The regulatory road to net zero

There is a growing groundswell of opinion that some new form of regulatory methodology and settlement will be needed to deliver our net zero commitments.

The final determinations for electricity and gas transmission and gas distribution have led many companies to seek redress from the Competition and Markets Authority (CMA). DNOs are tussling with their RIIO plans and trying to understand how to accommodate a highly uncertain future with networks that were never designed to operate in the ways signalled in the 10-point plan.

In the water industry, the CMA’s determination has highlighted the need for companies to consider the interests of consumers through the lens not only of short-term bills but also in terms of long-term resilience (such as the ability of infrastructure to cope with increasing demand and a changing climate). Both the CBI and the National Infrastructure Commission have also called for a net zero duty to be placed upon regulators.

It is clear that the siloed nature of industry regulation is not designed to deliver an optimal solution. While it needs broad debate, a new regulatory settlement should include:

• A comprehensive net zero plan
• How to trade off potential increases in customer bills against future environmental impact
• Longer term certainty and ability to invest ahead of need
• Increased use of competition
• Net zero specific risk reward mechanism

In establishing this new framework, we need to look broadly at alternative regulatory models but given the scale of change, appropriate models may not exist, and we may need to create new ones.

A comprehensive net zero plan

The UK will look very different in a 2050 net zero world, but there is no unified cross-sector model for this, nor for any interim stages. This model is essential to give all regulated industries a baseline to work towards. Without this model, we cannot plan the optimal long term solution. For example, do we have sufficient renewable generation to support EVs; do we have sufficient scarce water to support hydrogen; what is the correct balance between investing in flexibility and reinforcing the network?

Absent a model, each company has to make its own determination for planning and, without a common baseline, they are likely to adopt the least change option, in an expectation that regulators will want to minimise cost. There is of course a place for distributed planning as there will be regional and local variations. However, the sums involved are vast. National Grid ESO, for example, estimate £3 trillion is required to upgrade the energy system alone; this is not the kind of expenditure that can be planned bottom up.

Balancing current customer bills and future environmental impact

The ICCC’s official estimate is that the cost of meeting net zero will be £50 billion pa, although this is expected to be increased pre COP26. In practice, a significant proportion of this spending may need to be front-loaded to provide the right infrastructure platforms. The regulators will now have to make trade-offs between allowing this expenditure and the impact on current customer bills, but there is no guidance on how they should make this judgment. The CMA has taken this into account to an extent in its decision on PR19, but government and regulators need to develop a firm framework to work within.

Longer term certainty and ability to invest ahead of need

It is fundamentally important that our regulatory model provides sufficient certainty to attract investment. Investment also needs to start early – perhaps without the firm evidence usually required to approve investment plans. The regulators need to find a mechanism to provide this certainty.

Ofcom’s recent market review provides a good example of a regulator moving towards this. The review recognises that the move to home working necessitates a faster rollout of fibre and sets a long-term path for future decisions.

This includes a statement that they do not expect to introduce cost-based price controls for at least the next decade and that, if subsequently introduced, they will follow the fair bet principle. This would allow BT to keep returns in excess of cost of capital up to that point and earn at least cost of capital going forward and so provides certainty over the whole fibre investment lifecycle.

One factor in providing certainty will be the development of improved mechanisms to manage the uncertainty that will become a crucial factor in a net zero world. RIIO-ED2 for example includes a net zero re-opener and a mechanism on strategic investment.

However, without a central baseline, it is difficult for companies and investors to assess the extent to which these would support change and Ofgem is yet to publish the assumptions that underpin the mechanisms.

Introduce competition where possible

One feature of telecoms that allows Ofcom to provide greater certainty to BT is the increase in competition, with other providers laying fibre networks.

Other regulators need to look at where competition can be introduced in the move to net zero. A top down plan could help identify major infrastructure developments that could be separated and competed for. The Thames Tideway model is a good example of the ability to carve out such a development and allow competition on a range of factors, including cost of capital.

Net zero specific risk reward mechanism

The expenditure required to achieve net zero makes it even more important that this is undertaken within an appropriate risk and reward framework. A baseline and greater clarity on the management of uncertainty will provide the potential for net zero outcome delivery incentives (ODI) that ensure an appropriate risk reward balance is maintained.

The UK has taken a world leading role in its legal commitment to net zero. However, there is a risk that our regulatory regimes are still designed to fight the battles of the last decade and they must be enhanced to take full account of the net zero commitments.