How Performance-Based Regulation Affects Electricity Network Companies in the UK - Global Lessons: Part 2

This blog was coauthored by Mark Livingstone

Ofgem published its decision on the next generation of price controls (RIIO-2 framework) in July. Drawing on the elements of the newly proposed framework, this two-part blog seeks to highlight some points of significance for network companies and regulators globally. The first focused on the evolution of the regulatory framework in the UK, compared RIIO (stands for Revenue = Incentives + Innovation + Outputs) against other approaches, and drew out the key challenges. This second blog focuses on the proposed changes under RIIO-2, their effect on network companies, and lessons that can be learned globally.

Part 2: Proposed Changes under RIIO-2, Implications for Network Companies and Points of Global Significance 

The key elements of Ofgem’s decision and implications for the network companies are outlined in the table below.

RIIO-2 Proposed Changes and Impact on UK Network Companies

(Source: Guidehouse, Inc.)

Discussion: Points of Global Significance

The above elements all pose significant challenges but may also create opportunities for network companies. They also bring to light areas of global significance regarding network regulation and companies’ overall returns, the information asymmetry challenge, whole-system innovation, and the optimal regulatory term.

Performance-based regulation has been shown to encourage greater benefits for consumers. However, this involves a degree of complexity and the possibility that regulators may be embarrassed politically by the returns high performing companies are able to achieve. If there are clear gains to both consumers and network companies from positive investment behavior, the need for tight cost control may be less necessary than some regulators believe. Honoring incentives earned by network companies is also likely to spur a different investment mindset at companies over the long run.

Understanding whether savings in spending are due to genuine efficiency or clever management of inputs is not as easy as originally expected. Therefore, future regulation in a more data-centric and DER-oriented world will need to improve accuracy and effectiveness of forecasting, or at the very least minimize information asymmetry between the regulator and regulated companies.

Innovation benefits are another feature of RIIO that global regulators would do well to take note of given the degree of change the whole system is facing. Proposed refinements include focusing innovation on areas of greatest consumer benefit and allowing a level of third-party involvement. With future innovations requiring thinking across power, heat, transport, and gas—as well as power—the strictly siloed approach to regulating electricity and gas may not be fit for purpose as far as optimal customer solutions are concerned.

In terms of the optimal regulatory term, longer terms for price control periods are easier in theory than in practice; the decision with RIIO-2 to reduce the period from 8 to 5 years highlights the challenges that regulators face with managing return expectations and the appropriate treatment of forecast uncertainty. Conversely, longer term regulatory periods should encourage more investment and innovation, so a balance may be required. 

RIIO-2 has a strong focus on reducing the risk of excessive company returns. However, more needs to be done to prepare the companies for the energy transition and enable them to become truly data-centric and customer-centric as distribution system operators (DSOs) with a wider range of responsibilities. A whole-system approach is essential for the efficient development of networks that deliver real value to consumers with increasingly blurred boundaries between gas, electricity, heat, and transport. As the regulatory framework evolves, companies need to ensure they are well-equipped to respond to increasingly tougher price controls. Are network companies up for the challenge? And are regulators prepared to be forward-thinking enough to recognize the new business model DSOs face and ensure they have the right balance of risk and return to invest?