Utility Week

10 | 16TH - 22ND MARCH 2018 | UTILITY WEEK Policy & Regulation Analysis O fgem's RIIO2 framework – which is now open to consultation until 2 May – focuses on five key themes for regu- latory evolution: giving customers a stronger voice; responding to how networks are used; driving innovation and efficiency; simplify- ing the price controls; and fair returns and financeability. Building on principles The substance behind the first two themes will have raised few eyebrows on network boards, building as it does on established and broadly popular RIIO principles or other Ofgem planning. In the case of customer voice, changes primarily revolve around formalising the set-up of customer engagement groups at distribution level and user groups for trans- mission companies. Since most networks established engage- ment forums of some kind during the first years of RIIO1, this new requirement should be met easily. And when it comes to respond- ing to how networks are used, the RIIO2 pro- posals largely reiterate thinking set out in the Smart Systems and Flexibility Plan, pub- lished by Ofgem and the Department for Busi- ness, Energy and Industrial Strategy in 2017. Even confirmation of the hotly trailed reversion to a five-year timescale for RIIO2 – undoing the eight-year regime initiated in 2013 to support longer-term planning – has been met with relative equanimity. While most networks, with the notable exception of UKPN, told Ofgem they would ideally like to retain the eight-year control, no one is up in arms about the regulator's decision to push ahead with shortening it – largely because the framework has made provision for longer-term planning to be allowed in instances where networks can bring a com- pelling argument to the table. There's also a common acknowledgement of the fact that the eight-year RIIO experi- ment proved incompatible with load-related forecasting for power networks in a rapidly changing industry environment. On the third theme, network leaders will be relieved to see Ofgem intends to retain regulatory funds for innovation, albeit with a stronger focus on seeing transfer into busi- ness as usual and projects that address critical challenges for energy system transformation. Prior to the framework's publication, there had been genuine worry in some quar- ters that Ofgem would roll back the Network Innovation Allowance in particular, signifi- cantly reducing the amount of ring-fenced resource for explorations of new technology benefits and smarter ways of working. Setting outcomes It's the final two themes that are likely to prompt the most fulsome and concerned consultation feedback, however. Broadly speaking, there's a concern that these chapters indicate a move towards rate of return regulation rather than development of an incentives-based regime. There's worry in some quarters that this shi is indicative of a regulator that is susceptible to political influ- ence and responding to short-term economic trends at the expense of longer-term interests. On plans to simplify the price control, industry views are mixed. Some strongly sup- port the proposal to scrap the fast- tracking mechanism and Information Quality Incen- tive (IQI) used in RIIO1 to encourage more accurate business plan submissions. Others defend the mechanisms and will no doubt submit evidence in the coming months to advocate their retention. The most spirited defence is likely to emerge from West- ern Power Distribution, the only network to achieve fast tracking, and its associated pro- cedural and sharing factor benefits, for RIIO1. Ofgem's position is that widespread under- spends against forecast costs for RIIO1 show the fast tracking and IQI mechanisms have not successfully overcome perceived gaming of the regulatory regime by many networks. The regulator's consultation document claims networks have "systematically given forecasts that turn out to be significantly above their actual costs". Given the scale of the underspend seen to date under RIIO, it says it is "very hard to conclude that the IQI was effective in its primary purpose of getting companies to reveal their best view costs, despite the incentive that it offered". "Instead," the document concludes, "com- panies may have considered the gains from inflated forecasts (and their potential influ- ence on our baseline view of costs) would be greater than any foregone IQI rewards." Ofgem has proffered three potential solu- tions: amending the IQI across all sectors; removing the fast-tracking route for distribu- tion; or replacing both the IQI and fast track- ing for distribution with a "single business plan incentive". With industry views on the effectiveness of both information quality mechanisms divided, someone is bound to end up disap- pointed by the regulator's final decision. Curbing returns But the most worrisome RIIO2 proposals for network leaders and investors come under the fair returns chapter. This section of the consultation document clearly shows Ofgem moving to pacify the very public concerns that have recently been expressed about the level of returns enjoyed by shareholders in monopoly utilities. It puts forward what one network leader describes as an "aggressive" preliminary approach to setting the cost of capital in RIIO2 as well as a set of other options for curbing network returns, including a pro- posal to "anchor" returns by capping the RAV-weighted average return across the sector at a predetermined level. Downward pressure on the allowed cost of capital was universally anticipated for RIIO2, with Ofgem chief executive Dermot Nolan having made it abundantly clear that the next price control would set lower bands for equity and debt costs in various letters and speeches over the past year. Nervousness over just how low the regu- lator might go will recently have increased, however, given the precedent set by Ofwat in setting the weighted average cost of capi- tal (Wacc) for PR19 – the water regulator outstripped the lower-end expectations of financial analysts when it announced in December that the AMP7 Wacc is set to settle at just 2.4 per cent. Five themes for framework Ofgem's keenly anticipated RIIO2 framework document is out, and as expected, includes some significant and controversial proposals for the future of energy network regulation, says Jane Gray.

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