Ofgem has opted to fund the electricity system operator (ESO) using the same totex model applied to other network companies, but without a mechanism for sharing overspends or underspends with consumers.
The decision is a departure from its initial proposal in December to use a cost-passthrough approach, with a disallowance mechanism for demonstrably inefficient costs and profit margins being determined on an activity-by-activity basis dependant on risk.
The ESO is currently funded through price control for electricity transmission. But following its legal separation from the rest of National Grid in April, the company will begin its first individual RIIO price control in 2021.
As part of the totex model chosen by Ofgem, the ESO will recoup some of its expenditure as “fast money” during the year in which it is incurred.
The rest will be added to the regulatory asset value (RAV) and repaid over time as “slow money”. In the meantime, the ESO will receive a return on the RAV reflecting the average cost of securing capital from investors and lenders.
The ratio of fast to slow money will be set in advance and is expected to broadly mirror the split between operational and capital expenditure in the ESO’s biennial business plans.
The regulator said it may provide additional renumeration for certain risks.
Ofgem laid out the position in a follow-up to its May decision to withdraw the cost-passthrough proposal on the basis it would be overly complicated.
At the time, the regulator proposed two new options – the totex model it has now adopted and an alternative version that would see all expenditure treated as fast money.
Ofgem said the first option has a number of key benefits over the second: it will support the fair distribution of costs between current and future consumers; it will lead to more stable and predictable balancing charges; and it will make it easier for the ESO to cope with short-term losses that could otherwise hinder Ofgem’s ability to impose financial penalties.
It is also considering the potential advantages of applying “asymmetric incentives… where there is greater financial reward for outperformance than financial penalties incurred for not meeting expectations.” This too is a departure from its initial proposal in December.
The regulator said it needs the ESO to be “proactive and willing to try new and innovative types of solutions” and highlighted stakeholders’ concerns that a substantial penalty for underperformance could make the ESO risk averse and affect its financeability.
It will nevertheless retain the option to apply some form of downside incentive.
“These decisions build on our previous ones, to ensure that the components of our price control work together as a coherent package,” Ofgem stated.
“The combination of a two-year business planning process; a pass-through of efficient costs; the appropriate remuneration of risks; a strong incentives scheme; access to RIIO-2 innovation allowances; and a proportionate cost monitoring process, will together enable the ESO to be ambitious, proactive and flexible.”
Having confirmed the funding approach for the ESO, Ofgem is now consulting on the financial parameters within the model.
It has requested responses by 25 September to allow a decision to be made in the autumn before the ESO submits its finalised business plan in December 2019. It will also accept responses to its queries concerning financial incentives until 9 October.