Getting ready for RIIO2

Ofgem's consultation on RIIO-2 has closed. Utility Week highlights the key areas of debate.

Ofgem fired the starting gun on the all-important planning for the next regulatory settlement, RIIO-2, in July. It’s early days yet – the current price controls for gas and electricity transmission (RIIO-T1) and gas distribution (RIIO-GD1) networks run until 2021, while the electricity distribution price control (RIIO-ED1) runs until 2023. But with so much up for debate, planning needs to start early.

The industry consensus is that RIIO-1 has so far delivered on its promises. The annual reports published in February this year showed that networks are driving up service levels – earning many millions of pounds in regulated rewards – whilst also underspending their investment allowances.

But this success must be taken in the context of the row over network returns, which shows no signs of dying down. Earlier this month, the Economy and Climate Intelligence Unit claimed networks were making ‘unusually high’ profits of 32 per cent – a claim based on analysis which the ENA branded ‘deeply flawed’. With Dieter Helm’s cost of energy review looking at the whole value chain, network costs are sure to remain in the spotlight for the next few months at least.

Against this complex and shifting backdrop, the regulator must seek to develop a framework that will satisfy both the networks and their critics while delivering protection and fair value for customers. To start the process, Ofgem asked networks for their views on key issues the next framework must address. The consultation closed on September 4 – here, Utility Week rounds up responses on seven of the biggest areas of debate:

1. What’s a fair return for a regulated monopoly network?

It comes as little surprise that the networks all felt the returns they are getting under RIIO-1 are fair – nor that they declined to put a number on the ‘right’ level of profit.

Cadent mounted a particularly robust defence of its returns, arguing: “The financial returns seen so far in RIIO-GD1, with some companies achieving low double-digit returns, have been the result of GDNs responding to the incentives within the regime to deliver significant service improvements whilst also driving cost reductions for customers, with 37p in every £1 of efficiency savings being returned to customers within the control period.

“If network companies had not responded to these incentives then they faced significant financial penalties which would have seen their financial returns fall to around or below the cost of debt.”

Cadent acknowledged that it can be difficult for customers to see the value they are receiving for the returns made by networks, suggesting: “At RIIO-GD2, by aligning networks’ financial performance with recognisable outcomes which can be observed and understood by customers it will help demonstrate that they have been value for money.”

National Grid Gas and National Grid Electricity Transmission (NGG & NGET) has a similar suggestion: “To achieve greater levels of legitimacy we think the key issues for the price controls will be the calibration of performance benchmarks, better transparency and understanding of the risks managed by networks to ensure commensurate rewards are given.”

2. How should the cost of capital be set?

Setting a fair cost of capital that reflects the current low-interest environment while maintaining long term financeability is a challenging issue for all regulators – and one Ofwat, for example, is also grappling with in its next price review, PR19. Ofwat has concluded that using historic data to indicate future returns is not valid in the current environment – a conclusion, based on analysis by PwC, that many of the water companies have taken issue with.

Energy networks agree that the unique economic environment necessitates a rethink of the cost of capital. NGN welcomes Ofgem and the UK Regulator Network’s decision to commission an expert report on the issue, and says: “There is a popular view that recent evidence of unprecedentedly low risk-free rates coupled with bewilderingly high Market-to-Asset (MAR) ratios seemingly suggests an imbalance between returns the market requires and the cost of capital RIIO-1 settlements off. However we would argue that high MARs may not necessarily signal that the cost of capital, allowed in RIIO-1, is too high. Premia that investors are prepared to pay depend on investors’ expectations of the overall future operating performance of a company and costs of financing… A large part of the valuation premium could therefore be explained by bidders’ optimism bias rather than poorly calibrated WACC parameters.”

NGG & NGET issues a plea for investor confidence, and warns that long-term decisions shouldn’t be based solely on short-term economic factors: “As network investments are long term in nature the allowed return should reflect both the long-term and short-term risks and uncertainties faced by companies. It is therefore imperative that, in setting the allowed cost of capital, regulators do not focus solely on short-term market conditions.”

3. Should the price control period stay at eight years?

One of the heavily trailed questions about RIIO-2 is its length, with Ofgem indicating that, given the uncertainty arising from the energy transition, a shorter control may be better.

WPD argues for the retention of an eight year price control, saying: “It is very difficult for network companies to innovate in see results in time periods shorter than eight years. It would be ideal if network companies are given targets that align to customer needs, and then left to deliver those targets in a way that it is economically favourable.”

Cadent supports an eight year price control for gas, but suggests that shorter period may be suitable for electricity, and that the two do not need to be the same length: “There is less uncertainty now in the GDNs’ role than when RIIO-1 was set, however we can see that there is still significant uncertainty in what the electricity networks will need to deliver which may warrant a different approach.”

National Grid Electricity System Operators (ESO) agrees that “an eight year price control may not be right for the ESO.”

Nearly all consultation responses seen by Utility Week call for greater uncertainty mechanisms. As NGG & NGET says: “The critical factor for the RIIO framework review is… whether uncertainty mechanisms can be designed to deal appropriately with these uncertainties rather than focusing on the length of the control period itself.”

4. Should the price controls be aligned?

There is a school of thought that to deliver whole-system planning, the price controls for transmission and distribution – and perhaps those for electricity and gas – should be aligned.

Opinion among the networks is divided on this question. NGN supports the alignment of the electricity transmission and distribution controls, and says “we believe there to be an equally strong case for consideration of aligning the gas and electricity distribution controls.”

Cadent suggests “customer outcomes, outputs, incentives and innovation funding” should be aligned, but says “this does not necessarily require the alignment of price control start points and durations.” WPD supports the alignment of transmission and distribution controls, while National Grid suggests “further work is required to set out and attempt to quantify the advantages and disadvantages.”

5. How should stakeholders be engaged?

The networks agree with Ofgem that customers, and their representatives, should be engaged throughout the price control process. ENA speaks for its members in its umbrella response to the consultation, which suggests setting up expert panels, including customer representatives, to operate throughout the next price control period, and contribute to the assessment of RIIO2 business plans.

WWU suggests communicating with customers in new ways: “We recommend the use of technology (such as apps, media tools, polls etc) to encourage wider engagement and reach more stakeholders… We recognise the need for a variety of engagement techniques to ensure a wide range of stakeholders are consulted, particularly hard to reach consumers, those in fuel poverty and future bill payers.”

6. Does innovation funding deliver results?

Innovation funding is one of the success stories of network regulation, and the networks all speak positively of it and call for its continuation, in one form or another.

WPD says: “The recent and historical innovation stimulus available to DNOs has enabled the UK to lead on innovation within the electricity industry worldwide. It has allowed a higher level of risk to be taken in trying new techniques and technology and allowed DNOs to simultaneously develop a broad pipeline of innovation projects. It has enabled earlier and faster development of new techniques and technology than would have been the case without the stimulus and given the platform to encourage deployment of these within companies.”

Cadent also praises the impact of innovation funding, but has some suggestions for improvement under RIIO-2: “The combination of a specific innovation stimulus and the incentives inherent in the RIIO model has been a success in RIIO-1 but there is scope for improvements around flexibility, reducing the administrative burden and cost. The RIIO framework could be evolved further with increased cross sector measures, including innovation, to ensure that the most effective and efficient investment is undertaken to drive the delivery of the outcomes required by customers.”

7. Should Ofgem keep the fast track?

Opinion is divided on whether the fast track option included in RIIO1 should be continued to RIIO2 – and it is no surprise that WPD, the single company fast-tracked last time round, should support the model. It says: “Fast tracking should be retained for all sectors. The potential to be fast tracked incentivises companies to submit a high quality business plan to Ofgem. It provides significant benefits to customers in that it encourages companies to reveal information earlier in the process and drives efficiencies and improves proposals for delivery from the companies remaining in the process.”

Other networks are not so sure. Cadent argues: “Ofgem should take the time to focus on ensuring that benchmarking, outcomes, measures and customer value assessments are fit for purpose rather than retaining the fast track process. Some of the main challenges seen during RIIO-GD1, and other RIIO regimes, are as a result of there not being enough time for Ofgem to work with network companies and other stakeholders to design, develop, justify and implement the measures within the framework. By removing the fast track process it will enable more time for the work to take place.”