Analysis: how are the energy networks funded?

by Frontier Economics

As an example, the recently published Common Wealth report “Hiding in Plain Sight” discussed the operating profit margin achieved by the sector, and used this to draw the conclusion that the profitability of the sector may be unduly high. We set out our key observations on this topic in this short article:

• Operating profit margin is the wrong measure to use in order to assess profitability and it is therefore wrong to draw a conclusion on profitability based on operating margin. The correct measure of profitability is returns.
• A reasonable level of return in a capital intensive industry can be expected to translate into a high operating margin. For example, a 3% return on assets translates to approximately 30% operating margin in the electricity transmission sector.
• The combination of high upfront costs and long-lived assets means that the energy network industry is by its nature highly capital intensive. A high operating margin should therefore be expected, but this alone does not allow us to infer anything about the level of allowed returns.

Attention should therefore not focus on the operating margin – which does not directly measure profitability – but instead on allowed returns. The sector regulator Ofgem has just set allowed returns at unprecedentedly low levels for the forthcoming regulatory period.

Download the full report