Is RIIO2 going according to plan?

Fernando Dominguez says network companies should expect the unexpected when preparing their RIIO2 business plans with net zero in mind.

With the government’s sights set on net zero emissions by 2050, the challenge for the regulated energy sector is how to adapt to facilitate delivery of this target. The adjustments required will depend on the approaches and technologies the UK chooses. For example, gas distribution companies will face different investment patterns if both heat and transport are decarbonised using electricity relative to one where either or both are decarbonised using hydrogen or biomass-based methane.

In the short term this translates into a significant challenge because energy firms, as part of their RIIO2 submissions, are required to put together five-year investment plans without having clarity about the long-term services they will be expected to deliver.

They must develop business plans that optimise the evolution of their networks against a range of different scenarios while at the same time ensuring that they are able to dynamically adapt activities and investments as additional information surfaces.

Strategies that prepare for multiple outcomes are likely to include activities and investments that ultimately may not be required. Ofgem’s final proposals for RIIO2 will therefore need to ensure that network companies are not penalised for decisions that may lead to stranded costs.

When putting together their business plans, companies need to ensure they reflect the different future scenarios. Importantly, business plans should explicitly consider the potential for uncertainty reducing the information available during the price control period, how this could change the activities that could be considered efficient, and how that is reflected in charges to consumers.

As such, energy companies need to develop business plans that include a package of tools and proposals allowing them to deliver efficient results for consumers. The process to develop this package can be divided into three crucial stages.

Ofgem tools

The first stage involves ensuring a good understanding of the different tools Ofgem is putting forward, including those already in place in RIIO1. For example, in RIIO1, Ofgem included a re-opener called the mid-period review (MPR) to account for the long duration of the price control (eight years). With the reduction of the regulatory period to five years, this MRP would seem unnecessary, but Ofgem has decided to keep some re-openers to facilitate changes in scope.

Even if the mechanism is the same, the way it will need to be implemented will be different. For the RIIO1 MPR, Ofgem spent significant time identifying the areas of the final determination that should be reconsidered. In RIIO2, Ofgem is likely to want to take less time, which means the process and objectives of the MPR would need to be clearly defined as part of the initial RIIO2 determination.

Consistent application

Once the different tools have been considered, companies will need to ensure that they apply them consistently. A clear framework will need to be established for the right tool selection, factoring in the types and levels of uncertainty faced. As part of this framework, companies will need to consider:

•  What is the type of uncertainty? Is it unclear whether or when the need for the investment will rise? Can the cost be quantified? Is there uncertainty about the outcome?
•  Does the company require that the uncertainty mechanism includes an ex-ante allowance?
•  When should the uncertainty mechanism be applied? (for instance, end of regulatory period versus in-period adjustments to revenue allowances).
•  Is there a clear method of appealing decisions taken once uncertainty is reduced?

Holistic plan

Once the right tools have been identified, it will be important to ensure these options are considered and presented as part of a holistic plan, explaining both how each is expected to work and, more importantly, the interaction between the different tools. This will help ensure Ofgem understands the relevant requirements and costs.

In the absence of well-articulated plans, companies could face significant financial challenges. For example, if Ofgem considers that there is not enough evidence for certain investments, then should the need for an investment materialise, the company may be required to absorb the costs. While the company can recover a share of this expenditure at the end of the price control period in the true-up of totex, it would still need to finance the full cost of the investment during the period as well as a share of the actual costs of the investment.

Mitigating risk

To mitigate this risk, companies should consider the following questions for each project they are putting forward:

•  What types of uncertainty are they facing for this project?
•  Using the framework discussed above, what type of uncertainty mechanism would the expenditure require?
•  Can any mechanism proposed by Ofgem be used to operate as the required uncertainty mechanism?
•  How does each possible uncertainty mechanism to be used in this case interact/integrate with uncertainty mechanisms being proposed for other projects?
•  How does the uncertainty mechanism interact with other components of the regulatory framework?

It is vital the decision for each project forms part of a broader strategic decision to ensure the package is both internally consistent and does not unnecessarily increase the burden on companies and the regulator during the regulatory period.

The answers to these questions will form the foundation of the proposals to be put forward to Ofgem, in such a way that companies can obtain the best outcome within a complex framework, helping the regulator to understand the plans and focus on delivering the best outcome for consumers.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions, position or policy of Berkeley Research Group or its other employees and affiliates.