Ofgem is considering whether to abolish, retain or amend an incentive to efficiently book exit capacity on the transmission network as part of the RIIO2 price control for gas distribution networks.
It said the current mechanism has lavished “substantial rewards” on network operators, whilst offering questionable benefits in terms of reducing overall costs to consumers.
The regulator had put the issue to one side while it awaited clarity on reforms to the transmission charging regime. Last month it gave preliminary approval to a modification to the Uniform Network Code (UNC) that would reduce geographical variation in charges.
Transmission fees are currently split between capacity charges, which grant users the rights to flow gas onto and off the network but are payable regardless of whether they are exercised, and commodity charges, which are paid on actual flows. Both sets are further divided into entry and exit charges, with an even split between the two.
Capacity charges vary based on location and are intended to reflect the long-run marginal costs of increasing capacity at each entry or exit point. Commodity charges are geographically uniform and are used to recover any residual costs not recouped through the capacity charges. The declining utilisation of the transmission network means costs are increasingly being recovered through commodity charges.
UNC678A, the version of the modification preferred by Ofgem, would introduce a new “postage stamp” model for setting the reserve prices for capacity auctions that would flatten them across entry and exit points. It said this would enhance competition and encourage gas to be supplied from the cheapest source, regardless of its location on the network.
Under the current price control, exit capacity charges incurred by gas distribution networks (GDNs) are passed directly through to customers. To incentivise efficient spending, GDNs are rewarded for minimising overall bookings and making greater use of exit points with spare capacity (and therefore lower charges) and penalised for booking in excess of pre-set targets.
In a new consultation, Ofgem highlighted several issues that will need to be addressed when considering the future of the incentive.
Although not yet set in stone, it said the underlying charging regime will see reforms in October: “The RIIO-GD1 incentive is structured around the previous charging model, where exit capacity prices reflect the amount of spare capacity at each offtake, and we think this raises an important question over whether the existing approach will still be valid in future.”
It is also questionable whether the current incentive has any benefit to consumers in terms of reducing costs. The transmission network is already operating at significantly below full capacity and demand is expected to remain largely flat over the coming decade, meaning there is little value in the charges as a price signal for investment. Lowering the proportion recouped through capacity charges also has no effect on the overall costs recovered through exit fees.
“While booking reductions may lead to future savings in the form of reduced investment needs, there is no direct link between current prices and the level of future costs avoided,” the regulator added. “All of this makes it challenging to calibrate the rewards and penalties associated with an incentive, so that these do not exceed the benefits created for consumers.”
Ofgem said GDNs have “consistently outperformed their targets” and as result received “substantial rewards”.
It continued: “We would expect these rewards to reflect enduring improvements that have been made to booking processes, which should remain in place whether or not there is an incentive in RIIO GD2. If the improvements made are not expected to be enduring, they would represent significantly less value to the consumer.”
Ofgem cited a total of eight potential options for the future of the incentive as proposed in a report commissioned from CEPA, which was released alongside the consultation.
They include: retaining the incentive as it is; creating an uncertainty mechanism to allow for its modification or removal once changes to the charging regime have been finalised; modifying the incentive, for example, by introducing a bespoke sharing factor or turning it into a discretionary reward; or removing it outright.
The regulator said it is leaning towards the latter: “Based on CEPA’s analysis, and our own initial assessment of the evidence available, we do not currently see a case for keeping the existing incentive in RIIO-GD2. Unless we are presented with compelling evidence to the contrary, we do not expect to follow the current approach in RIIO-GD2.
“Our initial view is that removal of the incentive, possibly combined with enhanced obligations, appears to be the most suitable policy option for the next price control.”
Ofgem said it can see little point in retaining the incentive when the benefits to be gained through either reduced investment or more efficient booking are few or none. What’s more, the regulator said redesigning the incentive to better reflect the benefits to consumers may be complex and time-consuming.
It has given concerned parties until 27 March to submit responses and persuade it otherwise.