Incentivising utility networks to improve consumer outcomes

Regulators seek to protect the interests of current and future consumers by reducing unwarranted expenditure, while encouraging companies to innovate to achieve long-term benefits. Used well, regulatory incentives focus management attention, justify investment decisions, and align company behaviour with what consumers value most. But unrealistic targets, inappropriate methodologies, or weak lines of sight between action and reward don’t just fail to drive improvement – they actively undermine it.

As a result, today’s regulatory incentive regimes seem geared towards penalty over reward, making it difficult for companies to fund and implement innovations that lead to better service for consumers. The challenge for regulators is designing today’s incentive frameworks for a system that is fundamentally more complex than previous eras.

A changing system built on old assumptions

The logic underpinning incentive-based regulation was developed in a relatively stable environment. Demand growth was predictable, networks expanded incrementally, and performance improvements could be expected year on year as companies caught up with best practice.

Today’s system looks very different. Energy network companies face rapid electrification and increasing asset utilisation, aging infrastructure, energy network and water companies all face exposure to severe weather and climate impacts, volatile global supply chains and labour constraints, and an expanding set of policy objectives to adhere to. Yet many incentives still assume that improvement is linear, performance is largely controllable, and risk can be managed. As that gap between assumption and reality grows, incentive design matters more than ever.

Incentive design weaknesses have real consequences. Companies increasingly focus on downside risk rather than pursuing upside opportunity. Resources are directed to maintain baseline performance and mitigate exposure, rather than towards innovation, resilience, and optimisation. Consumer funding is often used to avoid penalties rather than support new or higher value outcomes. Over time, this dynamic can dampen ambition, discourage risk taking, and undermine the very innovations that incentives are meant to unlock. The system ends up rewarding ‘not being bad’ rather than ‘being better’.

So, what does good incentive design look like? The answer isn’t fewer incentives, but better ones.

Focus on a fair bet

The energy network Interruptions Incentive Scheme (IIS) demonstrates both how effective incentives can be – and how they can drift out of alignment. IIS has been instrumental in transforming reliability across UK distribution networks, driving substantial reductions in customer interruptions and minutes lost. Despite its success, under RIIO-ED2 electricity distribution price control regulations, the balance has shifted. Targets have continued to tighten, ex ante service funding has been removed, and exposure to external risk has markedly increased. For future price controls, the sector would benefit from re-baselining incentives so they represent a fair bet. That means setting tangible targets that account for starting position and diminishing returns, applying methodologies that explicitly recognise external risk, and ensuring upside and downside opportunities are credible and symmetric.

Create – don’t compare – value

Incentives should increasingly focus on value creation rather than relative comparison. League tables are powerful during periods of convergence, but as performance improves, regulators may need to place greater weight on absolute standards, forward looking indicators and metrics that support long-term resilience and system efficiency. For future price controls, the sector would benefit from upfront confirmation of absolute standards, enabling them to meet and exceed them.

Establish clear lines of sight

Finally, line of sight is non-negotiable. The Distribution System Operation (DSO) Output Delivery Incentive (ODI) was introduced in RIIO-ED2 regulations to encourage network companies to develop new capabilities across three key DSO roles. Its objectives are widely supported, and there’s clear evidence that it has driven activity and focus across the sector. However, the mechanism relies heavily on qualitative assessment by panels and stakeholders, with limited use of objective, standardised metrics – which Ofgem and Distribution Network Operators struggled to agree on at RIIO-ED2.

As the DSO role expands – across voltage management, flexibility market operation, whole system planning, and closer interaction with the National Energy System Operator (NESO) – these shortcomings become more acute. It’s precisely in these high value, transformational areas that companies need the clearest lines of sight between actions, outcomes, and reward. For future price controls, the sector would benefit from greater and early transparency of intention.

Getting the balance right

Strong regulatory backstops and enforcement will always be necessary for non-compliance or serious service failure. But outcome based incentives should primarily motivate improvement and reward consumer value, not reduce allowed revenue through structurally biased mechanisms.

Well-designed incentives support long-term investment, encourage innovation, and improve outcomes for consumers. Poorly designed incentives do the opposite, even when intentions and ambitions are sound. As RIIO 3 begins for Gas and Electricity Transmission and Gas Distribution and RIIO-ED3 development starts in earnest, attention will turn to whether incentive design has kept pace with a more complex, risk-exposed, and capital-intensive system. The industry will watch Ofgem’s approach to incentives closely – across scale, structure, balance, and credibility.

The question facing regulators and companies is no longer whether incentives are the right tool, but whether they are designed with sufficient realism, clarity, and discipline for today’s ecosystem.