Utility Week expert view

“The new network regulation regime RIIO’s fast-track scheme could reward DNOs for punting for high expenditure allowances with an eye to underspending”

Among the many and various changes to network regulation that produced the catchily named new regime Revenue=Incentives+Innovation+Outputs (RIIO) is the fast-track scheme. This offers the opportunity for regulated companies to get a flying start to their price control period. But the companies are not the only winners.
A network can win fast-track status by producing a business plan that is “well justified and in the interests of customers”, which equates with close alignment with Ofgem’s initial expectations for the business. Fast-tracked companies can get on with business outside the price control process some nine months to a year earlier than the rest. And fast-trackers avoid the detailed scrutiny of their business plans that is applied to the rest, leaving them with a revenue settlement close to that in their plan.
But fast-tracking is the latest ruse by the regulator to get the regulated companies to quit trying it on with high bids for expenditure allowances at price review time so they can undercut them and bank the difference. In 2005, Ofgem came up with the Information Quality Incentive (IQI), which rewarded distribution network operators (DNOs) for being less devious (sorry, “risk averse”) with their expenditure forecasts. Under IQI, a DNO who came in with expenditure that lined up closely with Ofgem’s benchmark cost calculation got a better allowance than one who didn’t.
Investors doubtless will be attracted to the networks that manage to bag the revenue hike that fast-tracking can bring through less exposure to IQI penalties for inaccurate forecasts and better share of underspend, which are part of the fast-track deal. But so far, the success rate in fast-track bids has not been impressive. Following the first foray into RIIO in 2012 – the price control reviews of the transmission companies and, separately, the gas distribution networks (GDNs) – only the two Scottish electricity transmission businesses qualified for fast-tracking. DNOs know it’s not going to be an easy ride.
In fact, concern was voiced by one respondent to early consultation on the RIIO power distribution review (ED1) that the proposed changes to IQI and underspend share along with lower scrutiny for fast-track companies could prove a compelling incentive for DNOs to “adopt an overly aggressive and optimistic approach to their ED1 bid in an effort to obtain additional rewards whilst minimising regulatory scrutiny”.
The fast-track set-up could undermine the good stuff in the IQI by rewarding DNOs for the very behaviour the incentive was introduced to curb – punting for high expenditure allowances with an eye to underspending.
The IQI game is notoriously complicated, but fundamentally it goes like this: if your bid for total expenditure (capital and operational – totex) is close to Ofgem’s benchmark, you get the best initial extra allowance. The further away you are – above or below – the lower the allowed totex. Also, if you do underspend you get to keep more of the shortfall if your bid lined up with the benchmark. The downside here is you are hit with more of any overspend. And the final payoff is proportional to the closeness of the actual outturn expenditure to the DNO’s bid.
So a DNO whose outturn spending lines up with its forecast or comes under it will get a top-dollar payoff – about 7.5 per cent of totex and a top-level share of any underspend. An average DNO’s haul might be about £10 million a year – a decent reward for playing it straight. Those who come in wide of their forecast will be penalised.
However, a fast-tracked DNO is decoupled from the downside of IQI that comes with delivering an outturn that differs from forecast. And it picks up all the upside for coming in under forecast while receiving a 2.5 per cent additional allowance which is guaranteed money irrespective of the outturn expenditure. While that might arguably be a reasonable reward for not overbidding, the lack of downside for high outturn is a glorious incentive to bid high and come in low – a back of a fag packet figure being about £25 million a year.
Far more precisely, consultancy Cambridge Economic Policy Associates calculated excess spending could add about £20 a year to power bills. But at a time when networks are being hauled into the light for public scrutiny as they spend twice as much money in the next seven years as they spent in the preceding 20, we don’t want the regulator to go handing them a wad of unearned profit.
This is a difficult one for Ofgem because determining efficiency is tough and the companies have ways at their disposal to make strong cases to be considered efficient. The regulator needs to be sure its efficiency appraisal is sharp. A natural expectation might be to see only the upper quartile performers on the fast-track – three or four DNOs – and to view with suspicion any more than that.
RIIO has been devised to address a period of fierce need for growth in investment with associated risks. It has been constructed with a raft of drivers, triggers for reopening price controls and timetabled reviews to address the inevitable uncertainties. This is wise. So it would be a pity were the fast-track to derail it.
Trevor Loveday is a freelance journalist