Ofgem to keep outturn DSO incentives switched off for ED2

Ofgem has confirmed its decision to keep the outturn DSO incentives that were due be introduced this year switched off for the remainder of the RIIO ED2 period after concluding it would not be possible to set appropriate targets.

The regulator has also decided to reallocate the value of these incentives to the other two parts of the wider distribution system operation (DSO) incentive.

For the ED2 price controls, which began in April last year, Ofgem introduced a new DSO output delivery incentive (ODI) worth +0.4%/-0.2% of return on regulatory equity (RoRE) in total.

In its final determinations, the regulator said distribution network operators (DNOs) would be judged on three criteria: a stakeholder survey, a performance panel assessment, and a series of outturn performance metrics. It said the stakeholder survey and performance panel assessment would each be worth 40% of the overall value of the ODI, while the three outturn performance metrics would together account for the remaining 20%.

The three outturn performance metrics cover:

• Flexibility reinforcement deferral – encourages DNOs to use flexibility to address network constraints when it is the most economic solution
• Secondary forecasting – promotes visibility and accuracy over the utilisation of pole and ground-mounted transformers
• Curtailment efficiency – incentivises DNOs to limit the curtailment of users with flexible connections

Ofgem decided that for the first year of the ED2 period these outturn incentives would be switched off, meaning it would not set targets and DNOs would not be subject to the associated rewards and penalties. It nevertheless required DNOs to report performance data to enable the incentives to be switched on from the second year onwards.

However, Ofgem revealed in February that it no longer intended to switch on these incentives during the ED2 period, stating: “Even though we think metrics can have clear value, a combination of data quality concerns, notably a lack of historical data, persistent issues with the methodologies themselves and the risk of perverse incentives mean we do not think we can set appropriate performance targets at this point in time.”

In a consultation on the proposals, the regulator said it also planned to reassign the value of the incentives to the performance panel assessment, meaning this would account for 60% of the overall value of the DSO ODI.

Ofgem has now confirmed its decision to keep the outturn incentives switched off for the entirety of ED2, although it has also opted to reassign their value to both the performance panel assessment and the stakeholder survey, splitting it equally between the two.

Ofgem said all of the respondents to its consultation agreed that none of the outturn incentives should be switched on the for the second year of the ED2 period, which began in April this year.

However, in contrast to the other distribution network operators (DNOs), UK Power Networks (UKPN) did push for the incentives to be switched on later in the period if the problems with metrics could be resolved.

Flexibility Reinforcement Deferral

Ofgem said issues with this metric included “persistent inconsistencies” within parts of the methodology and “a number of anomalies” which raised concerns about the accuracy and integrity of data.

The responses to its second Request for Information (RFI2) showed four licensees lacked historical flexibility data, while three of them had a score of significantly more than 100%.

Although some deviation was expected due to geographical differences in the availability of flexibility services and known variation in DSO activities, Ofgem said it was concerned by the “significant disparities” in the data provided by DNOs.

Given these problems, Ofgem said it does not believe that “realistic and meaningful” targets could be set in the coming years. It said the earliest this could be done is the final year of ED2.

The regulator said there was disagreement among DNOs regarding the level of development of this metric.

Scottish and Southern Electricity Networks (SSEN) said there are fundamental issues with its design, which mean it is inappropriate to report against it in its current form, while Northern Powergrid raised concerns that performance is volatile and sensitive to externalities such as flexibility market growth, tender success and the location of flexible assets.

Ofgem said it agreed with UKPN that the right principles are in place for the metric to function, but acknowledged that it needs substantial refinement.

Secondary forecasting

Based on the RFI2 responses, Ofgem said all licensees had a starting score against this metric of more than 95%, with several exceeding 98%. Although these “very high” figures could reflect the efficacy of their forecasting capabilities, the regulator said it believes they are tied to the methodology.

Ofgem noted that if the target was set according to their average performance, 11 of the licensees would start ahead of it, meaning they would be rewarded for merely maintaining their current performance, rather than exceeding it. It said this elevated starting position would also leave little room for improvement.

It said there was “overwhelming agreement” among DNOs that the metric is “unsuitable and does not adequately serve its intended purpose”. UKPN described it as inappropriate and simplistic, and pushed its own version of the metric, whilst Northern Powergrid warned that it could encourage perverse behaviours.

One stakeholder called for Ofgem to drive progress on secondary network visibility using minimum standards on the installation of monitoring equipment on low-voltage assets, which the regulator said it may consider in future.

Curtailment efficiency

Ofgem said its main concern with this metric is a lack of available data to inform target setting as only seven out of the 14 licensees were able to provide a historic baseline dataset, and five of these have a small volume of flexible connections: “These data limitations reduce insight and limit our ability to set robust targets, risking the potential value of the metric.”

DNOs also provided evidence that as curtailable capacity increases so does the need to curtail, meaning the incentive could unintentionally reward them for limiting the growth of flexible connections. Ofgem said a ‘target adjuster’ mechanism was developed to tackle this issue, but this too was limited by a lack of data.

It said the earliest this incentive could realistically be switched on is the final year of ED2 and there is value in having certainty for the remainder of the period.

DNOs disagreed on the current state of this metric. UKPN suggested it is the closest of the three to implementation, but Electricity North West said it will need significant work before it is fit for purpose. Northern Powergrid said it requires more fundamental reconsideration, arguing that it incentivises behaviours that are inconsistent with the outcome of Ofgem’s significant code review of network access arrangements.

Ofgem said although there is an “inherent challenge” in determining targets, the core objective is “important and desirable.”

Reporting requirements

Ofgem said it intends to continue working with DNOs to further develop the metrics and enable “robust” reporting requirements to commence in the third year of ED2. The regulator said this will allow it to build up the evidence base to then switch on the incentives for ED3.

The only DNO that opposed continuing with reporting requirements in ED2 was Northern Powergrid, which said in the absence of meaningful and objective assessments, Ofgem should instead turn off the whole incentive mechanism and use public-facing reports to hold DNOs to account.

Ofgem responded: “By turning off the incentive altogether, we would potentially overlook valuable opportunities to achieve key DSO objectives outlined for RIIO-ED2. Therefore, while acknowledging the concerns associated with the current set up, the potential benefits of retaining the incentive outweigh the risks of discontinuing it entirely.”