Where is Ofgem’s ED2 net-zero strategy?

Price-control design is both complex and “mission-critical”. At stake is how the billions of pounds of funding allowed by the regulator for distribution network operator (DNO) investment and operations will be shaped for the coming five years and beyond.

Rightly, there is a strong focus on cost-efficiency. But, concern about past returns shouldn’t wholly dictate the future. In getting the price-control “right” via the RIIO incentives, Ofgem can steer companies to deliver in ways which are ambitious and innovative across-the-piece, yet fair for both current and future consumers. Get the signaling wrong, and companies may simply perform “to the test”.

Ofgem has some important ED2 elements broadly right. But there is much detail to batten down before publication of the final methodology in December.

Faced with significant uncertainty on uptake rates for electric vehicles and electric heat in the next five years, Ofgem’s proposal to develop new and more “automatic” mechanisms for funding “uncertain” DNO investment – over and above initial baseline revenues – is helpful. Provided Ofgem can get the detail of this broadly right – neither over- nor under-rewarding the companies while not being too bureaucratic – this should afford the DNOs more flexibility for their future network plans. It should also enable them to support the legitimate net-zero ambitions of other stakeholders, in particular devolved government and regional and local authorities.

The new strategy delivery incentive – for large connections, for the DSO role and, importantly, for consumer vulnerability – is also welcome. DNOs are required to demonstrate delivery against common principles and new baseline standards (to “bank” ED1 improvements into BAU) whilst framing these within a broader company-level strategy. These strategies must be formulated with stakeholders and are intrinsic to development of the company’s business plan. Key to this new model is “money-on-the-table”. Falling short on standards will be open to financial penalty. Delivering above and beyond can bring financial reward. This sends a clear signal to the companies that what they do in these areas is of real consequence.

So, why has Ofgem not introduced an equivalent strategy delivery incentive approach in the ED2 methodology for decarbonisation and net zero?

Rather, Ofgem has set out a broad environmental framework underpinned by far weaker reputational incentives. Given the ambition of Ofgem’s own Decarbonisation Action Plan, plus the CCC’s upcoming sixth carbon budget which will align with net zero, Ofgem’s reticence is puzzling. Other than their understandable “least-cost” message, what further signals does Ofgem wish to send to the DNOs via price-control incentives about the importance of concerted action on decarbonisation in ED2?

Building a more accurate environmental picture

There are some good elements to the proposed new environmental framework. Against ED1, the Environmental Action Plan (EAP) will include baseline standards and clearer expectation on common approaches. There will be more consistent and comprehensive environmental reporting of business carbon footprints and progress against long-run science-based targets, as well as other environmental indicators. Over time, clearer reporting via Annual Environmental Reports (AERs) will allow DNOs, the ENA, Ofgem and wider stakeholders to build a better-informed more accurate environmental picture – including cross-sector and cross-vector.

The energy networks generally have a strong corporate commitment to sustainability. But in the face of a tough price control, this could come under pressure. Across key environmental outcomes, what in practice would motivate DNOs to stretch themselves? On AER reporting, on distribution losses, and SF6 leakage there are only relatively weak reputational incentives. In some instances, these are actually weaker than in ED1.

Take distribution losses for example. The picture is complex, but these amount to around 6 per cent of all electricity generated. Losses are set to rise with new net-zero investment and heavier network loadings This is an issue for both efficiency and emissions. Losses represent ~95 per cent of emissions associated with DNO business carbon footprint today (but will reduce in the long-run with more renewables).  All the more reason therefore for Ofgem to retain the present ED1 financial incentive for losses (or something akin) to signal to companies that losses do indeed matter and that finding new approaches to measurement and eventual better management are a must. Under current proposals, companies will be financially incentivised to connect new low-carbon technologies but not similarly incentivised to consider associated losses.

Ready-made solution

Ofgem says it has not ruled out considering how financial incentives for environmental outputs could drive additional value for consumers in ED2 and we would urge them to look hard at the options. But in practice there is a ready-made template with the strategy delivery incentive adopted for other areas. A company strategy for decarbonisation and net zero would bring together a cross-cutting incentive mix: clear baseline standards, a mechanism to ensure companies deliver on commitments, financial incentives with some metrics to stretch performance, plus reputational incentives where outputs are not yet readily measured or assessed.

In a similar vein, the distribution system operator (DSO) principles and baseline standards set out by Ofgem are largely silent on delivery of near-term decarbonisation and net zero. There is a strong case to consider a specific duty around decarbonisation and net zero right across the DSO role (network planning, connections, operations, despatch and market development). Such a DSO duty would sit well as a part of Sustainability First’s proposed approach on a strategy delivery incentive. It would also sit well with whole-system thinking.

To conclude: Ofgem should step back and consider the overall ED2 package in-the-round. If certain areas of DNO activity are singled out for financial incentives to stretch company ambition and delivery, but not others, what sort of signal does that send? Senior managements will inevitably focus on those areas with money on the table. Unless incentive arrangements for decarbonisation and net zero are treated in an equivalent way we will be looking at incrementalism and not the step-up needed for ED2. Which in turn could make Ofgem’s task of delivering on its Decarbonisation Action Plan and UK net zero all the harder.