Costs and benefits of infrastructure investment

18 Aug 2022

In the light of the current cost of living crisis, Prof Keith Bell explores the costs and benefits of infrastructure investment. Touching on the privatisation of ‘natural monopolies’, the role of the regulator and decision making around investments, he highlights the needs of the sector (£40-110 billion and an additional 50,000-130,000 people) and asks how things will change with the creation of a Future System Operator.

Keeping your fingers crossed

An article in The Guardian by Fiona Harvey on August 15th had the headline: “England ‘failing to invest in water networks to avoid future droughts’”. It quoted Sir John Armitt, chair of the National Infrastructure Commission, as warning that “Investment is better than keeping your fingers crossed, and than relying on emergency measures”. According to the article:

“Ministers could not prevent dry weather, but they could direct investment into infrastructure to cope with it, such as reservoirs and cutting wastage,” he said. “The government should set out what degree of risk from drought they would see as reasonable, for people to manage and expect.”

“Water bills may have to increase to pay for the investment needed,” he warned. “If you want greater resilience to drought, then you have to increase water bills or general taxation [to pay for it],” he told the Guardian in an interview.

The Climate Change Committee, among others, has been warning for some time that key infrastructure such as water pipelines and reservoirs need to be adequate for a world that is already seeing significant climate change and will see much more however good we are at reducing greenhouse gas emissions. If infrastructure isn’t already adequate, why not?

Key infrastructure in private hands

Many key infrastructure providers – gas, electricity and ‘wired’ telecommunications networks, and water treatment, storage and pipeline facilities – were privatised in the late 1980s and early 1990s. Being viewed largely as ‘natural monopolies’, regulators decide how much money these companies should receive from service users.

Since the early 1990s, there has been modernisation of technology and practices, such as roll-out of mobile communication networks with 4G and 5G frequencies, or use of high voltage direct current for power. Relative to the status quo, regulators would argue that consumer bills have also reduced. (Would all of those things have happened without privatisation?) However, plenty of campaigners would also argue that the owners’ profits have been excessive, while defenders of current arrangements would point towards their ability to provide access to large amount of private capital for investment and solid income for investors such as pension funds.

Sir John Armitt’s comments highlight a longstanding tension in the regulatory arrangements for ‘natural monopolies’ that provide physical facilities that cover wide areas and, in the case of energy and wire or fibre communications, facilitate services provided by others in a market through which users can – in principle, at least – make choices. What is most important: the costs, or the benefits?

The approaches taken by the regulators – Ofgem, Ofwat and Ofcom – tend to have focussed on minimising costs to consumers while enabling what they regard as reasonable investment and recovery of infrastructure providers’ costs – achieved through customers’ bills. That entails judgment on two fronts: what is the need for investment, and how efficiently can that be delivered and regular operations be carried out?

Investment in energy networks

In the sector with which I’m most familiar – energy – the regulator, Ofgem, depends entirely on the network companies to make the case for what investment is needed. Quite often, in Ofgem’s setting of the prices that the network companies can charge, the company’s request for funding to cover a certain investment is rejected, usually on the grounds of what Ofgem regards as the company’s failure to provide strong enough evidence of need.

This approach puts the burden of proof on the companies. While proposals for investment (and their costs) have been queried by Ofgem, I don’t recall ever seeing them challenge a company’s failure to propose an investment.

How suitable is the relationship between the regulator and the network companies against a background of the need for preparedness against climate change and, in the electricity system, to facilitate much higher flows across many parts of the transmission network, something that high volumes and costs of wind curtailment due to network limits suggest is already lagging?

Ofgem has always been suspicious that the network companies will do all they can to add to the size of their asset bases and have customers pay for it. Ofgem, as an economic regulator, lacks knowledge of the engineering of an energy system. To comply with their licence obligations, they expect the companies to have that knowledge and to use it to identify investment need and to present clear, evidence-based cases. However, I have heard suggestions from people within the industry that Ofgem’s lack of knowledge leads them to, at least some of the time, simply not to understand the cases being made.

A more strategic direction?

In respect of transmission network investment and the timely provision of sufficient capacity for the future, Ofgem, the regulated network companies and the UK Government seem to agree that existing processes are inadequate. This has led to separate reviews of the ways in which the offshore and onshore networks are planned, the Government’s decision to create a “Future System Operator” (FSO), and a raft of recent publications including one from BEIS and Ofgem on an “Electricity Network Strategic Framework” and from the electricity system operator (ESO) part of National Grid on “The Pathway to 2030”. An Electricity Networks Commissioner – the former CEO of National Grid’s UK business, Nick Winser – has also been given the task of proposing how the timeline for delivery of major electricity transmission infrastructure can be halved.

One of the reasons put forward for the creation of the FSO is that there is a need for some kind of institution that can take a strategic view of investment requirements across the energy system as a whole and make quite specific recommendations, reaching beyond present day actors’ focus on just on gas or electricity. Government also envisages this body being not-for-profit – a move intended to counter anxieties about commercially-driven biases – and being developed from the present day ESO.

There is a certain logic to the FSO being created from the current ESO – for example, the FSO will operate the electricity system, which the ESO currently does, and it will carry out energy system foresighting, which the ESO currently does through its Future Energy Scenarios. However, informed industry insiders point out that many of the investment planning processes currently judged to be inadequate are primarily owned by the ESO and concerns about them have been known for many years. They also note that credible planning of infrastructure that can be navigated through consenting processes, and is resilient against climate change, depends on detailed knowledge of technologies and conditions on the ground, knowledge that the ESO doesn’t have at its fingertips. Does the FSO need somehow to acquire that knowledge or to develop much better working relationships with asset owners than those that apparently exist between them and the ESO at the moment?

Plus ça change, plus c’est la même chose?

Filling in holes in knowledge is a major challenge. Across the industry as a whole and in academia, it is already proving difficult to recruit and retain people with the right kind of expertise and fill in the experience gap created by departures from the sector.

In principle, the FSO will be able to make more ‘holistic’ and ‘strategic’ investment recommendations than the network companies do now. However, who will decide whether to follow those recommendations and whether the funding will be allowed? Commitment to an investment still depends, in the case of network infrastructure, on a network owner; an allowance for recovery of the cost of that still depends on Ofgem.

Will Ofgem have any more confidence in an investment case presented by the FSO than it currently has in cases made by the network owners? To a large extent, that depends on how ‘tooled up’ the FSO is, and that depends, to a large extent, on its funding – to be determined by the Government? – and ‘culture’.

The Electricity Networks Strategic Framework suggests that £40-110 billion of investment in electricity network infrastructure and an additional 50,000-130,000 people in the onshore networks sector will be needed between now and 2050. When it comes to approval of individual projects, how will tensions between impacts on local environment and communities and wider energy system needs be resolved, and how will efficient delivery by industry actors be ensured and excessive profit avoided? How good are Government and regulators at assessing risks, especially those that have low probability but very high impact, including the effects of extreme weather such as floods, heatwaves or extended wind ‘droughts’? And, amidst a very difficult “cost of living crisis”, where will their biases sit: towards minimisation of costs to consumers in the short term, or maximisation of benefits to citizens in the long term?

Keith Bell holds the Scottish Power Chair in Future Power Systems at the University of Strathclyde, is a co-Director of UKERC and leads the UKERC research theme on Energy Infrastructure Transition.