenditure (before capital contributions) for the price review: PR4 Projected (2014 real) PR3 Projected (nominal) New Business Generation Connections Line Diversions Distribution Reinforcement Asset Replacement NAGZ 88 - IT, Telecoms, Fleet & Premises Smart Metering Dismantling Total Distribution 1,774 1,252 Transmission * 1,239 1,048 Total 3,013 2,300 * Transmission CAPEX is included for completeness Figure 8: DSO Capital Expenditure Programme Capital contributions from distribution and transmission customers are estimated to be 214m and 116m respectively. Distribution capex is forecast to be 1.77bn compared to a final outturn for PR3 of 1.25bn. The main elements of the increase are due to the following reasons: 0.1bn as a result of increased new connections and associated line diversions due to pick up in the economy. This is largely outside of the control of ESB Networks and may increase or decrease based on customer behaviour 0.3bn in Asset Replacement to meet the required investment that was deferred during PR3 0.1bn Non-network investment to meet the systems requirements that were deferred during PR Transmission As noted above, the transmission capex is included for completeness of the capital expenditure. This expenditure is driven by EirGrid and a separate submission TF01 Transmission Capex Overview sets out this expenditure in more detail from the TAO perspective. 15

17 6.2 Smart Metering As mentioned in the introduction, the base case PR4 submission does not include the full Smart Metering capex as the decision to proceed has not yet been taken. The next phase of the National Smart Metering Program (NSMP) involves : Designing the regulatory framework to support policy decisions Designing the changes to the retail market to support implementation of policy decisions Designing the approach to timing and sequencing of delivery of decisions Launch of ESB Networks procurement of the high cost products and services, once sufficient information is made available. ESB Networks will not award any contracts from this procurement process or proceed with full roll out as it is the intention of CER to reassess the case for smart metering at that point, before the CER go/no go decision. ESB Networks estimates that the cost of this next phase of work which will be completed in Q at a cost in PR4 of 23m. As per the current Cost Benefit Analysis (CBA) the expected capital spend on smart metering in the period is 798m. 6.3 Prioritisation of Distribution Capex In developing the final programme, ESB Networks was very conscious of the affordability impact of PR4 plans, particularly in relation to the larger asset replacement and reinforcement programmes. As a result, a number of steps were taken to reach the final programme: 1. An initial assessment of required expenditure was carried out (Safety, Reliability, Policy & Environment) 2. A Risk & Cost Benefit analysis was carried out on each element of the Asset Replacement programme 3. An independent high level review of initial assessment was commissioned 4. An independent unit cost benchmarking was commissioned. Step 1: Initial Assessment ESB Networks set out all proposed programmes on a prioritised basis. The following categories were used: Priority Programmes Mandatory New Connections Priority 1 Priority 2 Priority 3 Response CAPEX Safety driven programmes Plan to keep safety risks at a level that is in line with UK DNOS and European DSOs Security of Supply Driven Programmes Expenditure mainly driven by requirement to meet planning standards Based on forecast loads adjusted for SMART metering impact Include also Elevated N - 2 Risks Renewal CAPEX Programmes that reduce risk and improve continuity Figure 9: Prioritisation of Distribution Capex 16

18 6.3 Prioritisation of Distribution Capex Step 2 Risk & Cost Benefit Analysis All proposed programmes were then considered from a risk and cost benefit perspective using a methodology developed with EA Technology as part of the PR3 process. This is a similar method to that used by DNOs in GB and elsewhere. The following formula is applied: Benefit ( Risk, Cost) Cost Where Risk = Probability of Failure / Event X Consequence f ( s, r, c, e ) s = Safety r = Continuity of Supply c = Cost e = Environment Each programme was essentially considered in context of ways the asset could fail and the impact of those failures. A lower programme of work developed following this process. Step 3 Independent High Level Review of Initial Assessment ESB Networks requested Parsons Brinckerhoff (PB) to consider and review the strategies, policies and practices adopted in assessment of load related and renewal expenditure forecasts for the PR4 period by comparison with GB DNO practices. The review concluded that expenditure planned is broadly in line with that of UK DNOs. The following extracts from the report support this: An initial order of magnitude benchmarking assessment against DNO companies with similar customer numbers or line length shows that this sum is of the right order of magnitude if not low. The basis of the forecast is sound and is unlikely to lead to stranded network capacity. If anything it exposes ESB network to a level of risk since load growth will undoubtedly take place and there may be little benefit gained for some time from the introduction of SMART metering or from legislation intended to introduce efficiency initiatives. Bearing in mind that the submission as a whole appears low and since the load related content of the submission is proportionally high compared to the ratio of DNO load related expenditure to asset replacement expenditure, there appears to be prima facie evidence that the asset replacement expenditure has already been minimised. The review has given ESB Networks significant confidence that the programme proposed is in line with peers, is unlikely to result in stranded assets and is investing in asset replacement at a level that is adequate yet affordable. Step 4 Independent Unit Cost Benchmarking Results to date from unit cost benchmarking indicates that ESB Networks construction costs are well within comparable DNO costs for lines and cables and comparable with equivalent DNO s costs for substations. Expenditure in this area is expected to rise from a forecast of 229m in PR3 to 305m in PR4. The PR4 period is expected to see modest customer growth. For 2016 to 2020, the anticipated volume of new connections is expected to grow gradually 17

19 6.4 New Business from the dip of the previous five years ( ) to the levels as predicted in the table below based on increases in population, declining emigration and Government support in financing programmes for the construction of social and affordable housing units G1 - New housing Schemes 7,000 8,500 9,500 11,500 13,500 G2 - Non-scheme Houses 5,500 6,000 6,500 7,000 7,500 G3 - Commercial/ Industrial Supplies 4,500 4,500 5,000 5,500 6,000 17,000 19,000 21,000 24,000 27,000 Figure 10: New BusinessForecast PR4 Supply of new housing (G1 & G2 connections, especially in regions around the greater Dublin area, is short and prices are beginning to rise. ESB Networks expects to see a rise in completions in the forthcoming PR4 period due to this correlation. The significance of this rise is expected to be modest as the current rates of price rises are believed to be unsustainable, therefore, dampening the supply growth levels. Non-Domestic connections cover a wide variety of types of connections. Therefore, it is more difficult to link/correlate these new connections to external factors such as house prices. It is forecast that these G3 connections are likely to remain at approximately 5,500 for the duration of PR4. See DF05 New Connections for further detail. 6.5 Generator Connections The PR4 period covering years , will cover the majority of the construction of the Gate 3 projects that have contracted in mid-2013, and the remainder of the Gate 2 projects which have not connected to date. A projected renewable generation capacity of 1,250MW has been estimated to be connected to the distribution system in this 5 year time period. This is less than the current level of contracted generation, as it is generally expected and acknowledged that not all the contracted Gate 2 and Gate 3 connections will progress through to connection, for various reasons. Currently, ESB Networks best estimate of renewables that will connect to the distribution system is as follows Distribution Connected PR2 600 PR PR ,050 Figure 11: Generator Connections Forecast PR4 ESB s estimate of capital expenditure in this area for the PR4 period is 109m. Given the expectations of receipts towards the close of PR3 to meet the REFIT deadline, it is driving most of the PR4 expenditure into the early years with almost 75% ( 82m) of the total amount forecast to be incurred in the first two years (2016 and 2017), and the remaining 25% ( 27m) spread out over the latter three years as further projects progress to completion. ESB Networks provides non-chargeable line diversions for customers in return for use of land, whereby if the customer 18

20 6.6 Line Diversions decides to develop his or her land, line diversions are carried out at no charge to the customer. Therefore, line diversions are strongly correlated to land development or New Demand Connections. In PR3 the sum allowed for line diversions was based on 11.4% of the cost of New Demand Connections whilst the outturn is forecast to be 22%. This rising percentage is due to the fact that there is a portion of line diversions that arise from developments not needing a new connection, e.g. farm sheds. With new connections being at a such a low level, these now represent a higher proportion of the line diversion cost. The Line Diversions forecast of 92m has been based on a long term historical performance from 2006 to This long term approach has been taken due to the recent variance in the PR3 period. Based on these recent lower outliers in PR3, an objective method of determining a true reflection of the forecast costs is to apply a linear trend to the average of all costs from the PR2 and PR3 periods inclusive. Further detail on this proposal can be found in DF28 Line Diversions. 6.7 Reinforcement PR4 Proposal PR3 Forecast HV Reinforcement 252m 227m MVLV System Improvements 41m 34m 20kV Conversion 25m 60m Total Reinforcements 318m 321m HV Reinforcement Figure 12: Reinforcement PR4 & PR3 Two major studies have been carried out by ESB Networks to identify the HV load related investments required over the next ten years, i.e. the National HV Network Investment Plan and the Dublin HV Investment Plan. These documents set out in a very detailed way how the 110kV and 38kV Distribution Networks will need to be reinforced in order to bring these networks within Distribution Planning Standards. The Network load related reinforcements that have been proposed for delivery during the PR4 period are based on a zero cumulative load growth forecast for peak demand from Although there is uncertainty in relation to the timing of Smart Metering roll-out, the submission has been further refined to take account of the introduction of Smart Meters which is expected to reduce the contribution of domestic load to system peak by 8%. On the basis that domestic load comprises approximately 50% of the total load the total peak is expected to be reduced by 4%. Following an increase in electricity consumption of 70% between 1995 and 2010, demand electricity reduced by 3% in 2011 to In this context even though there has been significant expenditure on the networks over the three previous price reviews, there are still deficiencies on the network. These are present due to the high load growth that occurred since the early nineties through to the second half of the last decade when the economy went into recession. The level of investment in the Distribution Networks during the nineties was minimal when the principal objective during that pre-regulation period was to contain the price of electricity while ensuring that there was adequate generation capacity available. The PR4 programme will address deficiencies such as plant overloading, non-compliance with voltage standards and 19

21 6.7 Reinforcement breaches of safety standards (short circuit deficiencies). A programme of network reinforcements is proposed to address these breaches of planning and safety criteria and includes: Provision of additional 110kV, 38kV and MV and LV circuits Development of new 110/38kV, 110kV/MV, 38kV/MV or MV/LV Substations Installation of 110kV and 38kV and MV/LV transformer capacity. The planned expenditure programme is as follows: Voltage PR4 Submission m PR3 Expected Spend m 110kV kV MV/LV Total Figure 13: HV reinforcement forecast spend The increase in the projected expenditure on 110kV reinforcements in PR4 over the expected expenditure in PR3 reflects the deferral of projects in the last price review. Examples include new 110kV substations to replace existing overloaded 38kV substations or to provide relief to the existing 38kV Network. The projected level of expenditure on 38kV reinforcements in PR4 reflects the reduction in the numbers of overloaded 38kV Substations but provides for the uprating of those substations that remain overloaded. There has been significant reduction in MV/LV expenditure over the past three price reviews, reducing from 139m in PR1 to a projected expenditure of 40.8m in PR4. MVLV System Improvements MV/LV network reinforcements are carried out to address deficiencies that arise on any part of the MV or LV network. The work carried out under this programme is response in nature, driven by growth in the networks where network is overloaded, voltage needs to be improved and protection systems upgraded. While other programmes for asset replacement or capital work on the medium and low voltage networks deal with specific concerns on these networks such as the replacement of MV switchgear or the LV renewal programme, the MV/LV Network reinforcement budget addresses the operational performance of the MV and LV network in the area of continuity and voltage. The programme is comprised of a large volume of small individual jobs. 20kV Conversion 20kV conversion is the optimum and most effective means of addressing the major voltage problems associated with long rural networks but also provides significant additional capacity and strengthening of local rural networks without the requirement for HV Substation reinforcement. Significant progress has been made on the conversion of the rural 10kV overhead networks to 20kV operation. By the end of PR3 47,000km of MV Networks will have been converted to 20kV operation which represents 57% of the total length of MV Overheard Network. For PR4 it is proposed to convert a further 4,000km to 20kV operation at a cost of 25.3m. These proposals are being driven by the need to address significant voltage issues on the identified networks. ESB Networks has adopted a clear and focussed strategy in developing its asset renewal plan for the period