How Performance-Based Regulation Affects Electricity Distribution Companies in the UK - Global Lessons: Part 1

This blog was coauthored by Mark Livingstone

The UK energy regulator, Ofgem, published its decision on the next generation of price controls (RIIO-2 framework) in July. Drawing on elements of the newly proposed framework, this two-part blog series seeks to highlight some points of significance for network companies and regulators globally. The first focuses on the evolution of the regulatory framework in the UK, compares RIIO against other approaches, and draws out the key challenges. The second blog will focus on the proposed changes under RIIO-2, their impact on network companies, and lessons that can be learned globally.

Part 1: RIIO Evolution, Comparison with Other Frameworks, and a Deep-Dive into Challenges 

The UK has been a world leader in establishing performance-based regulation for electricity and gas networks. Ofgem is now under pressure to demonstrate that the returns being earned by the energy network companies it regulates are legitimate. Politicians, mainstream media, and industry experts are asking questions regarding the toughness of cost allowances and the returns to shareholders under the current RIIO regulatory framework.

Evolution of RIIO and Comparison against Other Regulatory Approaches

RIIO (stands for Revenue = Incentives + Innovation + Outputs) is Ofgem’s performance-based framework that ensures consumers get the necessary investment in energy networks at a fair price. RIIO came to replace Ofgem’s traditional price-cap (RPI-X) framework. Although the price-cap regime delivered lower network prices and improvements in network reliability, it ultimately failed to keep pace with the scale of investment in low carbon infrastructure and incentivize risk-averse network companies to innovate.

The introduction of RIIO was a step away from traditional regulatory approaches that focus on inputs (i.e., regulating allowed costs). It marked a shift to long-term performance, outputs, and outcomes, urging network companies to deliver wider objectives rather than just building new infrastructure. It also aimed to strike a balance between capital and operating expenses by not favoring one over the other.

RIIO can be compared to other recent regulatory approaches, such as New York’s Reforming the Energy Vision (REV) model. The REV model also signals a departure from traditional approaches, by offering revenue and shared savings incentives to the network companies. However, REV could be seen more as a hybrid of cost-based regulation and RIIO, rather than a truly novel approach.

A comparison between the above-mentioned frameworks and RIIO against key regulatory dimensions can be found in the table below.

Key Challenges

The newly proposed framework seeks to tackle two of the most contentious issues under RIIO-1: the way cost allowances are set and the cost of equity range. Both issues trigger heated debates, particularly where companies have achieved outperformance and made double-digit equity returns. In many cases, Ofgem has been unable to accurately determine whether outperformance was achieved genuinely through innovation and cost-effective delivery, or as a result of forecasting errors and selective prioritization of expenditure. On the cost of equity range, Ofgem has not yet come to a consensus. However, early indications suggest that this may be set as low as 3%-5%. Ofgem’s final decision is expected in December, only months after Ofwat, the water regulator, set the lowest ever cost of capital for the water industry.

A further area of challenge is the need to embrace a changing DSO business model for network companies. This will require new outputs to reflect new DSO functions, so incentives require further attention. Our second blog picks up on this and other related themes.