RIIO reality bites

For its next iteration of RIIO, Ofgem has taken a tough stance with network companies. Tom Grimwood assesses company responses before the regulator pronounces on their fate.

By the end of this month, Ofgem will issue its final decision on how it intends to implement the RIIO framework for the next round of price controls starting in 2021, RIIO2. The regulator published its second consultation on price controls in December and has been mulling over the responses since the middle of March.

In contrast to the first consultation, which considered the framework in general terms, this one examines in more detail how it will be applied for each of the individual price controls. This excludes the price control for electricity distribution, which will begin two years later than the rest in 2023. Nevertheless, the six part consultation does explore a number of mechanisms that will be applied across the industry, including to distribution network operators (DNOs).

Although the core principles are essentially the same, Ofgem has proposed a number of tweaks to the framework, which taken together will have a substantial impact on how networks are incentivised and how much money they can earn.

Perhaps the biggest single change is to the baseline allowed cost of equity – the rate of return it considers necessary and sufficient to attract investment. Depending on the sector, this ranges between 6 and 7 percent for the current set of price controls.

Pressure over profits

In recent years, Ofgem has experienced mounting pressure to reduce this range, in particular from Citizens Advice. The charity claims network companies are on course to rake in £7.5 billion in“unjustified pro tests” over RIIO1, partly because Ofgem overestimated the level of business risk faced by network companies and therefore set the cost of equity too high.

In its first consultation published in March 2018, Ofgem said it planned to lower it to between 3 and 5 per cent for RIIO2, thereby saving consumers £5 billion over the shortened five-year price controls.

Ofgem said in December its working assumption for the allowed cost of equity was around 4 per cent, although this number is based on the new CPHI (consumer price index including housing) measure of inflation, which it intends to adopt. It did not give an equivalent figure using the old RPI measure of inflation, although the consultation suggests it would be around 3 per cent when calculated on this basis.

This means that for some networks the cost of equity could be less than half of what it was previously.

The move was praised by Citizens Advice in its response:“Ofgem has proposed an ambitious package of measures that promises to deliver significant benefits to consumers. It is particularly the case with the cost of capital where our analysis has demonstrated the significant gains which should be made.”

But the networks argue Ofgem has gone too far. National Grid, for example, said the reduction “runs counter to the concept of a stable, predictable regulatory regime”.

“The allowed equity return figure is a full 100 basis points below the proposals for the water sector, where less market disruption is expected in the next price control period and construction risks are lower,” it remarked.

“The consequences of applying such a reduction in the core incentive to invest would impact consumers in the short and long term… Companies would be forced to become more cautious on investment, needing funding security before beginning any work leading to risks being passed on to
consumers…”

It said these reactions and other unintended consequences “would quickly offset any short-term bill reductions”.

Flawed thinking

The 4 per cent cost of equity proposed by Ofgem incorporates a 0.5 per cent reduction to reflect investors’ expectations of outperformance by network companies. National Grid said this adjustment is both “conceptually and practically awed”.

“From a conceptual perspective, the justification confuses windfall gain from poor price control setting and outperformance from incentives.

“If the wedge is meant to apply to windfall gain, then this suggests lack of confidence in proper calibration of the price control even before it has been attempted. “If instead, the wedge is being introduced in relation to outperformance from incentives, then the approach does not recognise and appreciate the consumer benefit of incentives-based regulation, the widely accepted solution to the existence of monopoly.”

Cadent said the measure was “conceptually awed and arbitrary in nature” as well as being “duplicative to other proposed mechanisms”.

“It is noteworthy that Ofgem has set the baseline cost of capital lower than its midpoint estimate of the [capital asset pricing model] based cost of equity, which appears to be a significant departure from regulatory precedent,” the company remarked.

Citizens Advice said it supported the measure in principle but called for a “more formal approach” to deriving the adjustment. It suggested the 0.5 per cent reduction was “overly cautious” in that it “does not reflect the actual past outperformance levels of about 3 per cent in RIIO1”.

Volatility Concerns

Ofgem has also proposed to index the cost of equity against the risk-free rate – one of the components of the cost of equity. This refers to the rate of return an investor would expect to receive from a government bond, where there is no risk of the money not being repaid.

While not opposed to this change outright, SP Energy Networks raised concerns that volatility in the risk-free rate driven by short-term business cycles could make it more difficult for networks to secure financing.

Northern Gas Networks similarly expressed fears that a move to indexation could lead to “increased volatility and reduced predictability of customer bills, of cash flows and of returns for shareholders”.

“We understand that indexation of the risk-free rate has been designed to avoid forecasting errors and to substitute the established ‘ex-ante + aiming up’ approach which has been a common practice among utility regulators since privatisation,” it added.

“However, we do not share a belief that indexation is by definition a better substitute for this established practice. The fact that the risk-free rate has turned out to be lower than predicted in RIIO1 does not in itself warrant a transition to mechanistic indexation.”

Return adjustment mechanisms

To provide further “failsafe” protection against windfall gains, Ofgem is planning to introduce “return adjustment mechanisms” to limit the amount by which network returns can exceed expectations.

For transmission networks, they would take the form of “sculpted sharing”, whereby deviations from a set threshold would be reduced to bring returns closer to this point.

The regulator said “anchoring” is the preferred option for gas distribution networks. Under this mechanism, companies’ returns would be adjusted only if the sector average moved too far from a set threshold – Ofgem has suggested a collar of 3 per cent above or below the average allowed return for the sector. Returns would be adjusted proportionally to bring the sector average within this range.

While protesting against the reduction in the allowed cost of equity, National Grid reluctantly accepted these measures: “While ideally these would not be required, we recognise that they may be needed in the short term to maintain legitimacy and allow other areas of the framework to be developed unfettered by concerns of excessive returns.”

Cadent was supportive of return adjustment mechanisms as a “backstop to address any structural errors that lead to windfall under-performance or outperformance”. But it also urged Ofgem not to adopt anchoring for gas distribution, arguing that adjustments should be applied on an individual basis, not to the sector as a whole. It said the market would be “heavily distorted” by the proposed measure given Cadent’s sizeable share.

SP Energy Networks opposed the proposals in any form. It said the introduction of return adjustment mechanisms would represent a “material departure from the longstanding and highly successful regulatory framework for electricity networks in Great Britain”.

“Even the mere possibility that the mechanism could apply may reduce companies’ ambitions and attempts to be more innovative and efficient,” the company added. It said this issue could become amplified as the price controls progress and some companies realise they are on course to breach the thresholds.

It said return adjustment mechanisms would bring additional uncertainty for investors, adding to financing costs, but welcomed Ofgem’s decision to steer clear of discretionary adjustments, which it said would make this problem even worse.

Northern Gas Networks was similarly opposed to return adjustment mechanisms in general but was particularly worried about the anchoring method being proposed for gas distribution, warning: “Proposals for cross-sector averages put licensees at the mercy of other players, without the information to be able to make informed decisions.”

Scoring system

Another major change for RIIO2 is to the procedure for assessing business plans. For the first set price controls, these business plans were subjected to an initial assessment by Ofgem. Any that were good enough to be approved at this stage would be fast-tracked and thus receive a higher sharing factor, allowing the authors to keep more of any underspends against their allowances.

The rest would be required to resubmit theirs, which in combination with Ofgem’s own cost estimates would be used to calculate the information quality incentive (IQI) benchmark. The benchmark was weighted towards the regulator’s view.

These slow-tracked companies would then be assigned sharing factors based on the difference between their cost forecasts and the benchmark.

For RIIO2, Ofgem plans to remove both fast-tracking and the IQI. It said IQI has failed to prevent networks submitting excessive cost forecasts and takes no account of the qualitative aspects of their business plans.

It instead intends to score the business plans on both cost and quality and then apply rewards and penalties on this basis. There would be a maximum overall loss or gain of 2 per cent of totex allowances (see chart, above). Rewards would come from a shared pot, meaning the more companies were scored highly, “the more the reward for individual companies is diluted”.

Sharing factors

Ofgem has additionally proposed to introduce “blended” sharing factors. This would see the regulator initially apply different sharing factors to different parts of networks’ spending allowances, depending on its level of confidence in the accuracy of the corresponding forecasts.

Those cost items in which the regulator has a high level of confidence would be allocated a higher sharing factor, and vice versa.

Ofgem would then calculate an overall sharing factor for the total allowances based on a weighted average of the constituent parts.

“This could incentivise companies to provide us with information that would allow us to set allowances with higher levels of confidence,” the regulator explained.

Citizens Advice gave its backing to the removal of the IQI: “The intentions behind the IQI were sound, but it’s ability to deliver didn’t materialise, so it’s good that Ofgem is reworking the method this time around.”

It was also welcomed by the University of Exeter’s Energy Policy Group (EPG) which has previously claimed the IQI allowed DNOs to “game the system” by submitting inflated cost forecasts. The academic body said it would also be “happy for penalties to be more than the plus/minus 2 per cent” suggested by Ofgem.

Network reaction

Network companies thought differently. Northern Gas Networks said Ofgem’s proposal to include quality and ambition in its assessment of business plans would make it “highly subjective”.

It lamented the lack of clear guidance on the exact criteria by which they will be judged and warned there were some elements of the proposed methodology that could actually discourage networks from stretching themselves: “Including ambition in the plan which is not accepted may attract a financial penalty but submitting a less ambitious plan will attract no reward or penalty – seemingly providing an incentive for a conservative approach.”

SP Energy Networks accepted that the IQI mechanism is not without flaws but said it is better than the alternative and should be improved upon rather than abolished entirely. It said removing the network companies’ own forecasts from Ofgem’s assessment of costs could create “inequity” due to the “greater potential for unintended differences in allowances between companies”.

Meanwhile, blended sharing factors would introduce “a new degree of complexity which requires consistency checks across price controls and sectors”.

UK Power Networks agreed on the latter point but argued Ofgem should apply “a single, common, totex sharing factor to all network companies”. This, it said, would encourage whole-system thinking by providing a level playing field between companies that could potentially deliver the same outputs for customers.

Outputs

On the subject of outputs, Ofgem is planning to consolidate the six previous categories into just three, namely: meet needs of consumers and network users; maintain a safe and reliable network; and deliver an environmentally sustainable network.

It also plans to distinguish between three types: licence obligations; price control deliverables (PCDs); and output delivery incentives (ODIs).

Licence obligations will cover minimum standards that networks must meet or face penalties or enforcement actions.

PCDs will refer to outputs that are directly funded through the price control settlement. Examples include large one-off capital projects, such as the strategic wider works from RIIO1, or activities that are tied to changes in government policy. These will be considered on a case-by-case basis. Some may be funded upfront, with Ofgem clawing back money if they fail to materialise. Others will only be allocated funding once work has actually begun.

And ODIs will describe “service level” outputs for which networks can be both rewarded and penalised.

Ofgem said some could be a mixture of all three types and that networks could propose bespoke outputs within their business plans. Some targets and incentives could possibly be relative and dynamic in nature. Networks could be granted rewards from a shared pot for the sector or judged based on their performance compared with their peers. Targets could become more challenging over time to keep driving incremental improvements.

Electricity North West said dynamic targets could be useful but only if they were absolute and mechanistic. Relative targets would make it harder to justify investment “as one cannot predict the behaviour of others”.

Cadent said dynamic targets should only be used in instances where improvements are bankable. It said relative targets would “disincentivise collaboration among, and the sharing of best practice across, networks” and should not be used at all.

SP Energy Networks was against both but described the new output categories as “reasonable and sensible”. They were also supported by Cadent, which said they mapped closely on to their own suggestions. Electricity North West said they do not capture the “full range” of consumers’ interests and put forward a longer list of five.

Commenting on the package more widely, Northern Gas Networks described Ofgem’s proposals as “the most complex set of arrangements that the UK regulatory framework has seen since inception. They are an order of magnitude more complex than those at RIIO1 and as such have failed in your stated objective of simplifying the regulatory framework.”

“The broader proposals conveniently move between explaining networks as very low risk because of their monopolistic nature, while at the same time bringing forward mechanisms that expose them to risks faced by companies in competitive markets such as exposing large elements of the expenditure base to competition and using dynamic and relative target setting to outcomes.”

Wider reaction

Ofgem obviously now views the current RIIO price controls as too generous to networks and is understandably keen to avoid repeating any mistakes. Its biggest worry appears to centre on its ability to make accurate long-range forecasts, especially when compared with the companies it is regulating.

Its proposals for RIIO2 – a shorter price control period, failsafe mechanisms and the new business plan incentive and sharing factors – reflect this. They are heavily focused on protecting consumers from windfall gains by networks, which Ofgem fears benefit from an asymmetry of information.

Some outside observers think Ofgem should have afforded more of its attention to other issues. The University of Exeter’s Energy Policy Group decried a “general lack of ambition” with respect to climate change: “There is an absence of decarbonisation targets and not even any recognition of the central role that the energy system has in driving climate change. This is not acceptable and needs to be front and centre of Ofgem’s focus.”

It said there is a “major gap” over the future of gas. While Ofgem cannot be the one to make a policy decision, by setting the issue to one side the regulator is “ducking their responsibility”. The group said there should be “carrot and stick” incentives for the delivery of low-carbon gas.

It also called for Ofgem to consider RIIO2 not in isolation, but alongside reforms to network charging and industry governance: “Increasing renewable energy implementation and use, demandside response, smart and flexible energy system, requires a changing system operation, market design, retail policy and network access and charging regime – all of which Ofgem is responsible for.

“Thus, Ofgem is a centrally important body for transforming the energy system. There is a complete lack of detail in RIIO2 on climate and this is untenable with what the science says is needed.”

Sustainability First lauded Ofgem’s decision to focus on the environment as one of the three output categories but said the regulator needed to flesh it out more. It said the requirement for annual sustainability reporting applied to DNOs within RIIO1 should be extended to all sectors.

The thinktank said the consultation sent out a “very low key and cautious message” with regards to the decarbonisation of heat and that the price controls should do more to encourage gas networks to deploy low and no-regrets measures.

The Institute of Engineering and Technology also took issue with Ofgem’s decision to adopt a narrow definition of “whole system”, which will only cover the networks themselves.

It said the implications would be “serious and far reaching”, preventing networks from “playing a wider part in the co-ordinated development of the end-to-end national energy system… This will result in additional costs to customers, and likely frustrations when smart energy systems crash or, going forward, fail to upgrade seamlessly.

“The core of the knotty problem is that Ofgem is operating within its traditional role and remit: perhaps Ofgem’s role should be redefined, and/or should there be another party who addresses whole end-to-end technical co-ordination? These would appear to be questions for government as much as for Ofgem.” Whether these concerns have been heeded, we will find out shortly.

The ESO

With the body now legally separate from the rest of National Grid, Ofgem is planning to introduce a “bespoke” price control for the electricity system operator (ESO) during the RIIO2 period. As an “asset-light, service-focused” business, Ofgem said the ESO is “markedly different” from the other network companies and its price control will reflect this.

For one, the business plan submitted by the ESO may be shorter than the others, covering two years rather than five. Ofgem said this would give the ESO the flexibility to adapt its activities in response to changes in the energy system.

To reduce any incentive to hold back spending that may benefit consumers, Ofgem also intends to remunerate the ESO using a passthrough of actual costs rather than the RAV model.

The baseline profit margin would be determined on an activity-by-activity basis that reflects the corresponding level of risk and the regulator would adopt an ex-post, evaluative approach to determining rewards and penalties.  It said an ex-ante, mechanistic approach risks creating “perverse incentives that encourage the ESO to focus on certain narrow targets”.

Ofgem has identified eight main activities performed by the ESO:

• Operation of the energy system in real time.
• Facilitation and operation of balancing markets.
• Management of transmission network cost and optimisation of network planning and security.
• Administration and design of charging and access arrangements.
• Administration of industry codes.
• Delivery of the capacity market and contracts for difference mechanisms.
• Development of strategy and innovation.
• Production of future energy scenarios and outlooks.

The regulator said splitting costs between activities would enhance transparency and make it easier to compare the ESO’s performance with that of similar organisations, including those outside of the energy industry.

Ofgem would claw back a share of any costs that are considered to be “demonstrably inefficient”. It also plans to implement a “cost trigger” mechanism requiring the ESO to notify relevant parties whenever its actual costs deviate too far from its business plan.

The ESO backed the decision to create a separate price control for RIIO2 but warned it will not deliver on its aims without some key changes: “Ofgem’s proposals cannot be accurately described as a pass-through arrangement because they include a disallowance mechanism and evaluative financial incentives, meaning that our revenues are at risk.

“We cannot know the risk we are running in this model because assessment is undertaken ex post, with significant discretion for Ofgem to decide the outcome.”

As a result, the ESO said it would incur higher financing costs and become more risk-averse, “reducing our capacity to be innovative and ambitious”.

The ESO said the two-year planning cycle would further add to uncertainty and create a “significant administrative burden” for itself and others and that a five-year cycle would be better.  It did, however, support Ofgem’s proposals to break its cost down by activity.

Setting out its alternative, the ESO said: “Our model proposes ex ante approved business plan funding, with a sharing factor to drive cost-efficiency, plus a ‘flexibility mechanism’ that enables the ESO to be responsive to changes in the landscape and to meet changing stakeholder and consumer needs.

“Every two years, new costs incurred under the flexibility mechanism would be subject to an ex post proportionate review by Ofgem, with the potential for disallowance of expenditure that meets an agreed definition of ‘demonstrably inefficient’.”