RIIO2: Five themes for framework

Ofgem’s keenly anticipated RIIO2 framework document is out, and as expected, includes some significant and controversial proposals for the future of energy network regulation, says Jane Gray.

Ofgem’s RIIO2 framework – which is now open to consultation until 2 May – focuses on five key themes for regulatory evolution: giving customers a stronger voice; responding to how networks are used; driving innovation and efficiency; simplifying the price ­controls; and fair returns and financeability.

Building on principles

The substance behind the first two themes will have raised few eyebrows on network boards, building as it does on established and broadly popular RIIO principles or other Ofgem planning.

In the case of customer voice, changes primarily revolve around formalising the set-up of customer engagement groups at distribution level and user groups for transmission companies.

Since most networks established engagement forums of some kind during the first years of RIIO1, this new requirement should be met easily. And when it comes to responding to how networks are used, the RIIO2 proposals largely reiterate thinking set out in the Smart Systems and Flexibility Plan, published by Ofgem and the Department for Business, Energy and Industrial Strategy in 2017.

Even confirmation of the hotly trailed reversion to a five-year timescale for RIIO2 – undoing the eight-year regime initiated in 2013 to support longer-term planning – has been met with relative equanimity. While most networks, with the notable exception of UKPN, told Ofgem they would ideally like to retain the eight-year control, no one is up in arms about the regulator’s decision to push ahead with shortening it – largely because the framework has made provision for longer-term planning to be allowed in instances where networks can bring a compelling argument to the table.

There’s also a common acknowledgement of the fact that the eight-year RIIO experiment proved incompatible with load-related forecasting for power networks in a rapidly changing industry environment.

On the third theme, network leaders will be relieved to see Ofgem intends to retain regulatory funds for innovation, albeit with a stronger focus on seeing transfer into business as usual and projects that address critical challenges for energy system transformation.

Prior to the framework’s publication, there had been genuine worry in some quarters that Ofgem would roll back the Network Innovation Allowance in particular, significantly reducing the amount of ring-fenced resource for explorations of new technology benefits and smarter ways of working.

Setting outcomes

It’s the final two themes that are likely to prompt the most fulsome and concerned consultation feedback, however.

Broadly speaking, there’s a concern that these chapters indicate a move towards rate of return regulation rather than development of an incentives-based regime. There’s worry in some quarters that this shift is indicative of a regulator that is susceptible to political influence and responding to short-term economic trends at the expense of longer-term interests.

On plans to simplify the price control, industry views are mixed. Some strongly support the proposal to scrap the fast-­tracking mechanism and Information ­Quality Incentive (IQI) used in RIIO1 to encourage more accurate business plan submissions.

Others defend the mechanisms and will no doubt submit evidence in the coming months to advocate their retention. The most spirited defence is likely to emerge from Western Power Distribution, the only network to achieve fast tracking, and its associated procedural and sharing factor benefits, for RIIO1.

Ofgem’s position is that widespread underspends against forecast costs for RIIO1 show the fast tracking and IQI mechanisms have not successfully overcome perceived gaming of the regulatory regime by many networks.

The regulator’s consultation document claims networks have “systematically given forecasts that turn out to be significantly above their actual costs”. Given the scale of the underspend seen to date under RIIO, it says it is “very hard to conclude that the IQI was effective in its primary purpose of getting companies to reveal their best view costs, despite the incentive that it offered”.

“Instead,” the document concludes, “companies may have considered the gains from inflated forecasts (and their potential influence on our baseline view of costs) would be greater than any foregone IQI rewards.”

Ofgem has proffered three potential solutions: amending the IQI across all sectors; removing the fast-tracking route for distribution; or replacing both the IQI and fast tracking for distribution with a “single business plan incentive”.

With industry views on the effectiveness of both information quality mechanisms divided, someone is bound to end up disappointed by the regulator’s final decision.

Curbing returns

But the most worrisome RIIO2 proposals for network leaders and investors come under the fair returns chapter. This section of the consultation document clearly shows Ofgem moving to pacify the very public concerns that have recently been expressed about the level of returns enjoyed by shareholders in monopoly utilities.

It puts forward what one network leader describes as an “aggressive” preliminary approach to setting the cost of capital in RIIO2 as well as a set of other options for curbing network returns, including a proposal to “anchor” returns by capping the RAV-weighted average return across the ­sector at a predetermined level.

Downward pressure on the allowed cost of capital was universally anticipated for RIIO2, with Ofgem chief executive Dermot Nolan having made it abundantly clear that the next price control would set lower bands for equity and debt costs in various letters and speeches over the past year.

Nervousness over just how low the regulator might go will recently have increased, however, given the precedent set by Ofwat in setting the weighted average cost of capital (Wacc) for PR19 – the water regulator outstripped the lower-end expectations of financial analysts when it announced in December that the AMP7 Wacc is set to settle at just 2.4 per cent.

It’s unclear yet whether the network Wacc will equal or even exceed this historic low, given that Ofgem has not made any firm decisions on its formula for setting the cost of debt over the next price control.

However, it has used a very similar methodology to that employed by Ofwat for setting the cost of equity – the baseline rate of return that it considers necessary and sufficient to attract investment.

The suggested range for RIIO2 is between 3 and 5 per cent, which compares with a RIIO1 level of between 6 and 7 per cent.

Some network leaders will no doubt take issue with the methodology for making this cost of equity assumption. There’s a school of thought, for instance, which argues current negative risk free rates – a consequence of quantitative easing in the wake of the global financial crisis – are likely to be a relatively short-lived phenomenon and should not unduly influence the regulator’s calculations.

However, with Ofgem stressing that its cost of equity calculation remains extremely tentative at this stage, executive teams may hold their fire for more critical financial elements within the framework – for instance, seeking to influence progress on the cost of debt methodology, which was the dominant factor in finalising the Wacc – and giving feedback on a range of other measures proposed to introduce tighter control of network returns.

For example, Ofgem’s option of capping the regulated RAV-weighted average return across the sector in order to provide absolute confidence that the sector as a whole will not achieve an excessive return on regulated equity, was met with some consternation by at least one power network.

A senior network spokesperson tells ­Utility Week such an approach to curtailing returns could significantly undermine the incentives-based principle on which RIIO was originally built, since outperformance benefits would be slashed if the sector performed strongly across the board. They say anchoring would “introduce a high level of uncertainty around the accessibility of outperformance incentive payments and drive up the risk involved in investment”.

Ofgem’s appraisal of the potential pros and cons of its options for controlling excessive returns are summarised in the table below.

Overall, networks have received their draft framework for RIIO2 with reserved positivity. Official and unofficial comments on the consultation document approve the emphasis on customer value and continued support for innovation – including plans to extend this to third parties and to focus funding on projects that promise to uncover resolutions to key energy system transformation challenges.

But there is a palpable nervousness that the regulator’s schemes for ensuring “fairer” network returns could become overzealous and undermine the effectiveness of the RIIO regime’s performance-focused incentives.

Next steps to refine the framework are likely to bring an escalation of this tension between the need to address immediate political and economic issues and the need to retain the interests of patient capital.