The move to a total expenditure, or totex, regime was first suggested by Ofgem in March 2008 when the energy regulator launched its RPI-X@20 review. From this comprehensive review of the previous regulatory regime, which had endured since privatisation in 1989, emerged the RIIO (revenue= incentives+innovation+outputs) model.
Part of this change in approach saw the old operational and capital expenditure model – where funds were allocated and accounted for separately – become totex. Totex was first used in the electricity distribution network price control DPCR5 (2010-15) but it was central to RIIO, which came into force first for electricity transmission in April 2013 and then gas transmission the following year.
Water regulator Ofwat’s shift to totex was confirmed in July 2013 with its final PR14 methodology, and also came into effect this April.
The main driver behind the change is to remove the perceived bias towards capital expenditure.
“Intuitively totex is the best solution because it is the lowest cost over the whole life of the asset,” says British Water director Paul Mullord. “It should open the door to more adult discussions about the real cost of doing things and that some things which may on the face of it may be less attractive may be more attractive when you look at it from a totex angle.”
Ofgem says totex will “deliver long-term value-for-money network services for existing and future customers” and will make the companies “indifferent” as to whether it presses ahead with a capex or opex solution.
The water regulator states that the shift will “enable companies to make a return for spending wisely on operations, rather than just assets”.
However, there is an argument that says totex is a “red herring”, as claimed by Thames Water head of strategic business planning Sarah McMath. She says it is the shift to an outcomes-based approach by the regulator that gives the companies the freedom to choose the more suitable – and cost effective – solution.
Northern Gas Networks operations manager Richard Hynes-Cooper states that the innovation ‘I’ in RIIO has been an important factor in new solutions being used and developed by gas networks. But he also says that this goes hand-in-hand with totex, because the new structure grants the utility companies the freedom – and financial returns – to use opex spending, rather than capex and building a new asset.
That is what the regulators wanted to achieve.
RIIO decisions face reality check
The energy sector’s RIIO regime introduced totex and extended the review period to eight years, but it also introduced a mid-point review to cover any material changes to outputs as a result of clear changes in government policy.
Alongside the shift to totex, another key element of Ofgem’s adoption of RIIO was extending the price control period from five years up to eight. The aim being to inspire longer-term thinking and provide more certainty for investors.
However, one of the concerns of a longer price control period, according to Jefferies analyst Peter Atherton, is “locking in” potentially bad deals – either for consumers or the companies. He says this could be “pretty damaging” without a safety valve and the ability to adapt to changing external factors such as new government policies.
Ofgem created the RIIO framework with one built in: the mid-point review.
For the electricity transmission (T1) and gas distribution (GD1) price controls, the time to run a regulatory eye over the 2013 determination is almost upon us. Ofgem started the ball rolling when it issued a consultation on 12 November setting out some issues with RIIO-T1 that a mid-point review could address. It said RIIO-GD1 did not have “any material issues”, meaning the totex regime and price control settlement that came into force in April 2013 was working as planned.
Certainly, that is the view of Northern Gas Networks chief executive Mark Horsley, who told Utility Week the review would show that the RIIO principles – including totex – are being delivered.
On the electricity transmission front, Ofgem has highlighted some issues it may look into in more depth. These include the network output measures, the customer and stakeholder incentive mechanism, and the strategic wider works submissions.
Should the response to the consultation be followed up with a mid-term review, any policy proposals will be made by summer 2016 before a decision is made by the autumn of the same year. Ofgem will consult on a mid-point review for RIIO-ED1 in 2018.
The water sector retained five-year controls and so there is no review mechanism.
Contractor view: Totex changes the maths of existing facilities as well as new ones
The new concept of totex changes the rules fundamentally for water companies. Now, when investments are being considered, it is the total cost – including energy usage, maintenance, etc – which has to be considered, not just the capital value.
The totex concept also focuses attention on existing infrastructure and how efficient the installed equipment is, in particular in the area of energy usage. The new Ofwat rules will force utilities to examine historical installations and determine whether it may be beneficial to replace them with new technology offering lower operating costs.
Over the period of AMP6 (2015-20), wastewater expenditure is forecast at nearly £21 billion across all companies, with up to 50 per cent of this accounted for by wastewater treatment, because water companies are also obliged to improve performance to meet the new discharge standards prescribed by European regulation. Controlling wastewater processing costs is therefore likely to become highly significant, both in the context of existing and new installations. The capital investment limit for the 2015-20 is £44.3 billion, 5 per cent lower than the projections supplied by the water companies. An immediate consequence is that the sector will need to enhance productivity and become more cost-efficient. This means buying smarter and managing sewage treatment and assets more efficiently.
New technology providers such as Mapal Green Energy are well positioned to help. With a track record of delivering more efficient wastewater aeration processing technologies, especially in terms of power usage, such system are likely to be essential in the battle to meet totex targets. With no moving parts, the energy bills of Mapal’s Floating Fine Bubble Aeration systems, for instance, are substantially reduced – by 22 per cent in the case of an installation run by Anglian Water, and fast switchovers are possible because wastewater plants do not need to be drained for new installations.
We believe AMP6 will give a huge boost to the rollout of floating fine bubble aeration technology across the utility sector. We currently have active projects with Thames Water, United Utilities and Anglian, all of which recognise the important energy savings possible. Add to that, lower maintenance and faster switchover times and the proposition is a powerful one for anyone who must now review existing capital and total expenditure models.
Zeev Fisher, chief executive, Mapal Green Energy
Investor view: We are just as the beginning of what will be a revolution for companies
The RIIO and AMP6 regulatory frameworks for utility companies has started to remove the separation between capex and opex, opening the door to considering total expenditure (totex). And with it we are starting to see a quiet revolution.
Capex spend remains favourable because it increases corporate asset value. However, the new totex regime encourages companies to trade off between capex and opex over the whole life of a solution. Enhanced asset risk and condition decision frameworks are being adopted to optimise cost, risk and performance.
The totex regime is enabling companies to bring alternative solutions in to play:
• In the water sector, for example, spending money to persuade farmers to change their practices in the use of chemicals on crops that end up in water courses.
• Across the utility sector, companies are increasingly buying IT in the form of cloud-based solutions (funded as a service through opex) rather than the traditional model of owning and implementing the solution.
With the new regime comes a greater incentive to shift from “spend as much capital as possible” to “invest capital as quickly and efficiently as possible to deliver outcomes sooner”. Leading utilities are deploying new and innovative ways of delivering programmes of work, drawing on the benefits of lean construction, offsite manufacturing and building information management.
So why is the revolution quiet? Like any major change, it takes time for people to accept and adopt new ways of working. There are also practical constraints, such as opex-funded interventions typically being a poor substitute for capital replacement when measured against asset risk and safety reduction. We expect to see a step change in the next regulatory period. The coming 12 months gives companies the opportunity to assess their initial learning of totex and build in to future business plans for maximum advantage.
Stephen Wardle, Adrian Chapman and Mark Turner EY
The remorseless pressure on bills
The energy and water regulators are looking to totex to help alleviate the severe political pressure to reduce utility bills.
The shift to a totex regime by Ofgem, and then Ofwat, has coincided with a period where keeping a cap on cost is crucial and prices are more keenly watched than ever before, especially when the beady eyes of politicians are firmly on the sectors.
The totex shift aims to drive utilities to get better value for money over the lifetime of their assets, which in some cases can be 50 years or more. This chimes with the “more for less” attitude taken by regulators in recent years.
The latest set of price controls, of which totex forms a part, will result in household bills being reduced by more than £40 a year by the start of next decade. In a world of austerity and “hard working families” any real-term cut in bills is welcome.
Former energy and climate change committee chair Tim Yeo was vocal about the impact that energy transmission and distribution companies had on bills, and in February this year called for Ofgem to “crack down” on these costs. However, at the same time he did admit that the new RIIO price control was “an improvement on what went before” in terms of limiting the cost impact to consumers.
By switching to totex and the new regulatory regimes, Ofwat and Ofgem are getting the utilities to take a longer-term view on their infrastructure and to think about the lifetime cost. The result is that rather than building a new asset and seeing its valued added to its regulated capital value, ongoing and potentially cheaper solutions can now be used without the energy and water companies missing out financially as a result.
Regulator view: Totex is a smarter way for energy companies to invest in and run their networks
RIIO introduced sweeping changes in 2011 to how price controls were set. However, a previous change we made, putting operational and capital expenditure into one pot instead of setting separate allowances for each, has also made a difference to how networks approach spending.
Before the change, companies bore the full cost of additional operating expenditure, but only around a third of the amounts that were capitalised. This created distortions by encouraging companies to find capital expenditure solutions where operational expenditure could have been used. They also recorded some expenditure as capital spending, when technically it was not. So Ofgem had to closely police the companies’ cost reporting, which was time-consuming for both sides.
The 2010-15 electricity distribution price control was the first to tackle this. Using totex, companies have the same incentive to spend either operating or capital expenditure. This corrects some of the distortions.
Ofwat has since followed our lead by adopting it for its 2015-20 price controls, and regulators in other countries are considering similar approaches.
Using totex has already made an impact. Companies are now considering innovative solutions such as demand-side response or batteries as alternatives to building more capacity.
Changes to how the gas distribution networks deliver the gas mains replacement programme in their 2013-21 price control also show how totex encourages innovation. The programme is no longer seen purely as capital expenditure asset replacement. Using new technology, networks are making mains inspections online, carrying out remote repairs and employing advanced leakage management. The aim is to repair some mains where possible instead of replacing them. The benefit to customers is a reduction in costs of around £2 billion over the price control, without any compromises on safety.
Finding innovative solutions is so important as the energy sector adapts to the low carbon economy. Electricity networks still need to invest in new connections but they must also find clever ways to operate grids so they can manage changing usage patterns. The totex approach gives them the right incentives to do this and we will keep challenging them to think creatively.
Maxine Frerk, senior partner, Smarter Grids & Governance Distribution, Ofgem