DNOs may be incentivised to help deliver net-zero target

Ofgem has suggested distribution network operators (DNOs) may be given financial incentives to help deliver the government’s recently adopted net-zero target as part of the RIIO2 ED2 price control.

In an open letter to stakeholders, the regulator promised a “tough but fair settlement” that pushes DNOs to “go further in decarbonising the economy whilst ensuring costs are kept as low as possible for consumers”.

“The expenditure and outputs that we expected DNOs to deliver in RIIO ED1 reflected the key services that they provide – reliability, connections, customer service,” the letter stated.

“We have previously focussed on these type of activities, which are within the control of DNOs to deliver and are directly linked to network services, rather than the achievement of wider outcomes linked to decarbonisation targets for energy, transport and heat.

“In light of decarbonisation goals, however, there may be reasons to more directly link DNOs’ revenues to the achievement of outcomes that go beyond the delivery of traditional network services.

“This might include, for instance, the decarbonisation of the transport or heating sectors, or tying revenues to outcomes that complement government goals such as reducing peak prices, increasing renewables and reducing demand on the network.”

Ofgem pointed to the distribution service provider model proposed by the University of Exeter’s Energy Policy Group as an example of how this might work.

The purpose of the letter was to kick off a new consultation on the regulatory framework for the RIIO ED2 price control. It comes shortly after Ofgem completed another consultation on the methodology that will be used when setting the price controls for transmission, gas distribution and the electricity system operator, which will begin two years earlier in 2021.

Ofgem’s initial proposals for electricity distribution share a number of features with the agreed methodologies for other sectors. They include a five-year settlement period, a new mechanism for incentivising network operators to submit accurate business plans, and a return adjustment mechanism to prevent returns from exceeding expectations.

The regulator has also proposed to use the same methodology when setting the baseline spending allowances for DNOs. Back in May, Ofgem said the baseline allowed return on equity would be set at 4.3 per cent – the “lowest ever” rate – if applied the methodology was applied at the time. The figure is based on the new CPIH measure of inflation that the regulator intends to adopt for RIIO2.

To support the decarbonisation of the energy system, DNOs will need to take a more proactive role in the management of their networks, transforming themselves into distribution system operators (DSO). Alongside the letter, Ofgem has released a new paper setting out the various functions that DSOs will need to fulfil, which it is also consulting on.

DSO functions

Source: Position paper on Distribution System Operation: our approach and regulatory priorities, Ofgem

But the letter itself suggested some of these functions may need to be regulated separately to traditional network activities. Ofgem noted the recent separation of the electricity system operator from the rest of National Grid due to perceived conflicts of interest and said similar issues could arise from DNOs’ evolution into DSOs.

“We will be carefully monitoring developments and will consider whether, over time, there may be a case for greater separation of certain DSO functions from the DNOs,” it added.  “This includes considering the effectiveness of DNOs in managing conflicts of interests and neutrally facilitating markets.”

Commenting on the launch of the consultation, Ofgem executive director for systems and networks, Jonathan Brearley, said: “Electricity distribution networks have a fundamental role to play in the UK’s journey to reach net zero emissions by 2050.

“Ofgem will strike a tough, fair settlement with companies which enables them to go further in decarbonising the economy and ensures that costs are kept as low as possible for consumers paying for the required investment.

“All our network price controls will pave the way for an affordable, reliable and more sustainable energy system which protects consumers both today and in the future, including those who are in vulnerable situations.”

The deadline for responses is 15 October. Ofgem said it will make a decision on the regulatory framework in the fourth quarter of 2019.

It will then launch a further consultation on the methodology for setting the RIIO ED2 price control in June 2020, before reaching a final decision the following November.