Should DSOs be separate from networks?

Having confirmed plans to completely separate the Electricity System Operator from National Grid and establish a fully independent Future System Operator by 2024, Ofgem is now exploring potential options for system operation at the distribution level. In the first of a two-part analysis, Utility Week looks at the positions taken by electricity distribution networks, both in their RIIO ED2 business plans and their responses to a call for input by the regulator.  

As part of the transition to a net zero energy system, distribution network operators (DNOs) are taking a more active role in the management of their networks, developing a series of distribution system operator (DSO) functions similar to those of the Electricity System Operator (ESO) at the transmission level.

However, in a call for input on the future of local energy institutions and governance issued by Ofgem in April, the regulator raised concerns that the current arrangements may not be suited to these functions, namely energy system planning, flexibility market facilitation, and real-time operation of local energy networks.

Ofgem said there are “institutional gaps and a lack of accountability” with regards to some functions, and even where there are clear roles and responsibilities, “it is not clear that these are assigned to the institutions best placed to perform them in future.”

Furthermore, there is also “insufficient, or ineffective, co-ordination between actors across the energy system at a sub-national level,” while “confusion and regional variances” could delay the transition to net zero.

Ofgem has therefore proposed four possible models for the future.

In the first, DNOs would continue to perform all DSO functions, with potential conflicts of interests being mitigated through internal separation. This could mean separating the DSO functions within the DNO, or creating a legally separate DSO under the same parent company.

In the second model, fully independent DSOs (IDSOs) would be established to carry out some or all of the DSO functions currently performed by DNOs. Ofgem said these IDSOs could be publicly or privately owned but would have separate parent companies to the DNOs.

In the third, DSO functions would instead be taken on by regional system planner and operators, which would develop regional energy system plans, perhaps with democratic oversight from local government. As well as electricity, these plans would cover other energy system vectors such as gas and heat. The regional system planners and operators would be fully independent from the DNOs but could be publicly or privately owned.

In the fourth and final model, DSO functions would be dispersed between different organisations, with the aim of maximising synergies within functions and allowing institutions to focus on their core competencies. Ofgem said there are various possible sub-variants to this model but, for example, suggested that the Future System Operator (FSO) could take on the role of market facilitator, whilst planning could be undertaken by a separate regional system planner.

Both as part of the RIIO ED2 business planning process and in direct response to the call for input, several DNOs have already indicated their opposition to all but the least radical of these options.

Conflicts of interest

In its RIIO ED2 business plan, Northern Powergrid stated its intention to create a new DSO business unit led by an executive director. This unit would feature an assurance function for progress monitoring and external reporting, which would facilitate an independent audit of investment decision-making processes.

However, the company said it does not believe that further structural changes, such as legal separation between DSO and DNO functions, would be justified, arguing this would undermine synergies between the two sets of functions and weaken incentives in the regulatory framework to optimise costs.

The company defended this position during an Ofgem open hearing in March in which Justin McCracken, chair of Northern Powergrid’s Customer Engagement Group, raised concerns over a potential “conflict of interest between the DSO’s role as a purchaser of flexibility and its role as a neutral facilitator of flexibility markets.”

Chief executive Phil Jones said this risk is “perceived” rather than “real.”

“Often people say, well, you’d rather build copper, wouldn’t you, that you’ll always seek to do that,” he remarked. “If that were true, I’ve yet to have it explained to me why there’d ever have been an underspend.

“It’s the same when we decided to use a short-term maintenance-oriented solution instead of a capital one, and I’ve been around a long time now and spent most of my career working with people to figure out how to do exactly those kind of things.”

He continued: “I just see flexibility as another way of optimising the total cost spend, so I think just to suggest that that is a particularly unpleasant form of substitute doesn’t make sense to me. It’s actually one of the most exciting and sensible forms of substitution.”

Jones described the legal separation of DSO functions as a “placebo” solution and said concerns over conflicts of interest could be adequately addressed through openness, transparency and external scrutiny. When asked by Ofgem chief executive Jonathan Brearley whether the company would make public disagreements between the DNO and DSO parts of the business, Jones responded: “Yes, absolutely.”

Speaking to Utility Week following Ofgem’s call for input, Northern Powergrid director of policy and markets Paul Glendinning says legal separation would “create additional costs for our customers to bear and reduce the significant benefit that an integrated DSO model delivers.

“As a combined entity we are uniquely placed to leverage synergies between the system operation and network operation component of our business. Separation further risks impacting service for customers by removing clear accountability from one party for delivering, and maintaining quality of, an essential service at the local level.”

“Some of the features in the other models have merits,” he adds. “However, given the enormous challenge of achieving net zero on time at a reasonable cost to customers we do not think it is appropriate for wholesale institutional change at this time.”

Weighing up the benefits

Scottish and Southern Electricity Networks (SSEN) has likewise expressed its opposition to DSO separation. In March, the company published a DSO action plan and an accompanying report commissioned from NERA Economic Consulting, which concluded that any benefits from separation would be “negligible” and likely outweighed by the 1-2% of avoidable additional expenditure that would be incurred through “more significant separation options.”

“To the extent there are benefits associated with DSO separation, they arise from avoiding perceived conflicts of interest the integrated DSO-DNO may have to favour network solutions over alternatives provided by Distributed Energy Resources,” the report explained.

“However, we find these benefits are likely to be extremely small, mainly because regulatory mechanisms already exist to mitigate any such conflicts of interest. We also find that DSO separation would interfere with achieving net zero, by absorbing substantial time and resources needed to achieve net zero and make transition to net zero more costly.”

The report instead recommended “ring-fencing”, which it argued would “avoid the perception of conflicts of interest”, while allowing DNOs to develop their DSO capabilities “without the loss of management time”.

“It also leaves open the option for Ofgem and government to pursue other separation options in the future, if evidence emerges that conflicts of interest exist, and the benefits of separation are material,” the report concluded.

Following the call for input, SSEN asked NERA to update its analysis and develop alternative proposals, which it presented to Ofgem in its formal response. SSEN said this new model, which it described as a variant of model one, would leverage key features of the others, whilst retaining synergies between DNO and DSO functions.

It would do this by creating the new role of a local net zero coordinator. NERA’s follow-up report said these entities would address “a gap in the current arrangements… wherein is no public body that is responsible for providing a strategic, long-term view on the path to net zero of local energy systems as a whole.”

SSEN said these “publicly-funded not-for-profit bodies” could be responsible for producing “local street-by-street transport and energy plans and scenarios” to be used by DNOs and gas distribution networks (GDNs), with democratic oversight from elected local net zero commissioners.

NERA said this model would help to address potential conflicts of interests that DNOs and GDNs may have but would avoid “separating the operational and investment planning activities that is likely to create inefficiency, or splitting the responsibilities for security of supply which could create a ‘moral hazard’ problem.”

Functional separation

Some DNOs appear to be more amenable to the kind of separation proposed by Ofgem in its call for evidence.

Ben Godfrey, DSO manager at Western Power Distribution (WPD) says the company is already working within Ofgem’s first model, having established a “functionally separate” DSO department over the last year.

He says the DSO functions will be externally audited and overseen by an independent scrutiny panel that he compares to the Customer Engagement Groups created as part of the RIIO2 process: “We see the DSO scrutiny panel that we put forward having a number of key individuals representing organizations and sectors that are involved in the DSO and flexibility space.

“And they will be able to provide expert opinion on where we should be heading and shaping our ambition to make sure that we’re delivering the best that we can do for customers.”

Godfrey says WPD did consider full legal separation as part of its ED2 planning but “steered away” from this option as “ultimately there’s no additional benefit in the short term for that kind of legal separation.”

“We’re still underneath the same license conditions and the codes,” he adds. “The only owner of the DSO would be the DNO so whilst it provides particular clarity on what was included within the DSO and what’s outside of the DSO, in terms of the conflicts of interests, we don’t think that legal separation by itself actually delivers any additional benefit.”

Godfrey cautions against making significant changes too quickly – i.e. during the course of the ED2 period – noting that DNOs are supposed to be “low-risk businesses”.

He recognises SSEN’s argument that further separation may create “artificial barriers” that could “stymie” progress and that the RIIO framework already provides strong incentives for the development of DSO functions. Furthermore, he says the planned establishment of the FSO during ED2 could offer valuable lessons on the effects of such institutional changes.

However, Godfrey also recognises concerns over potential conflicts of interests and says legal separation may be beneficial over the longer-term, describing WPD’s current plans as a “transitionary step”.

He says these benefits may emerge once the industry has headed “down the road of codifying and formalizing the DNO and DSO relationship.”

Godfrey say there may also be benefits in the more radical of Ofgem’s proposed models, stating: “I don’t think we should take anything off the table.”

He says it’s “very early” to say much about these models but “the call for call for input has done quite a good job of setting out what the potential landscape is.”

“I think the one thing for me that is missing in there is really the regulatory impact of some of these particular worlds,” he adds.

“We’ve got a very clear mechanism for delivering a combined ownership model one role, and we’ve got incentive based regulation, that really does quite a lot of the heavy lifting to make sure that there is sufficient competition between all 14 different license areas across the UK.

“We can see that if some of those boundaries were then a little bit more blurred and separate, separated across different companies, there would need to be a layer of arbitration and monitoring and financial mechanisms to be able to pass funding across those particular entities.”

Legal separation

UK Power Networks (UKPN) has taken a firmer position on separation, stating in its RIIO ED2 business plan that it intends to establish “an independent distribution system operator, as a legally separate entity, by no later than 2023”. The company said this business unit will have an independent supervisory board and will produce “an annual conflicts report which will be publicly available and highlight any conflicting decisions between the DNO and DSO.”

Suleman Alli, director of customer service, strategy, regulation and information systems at UKPN, disputes NERA’s conclusions that legal separation will have negligible benefits when compared to the costs: “Our view on it is when we look at the actual numbers ourselves, the marginal cost of separation in the way that we’ve described in our business plan is negligible compared to the value. It’s single digit millions compared to hundreds of millions of pounds of potential value.”

Alli says there are “progressive and modern ways” to achieve separation without duplicating systems: “We’ve taken a very pragmatic approach to trying to maximise the value for the lowest amount of marginal cost. It is possible to do.”

He says stakeholders have legitimate concerns over conflicts of interests, noting the varied responses of DNOs to changes in demand in terms of load-related investment: “If you look at the past, GB peak demand has fallen by about 12% over the last six years or so and if you look at the responses of other DNOs in terms of how they’ve responded to that exogenous change, in terms of the load-related expenditure, there’s quite a range of responses from those that have actually pared back expenditure and those that have not done so to the same extent.

“Now demand is only one indicator but it’s a litmus test and therefore I think stakeholders are wondering are DNOs responding appropriately to changes in exogenous factors based on past performance? And if the answer to that is no, then what’s going to be different in the future, where exogenous factors like the uptake of low-carbon technologies, like consumer behaviour change, are going to even more important; are going to have even more of an influence on potential investment needs?”

He continues: “That’s what stakeholders are saying to us and the only way we could address that and maintain the trust and transparency was to use a model which had significant separation to build that confidence, including a separate board and transparency reporting and all the other things that we put in our business plan.”

When asked about the more radical models put forward by Ofgem, Alli strikes a more cautious tone, saying: “As you move to the other models, what we need to think about as an industry and regulator is how would our requirements be met, how would we ensure clear accountability with sufficient control to be able to maintain reliability, maintain system security as well as deliver net zero at lowest cost.”

But he concludes: “It’s a really exciting time because Ofgem is again showing progressive thinking and trying to lead the way globally in terms of how distribution networks need to evolve and adapt to the changing environment.

“We think it continues to represent thought leadership by Ofgem in provoking thinking to say what is the right approach for the UK. And I think in the same way that the UK regulatory model has really set a standard for the rest of the world, I think the way in which we are evolving our thinking of local energy institutions and governance will hopefully do the same and maybe be a model for people to copy in other countries.”