The UK government’s plan to achieve a net-zero carbon emission economy by 2050 is criticised by some for not going far enough, meanwhile the nation’s energy networks are complaining this target is in jeopardy due to proposed regulatory price controls. The energy regulator Ofgem is currently planning a new system of consumer-protection price controls to replace the current framework.
What is RIIO?
The RIIO system applies to the 23 licensed network companies that maintain the UK’s one million km of electricity cables and 272,000km of gas pipelines.
The nature of such infrastructure (imagine having multiple companies each running their own transmission cables and pipes through our cities and the countryside) and the substantial investment it requires means these firms are effectively monopolies, safe from market forces.
Without restrictions, these monopolies could charge what they liked and the only way to switch to a lower tariff might be to move to another part of the country!
So, to protect homeowners and businesses Ofgem sets price controls – a limit on the money networks can make from people using their infrastructure.
Of course, they provide a vital service and the network needs maintenance and development, so the regulator needs to strike the right balance between customers getting a fair price, companies making enough to run the networks and investors getting enough of a return to make investing in our infrastructure worth their while.
Ofgem calls these price controls the RIIO Model, (Revenue = Incentive + Innovation + Outputs). The ‘standing charge’ on your energy bill is the result of this policy. The standing charge, around 35p per day, is the amount the distribution and transmission companies get from customers for using their networks.
This regime will be phased out between 2021 and 2023, with RIIO-2 price controls set to replace it. Energy regulator Ofgem has been working on these next-generation controls since 2018. It plans to announce the final version of RIIO-2 by the end of 2020.
Network companies are in the process of submitting their proposals for the new system to the regulator.
David Smith, Chief Executive of Energy Networks Association (ENA), has voiced concern about the direction Ofgem’s plans are taking and their compatibility with the UKs promise to reach net-zero carbon emissions by 2050. The ENA is an industry body which represents the companies responsible for operating the backbone of Britain’s gas and electricity infrastructure
“These proposals, if implemented, will have damaging impacts on the energy networks’ ability to deliver the government’s plans for clean growth and the wider economy, undermining efforts to build a smarter, more efficient energy system for the public,” he said.
“Costs are down, power cuts are at record lows and the amount of renewable energy connected to the grid is at an all-time high. Ofgem needs to build on this track record.”
Mr Smith called on Ofgem to learn from its RIIO-1 experience and highlighted the importance of Britain’s energy networks remaining attractive to investors while keeping costs low for consumers.
Are the networks right to worry?
The RIIO-1 system has certainly contributed to the UK’s progress in diversifying and greening its energy mix.
In the second quarter of 2019 35.5% of UK electricity generation came from renewables, up 3.3% since the same period in 2018. By summer of this year, the UK had 45.9 GW of renewable power generation capacity, 7.9% more than the previous summer. Not to mention the huge increase in reliability and stability of the grid in recent decades. The widespread powercut in August was all the more significant because of the rarity of such events.
That seems good value for money for 35p a day, but of course, things are more complicated than that.
Figures show investors and lenders are set to receive a return of £25bn by the end of the RIIO-1 regime.
According to research carried out by Citizen’s Advice, over the eight-year course of RIIO-1, the network companies will have actually made an extra profit of £7.5 billion more than they should due to flaws in the system.
The non-profit claims decisions by Ofgem were overly-favourable to the companies and to the detriment of consumers.
The regulator was too cautious when calculating how risky investments in the sector would be and therefore investors are making a high return more suited to rewarding investment in higher risk businesses. Network operators are typically seen as low risk attractive investments. This higher return is of course being paid for by energy consumers.
Ofgem’s calculations were also based on an assumption of high interest rates and bond rates making the cost of raising investment capital more expensive.
In actual fact, UK the base rate didn’t move from 0.5% between 2009 and 2015, its lowest level for 300 years. In 2016 it fell to an even lower rate of 0.25%. The UK rate has been on hold at 0.75% since 2018. The story is similar in other countries where potential investors could source funds.
The networks also benefited from Ofgem incentives towards efficiency which allowed them to keep money not spent on certain projects. Market conditions created lower than-expected costs for staff and materials, which meant underspending didn’t necessarily come from increased efficiency.
All this means that it has been a lot cheaper and less risky for investors to borrow money to put into the networks than Ofgem had predicted and its policies produced a greater return than is probably necessary.
What changes are Ofgem considering?
RIIO-2 plans show Ofgem may indeed have learned from its RIIO-1 experience, though perhaps not the lessons ENA’s Mr Smith had in mind.
The proposals include increased transparency on performance, finances and ownership, a cap on company profits, a greater use of real data instead of projections and a more realistic estimate of risk associated with investments.
The regulator is also considering plans to force the networks to return unspent money that had been earmarked for projects to consumers instead of holding on to it, which they have been so far allowed to do even in the case of cancelled projects.
Ofgem is also soliciting opinions and assessments from customer representatives and industry experts about how the network companies perform and to evaluate their plans for the future.
All in all, it seems like RIIO-2 promises a much tougher regulatory environment for the energy networks.
Mr Smith’s complaint over the new scheme was focused on the impact that it could have on the UK’s drive to decarbonize the economy and achieve net-zero carbon emissions by 2050.
However, looking at the gains of the networks over the lifetime of RIIO-1, along with the rapid progress being made in renewables, it’s clear there’s a lot of room to play with for the regulator.