Network underspends sign of RIIO success

Don't be surprised if incentives for cost outperformance work, says expert

The widespread outperformance of networks against their spending allowances under RIIO may be “evidence of the success, not the failure” of the RIIO price control framework.  

Mike Huggins, director of Frontier Economics’ energy practice, told Utility Week that Ofgem appears to have taken a “mostly negative” view of the underspends which networks are forecast to achieve in the current price control.

However, he reasoned: “Ofgem has put in place strong incentives to encourage cost outperformance, so perhaps shouldn’t be surprised when such outperformance subsequently appears.”  

Huggins’ comments come after Ofgem published an open letter last week seeking views on how the RIIO framework should be adapted for the second set of price controls, beginning in 2023 for electricity distribution and 2021 for gas distribution and transmission and electricity transmission. 

Ofgem senior partner for networks Jonathan Brearley warned the networks to “prepare for tougher price controls”, adding there is “strong evidence” that their investors are willing to accept lower returns in future than they have recently enjoyed.

He said the regulator could improve the way in which it evaluates networks’ business plans during the settlement process and will examine whether the information quality incentive (IQI) and fast-tracking procedure has been effective at encouraging networks to submit accurate cost forecasts.

Ofgem’s draft outline for RIIO2 was published on the same day Citizens Advice released a report which claimed that energy networks are projected to receive £7.5 billion in “unjustified profits” over the current eight-year price control period.

The consumer advocate complained that excessive profits are being made by underperforming networks. Among three reasons for this, it cited the incentive mechanisms used by Ofgem to encourage efficiency. It said these “actually rewarded companies that inflated their initial estimates for the cost of staff and materials”.

Writing in Utility Week, Brearley said Ofgem does not agree with Citizens Advice’s assessment but does think it “raises some important issues” which will be addressed in RIIO2.

Responding to the controversy, Huggins said: “Ofgem seems to place a mostly negative interpretation on cost outperformance, with a presumption that it signals that allowances are too high.”

“If this presumption is right, then it suggests that Ofgem believes that a wide range of mechanisms did not work well at RIIO1, including the IQI, fast-tracking and cost benchmarking”.

He suggested, however, that Ofgem might consider an alternative explanation for outperformance: “That the evidence Ofgem worries about is, in fact, evidence of the success, not the failure, of its high-powered incentive arrangements.”

RIIO Allowances and Forecasts

Source: Ofgem’s annual RIIO reports for 2015/16