Ofgem’s odd approach to network charging review

Ofgem's plan for a targeted review of the network charges regime is not joined up and misses some important points, says former regulator Maxine Frerk.

Ofgem has recently published what is billed as a potential significant code review on network charging.

I’ve said before this is a very arcane but hugely important area, so the review is welcome. But Ofgem is still only looking at part of the picture.

As Ofgem explains in its paper setting out its approach to the review, network charges are made up of what is called the “forward looking” element which is intended to be cost reflective to send signals about efficient use of the network. And then there is the “residual” element which needs to be recovered somehow – as network companies are entitled to recover the allowed revenues under their price control – but where there is no cost driver.

Ofgem’s new review only looks at the residual element. While this is significant – around 80 per cent on transmission and up to 50 per cent of distribution charges, it is still only part of the picture.

Ofgem has committed to consider the future of the forward-looking element as part of the flexibility project it is conducting in partnership with the Department for Business Energy and Industrial Strategy. However, this decision is odd for a number of reasons.

Firstly, on the key question about the future of the forward-looking elements, there already seems to be a clear consensus about the right approach. All interested parties seem to agree that this element should be cost reflective.

This makes government’s involvement surprising. Setting cost reflective charges is  a technocratic exercise to address issues which should be Ofgem’s bread and butter – like questions regarding the time horizons, levels of locational granularity and understanding what network cost drivers really are.

In contrast, reform of the residual element, which Ofgem is reviewing independently, quickly gets you into policy questions that government will inevitably want to have a major say in.

The pure economist answer on how you deal with residual costs is that you aim to minimise distortions. But Ofgem admits there are other factors like fairness – not an easy concept for regulators – and practicality.

It also acknowledges that some people might view some distortions as preferable to others. For example, favouring low carbon generation or encouraging energy efficiency might be viewed as positive distortions.

Interestingly, Ofgem has recognised suggestions from Massachusetts Institute of Technology (MIT), set out in its 2016 Utility of the Future paper, that residual costs might be recovered in line with property taxes in order to achieve a minimal distortion model that has the benefits of reflecting broader societal views on equity. Indeed, MIT also floated the idea of recovering the residual element through taxation, though Ofgem avoided reference to that.

The purist’s view of “no distortions” might work in an energy system where the rest of the system is nicely cost reflective but in a world of subsidies, if Ofgem levels the playing field there is the risk that government just has to tilt it further to achieve its policy goals.

Again, MIT has something to say here. It has pointed out that the issues with residual costs apply equally to the costs of policies – such as FITs – which create the same risks around distorting cost signals and grid defection and should be treated in the same way.

So, it seems odd that Ofgem feels that this part of the jigsaw is something it can pursue separately from government while the forward-looking element must be addressed as a joint exercise.

Quite apart from this being back to front in terms of the elements which will incite most government interest, it would make more sense to conduct a holistic review covering the forward-looking and residual elements at the same time.

This would allow a much clearer understanding of the impact that changes in one element might have on the other. In terms of practicality it might make sense to align the allocation of the residual with a cost reflective component (such as capacity) which would increase the chance of customers understanding what is going on in the system. Furthermore, the scale of residual charges might change radically, for instance, following a fundamental review of the forward-looking element. This would then have implications for proportionality and any fairness considerations.

I welcome Ofgem’s efforts to get a debate going on these issues but as ever it needs to take account of the wider picture. And that includes connection charges which is another whole issue not even touched on in Ofgem’s paper.