Ofgem recently published its draft determinations on the RIIO ED2 price control. This comes at a challenging time with an understandable focus on rising energy costs and the wider cost of living crisis – but also a growing recognition of the threat posed by climate change.
The headline messages from Ofgem therefore emphasise both the significant investment being made in net zero and the cuts that Ofgem has made to what the companies asked for. At an average of 17%, the “haircut” for ED2 sits midway between that for gas distribution (12-13%) and that for transmission (20-23%). And, as with transmission, this is not all about efficiency but also about pushing more funding out of baseline allowances into uncertainty mechanisms. In ED2 there is scope for revenues to be higher if demand for EVs and heat pumps really takes off through what looks like a workable – though not very transparent – volume driver that will support timely investment if it turns out to be needed.
Overall, the general sense is that Ofgem is happier with the quality of the business plans this time than for gas distribution and gas/electricity transmission, with the companies having had a chance to learn from the earlier controls as to what was expected. Ofgem too will have learned from the process – including the Competition and Markets Authority (CMA) appeal – and there seem to be fewer howls of outrage from the companies this time round.
That said, inevitably the companies will not be happy with what has come out. UK Power Networks will no doubt be disappointed that despite having tried hard to impress there were no bouquets from Ofgem. Others will be frustrated at Ofgem’s rejection of areas of spend they considered justified through stakeholder engagement and the tough efficiency targets imposed to try to keep bills down. All the companies will now be picking over Ofgem’s benchmarking and the adjustments they have made – and we can expect some movement at final determinations.
On cost of capital there is an interesting twist where Ofgem question whether high inflation benefits the companies who largely have fixed rate debt – and whether Ofgem should be clawing some of this benefit back for consumers. This suggestion was clearly a big worry on the investor call and Ofgem couldn’t provide any reassurance as their thinking remains at an early stage. Having come out of left field, late in the day, it is hard to see how Ofgem could actually do the necessary thinking and consultation on such a major shift before final determinations. Indeed, they have said that if they were to conclude action was needed it would apply to the other sectors as well. It would be an unprecedented step to change such a core part of the methodology mid-period but there is understandable public and political concern about prices that are pegged to inflation.
But that’s all standard price control stuff. In its press release Ofgem called this a “landmark five-year vision” which feels like a bit of an oversell. What is it that Ofgem is expecting the companies to actually deliver? Do they have any sense of what “good” looks like?
Ofgem have acknowledged the crucial role the networks have to play in facilitating the connection of EVs and heat pumps and supporting the move to net zero. But the scenario Ofgem has chosen is the most conservative of the net zero compliant FES scenarios sending a very down-beat signal to distribution network operators (DNOs) and others. Companies will be able to secure additional allowances through the automatic volume driver around load-related expenditure. But there remains a difference of view across the DNOs as to how far you can use flexibility as a short- term solution or whether it is more efficient to move ahead with reinforcement now to get ahead of the game. Ofgem say those looking to undertake more strategic investment haven’t made the case – but they remain open to argument. And in their latest Net Zero Britain discussion document they highlight this tension as one that needs to be resolved. But Ofgem themselves aren’t presenting a vision of what good looks like in this space.
And more generally on distribution system operators (DSOs) and the market for flexibility, again, the companies all have different commercial strategies and models (including on the degree of separation for the DSO). Ofgem seem happy to let these different approaches run. There may be learning to be gained from trying different approaches and Ofgem have metrics for checking on specific DSO outcomes (which are what matter). This will no doubt be an area that Ofgem will continue to scrutinise and it has a DSO reopener if it considers in future that roles need to be reassigned for example. But at this stage there isn’t a clear or common DSO vision.
On interruptions, Ofgem reminds us how successful financial incentives have been in driving improvements in both the number and duration of interruptions. But they raise a question about whether customers are willing to pay for further improvements. Absent a clear view on that, they have trimmed back the incentive. That may well make sense but it feels like a decision driven by a cost cutting mindset rather than one informed by any customer evidence or vision.
On vulnerability, Ofgem seem to have taken the strange call at this time of crisis of reining back heavily on spend by the DNOs to provide support to those in fuel poverty. In particular they have ruled out any spend on energy efficiency measures (beyond signposting and advice) on the grounds that this is funded by government through the Energy Company Obligation and Green Homes Grant. But on the same day the draft determinations were published, the Climate Change Committee put out its annual progress report criticising government for the lack of funding in this area. UK Power Networks had proposed a significant level of spend to support those in fuel poverty matched by shareholder funding, which Ofgem have rejected. One of their arguments is that this would lead to variations regionally in the level of support. That’s true but perhaps some levelling up might have been possible rather than levelling down?
Again, it feels as if this is driven by a cost cutting mindset rather than a vision for what DNOs should actually do in this space. This is disappointing as Sustainability First had argued that Ofgem and DNOs should make use of the ED2 period to reach a better understanding of what the scope of a DNO role might be in the wider energy efficiency landscape. In a welcome step Ofgem had previously identified energy efficiency as a theme for this year’s Strategic Innovation Fund but it is unclear how that fits with Ofgem’s position in ED2.
Finally on the companies’ environmental impact, this was a major disappointment for Sustainability First. Ofgem had previously proposed a financial incentive linked to an environmental scorecard which they have now dropped. At one level this makes sense given that what the companies were proposing was very narrow – but Ofgem could have pushed the companies far harder on meeting their environmental targets, including on long-run management of losses and SF6. And they have ignored our arguments for at least a beefed-up reputational incentive with an annual Ofgem report with red-amber-green ratings, for example, rather than leaving it to companies to spin their performance in their annual environmental reports.
Ofgem also continue to buy the companies’ arguments that rising losses are inevitable and not something to worry about – ignoring the substantial report Sustainability First submitted highlighting the rising costs of losses; the range of steps the companies are considering in their losses strategies (which show there are things that could be done); and the flaws in Ofgem’s approach to evaluation of such measures (relying on an outdated cost of carbon for example). Ofgem and the companies argue that with grid decarbonisation the carbon impact of losses will decline over time. But the point remains – as with all energy efficiency measures – that if we don’t manage losses, we will need more generation and more network capacity – adding to the cost of meeting net zero. Losses are a whole system issue that currently no one seems to own and which Ofgem urgently needs to focus on ahead of final determinations.
Having been there, I know that over the next few months Ofgem will be hunkered down with the companies working through the various criticisms and queries about the benchmarking and hoping to avoid another CMA appeal. What the companies mainly care about at this stage is how much they will get paid for what they have to do – and perhaps rather less about what they are actually being asked to deliver. But at the end of the day this is at least as important. It’s not just about the cost. It’s about the vision.