Utility Week

12 | 13TH - 19TH APRIL 2018 | UTILITY WEEK Policy & Regulation Market view O fgem introduced the RIIO price con- trol framework to give network com- panies a level of revenue that covers their costs and allows them to earn a rea- sonable return, if they deliver value to their customers, behave efficiently and achieve Ofgem's targets. We are halfway through the first price control period (which ends in 2021/2023) and Ofgem is consulting on how it will regulate network prices for RIIO2. The RIIO2 frame- work consultation was published on 7 March with various changes put forward. How is RIIO2 shaping up? Overall, Ofgem thinks that RIIO1 has worked well and that the incentive-based RIIO frame- work is still appropriate for setting price con- trols. The framework does, however, need to keep pace with a period of significant change in network usage, and Ofgem pro- poses reducing the price review period from eight to five years, but there is flexibility to allow for longer periods if this will benefit consumers. Ofgem also seems to have listened to political pressure to curb what are perceived as excessive network profits. This means the new framework will entail lower returns for investors, reflecting the low level of risk of a stable regulatory framework. Most commentary has concentrated on the proposed equity returns of between 3 and 5 per cent (as opposed to the 6-7 per cent under RIIO1). This has not come as a shock. Ofwat also proposed a lower weighted aver- age cost of capital in its periodic review of the water industry but it is the cost of debt that will really matter, and this is still to be determined. There will be much more competition in RIIO2, with the "new, separable and high value" criteria being applied to all projects across transmission and distribution, elec- tricity and gas. The consultation breaks the framework down into five key themes: giving consum- ers a stronger voice; responding to changes in how networks are used; driving innova- tion and efficiency to benefit consumers; simplifying price controls; and ensuring fair returns. Three of these are examined below. Responding to changes in how networks are used During the RIIO2 period, the way networks are used will continue to change. There is likely to be an increasing uptake of electric vehicles and electric or renewable heat, peer- to-peer local energy trading, increased use of battery storage to smooth out demand and the rollout of smart meters for consumers. All this means that building new pipes and wires may not always be the best option. The consultation asks what network com- panies should do to encourage a reduction in energy use by consumers (that is, energy effi- ciency measures) to reduce future investment in the networks. This is an encouraging sign that Ofgem is adopting the whole- systems approach advocated in the Smart Systems and Flexibility Plan. Driving innovation and efficiency The two main points under this theme are that innovation should become "business as usual", and competition "for the market" should be extended to all sectors, not just electricity transmission. Network companies need to try innovative ways of keeping up with the current period of change. The Network Innovation Competition and Network Innovation Allowance seem set to continue in some form, but will be reserved for innovation projects that can demonstrate long-term value. There should be greater co-ordination with wider public sector innovation funding and support, such as BEIS' Energy Innovation Programme and the Industrial Strategy Challenge Fund. There will be much more competition in RIIO2. Ofgem proposes applying the "new, separable and high value" (£100 million- plus) criteria not just to electricity trans- mission projects but across all the network sectors: electricity and gas transmission and distribution, to identify projects suitable for competition. Ensuring fair returns Ofgem has not yet finalised its methodol- ogy for setting the cost of debt, so this is still open for debate. It suggests the cost of equity should be between 3 and 5 per cent, justified on the basis that, according to Ofgem, most companies are making double-digit returns in real terms when this is a low risk invest- ment. This was no surprise, given that Ofwat also went in low in its price review and given the political climate around energy company profits and a threatened renationalisation of the industry if Labour win power. Ofgem put forward various options for controlling returns, including a hard cap and floor, a discretionary adjustment to account for variations between forecast and actual performance and competition between net- work companies for incentives. What does this mean? Dermot Nolan, Ofgem's chief executive, warns that "this will be a tougher price con- trol for network companies" and there is a risk that political pressure to control returns may obviate some of the benefits of an incen- tives-based regime. There is still much to be positive about, not least the opening up of all network pro- jects to competition and the continued fund- ing for key innovative projects. It is also encouraging to see Ofgem taking a more holistic view of the energy system and trying to factor in new ways for network companies to work within this: not just building new capacity but also encouraging energy effi- ciency and the decarbonisation of heat. Now is the chance for network companies to input their suggestions on how best to do this. What remains to be seen as part of this process is the view around political risk in networks. It has been an area largely viewed as apolitical where rational economic deci- sions get taken. There is a sense around recent events and in the industry that the echoes from the very political retail debate on cost is beginning to impact on networks and this process. Watch this space. Richard Goodfellow and Paul Dight, partners, Addleshaw Goddard RIIO2: what's new? Richard Goodfellow and Paul Dight look at some of the key changes proposed by Ofgem for the next iteration of the RIIO price control mechanism and what it means for network companies.

• Cover