Consultation response
Ofgem RIIO-2 Framework Consultation
May 2018
Ofgem and the regulated gas and electricity transmission companies are currently gearing up for the next price review for which the companies will soon submit their business plans to Ofgem. Based on what it thinks would be a reasonable recovery of costs, Ofgem will set the prices that the network companies can charge their customers for their services over the period 2021 to 2026.
A part of the ‘reasonable recovery of costs’ from customers in the last two price control periods has been to allow the network companies to invest in innovation. One question that Ofgem has asked in its most recent “RIIO-2 sector methodology consultation” was whether it continues to be fair to allow customers’ money to be used by the network companies for ‘innovation’ and, if so, within what scope.
The innovation funding allowances that Ofgem has had in place in the past – the Innovation Funding Incentive (IFI), the Low carbon Networks Fund (LCNF) and the Network Innovation Allowance and Network Innovation Competition (NIC) – have succeeded in reversing the dramatic fall in R&D expenditure that was seen in the years after industry liberalisation. But are they still needed?
I believe it is correct that Ofgem should re-assess the need for and value of the various innovation allowances. The regulator has a duty to protect network customers’ interests and needs to be sure that customers will benefit from the use of their money. However, important as it is that bills to today’s network users are kept to a minimum, it should not be at the expense of higher bills or poorer service to future users.
Ofgem expects that a ‘cultural shift’ will have happened within the network companies so that “more innovation takes place as part of [the network companies’] BAU activities”. It seems to me this is somewhat true, but only to the extent that it delivers a reduction in cost in the short-term. What is less certain is whether the network companies would invest in research, development, demonstration and deployment of innovations for which a net return can be expected only within a future price control period, i.e. after Ofgem has reset the companies’ allowed revenues.
The main criterion for allowing customers’ money to be used for innovation is that it benefits customers in the long-term. An innovation project can address the resolution of uncertainties and so help to realise opportunities to reduce costs or improve service. However, useful R&D would concern gaining an understanding of risks that threaten reliability of supply or cost, such as the possibility of the system becoming less resilient.
Ofgem has proposed that, in the forthcoming price control period, there will be a focus within larger innovation projects on the ‘energy system transition’. This seems reasonable to me, provided the challenges to which projects are directed are appropriately identified and well defined. However, the challenges associated with management of legacy assets should not be neglected. Moreover, it is important that the right partners are engaged in projects, and that network licensees are closely involved, i.e. at a much deeper level than simply project management or as passive observers.
Many of the challenges associated with the energy system transition concern behaviour of the system rather than simply individual assets, and the commercial and regulatory environment. This includes the signals given to different parties to carry out certain actions. A particular challenge is that, in respect of system issues, the costs and benefits are unlikely to be equally shared between the different parties that are affected. A privately owned network licensee is unlikely to fund their own involvement in innovation projects that seek knowledge if their costs exceed their own benefits.
How well have the innovation allowances been used to date? An important measure is how much learning has been generated, supported by evidence, and how well it has been disseminated, including on things that didn’t work. UKERC reviews of electricity industry R&D and energy system demonstrators have found wide variation in the quality and accessibility of reporting. The Energy Networks Association’s Smart Networks Portal has been a very welcome development but is far from perfect. The content of official project documentation is not yet easily searchable and often contains little detail.
It is hard to tell which 3rd parties were involved and who did what; too often, external parties are denied access to project data. This, frankly, is not good enough and there is a clear need for network licensees’ conduct and reporting of innovation projects to improve to the level of the best and to learn from academic good practice. Governance arrangements around, in particular, the Network Innovation Allowance (NIA), can and should be improved.
Ofgem is giving particular consideration to whether the Network Innovation Allowance should continue. Across the portfolio of projects, I am confident that the net benefits of NIA outweigh the total costs. The NIA helps relationships between collaborators to be built and maintained, allowing knowledge to be transferred and people’s understanding and skills to be developed and ‘tacit knowledge’ retained, something that is in customers’ long-term interests.
Significant enhancement of NIA can be achieved through gearing with public sector funding such as via EPSRC, although this is being made more difficult due to an apparent re-orientation of EPSRC’s priorities for doctoral training away from the energy system and, within it, the gas and electricity systems.
Scrapping NIA on the grounds that the licensees’ reporting of its use has not made the benefits sufficiently clear would save a certain amount of money on network customers’ bills (an amount that is likely to be small relative to other measures that Ofgem might adopt). However, it would also mean giving up the opportunity for relatively early stage, small scale exploration of ideas and system risks that, over time and across the portfolio of projects, would be of benefit to customers.
As much as anything else, larger ‘energy system transition’ projects are very likely to depend on knowledge gained from such smaller projects. As Ofgem’s proposals stand at the moment, areas of innovation such as how to manage legacy assets in the medium to long-term would also suffer. It cannot be assumed that the gap left by scrappage of NIA would be filled by UK Research and Innovation (UKRI).
Instead of scrapping NIA, I would advocate retaining it though with a revised remit backed up with improved governance to ensure better quality work and clearer reporting of outcomes.
RIIO-2 (Revenue = Incentives + Innovation + Outputs) will be the next price controls for the network companies running the gas and electricity transmission and distribution networks. Ofgem states that RIIO is designed to encourage network companies to: “put stakeholders at the heart of their decision-making process; Invest efficiently to ensure continued safe and reliable services; Innovate to reduce network costs for current and future consumers and play a full role in delivering a low carbon economy and wider environmental objectives.”