Challenges around RIIO2
In RIIO2 Ofgem aims to address its concern that the regulated networks sector is earning too much and delivering too little. It is fiercely 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 fine tuning to avoid unwelcome side effects.
The first of these is the level of outperformance 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 opportunities 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 efficiency beyond Ofgem's view of an efficient business plan will be critical to how the companies' management react.
Ofgem's decisions around the level of overall stretch will strongly influence the inherent incentives and capacity of organisations to support the transformation of the industry and sustain a resilient energy future. Getting this wrong may end up with management effort focused on short-term delivery of outperformance to meet shareholder 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 approach to how, where and when investments are made. It will not reward overachievement in targets; and will penalise those who fail to deliver under its new Consumer Value Proposition. During RIIO1 companies have been deploying resources to create greater agility to deal with the increasing uncertainty 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. However, 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 approach places far greater emphasis on collaboration and coordination. It has decided not to progress with the information sharing incentive outlined in December'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 benefits 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 solutions which incorporate options from, and benefits 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 investment, to another business on costs grounds, with the original proposer receiving no direct benefit. Adopting the broader definition of whole system means Ofgem needs to design the detailed mechanisms to avoid a four-way sector fight 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 stifled and that all those involved have the right incentives to meet the challenges of the Government's Net Zero commitments.