The bridge to RIIO3

Ofgem has belated kicked off the process of examining what the next round of price controls could look like. Maxine Frerk asks whether the regulator has left it too late to entertain it more radical suggestions for overhauling the price control process. She also points to some worrying omissions when it comes to thinking about the future of gas networks.

It’s a bit like painting the Forth Bridge. RIIO ED2 (the electricity distribution price control) isn’t yet wrapped up and already Ofgem is starting the process for RIIO3, with an open letter inviting initial views.

It was a strange letter that had the feeling of something cobbled together in an afternoon after a brief conversation with the transmission networks. Ofgem clearly felt it couldn’t just put out an open call for input without giving some direction but aside from the observation that there’s a lot that needs doing on electricity and a lot of uncertainty on gas it did not say much.

Contrast that with the open letter that kicked off RIIO2 which was three times the length and set out the high-level principles Ofgem expected to follow, including a stronger voice for consumers, simplifying the framework and a more adaptive approach.

Or the equivalent consultation kicking off PR24 for the water sector in December 2020 (ie nearly a year earlier in the process) which included a comprehensive review of the lessons learned in PR19 and the launch of an Ideas Lab to let companies and others feed in thoughts on how to improve the framework against some clear high level challenges set out by Ofwat.

Given the short timescale it is worrying that Ofgem’s letter is essentially inviting views on whether they should take a completely different approach from RIIO – going back round the loop on negotiated settlement, ex post rate of return regulation etc. Ofgem went round these more radical ideas at the start of RIIO2, which just wasted a lot of time so that in the end the whole process for transmission and gas distribution was highly compressed. The Sector Specific Methodology was only published in May 2019 with draft business plans due to be submitted just over a month later. That should be the first lesson from RIIO2 – ensure there’s enough time to do a good job.

That said, Ofgem is absolutely right that the scale and nature of the challenges ahead means that some things do need to change. However, the RIIO framework is pretty flexible and a focus on incentives, innovation and outputs must still be right. Any move away from the regulated asset value model (which has just been hailed as the way to deliver nuclear) would clearly spook investors. So, the question is how the RIIO model can adapt to meet the new challenges – and the answer needs to vary much more explicitly by sector.

On electricity transmission, which appears to be top of mind for Ofgem, there has been a huge amount of work going on in response to the government call in the British Energy Security Strategy for networks not be a barrier to the ambitious levels of renewable generation targeted for 2030. National Grid Electricity System Operator(ESO) has set out the strategic investment projects it considers are needed based on its Holistic Network Design. Ofgem has then consulted on accelerating onshore investment – effectively giving a green light to the need for the investment identified by the ESO and streamlining the current RIIO processes for looking at the proposed costs. This provides a template for how T3 needs to evolve.

Longer-term view

These major investments don’t fit into neat 5-year packages and the plans have to start with what is needed to meet net zero and long-term political goals on energy security. But this accelerated approach has been designed to work alongside the existing RIIO process and should provide a role model for how it might work going forward. That would leave the 5 yearly price control for transmission playing a smaller role but still an important opportunity for a stock-take on cost of capital, operating costs and wider environmental actions, for example.

On gas, Ofgem really needs to get its thinking cap on – and to have some serious conversations with government (including in Scotland and Wales given their remit on heat). Apart from the obvious point that the direction for heat decarbonisation is still unclear, the letter offers no suggestion about what that means for GD3 – and the ideas that Ofgem floats based on the challenges in transmission simply don’t read across to gas. In terms of the future direction they suggest there are equally credible scenarios of “steady demand” or “declining demand” – which is an odd framing of the challenges ahead. The big question is what scenarios should the gas distribution networks (GDNs) be planning for in terms of the role of hydrogen. The lesson from ED2 is that you can’t simply leave it to the networks to pick their own scenario. Uncomfortable as it is, the regulator ultimately has to specify a scenario against which to allow baseline funding (and for benchmarking) with clear mechanisms for flexing the plan in the light of different outcomes.

As a part of this process Ofgem needs to force the GDNs to start to articulate what a closure of parts of the gas network would look like – not just the hydrogen future they would like to see. Clearly safety has to be maintained while there are any customers still connected to the network but you cannot have the last few customers picking up the tab for the whole network. And if hydrogen is part of the solution for domestic heat what actually does that involve and what is the cost. If there is a lesson from transmission it is the need to look beyond the 5-year price control window to start to form a longer term view of the implications of different 2050 pathways for gas.

Finally for electricity distribution it is hard to think about ED3 while ED2 is still being finalised. But at some level the issues that have been key to ED2 – the distribution system operator role and the balance between reinforcement and flexibility – will be the same going forward but in spades. Capturing the learning from the current process will provide pointers to the changes needed for ED3.

In each case the problem isn’t the regulatory design per se but being clear on the outputs that matter and how to design the incentives to deliver them – and how to make the process more flexible to cope with the uncertainties.

The one question that Ofgem don’t seem to be asking is whether they should be looking to align the timings for the different price controls. The idea has been floated before as a way to encourage whole systems thinking but rejected as it creates resourcing problems for the Ofgem team. But it would at least allow a period for proper reflection before the next cycle which they don’t have with the current overlapping controls (and inevitable CMA appeals).

Of course, the Forth Bridge repainting problem was eventually solved back in 2011 when Network Rail found new techniques and products that meant that it won’t need to be re-painted for at least 25 years. Ofgem aren’t going to be able to pull off that trick but some fresh thinking, focussed in the right direction, is clearly required.

Maxine spent 15 years at Ofgem, latterly taking on responsibility for all aspects of the regulation of distribution networks. Since leaving Ofgem she has been working as an independent consultant for a mix of regulated company and consumer / community group clients.