Table 1

Table 2

Operator Profiles

In France, the electricity and gas regulator is Commission de Regulation de l'Energie (CRE). Although the French electricity sector was liberalized in 2007, Electricité de France S.A. (EDF; BBB+/Stable/A-2) remains the leader in terms of generation and supply. The French energy mix is characterized by its low-carbon nuclear fleet, producing about 75% of the total output, and significant hydropower production. Wind and solar account for less than 10% of output today. Because of the high nuclear output, gas penetration is lower than in other Northern European markets.

The EU's Third Energy Package imposed legal unbundling of transmission and distribution system operators (TSO and DSO), as well as storage facilities and liquefied natural gas (LNG) terminals, from generation and supply.

The French electricity distribution network is mostly operated by Enedis, which is fully controlled and owned by EDF, although independent under the French Code of Energy, and run in the form of a concession. By law, EDF is the only company that can operate this concession. Smaller, local distribution networks also exist, but Enedis operates 95% of the national grid. Regarding electricity transmission, RTE Reseau de Transport d Electricite (RTE; A/Stable/A-1) is the only operator. While RTE is majority owned by EDF (50.1%, held as a dedicated financial asset to finance EDF's nuclear liabilities), EDF cannot control RTE due to EU requirements. At the same time, French law requires state-owned entities to fully own and control RTE. Unlike Enedis, RTE owns its assets and operates it via a concession contract with the state.

In the gas market, the distribution network is fully operated by Gaz Réseau Distribution France (GRDF), a 100% subsidiary of ENGIE SA (BBB+/Stable/A-2). GRDF operates under a concession framework (regional collectivities are the owner) and operates under a public service contract (CSP) renewed every five years with the state (current one runs until 2023). The national gas transmission network has two major operators: GRTgaz (75%-owned by Engie) and Terega (owned by a consortium led by Snam and EDF). Unlike electricity networks, gas networks are less constrained on their ownership structure. The law (Loi Pacte 2018) only requires for a majority ownership from state-owned entities for GRTgaz, although we still consider this operator is strategic for the French state.

Table 3

Assessment Factors

Regulatory stability: Predictable and transparent framework since 2000

The French regulatory framework has been stable since it was created in 2000, with recent regulatory reviews in line with other European regulatory frameworks in terms of lower overall returns on capital and increased capital expenditure programs. Regulatory periods have been progressively increased to four years. The regulator favors incremental changes to ensure the overall stability of the framework, which provides operators with predictable cash flows.

In early 2020, the regulator CRE approved remuneration calculations for the gas sector's next regulatory periods--which started in April 2020 for transmission (ATRT7) and storage (ATS2), and in July 2020 for distribution (ATRD6)--and confirmed continuity in the formula (see table 2). Incremental changes for gas transmission specifically included:

• A lower weighted average cost of capital (WACC; 4.25% for transmission, 4.10% for distribution) since the regulator accounts for a pass-through of the reduction in corporate tax in France over the period, the lower cost of debt, and a higher asset beta (0.50x versus 0.48x) to account for the increasing uncertainties that investments in the gas sector are facing with the energy transition.
• A reduction of incentives for new investments, with a limited period of remuneration of four years for some new projects and the removal of incentives for the development of network interconnections, considering reduced needs with the current gas transmission network being appropriately sized.
• Additional remuneration to reflect maintenance cost increases due to an ageing network,even if the regulator maintains a solid focus on operating efficiency, it decided to remunerate extra operational costs as requested by gas players. This highlights willingness by the regulator to incorporate industrial challenges into tariff equation.

In January 2021, the CSE, following the CRE's recommendation, confirmed that the tariffs for power transmission over the next four-year regulatory period starting Aug. 1, 2021, (TURPE 6) will be determined following the same remuneration formula and same parameters as during the current period (TURPE 5).

• We consider that there is broad continuity in the remuneration design, despite the lowering of the WACC to 4.6% from the current 6.125% and marginal adjustments to incentives level.
• The planned decrease in regulatory remuneration for RTE is in part due to lower income tax during the next regulatory period (26.47% compared with 34.43% currently) and the mechanical erosion of the French treasury yield, which serves as a reference point for determining the WACC, to a risk-free rate of 1.7% from 2.7%.
• CRE decided to maintain the asset beta unchanged at 0.37x, ensuring proper European benchmarking and considering the framework protects RTE's earnings against most risks

The regulator has also maintained the remuneration formula for power distribution investments in the next regulatory period starting Aug. 1, 2021 (TURPE 6) by leaving the margin on assets unchanged at 2.5%, while decreasing the additional regulated equity remuneration component to 2.3% from 4.0%. This results in compound remuneration dropping to 4.8% from 6.5% in the current period. The margin on assets remained stable at 2.5%, despite a lower risk-free rate and tax rate, thanks to the CRE increasing the asset beta to 0.36x from 0.34x to reflect better European comparability. CRE is reinforcing the incentive measure on quality of service with an aim to reduce the connection timeline by 30% on average by 2024 from 2019 levels.

Chart 1

Tariff setting: Detailed and transparent

We view the regulatory process as transparent and allowing players for interacting in detail with the regulator in times of reset. Traditionally, players submit their projected business plans to the regulator, and engage in constructive dialogue on the remuneration framework. Business plans are audited by an external party, leaving CRE the power to make final suggestions and adjustments. The state body Conseil Supérieur de l'Energie (CSE) is in charge of reviewing CRE's proposals. There is a very limited track record of legal dispute between the CRE and regulated entities, and we're not aware of appeal mechanisms in place in terms of disagreement.

The regulatory framework for both power and gas contains a regulatory asset base (RAB)-based tariff with full coverage of costs and a consistent track record of allowing a good return on investment. The tariffs under the TURPE (electricity) and ATRT (gas) framework both are based on a real rate of return with RAB and are linked to projected inflation. Authorized revenues are also linked to inflation with an adjustment mechanism (see CRCP in section below, which is used to adjust between projected and real inflation). It offers protection against volume and commodity price fluctuations since remuneration is RAB-based. Works in progress are remunerated at nominal cost of debt before tax (power and gas transmission), while there is limited remuneration for distribution projects, since they are considered as bearing shorter time lead or insignificant for gas distribution.

RAB-based allowed return

Allowed returns consist of net operating expenses allowed plus investment expenses allowed, calculated based on capital asset pricing model of WACC (nominal pre-tax) return applied to RAB, adjusted for CRCP (see bullet below) and efficiency factors.

• RAB is equal to the net asset value at opening of the period plus new commissioned investments minus depreciation. The RAB is updated annually to reflect net investments.
• The WACC is different for DSOs and TSO and between industries; it reflects the cost of debt, expressed as the sum of the risk-free rate of return and a sector-based credit spread (the interest premium that reflects the rate of risk inherent in the investment) and the cost of equity (with beta risk premiums of equity investment).
• CRCP, or Compte de Régulation des Charges et des Produits, corresponds to a compensation mechanism that allows for the adjustment of realized revenues toward authorized level. The tariff trajectory is corrected each year to match effective and authorized revenue. This enables recovery of revenues shortfall in the subsequent period (CRCP mechanism, tariff fluctuation within +2%/-2% plus French consumer price index).

Chart 2

Chart 3

Chart 4

Incentives to accompany the energy transition

On top of RAB remuneration, the regulator sets out incentive mechanisms to encourage operators to actively manage controllable costs and thus improve their performance. These financial mechanisms result in symmetrical treatment, that is bonuses or penalties, depending on whether objectives are met (with the exception of power distribution penalties for length of connection). Across electricity and gas sectors, we believe those incentives require operators to effectively rationalize costs, but are reasonable and achievable. We also note that the quality of service of the French network is above average, with interruption periods that are among the lowest in the world.

• Electricity transmission incentive mechanisms refer to operating and capital expenditure (opex and capex) containment measures, quality of service, and research and development (R&D) initiatives (total R&D spending envelope of €156 million for RTE to be spent over 2021-2024, +15% versus the current period)
• For power distribution, the upcoming regulatory period maintains the current service quality incentives while including a penalty mechanism to encourage the reduction in connection time. CRE disclosed a public objective of a 30% reduction in connection time by 2024 from 2019 levels. R&D allowance for power distribution over the four-year period totals €227 million net of subsidies for the sole operator Enedis.
• Gas incentives also include service quality, as well as opex and capex targets. Overall, these incentives are very marginal, since they correspond to only minimal incremental revenue. The ongoing regulatory period embeds R&D and innovation incentives primarily around biomethane, representing a total allowance of €124 million for transmission and €62 million for distribution over 2020-2023. Although increasing markedly since the previous regulatory period, these incentives remain lower than to R&D grants for electricity. Hydrogen and renewable gases are also part of the scope of R&D incentives (almost half of the envelope), with no precise targets. This fits France's energy roadmap for 2020-2035 (PPE - programmation pluriannuelle de l'Energie) that made it into law, with targets of injecting 6 terawatt hours (TWh) of biogas into gas grids by 2023 and 14TWh-22TWh by 2028. However, we note the discrepancy between ambitious hydrogen targets and the limited R&D incentives in the regulation until 2023.

Chart 5

Chart 6

Financial stability: Strong, based on full and timely cost recovery, but evolving toward more demanding operating performance and lower remuneration in gas

We assess both the electricity and gas operators' volatility of earnings throughout a regulatory period as low.

That said, for electricity, although the regulatory hedge is effective against volume and market volatility over several years, it can lag events by some time, mitigating the positive effects. RTE has historically experienced a relatively high amount of noncontrollable costs, especially compared with the gas transmission networks. This can create high volatility in earnings for a particular year, although over several years the impact is close to neutral.

The tariff for power transmission operator RTE in place from Aug. 1, 2021, remains very much aligned with the current remuneration formula, although it embeds an important reduction of the WACC to 4.6% from the current 6.125%. These lower returns will come at a peak time in the investment cycle, with increasing investments during the TURPE 6 period, and will put pressure on RTE to continuously improve efficiency in the context of the energy transition. CRE has validated RTE's long-term investment plan principles (SDDR, or Schema decennal de developpement du reseau), which requires about €33 billion over the next 15 years on top of €3 billion for ancillary investments (real-estate, IT, logistics). We thus expect investments needs to remain high for RTE, with an increase of its annual spending from about €1.5 billion in 2019 (up to €2.1 billion in 2022 and €2.35 billion in 2024). This corresponds to a 50% increase of investments on average in the upcoming regulatory periods from the current one. Those investments will help integrate increasing renewable energy sources, including offshore wind, and encompass large interconnection projects in 2024. We note that RTE has invested significantly over the past decade in the resilience of its network, notably to bury a large part of its lines to protect them from extreme weather conditions. All in all, we still view financial stability as strong for electricity transmission, with a strong projected increase in RAB allowing earnings' growth, despite lower WACC and manageable incentives.

Electricity distribution activities will be supported by the maintenance of a healthy return on investments and the significant increase of the RAB as a result of the digitalization of the network via Linky smart meters, with an estimated book value of about €3 billion by 2021 and remunerated at a 7.25% nominal pre-tax rate of return from 2022, plus additional incentives. Average annual Linky capex will amount to €226 million under next regulatory period, while it reached €742 million over 2017-2019. Excluding Linky, distribution RAB is increasing by about 2.3% each year due to maintenance and small expansion projects. This increase in the asset base will compensate for the remuneration of investments on the distribution grid (excluding Linky) falling to 4.8% from 6.5% currently. Enedis' earnings over the next four years will benefit from the positive CRCP balance (€588 million as at Jan. 1, 2021) and the contribution of the CRL Linky (see chart 4).

Regarding gas, the structure of the new tariffs is very much in line with that of previous periods and ensures predictability. The new regulatory parameters applied in 2020 maintain a fair but diminished level of remuneration for gas assets, while acknowledging higher uncertainties for the role of gas going forward, taking into consideration accelerated electrification and lower gas consumption by 2030. Lower rates of return for gas transmission, distribution, and LNG storage are primarily a reflection of lower interest rates and a decrease in the applied tax rate as an average over the regulatory period. It is partially compensated by higher asset beta, reflecting the higher risk of the gas sector than in the last period. CRE assesses the transmission gas network as adequately sized, with the end of large investments for the merging zones in France. Most new investments will come from innovation, including biomethane and hydrogen, but at a relatively small scale during the current regulatory period. In distribution, which represents a €15 billion RAB, investments in biomethane will partly compensate for the lack of expansion projects. For about €1,000 million of investments per year, 25% is dedicated to smart metering.

Regulator's independence: Strong owing to independent finances and annual board replacements

The French Energy Regulatory Commission (CRE) is a body independent from the French government. It shows a very low level of political interference. There is a solid track record of stability of the regulator since 2001, with four-year regulatory periods and a well-defined regulatory framework with transparent conditions. The CRE's president is nominated for a six-year mandate by decree of the French president.

Appendix