Who needs innovation?

Regulatory models need predictability, but innovation is by definition disruptive. Charles Ford looks at how regulators are trying to square this circle and encourage utilities to be creative.

Innovation and the economic regulation of utility assets are not the easiest of bedfellows. But, despite the fact that economic regulation has typically entrenched long-term thinking, innovation – challenging the assumptions underpinning such models – has the potential to deliver more for less.

Any environment where the cost of provision is largely agreed and embedded upfront, risks leaving little flexibility to allow for innovators to enter and disrupt. So how do you leave space for innovation?

Unsurprisingly at a time when significant change to network use is expected, policymakers and regulators are focused on this conundrum. Many hours and days have been spent reimagining the regulatory landscape and considering how regulation can incubate technological, operational and financial innovation to ensure the industry is able to respond to change and implement it.

Since privatisation, a large amount of the regulatory activity in the utility sector could be characterised as incentivising incremental innovation in the context of a regional monopoly provider. By stimulating competition between providers and permitting investors to share in the benefit of outperformance, regulators have driven efficiency. That structure has also promoted information exchange, with the regulator promoting a symbiotic relationship.

However, these traditional approaches were felt to have been a bit blunt. The perception was that metrics applied across a utility business did not distinguish sufficiently between spheres of activity, nor did they sufficiently support significant investment in network change. The regulator could not demand rapid innovation; it could merely assess how incremental improvements had been made.

So policymakers and regulators have increasingly looked beyond this incremental approach at more proactively managed regulatory models such as the independent infrastructure provider framework used for Thames Tideway, unbundling of customer-facing services, offshore transmission owners, competitively appointed transmission owners, and the broader RIIO programme. In effect, these new models bring regulatory innovation, which helps drive inputs as well as measuring outputs on the traditional regulatory basis.

Contestable opportunities

An area of common focus for policy­makers and regulators has been to increase the contestable opportunities in each sector through carving out standalone projects. This has allowed them to:

•    achieve specific outcomes;

•    address the historic concerns with the past inefficiency in the promotion of new infrastructure by providing for a more focussed regulation;

•    drive efficiency though competition – in turn driving innovation and better value for money for customers.

At the same time as looking to stimulate competition among providers within those aspects of any network that are supported through economic regulation, policymakers and regulators are looking to areas of the industry that can be broken apart from the core of the utility business that benefits from regulatory support. So, to take an example, customer-facing activities can be exposed to consumer choice and real market innovation as the costs that underpin these do not justify any particular economic support.

In the traditional geographic monopoly model, technical innovation has largely been supported by reward for doing something cheaper. To take an example, ice pigging in a novel way can bring efficiencies in cost to network owners in the cleaning of water pipes. The regulatory model allows the utility and its investors to take the benefit of the early cost saving compared with the basis allowed for in the regulatory settlement, while allowing the consumer to ultimately take the long-term benefit of the efficiency by resetting the long-term operational expectation. But the technology has its limits – it does not uprate the pipe capacity.

What about technology that responds to changes to the network’s need? How should regulation help drive and respond to that, and the short-term risks of developing new technology before it is certain to be a deliverable solution?

One example of regulatory thinking on this point is Ofgem’s introduction of an incentive to support the development of technologies that will address the new demands forecast to be placed on the network in the foreseeable future. More will be able to be gleaned from Ofgem’s thinking now that the successful bidders for 2015 have been confirmed.

So what about new technology that does away with the need for the network altogether, or a part of it?

Where the network owner has accepted usage risk, the regulator’s job is comparatively easy: the market will decide between the regulatory supported cost of provision using the existing technology and the market price of the new technology.

Where the network owner is funded on an availability basis, policymakers and regulators may have a harder question to assess: will the adoption of the new technology prior to the end of that support period be sufficiently beneficial to justify the costs of bringing to an early end the regulated provision (or allowing it to carry on potentially unused and running in parallel)?

Finding the balance

If the benefits of efficiency are socialised into reductions in wholesale or consumer cost distributed across all users, the question of who benefits is comparatively easy to answer, but what about innovation that benefits a small section of a community?

Differentials in the provision of essential services are not politically popular, particularly where it is acknowledged that returns are supported by explicit or implicit public sector support. Having developed a new regulatory regime that embraces innovation, the next headache for policymakers and regulators will be to ensure that the benefits are appropriately shared.

Charles Ford, counsel and member of the infrastructure, energy, resources and projects team, Hogan Lovells