Utility Week

14 | 30TH NOVEMBER - 6TH DECEMBER 2018 | UTILITY WEEK Policy & Regulation Analysis A s the film First Man reminded us, Neil Armstrong conquered the paradox of turning one small step into one giant leap. As regulated asset businesses look to the next stage of their evolution, it is clear they face a similar challenge. Regulators, politicians, policymakers and the public are demanding more from these businesses in a future world that is a giant leap from the cur- rent position. Regulated asset businesses are naturally cautious, engineering-focused and evidence- based, more accustomed to taking small steps, so how can these businesses make the necessary changes? Answering that question requires an understanding of the evolution of regulation and associated political and public pressure, where the businesses are and the scale of the challenge. The diagram "Evolution of elec- tricity and water regulation", right, maps out these factors. Regulation has developed significantly since its inception post-privatisation. The initial RPI-X regimes focused on cost reduc- tion and point incentives such as the inter- ruptions incentive in electricity. These were effective in driving cost out of the busi- nesses, reducing prices for customers and improving baseline performance. They were far less effective at delivering an improved customer experience, ensuring asset invest- ment was correctly focused and encouraging innovation. The subsequent regimes aimed, to an extent, to address these issues. RIIO1, across gas and electricity distribu- tion and transmission, introduced a more sophisticated output-based regime, attempt- ing a more holistic approach and complex incentivisation model, with incentives such as the broad-based measure of customer satisfaction. Stakeholder engagement was given greater prominence but centred on the companies' view of what was right for cus- tomers rather than directly engaging in true customer centricity. It also "tipped its hat" to social obligation, centred on vulnerable cus- tomers and supporting the transition to the low carbon economy. PR14, in the water industry, trumped this and aimed to move to an outcome, as opposed to output model. Under this model, companies set their own outcomes and measures and introduced a radical approach to give customers a greater say in those success factors and the costs required to drive them. Both these regimes had merit and have undoubtedly achieved better outcomes for challenging political climate where, aer 30 years of post-privatisation progress, re- nationalisation is openly being discussed. Regulators are responding to this. PR19 sets out common commitments that will enhance regulatory scrutiny, a much lower Wacc is clearly signposted and there are clear pressures on corporate structures in the water industry. The RIIO2 regimes are further away, but Ofgem is very clearly addressing the same issues. Companies have made significant pro- gress in responding to these changes but it is difficult to avoid the conclusion that they are continually having to catch up with the regulatory and political pressures. The network companies have achieved substantive cost savings and have trimmed down to become leaner efficiency-focused businesses, but they now need to embrace technical, organisational and commercial innovation to facilitate the emerging world of distributed energy. They, arguably, have four years to establish this, and forward- thinking companies are already planning for the challenge of a lower Wacc, greater cost and customer demands and a more innova- tive environment. The water industry is facing the big- gest challenges. Although PR14 was a more forward-looking regime, and has stimulated some efficiency gains, the scale of change required to position companies for the demands of PR19 is that much greater. Water companies cover the full value chain from source to customer including retail, with added interfaces and associated complexity. The water industry now faces its own tri- lemma of the most significant change in the shortest timescale, while bearing the brunt of the political pressure. How then should companies meet these new challenging targets and ensure they Regulated asset businesses need to make 'giant leaps' The mantra for utilities has for a long time been 'evolution, not revolution', but Mark Fitch and Liz Parminter say that today's business environment calls for more dramatic action. Regulated asset industries are naturally attuned to playing a long game, but it may now be time to turn that on its head customers, but that success has been almost completely overshadowed by the debate on corporate structures and financial rewards. While regulatory policy was focused on pro- tecting the interests of customers through greater efficiency and creating a flexible environment in which the right longer term decisions would be made, some owners were focused on capital structures and financial engineering. This was exacerbated by the setting of the weighted average cost of capital (Wacc), which, with hindsight, is generally recog- nised as having been high in a post-financial crisis world of sub-1 per cent interest rates. This has led to the development of a more

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