Regulating for success in addressing climate change

As part of our Countdown to COP focus on the future of regulation, the National Infrastructure Commission’s Giles Stevens gives his view on why overhauling the regulatory process is essential for meeting the net-zero target.

The Climate Change Committee (CCC) last month sent out a stark warming about the country’s preparedness for the impacts of climate change. Put simply: we’re not.

The CCC’s conclusions on infrastructure were unambiguous: it is already vulnerable, and the risks it faces will only increase. The National Infrastructure Commission’s own resilience report last year highlighted how the country’s energy and water systems are vulnerable to shocks and stresses created by climate change, such as more frequent heatwaves and increased flood risk.

Utility firms face a double challenge: make progress on adapting to the expected impacts of climate change by making their infrastructure more resilient, while simultaneously redoubling their efforts to reduce emissions. An evolution of the regulatory environment in which they operate, such as the Commission has called for, could better support progress on both.

It’s necessary because building resilience requires a long-term approach. Yet the regulations governing utilities have shaped a world where the focus is too often on the next five years, than the next fifty.

Every time we experience a major flood or extreme weather event, the urgency of the need to invest in adaptation effectively is thrown into sharper focus. The Commission believes a resilience duty on regulators, backed up by a supportive policy framework from government, is essential if utilities are to catalyse the huge investment needed to deal with the realities of a warming world.

Decoupling investment categories

The existing five-year review periods are fine for managing maintenance and marginal enhancements. But they can encourage trade-offs and compromises, instead of the collaboration and far-sightedness that adapting to climate change will require.

And judging by the recent water appeals, and those ongoing in the energy sector, they can create antagonism between supplier and regulator at a time when collaboration and a shared vision is required.

And they’re costly. Supplier appeals against Ofwat’s pricing decisions this Spring reportedly cost at least £26 million.

The current system has – as Stephen Littlechild told the CMA last year – “gradually gone awry”. And that’s not good for a concerted response to climate change impacts.

In our 2019 report Strategic investment and public trust we recommended decoupling crucial decisions on significant infrastructure investments from the price review process and using open competitions instead.

We proposed this for a number of reasons. With bids locked for up to thirty years, the cost and effort of reviewing every five years is reduced.

Competitions also operate over multi-period settlements and allow for the development of effective resilience strategies in line with the principles we outlined.

They boost transparency, addressing the information asymmetries between regulator and suppliers by revealing the actual cost of capital and likely returns over the long term.

As the number and frequency of appeals grow, the transaction costs associated with running competitions – often used to argue for the status quo – look increasingly justified in comparison.

Dual duties

Investment in adaptation must coincide with a redoubling of efforts to reduce emissions. To its credit, the UK government has some of the world’s most ambitious environmental targets, including its target of a 78 per cent reduction in greenhouse gas emissions by 2035.

The Commission believes a specific climate change duty on regulators would help turn this ambition into reality. It, along with a resilience duty, would together represent the biggest change in regulation in three decades. There are signs that regulators and suppliers are amenable to such an approach.

Ofwat’s recent draft decisions on its green economy recovery programme, for example, will lead to an additional £862 million in environmental improvements by companies, on top of their existing PR19 packages.

We also saw a real emphasis placed on resilience by the government and regulator when inviting the water industry to submit schemes to support a green recovery.

Regulation for the nation

A new framework for regulation to encourage the required investment in our utilities must, however, continue to protect the interests of customers.

The public still needs some convincing that government climate ambitions are deliverable and affordable: Ofgem’s ‘green, fair future’ campaign is welcome recognition that regulators have to engage consumers in the shift towards a low carbon economy.

A government commitment before COP26 to new regulator duties on resilience and emissions reductions would send an unambiguous signal to investors, providers and customers that there’s an action plan to back up the ambitious goals on climate change.

As Ofwat gears up for PR24, it bears repeating: if the regulatory process fails to generate the necessary private sector investment across our utilities, we risk falling behind in the race to adapt to the realities of global warming – and it’s a race we can’t afford to lose.