The draft determinations for gas and transmission networks proved Ofgem is serious about holding companies to account for their costs and investments. Ahead of official responses from the affected companies, Nicholas Cass-Tansey, Energy & Utilities expert at PA Consulting discusses the regulator’s approach and how it compares to Ofwat’s in PR19, as well as looking at what distribution companies can learn for their business plans.
The draft determinations for the electricity and gas transmission (Tx) and the gas distribution (Dx) sectors were released in July, but it is already abundantly clear that RIIO2 is set to be a totally different price control process. This is evident in the incredibly high bar set by Ofgem for the requirements needed to justify costs for proposals over the next five-year period.
In December 2019, networks submitted business plans for 2021-2026 that would help support the UK’s transition to net zero. They also needed to meet the needs of their customers and ensure value for money, whilst at the same time effectively managing network risk.
Of the eight network business plans submitted (excluding ESO), seven proposed higher costs than RIIO1 actual totex. For transmission companies total load related expenditure (LRE) proposals were on average 50 per cent lower than RIIO1 LRE capex (this is largely due to LRE being associated with PCDs or uncertainty mechanisms), whilst total non-load related expenditure (NLRE) saw a 30 per cent increase on RIIO1 expenditure.
The initial narrative from the sector specific methodology decision was that companies would be held more accountable for their costs and be challenged on efficiencies during the process. One of the mechanisms Ofgem introduced was the Business Plan Incentive (BPI); targeted at ensuring high quality and ambitious plans that will help to achieve benefits for consumers whilst challenging networks on the strength of the evidence and justification of costs.
It is immediately evident that Ofgem has stuck to its guns and demonstrated how serious it is that networks are held accountable for their costs and investments and that they demonstrate this by submitting well-justified well-evidenced business plans that meet consumer needs. In the recent draft determinations, networks saw a 33 per cent reduction in baseline totex compared to their proposals (45 per cent for transmission network’s business plans).
Ofgem stated that “the information we received in many cases did not provide sufficient justification for spending consumers’ money”. In doing so, it has sent a clear message that companies need to up the quality of their justification of expenditure during the next phase of consultations. Significant scrutiny was also given to Engineering Justifications where £2.7 billion of NLRE proposals were removed from Transmission BPs due to companies’ not meeting Ofgem’s significantly higher bar, when it comes to evidence and justification.
Not meeting these new stringent requirements can have substantial material impact, not only with disallowed costs, but companies also risk receiving a penalty under the BPI, as we see it in action for the first time. Under the scheme, networks are given a penalty or reward; using a four-stage assessment approach to challenge networks on the level of evidence, justification and cost scrutiny. During the draft determinations, two networks, National Grid Electricity Transmission and SSE Transmission, both hit the 2 per cent totex penalty cap. Both NGET and NGGT failed Stage 1 of the BPI in relation to CBAs and EJPs not meeting this high bar set by Ofgem.
Transmission companies were hit the hardest in stage three of the BPI assessments, with over £140 million (£285 million without 2 per cent totex cap) in penalties related to “unjustified” low-confident costs.
A glimmer of hope: Lessons from PR19 draft and final determinations
Whilst networks have seen significant costs shed from their initial proposals, it is not all doom and gloom. Ofgem has encouraged networks to provide higher quality evidence and supporting data to back up proposals.
It looks as though Ofgem has adopted a similar stance to fellow regulator Ofwat’s PR19 determinations process; where companies saw significant gaps develop between their initial business plans and draft determinations, which closed somewhat following additional evidence. Perhaps Ofgem is adopting a similar stance to test network company proposals in an effort to get Networks to meet their high bar in relation to evidencing proposals.
Ofgem has clearly indicated that, as of now, the levels of justification and evidence required are significantly higher than in RIIO1 and what worked then will not necessarily work going forward. With Ofgem still very much committed to supporting the pathway to net zero, and its commitment to supporting a green recovery from Covid-19, the onus will be on network C=companies to ensure they step up to the challenge, meet this new RIIO2 threshold and make their proposals a reality.
Play by the rules: Learnings for electricity distribution networks
It is clear that RIIO2 is a whole new ball game, and in order to ensure a successful outcome DNOs will need to play by Ofgem’s rules. Plans will be scrutinised and DNOs will be challenged to provide robust evidence and justify the level of investment. When it comes to submitting proposals, DNOs need to ensure costs can withstand Ofgem’s assessment process. Where possible, proposals should be supported by historical data, external benchmarking and volume drivers and assumptions are well documented, transparent and are evidence based. As proven by the draft determinations, Ofgem is not afraid to come down hard and disallow costs where networks adopt a different approach to justifying their plans.
Becoming fully acquainted and up to speed regarding current expenditure and anticipated costs needs to be high on the priority list for DNOs; costs need to be well understood, well-evidenced and investment well-justified to ensure DNOs can meet the high bar seemingly set by Ofgem for RIIO2. This is even more critical for low-confident costs where identifying weaknesses in the evidence base sooner, rather than later, could help to safely navigate the risk of penalty under the BPI and ensure a good final determination.
With so much uncertainty surrounding net zero, DNOs will no doubt have a significant challenge to secure the investment required to ensure their networks can facilitate the uptake of distributed generation, electric vehicles and other low carbon technologies and not be a blockage in the road to net zero. Ofgem accepts that there is uncertainty around decarbonisation and has mitigated this by the addition of the net-zero reopener. However, the key question now is not whether DNOs are willing to support the transition, but whether they can provide enough evidence and justification to meet Ofgem’s exceptionally high bar for RIIO2 business plans.
Nicholas Cass-Tansey is an Energy & Utilities expert at PA Consulting