RIIO2: A big idea?

Former Ofgem executive Maxine Frerk mulls over the regulator’s recent decisions concerning RIIO2 and its efforts to introduce more flexibility to the network price controls in the face of great uncertainty.

As Ofgem’s RIIO2 draft determinations have sunk in and having now ploughed through the electricity distribution sector specific methodology consultation, I think I’m starting to see what Ofgem are trying to do. But it still needs a lot more thought. With “Net Zero” having risen up Ofgem’s agenda and acknowledging the uncertainty about the pathway for getting there, Ofgem has decided it needs to do network regulation differently.

This was initially set out in the Decarbonisation Action Plan, launched on Jonathan Brearley’s first day as CEO where Ofgem said: “we will make the network price control regime more adaptive to deliver the most effective transition at lowest cost”. At the time I skimmed over those words – making the regime more adaptive is one of those motherhood and apple pie statements that you can’t disagree with. But it turns out this was Ofgem’s big idea.

The problem is that there has not been a clear articulation of what this means.

Wind back three years and in an article in Network magazine you can find Jonathan, new in Ofgem, talking about his view that Ofgem needed to be more adaptable and respond more quickly. He drew a contrast between the public policy world, where you take ages to design something but you really strive to get it right, and the private sector, which would tend to set something up and then adapt it as it goes along or even drop it if it doesn’t work. He suggested Ofgem might need to become more like the private sector. He said Ofgem hadn’t yet worked out how to be more flexible. The worry is that three years on they still haven’t worked it out and their proposals for RIIO2 actually cut across the adaptive way that Jonathan observes the private sector itself would want to work to cope with uncertainty.

Back then to RIIO2 and the draft determinations where Ofgem’s big idea was in essence to move a large slug of the money that would historically have been given as an upfront revenue allowance into an uncertainty mechanism to be dished out during the price control as the need becomes clearer. Probably the best articulation of their thinking is actually in the investor briefing they gave which both highlighted their very deliberate shift to put more into uncertainty mechanisms but even tried to paint a picture that this could mean more money ultimately for the companies given the criticality of net zero.

What worries everyone though is that this emphasis on uncertainty mechanisms relies on Ofgem making quick decisions if we are to avoid delays to investment in essential infrastructure. On the Utility Week call last week, Ofgem acknowledged that, but apart from re-iterating that they will need to be more agile they have said nothing about how they will achieve that in practice. And it’s not just about culture change; there are legal steps that have to be gone through and a need for engagement and consultation which all take time. There is also an implicit assumption that as time moves forward the need for investment will become more certain. Of course, some things will become clearer but given the timescales for infrastructure investment there will always be uncertainty and Ofgem are going to deal with that.

Moving on then to electricity distribution, Ofgem again recognises the challenge it faces around strategic investment to cope with the uncertain growth in electric vehicles and heat pumps. This time at least the debate is taking place up front as part of the methodology consultation and when I read the summary announcing that they had identified four potential models for dealing with strategic investment my heart lifted. Was this the new thinking that was needed to navigate through these challenges? But in turned out that Ofgem’s big idea here was a 2 by 2 matrix where you could use national or regional forecasts, with or without volume drivers depending on the level of certainty associated with the costs. In essence, it is about what numbers Ofgem should use to run its models, not a new way of thinking about the problem.

The focus on volume drivers makes a lot of sense as a more practical solution for distribution as it does not require Ofgem decisions in real time. However, there is a big question about what the right volume driver is. There is no acknowledgement in the consultation of the fact that the costs for networks will depend heavily on the extent to which EV growth is clustered, for example. Getting the design of volume drivers right requires both an economist and engineering perspective. As ever, Ofgem’s proposals feel rather light on the engineering input. But hopefully there is time on electricity distribution to work some of this through.

Overall then, Ofgem’s idea of “adaptive regulation” is a move in the right direction but if it is to be the big idea reshaping regulation then it needs a stronger intellectual underpinning and clearer articulation, as well as a mindset shift on some issues. There are resources that might help with that and could enable some genuinely new regulatory thinking for the new world.

First, a scan of the academic literature on adaptive regulation yields a taxonomy that distinguishes between unplanned adaptive (coping with Covid) and planned adaptive (RIIO price controls) as well as between mechanisms that are discretionary (re-openers) or automatic (volume drivers) with a framework for thinking about which to use when.

Another perspective is provided by John Kay and Mervyn King in their book Radical Uncertainty. They make the point that uncertainty won’t go away, which puts limits on a reliance on cost benefit analysis and the quest for an optimal solution. You have to go with something that is roughly right and that takes you in the right direction. Viewing spare capacity as inefficient is right in a stable world but it has value in an uncertain world.

Finally, stakeholder engagement has a central role to play in adaptive regulation. In an uncertain world you need a diversity of views and strong antennae to help navigate through the unchartered waters. There’s a strong case for putting more decisions in the hands of those impacted rather than trying to control everything from the centre. Ofgem’s apparent disregard for stakeholder views in their draft determination suggests they don’t yet really understand why it is so important in the new world.

None of this is easy. If a move to adaptive regulation is Ofgem’s big idea then it needs more thought. The opportunity exists through the current consultations although the scope for radical change may be limited at this stage. On draft determinations the urgent question is how to make the uncertainty mechanisms work in practice. On electricity perhaps we have to turn the question round to think about what an adaptable network looks like and how you regulate to facilitate that. The hope is that the companies can overcome their wider concerns about the proposals to help Ofgem find a way through that is more adaptive but also workable.