RIIO-2: A networks price control fit for the net zero transition?

10 Feb 2021

Dr Jamie Stewart and Prof Keith Bell

December was a busy month for energy policy. Along with the publication of the UK Government’s Energy White Paper, the Climate Change Committee’s Sixth Carbon Budget and the Scottish Government’s Climate Change Plan Update, Britain’s gas and electricity markets regulator, Ofgem, published its final determinations for RIIO-2.

RIIO-2 is the exercise through which Ofgem determines the income that the gas and electricity networks will receive over the next price control period. The RIIO-2 process is staged, with this round of final determinations made for the 2021-26 period for gas distribution and transmission, and the electricity transmission network owners. Income for the Electricity System Operator (ESO) part of National Grid is also set but only for the period 2021-23. Business plans for electricity distribution will come next and are set out for the 2023-28 period (RIIO-ED2).

The RIIO regime where revenues (R) are a function of performance incentives (I), innovation (I) and outputs (O) was first established in 2013. As networks are run as regulated monopolies, the price control mechanism is there to make sure companies can, through efficient operation, earn a fair return on their activities while controlling the end cost to consumers. As has been strongly debated through the build up to the final determinations, there is a balance between keeping costs to consumers as low as possible, whilst ensuring that there is sufficient investment to run a safe and reliable network that can deliver on the net zero ambition.

The main points of contention in every price control tend to be: how cheaply does Ofgem believe the network companies can borrow money; what gains can be expected in the efficiency of their operations; what proportion of existing network assets will need to be replaced; how much reinforcement of the network will be needed to accommodate increased power flows; and what will asset replacement and reinforcement works and the procurement of new assets cost? The latter three factors determine the “non-load related” and “load-related” capital expenditure (Capex) allowances.

Delivering net zero at the lowest cost to consumers

In the draft determinations, Ofgem proposed that the next price control period would lead to an expected average £20 fall in annual network charges on bills per household. This was based largely on the assumed cost of equity being cut from 7.8% in the RIIO-1 period to 3.95% and Capex allowances being significantly less than the network companies had requested. For example, Ofgem allowed just £744 million over the RIIO-2 period for non-load related Capex (asset replacements) for the England and Wales electricity transmission owner, NGET, compared with the company’s request for £2651 million, a reduction of 72%. However, some network companies argued that the proposed tightening of revenue allowances proposals would lead to the potential for significantly reduced network reliability, and to reduced investor confidence and a higher cost of borrowing.

The final determinations increase the rate of return and baseline allowances from what was presented in the draft determinations, while still saving £2.3bn over 5 years compared with what the companies had requested. Ofgem says this will lead to an average £10 per year fall in network charges on bills while maintaining an attractive proposition to investors and ensuring that any increase in spending to facilitate net zero should not result in an overall increase in consumer bills.

Managing uncertainty in the price control period

A significant challenge Ofgem faces in a price control is that the future is uncertain, in particular: how many new wind farms will want to connect (and where); when and how will demand for electricity grow to facilitate the deployment of electric vehicles and heat pumps; and what is the long-term future of the gas networks?

The future role of the gas networks perhaps presents the greatest uncertainty for both the RIIO-2 period and beyond. A big component of the proposed spend in RIIO-2 for the gas distribution networks is related to the continued -health and safety driven- network wide replacement of old iron pipes with new plastic ones (known as replacement expenditure, i.e. Repex). For example, SGN’s Repex expenditure for RIIO-2 is £1,138m within a total expenditure (Totex) allowance of £2,680m. The use of plastic pipes could be important for facilitating the use of hydrogen in the gas distribution networks, but the costly replacement programme also presents a risk of becoming a ‘stranded asset’ if the networks are not used in the long term. In the final determinations Ofgem has allowed companies to continue with the Repex programme but has challenged some aspects of accelerating non-mandatory replacement.

To tackle broader uncertainty around the future use of the networks, Ofgem has also built in a number of ‘uncertainty mechanisms’ into the price control. For the gas networks, a Heat Policy re-opener (where companies can apply for more funding) will be used if regulation for gas quality or composition changes within the RIIO-2 period, or if gas distribution companies are asked to take on a broader role in energy efficiency deployment. Ofgem also outlines how a broader Net Zero re-opener could be triggered if Government policy signals a change in the future role of the gas networks during the RIIO-2 period. Similar uncertainty mechanisms are also in place for electricity, in particular around the volume and location of new generation connections.

A key challenge will be how the process around unlocking further investment will work. For example, how quickly Ofgem will be able to make decisions about additional spend and whether the mechanism for dealing with uncertainty will, itself, create uncertainty.

Delivering networks fit for a net zero world

With the publication of the Decarbonisation Action Plan in February 2020, Ofgem signalled its intention to focus on the net zero ambition being set by Government and ensure that they as a regulator facilitate the decarbonisation of the energy system at the lowest cost to energy consumers.  The RIIO-2 final determination document also focuses on net zero delivery, with a promise from Ofgem to improve co-ordination with key stakeholders including the National Infrastructure Commission, the Climate Change Committee and the devolved administrations.

Along with an aim of delivering a net zero energy system with a more joined up approach across the sector, Ofgem recognises that high value innovation projects, such as trials of hydrogen in gas networks, will be an important mechanism for getting the energy system ready for net zero. To facilitate this Ofgem has approved £660 million of innovation funding via the Strategic Innovation Fund and the Network Innovation Allowance. However, they also argue that the transition to net zero has the potential to ‘leave some behind’ and have unlocked £132m of funding to support customers in vulnerable situations. In RIIO-2, this could see the gas distribution networks companies in particular play a central role in supporting those who are less likely to benefit from the net zero transition.

Summing up

With a high degree of uncertainty about the nature and timing of the transition, the success of the price control may well be decided in how the regulator, network companies and those connected to the network can adapt in a dynamic and changing environment. In particular, how well will the new uncertainty mechanisms work in protecting consumers from potential excess expenditure by network companies while also facilitating timely investment?

The extent of the regulatory challenge can perhaps be seen from NGET’s load-related Capex allowance being boosted by £432m for projects identified by the ESO in its annual ‘network options assessment’ (NOA) process between the draft determination in June 2020 and the final one six months later, and by the networks companies’ submission of thousands of pages of additional justification in support of non-load related Capex that led to an additional £1.36 billion of allowance being granted in the final determination compared with the draft.

Arguably, an even greater test of the regulatory process awaits in RIIO-ED2 covering the period 2023-28. Major changes to the demand for electricity or the scaling up of use of hydrogen might not be seen until towards the end of the RIIO-2 period (2026) or after it. However, there are very likely to be significant pockets of electrification of transport and heat that will heavily impact on the electricity distribution networks, especially in the second half of the decade, or sooner in Scotland if the Scottish Government’s ambitions outlined in the Climate Change Plan update are to be realised. Moreover, the sheer scale of the electricity distribution networks – over 300,000 circuit km compared to around 20,000 for electricity transmission – presents major analytical challenges and raises important questions of how the transition can be delivered in the most efficient way.

Jamie Stewart is Depute Director of the Centre for Energy Policy at the University of Strathclyde

Keith Bell holds the ScottishPower Chair in Smart Grids at the University of Strathclyde and is a co-Director of UKERC.