Who should pay for the gas networks of the future?

Writing for Utility Week former Ofgem senior partner Maxine Frerk explores the responses to the regulator’s vision for the RIIO3 price control. In particular, she examines what it means for gas networks.

As Ofgem digests the responses to its RIIO-3 Sector Specific Methodology Consultation (SSMC) one of the biggest issues it faces is what to do about the gas networks.

Gas demand is expected to decline significantly over the coming decade(s) with the shift away from gas fired generation and the gradual move to electrify heat in the domestic and industrial/ commercial sector. There are debates about how fast that will happen – and as the Climate Change Committee has highlighted, the government is falling well sort of its targets in this space. However, the direction of travel is clear.

Equally it should be clear – but sometimes seems to get forgotten – that for as long as there is gas in the pipes they need to be maintained and kept safe. The level of investment in gas networks is not linked to the level of demand in the way that it is in electricity, which leaves a declining customer base paying an ever-higher unit cost.

GDNs push back against RIIO-3 proposals

As part of its SSMC Ofgem has started a welcome debate around how to manage this problem and avoid future customers picking up more than their fair share of network costs. Shorter asset lives is an obvious answer and indeed, back in 2013 as part of GD1, Ofgem moved to a “sum of digits” depreciation model for gas – which means higher depreciation in the earlier years – anticipating just this problem. At the time Ofgem said that it would revisit the issue of asset lives in GD2 when it hoped the position would be clearer. That review never happened. As a result, gas network assets are still depreciated over a 45-year asset life which for assets installed at the end of GD3 would take us to 2076, which looks increasingly untenable.

In their responses to the SSMC all four of the gas distribution networks (GDNs) push back against the need to revisit depreciation rates on the grounds that it is premature and risks spooking investors – citing difficulties they already face in getting longer term loans, for example.

However, what is most important to investors across the utility space is regulatory certainty and stability. It would be a naïve investor who wasn’t alive to the fact that ultimately we will need to move away from natural gas – what matters is that this happens in an orderly way and that assets aren’t stranded. Ofgem acknowledges this and has explicitly said that it is likely not in consumers’ interests for asset stranding risk to sit with investors.

This is important because what happens in gas will shape how investors across the utility space view regulatory risk – including investors in the new RAB models being introduced for nuclear and hydrogen. The messaging is therefore really important.

However, as the GDNs make clear, Ofgem doesn’t have all the tools at its disposal to deal with stranding risk and there needs to be a clear, joined up position with government. Ultimately it will probably have to be taxpayers who pick up any residual charges and decommissioning costs – as, by definition, at that point there won’t be any gas customers left to do so.

The GDNs are all calling for discussions between industry, government and Ofgem on the big picture around a “RAV recovery framework” and decommissioning costs. In my view, these shouldn’t be conversations behind closed doors but should include wider stakeholders and consumer groups, as advocated by the charity Sustainability First. Transparency should also give greater confidence to the range of debt and equity investors involved.

Unsurprisingly at this stage, the GDNs also all argue for a higher cost of capital, reflecting the asymmetric risk around stranding. However, to reject actions that Ofgem proposes that would mitigate the stranding risk but then demand compensation for that risk feels inconsistent. It is also worth remembering that the CMA in judging the GD2 appeals concluded that the answer on asset stranding was to reduce asset lives, not to increase the cost of capital. The GDNs look like they might be planning to test that again.

These issues aren’t unique to the UK

In France the regulator (CRE) carried out a study of gas network needs through to 2050. In setting the latest gas network price control they concluded that despite the fall in consumption, the size of French gas infrastructure is unlikely to change significantly between now and 2050. Moreover, gas operators’ costs are not expected to fall in the same proportion or at the same rate as gas consumption, leading to an increase in the unit cost of transmission – what they call the “scissor” effect.

To address this CRE had consulted on reprofiling depreciation or reducing asset lives – or ceasing to inflate the RAB in line with inflation (which has a similar effect). As with Ofgem’s proposals, the CRE received pushback around the change being too quick and adding to current high bills. Having already reduced asset lives to 30 years for gas distribution in the previous price control they decided to simply extend that to transmission and also to end indexation of the RAB for new assets.

An Oxera report commissioned by the GDNs summarises the range of approaches taken across a number of other countries. For example, Germany is looking for all assets to be fully depreciated by 2045, unless being repurposed to hydrogen, and is proposing to give more flexibility to the networks to take account of regional differences, with the aim “to prevent remaining customers from having to bear excessive cost”. The Netherlands use a flexible model of accelerated depreciation that can be readily adjusted over time. While there is no silver bullet it is clear that regulators internationally are all grappling with this issue.

How should Ofgem move forward?

To navigate through this, Ofgem needs to bring the debate back to its original question of how to avoid future consumers paying disproportionately for network assets.

The GDNs may be right that their networks will still be needed for decades to come. Ofgem says that decommissioning is unlikely before the 2030s but in reality (assuming we stick with a consumer led transition) it will be well beyond that before every single customer on a particular part of the network moves off, allowing it to be shut down. Acknowledging that is important and will help with investor confidence.

But that is a separate question from how the costs of the network should be recovered to avoid leaving a small base of future customers carrying a very large cost – in particular if significant industrial loads move away early.

The unit costs will be high anyway given the need for ongoing maintenance and, at some point, government will almost certainly need to step in. However, as regulator, Ofgem should be doing what it can now to mitigate that problem – as regulators internationally are doing.

What matters then is that the approach adopted builds on established models (to maintain investor confidence) and, at this stage, takes a conservative view on the likely rate of decline in gas demand to avoid over-burdening today’s consumers.

Ofgem’s objective of a stable unit charge for network depreciation feels right. But the challenges in forecasting demand make it unsuitable as a model for actually setting the depreciation rate. Shorter asset lives with the current sum-of-digits depreciation model would help bring us closer to that desired outcome, while being a familiar approach.

Getting a joined-up position with government is harder. Ofgem has recently called for government to reach a hydrogen heat decision as quickly as possible – and they are undoubtedly already talking with officials about the big picture issues around stranding and decommissioning. With a July election there is more prospect of an early political steer but there are plenty of other pressing energy questions for an incoming government to deal with so we shouldn’t hold our breath.

None of industry, politicians nor the main consumer bodies will want to see bills rise in the short term – and all would probably be happy to kick the can down the road. With only a month to go until the Sector Specific Methodology Decision is due out, Ofgem may therefore be tempted to put this on the too difficult pile. For the sake of future consumers, who don’t have a voice in these debates, I hope it doesn’t.

More coverage on the responses to Ofgem can be found on the Utility Week website, including the points made by the gas networks. We also explored Citizens Advice’s views on how any possible gas network decommissioning costs should be handled and its concerns around output delivery incentives for the ASTI framework.