"Building new pipes and wires may not always be the best option"

Ofgem introduced the RIIO price control framework to give network companies a level of revenue that covers their costs and allows them to earn a reasonable return, if they deliver value to their customers, behave efficiently and achieve Ofgem’s targets.

We are halfway through the first price control period (which ends in 2021/2023) and Ofgem is consulting on how it will regulate network prices for RIIO2. The RIIO2 framework consultation was published on 7 March with various changes put forward.

How is RIIO2 shaping up against RIIO1?

Overall, Ofgem think that RIIO1 has worked well and that the incentive-based RIIO framework is still appropriate for setting price controls. The framework does however need to keep pace with a period of significant change in network usage, and Ofgem proposes reducing the price review period from 8 to 5 years, but there is flexibility to allow for longer periods if this will benefit consumers.

Ofgem also seem to have listened to political pressure to curb what are perceived as excessive network profits. This means the new framework will entail lower returns for investors, reflecting the low level of risk of a stable regulatory framework. Most commentary has concentrated on the proposed equity returns of between 3 and 5 per cent (as opposed to the 6-7 per cent under RIIO1).  This has not come as a shock. Ofwat also proposed a lower WACC in its periodic review of the water industry but it is the cost of debt that will really matter, and this is still to be determined.

There will be much more competition in RIIO2, with the “new, separable and high value” criteria being applied to all projects across transmission and distribution, electricity and gas.

The consultation breaks the framework down into five key themes: giving consumers a stronger voice; responding to changes in how networks are used; driving innovation and efficiency to benefit consumers; simplifying price controls; and ensuring fair returns.  Three of these are examined below.

Responding to changes in how networks are used

During the RIIO2 period, the way the networks are used will continue to change. There is likely to be an increasing uptake of electric vehicles and electric or renewable heat, peer-to-peer local energy trading, increased use of battery storage to smooth out demand and the rollout of smart meters for consumers.  All this means that building new pipes and wires may not always be the best option.

The consultation asks what network companies should do to encourage a reduction in energy use by consumers (i.e. energy efficiency measures) to reduce future investment in the networks.  This is an encouraging sign that Ofgem is adopting the whole systems approach advocated in the Smart Systems and Flexibility Plan.

Driving innovation and efficiency

The two main points under this theme are that innovation should become ‘business as usual’, and competition ‘for the market’ should be extended to all sectors, not just electricity transmission.

Network companies need to try innovative ways of keeping up with the current period of change.  The Network Innovation Competition and Network Innovation Allowance seem set to continue in some form, but will be reserved for innovation projects that can demonstrate long-term value. There should be greater co-ordination with wider public sector innovation funding and support, such as BEIS’ Energy Innovation Programme and the Industrial Strategy Challenge Fund.

There will be much more competition in RIIO2.  Ofgem propose applying the ‘new, separable and high value’ (£100 million+) criteria not just to electricity transmission projects but across all the network sectors: electricity and gas transmission and distribution, to identify projects suitable for competition.

Ensuring fair returns

Ofgem has not yet finalised its methodology for setting the cost of debt so this is still open for debate. They suggest the cost of equity should be between 3 and 5 per cent, a reduction from RIIO1, justified on the basis that, according to Ofgem, most companies are making double-digit returns in real terms when this is a low risk investment. This was no surprise, given that Ofwat also went in low in their price review and given the political climate around energy company profits and a threatened renationalisation of the industry if Labour win power.

Ofgem put forward various options for controlling excessive returns, including a hard cap and floor, a discretionary adjustment to account for variations between forecast and actual performance and competition between network companies for incentives.

What does this mean?

Dermot Nolan, Ofgem’s CEO, warns that “this will be a tougher price control for network companies” and there is a risk that political pressure to control returns may obviate some of the benefits of an incentives-based regime.  There is still much to be positive about, not least the opening up of all network projects to competition and the continued funding for key innovative projects.  It is also encouraging to see Ofgem taking a more holistic view of the energy system and trying to factor in new ways for network companies to work within this: not just building new capacity but also encouraging energy efficiency and the decarbonisation of heat.  Now is the chance for network companies to input their suggestions on how best to do this.

What remains to be seen as part of this process is the view around political risk in networks. It has been an area that has largely been viewed as apolitical where rational economic decisions get taken. There is a sense around recent events and in the industry that the echoes from the very political retail debate on cost is beginning to impact on networks and this process. Watch this space.

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