1 April 2023 not only marked the start of RIIO-ED2 but also a big milestone for the RIIO framework – its 10th birthday, a period in which we have seen major changes.
The RIIO model was a significant overhaul of the previous price control regimes. These regimes had been used since the privatisation of the energy sector and were based on the RPI-X model and were in operation for over 20-years. Following an extensive review of the RPI-X model in 2010, Ofgem highlighted the need for a different approach, one which strongly incentivises companies to deliver better outcomes and explore innovative and new ways of working to benefit customers.
Ofgem’s two clear objectives for RIIO were to deliver value for money for existing and future customers, and play a full role in the delivery of a sustainable and innovative energy sector.
The verdict on RIIO-1’s delivery of value for money
Ofgem set allowances of almost £75 billion (normalised for 2021/22 prices) across the four different price controls of RIIO-1. Looking back, with the benefit of hindsight, the ability of companies to forecast need, particularly the load-related requirements, across an eight-year control period could do with further discussion.
At a high level, RIIO-ED1 would appear to have learnt from the earlier RIIO-T1/GD1 with a modest total underspend of 1.1% (£354 million) compared to 11% (£4.8 billion), which includes overspent allowances in gas transmission of £407 million (18%). The big question for customers, though, will be whether this approximate total underspend of £5.14 billion is a result of efficiency, innovation or unrequired investment – or companies deferring costs to maximise shareholder returns within RIIO-1.
Also, it is clear that the speed of delivery to meet the challenges to achieve net-zero goals is currently insufficient. In electricity transmission, an additional £20 billion of investment now sits outside the RIIO framework to accelerate delivery of major upgrades required to achieve the UK’s ambitious 50GW offshore wind targets by 2030, as outlined in the 2022 British Energy Security Strategy.
Does this signal a relaxation in the regulatory scrutiny seen under the RIIO framework? Will we see similar changes in future to accelerate the volume of required distribution activities?
Where next for customer satisfaction
The latest performance data (2021-22) indicates an overall average customer satisfaction score of 9.01, representing a 7% improvement over the past seven years of RIIO-ED1. Given the overall magnitude of the score, the current incentive framework provides limited head-room for further improvement.
For RIIO-ED2, Ofgem has further tightened targets (9.12 to achieve rewards compared to 8.2 in RIIO-ED1) and introduced a ‘dead-band’ – a range between 8.9 and 9.12 where there is no reward or penalty. To achieve the maximum outperformance reward, a score of 9.46, DNOs would need close to 50% of all respondents to give a 10/10 satisfaction score. This is ambitious, by any industry standards. Whilst some DNOs are already leading the way, making best use of digital, data and technology will be key here to drive further improvement.
The value to customers of the Interruptions Incentive Scheme
The Interruptions Incentive Scheme has driven continued improvement over the last eight years of RIIO-ED1. There has been a 23% reduction in average time lost for customers by the end of RIIO-ED1 (assuming the final year outturn continues the 3.6% average improvement glidepath seen so far) and a 26% improvement in the number of customers interrupted.
There is also a possibility that the final year improvement could well be more significant, like the final year of the previous price control. However, there is a question whether we are seeing diminishing returns for the customer with this incentive. With the final year of performance data still unaccounted for and average annual incentive reward for the 14 DNO licence areas of £123 million/year, it will have cost customers close to £1 billion to achieve these benefits.
Ofgem has clearly considered this in their approach to the reward and penalty exposures for interruptions in RIIO-ED2 with an asymmetrical reward/penalty (+1.5 to -2.5% RoRE) and highly challenging targets with a glidepath for further improvement. Ofgem will be looking at alternatives to the current setup in RIIO-ED3, which could include incentivising Short Interruptions that currently avoid incentive penalty and, where in multiples, are potentially more of a nuisance to customers.
The opportunities ahead under RIIO-ED2 and RIIO-3
Electricity distribution accounted for 42% of allowances set by Ofgem in RIIO-1. This is increasing to more than 50% of allowances in RIIO-2, and likely further increases in RIIO-3. This signals that electricity distribution networks are seen as critical to the transition to a low-carbon future and to supporting net zero.
The next decade presents the biggest challenges the industry has ever seen, there are key opportunities to continue providing lasting benefits to customers. The jury is still out on whether the RIIO mechanisms can provide the right incentives to deliver the massive infrastructure requirements that are needed. What is crystal clear is that the revolution needed on the Low Voltage networks will be immense.
The low voltage networks, once seen as the ‘last mile’ passive network that could be essentially installed and forgotten about are now the main way to meet changing customer needs. For the customer of the future to be able to freely connect low carbon technology and use the capacity in their connection agreements, the whole operating model for these networks must change.
If the opportunities are to be realised, there are five priority areas:
Multiple, yet finite, activities require optimisation
To maximise efficiency and accelerate delivery, new ways of working, better use of and increased procurement of data and insight, and a move towards adaptive planning and delivery models is needed. Provision of information through increasing proliferation of smart meters and roll-out of new and cost-effective monitoring technologies also requires new capability to transform data into actionable insight that will lead to different or better decisions across the five-year period and beyond.
Supply chain co-ordination is critical
This will be key to ensuring that the right skills and resource capacity is available and effectively used. New commercial models and closer integration with supply chain providers as partners will be needed to shift from the high-cost low volume environment to the low-cost high-volume environment required to enhance the low voltage networks to facilitate net zero.
Responding to unpredictable customer behaviour
Customer behaviour will not change at the same pace, will be geographically dispersed, and could be above or below forecast. The management of uncertainty presents an opportunity to either flex to meet increased demand or work to ‘get ahead of the curve’ to deliver cost efficient strategic investment. If the RIIO framework stays in place, there are 37 separate uncertainty mechanisms that require dedicated focus to demonstrate effective use and take steps to maintain the level of cost to customers. Activation of the right mechanisms, at the right time, with the right evidence will ensure funding is unlocked to expedite the low carbon transition.
Customers of the future will require more information and become increasingly active participants
The energy industry is playing catch up on this compared to other customer markets such as digital banking and retail. There is a huge opportunity to learn from other markets and accelerate the provision of usable information and find new ways to enable customer participation.
The dawn of the DSOs
The start of RIIO-ED2 marks the ‘official’ recognition of the Distribution System Operator (DSO). With that comes a wealth of licence conditions, new capability requirements and incentives. There is significant potential for DSOs to realise benefits for customers, through establishing markets for flexibility, reducing traditional reinforcement costs through active demand management, and openly sharing information between energy system participants. RIIO-ED2 will be crucial to demonstrate that DNOs have the capability, arrangements, and behaviours to show they can effectively discharge their duties as neutral market facilitators or face potential separation with local planning initiatives for the whole system.
RIIO-2 is likely to be the last reward driven incentive based regulatory price control for electricity and gas. Whilst RIIO-1 focused more on ‘carrot-based’ incentives to drive customer benefits, RIIO-2 is focused on a ‘stick’ to maintain service levels.
Ofgem is currently exploring possible alternatives such as ‘Plan and Deliver’ and ‘Freedom and Accountability’ regulatory models, focusing on information asymmetry being reduced and allowing companies more freedom to make decisions in the next round of price controls or ‘RIIO-3’.
To serve the changing needs of customers, future regulatory models must build on the adaptability that we are beginning to see in RIIO-ED2.