Ofgem faces RIIO-2 balancing act for net zero

The regulator recently issued the draft determinations for the RIIO-2 price control for the transmission and gas distribution networks and the electricity system operator (ESO). These price controls will run for five years from April 2021. Shortly after, it also set out the next stage of detail – the “sector specific methodology” – for the electricity distribution price control which will start two years later in April 2023. A key objective for Ofgem in this round of price controls is to enable decarbonisation; a key challenge is how to achieve this in a timely way without requiring consumers to pay too much, too early, or for investment that turns out not to be required.

There are significant uncertainties in the route – or routes – to decarbonising the economy, with important policy decisions still to be made in areas including electrification of transport and the roles of hydrogen and electricity in heating. Ofgem’s response is to seek to build in significant flexibility into the price control arrangements, so that they can adapt as the future network requirements become clearer. It has sought to limit the baseline spending for the transmission and gas distribution networks to only what they can prove to a high level of certainty that they require at the start of the price control. Any further funds will be accessed through “uncertainty mechanisms” of various kinds.

Among these uncertainty mechanisms are reopeners, which enable the outputs the networks are required to deliver and the allowed revenue they can collect to be altered. New for RIIO-2 is a net zero reopener that will enable Ofgem to implement changes to respond to a wide range of potential developments, including the nature and pace of the uptake of electric vehicles or the use of biogas. There will be a heat policy reopener to respond to policy decisions on the future of gas and heat for the gas distribution networks. These mechanisms add to others which, for example, enable the electricity transmission networks to flex for the volume of generation and demand connection volumes, and to apply for reopeners for larger investment projects.

A further key tool of the price control aimed at supporting net zero is the Strategic Innovation Fund, that will initially provide £450mn to support work aimed at making progress in key areas related to the decarbonisation of power, heat, transport and wider industry. Ofgem will set the challenges for the projects and aim to coordinate innovation funding with other public sector initiatives, requiring industry to collaborate in developing solutions.

For electricity distribution, Ofgem is considering options on approaches to strategic investment, looking at to what extent it would be useful to allow distribution network operators to make their own forecasts in key areas, for example, the rollout of electric vehicles.

For all this flexibility, there are threats to Ofgem’s agenda. The regulator was expected to lower the returns that the network companies could make for this round of price controls and – to the surprise of many in the market – has proposed to go as far as halving the return on equity to 3.95%. While Ofgem is seeking to prevent customers from overpaying, this has led some companies to argue that they will not be able to finance the investment required to deliver net zero.

By requiring a high standard of proof that the investments they want to make are really required, the regulator is seeking to ensure that consumers do not pay for assets that are not used. Yet by requiring the networks to go through potentially complex and time-consuming processes, there is a danger that there will be delays to achieving the strategic developments needed to enable net zero.

We provide regular coverage of these issues and others affecting the RIIO-2 price control process in our regulation services. For more information contact Vicky Simonds at v.simonds@cornwall-insight.com 

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