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NETWORK / 12 / JULY/AUGUST 2019 REGULATION Challenges around RIIO2 Mark Fitch, an energy regulation expert at PA Consulting, asks will Ofgem's RIIO2 decision dampen the network companies' energy for moving to net zero? I n RIIO2 Ofgem aims to address its concern that the regulated networks sector is earning too much and deliv- ering too little. It is ercely focused on dealing with this problem but that brings a real risk that it will hold back the progress of the energy transition. That means there are a number of aspects of the RIIO2 decision that will require careful ne tuning to avoid unwelcome side e• ects. The rst of these is the level of outper- formance required to earn the expected returns. While Ofgem's decision includes positive noises on cost of debt and equity, it still represents a substantial drop in returns from today. It comes with few new oppor- tunities and clear risks around increased competition in investment; no rewards for overachievement of output targets; and penalties for companies who have costs removed by Ofgem from their business plans. The level of embedded expectation of companies to deliver e- ciency beyond Ofgem's view of an e- cient business plan will be critical to how the companies' man- agement react. Ofgem's decisions around the level of overall stretch will strongly in€ uence the inherent incentives and capacity of organi- sations to support the transformation of the industry and sustain a resilient energy future. Getting this wrong may end up with management e• ort focused on short-term delivery of outperformance to meet share- holder expectations, leaving someone else to think about the longer-term transition. The second area of concern is around declining company autonomy. Like Ofwat with its common performance commitments and focus on long term resilience measures, Ofgem appears to be moving away from trusting the industry to reinvest to deliver the energy transition for customers. Instead it is taking a more directive ap- proach to how, where and when investments are made. It will not reward overachievement in targets; and will penalise those who fail to deliver un- der its new Consumer Value Proposition. During RIIO1 companies have been deploying resources to create greater agility to deal with the increasing uncertain- ty due to technological advances, changing consumer behaviour and calls for quicker action on climate change. If Ofgem brings in a stricter and more structured regulatory framework it risks slowing progress in these areas as investments are delayed by the need for the regulator to assess and approve investments. Ofgem's proposals have made a clear separation between incentivising strategic innovation and day-to-day innovation. A new innovation funding pot will be created to replace the existing Network Innovation Competition to encourage answers to the huge challenges of decarbonisation, EV rollout and distributed generation. How- ever, with no separate funding for day-to- day innovation, the lowest ever capital rate for energy network companies and a costs incentive framework that rewards certainty Ofgem may see a decline in willingness to take on the risk of innovation. With less certainty in rewards for companies through the Consumer Value Proposition, it may well make them less innovative in the short term rather than more. Ofgem's proposed whole system ap- proach places far greater emphasis on collaboration and coordination. It has decided not to progress with the informa- tion sharing incentive outlined in Decem- ber's consultation document and now states that greater coordination and information sharing should be considered business as usual. Whilst network companies will have a reason to consider whole system bene ts through the Business Plan Incentive, there is no direct incentive to collaborate with each other on a much greater level. They have also been encouraged to propose solu- tions which incorporate options from, and bene ts to, the broader whole system as part of this approach. This could result in a company suggesting a project in its plan but Ofgem moving it, and the associated invest- ment, to another business on costs grounds, with the original proposer receiving no direct bene t.'Adopting the broader de ni- tion of whole system means Ofgem needs to design the detailed mechanisms to avoid a four-way sector ght for investment; which could otherwise prove a distraction from actually delivering the energy transition. The regulator's challenge will be to get the balance right across these four areas to ensure that the industry's proactive and enthusiastic approach to the energy transition is not sti€ ed and that all those involved have the right incentives to meet the challenges of the Government's net zero commitments. "Ofgem's proposed whole system approach places far greater emphasis on collaboration and coordination." will be critical to how the companies' man- Ofgem's decisions around the level of overall stretch will strongly in€ uence the inherent incentives and capacity of organi- sations to support the transformation of the industry and sustain a resilient energy future. Getting this wrong may end up with management e• ort focused on short-term delivery of outperformance to meet share- holder expectations, leaving someone else to think about the longer-term transition. The second area of concern is around declining company autonomy. Like Ofwat with its common performance commitments and focus on long term resilience measures, Ofgem appears to be moving away from trusting the industry to reinvest to deliver the energy transition for customers. Instead it is taking a more directive ap- proach to how, where and when investments are made. It will not reward overachievement in targets; and will penalise those who fail to deliver un- der its new Consumer Value is no direct incentive to collaborate with each other on a much greater level. They have also been encouraged to propose solu- tions which incorporate options from, and bene ts to, the broader whole system as part of this approach. This could result in a company suggesting a project in its plan but Ofgem moving it, and the associated invest- ment, to another business on costs grounds, with the original proposer receiving no direct bene t.'Adopting the broader de ni- tion of whole system means Ofgem needs to design the detailed mechanisms to avoid a four-way sector ght for investment; which could otherwise prove a distraction from actually delivering the energy transition. The regulator's challenge will be to get the balance right across these four areas to ensure that the industry's proactive and enthusiastic approach to the energy transition is not sti€ ed and that all those involved have the right incentives to meet the challenges of the Government's net zero commitments. coordination." PAYING FOR THE NETWORKS