• Decarbonization
  • Policy and Regulation
  • Energy Policy

Understanding the Impact of Recent RIIO-2 Energy Network Decisions

Mark Livingstone
Dec 18, 2020

Guidehouse Insights

This blog was co-authored by Konstantinos Anagnostou.

Ofgem recently published its Final Determinations on the Revenues = Incentives + Innovation + Outputs (RIIO-2) business plans for UK gas and transmission networks and the electricity system operator. Among other initiatives, Ofgem unveiled a £30 billion (~$40.5 billion) investment package to help achieve net-zero energy targets, a flexible mechanism that would enable £10 billion (~$13.5 billion) or more of additional funding to be made available based on strategic investment needs. Ofgem also announced an innovation package consisting of £450 million (~$607 million) as a competitive strategic innovation allowance and £209 million as a targeted network innovation allowance. 

The rate of return is set at 4.3%, the lowest ever determined for network companies. Although it is slightly higher than the 3.95% proposed in the draft determinations, the figure is still significantly lower than base returns of 7%-8% that the sector currently allows.

By comparison, Ofwat, the UK’s water regulator, set a similarly low rate of return a year ago, and the water companies appealed to the Competition and Markets Authority against the decision. The success of their appeal led to the cost of equity being increased to 5.08%, with additional spending being added to their allowance. Will the success of this appeal be a foretaste for things to come in energy?

Allowed Return on Equity Movement Between Draft and Final Determinations for Electricity Transmission and Gas Distribution and Water

Allowed Return on Equity Movement Between Draft and Final Determinations for Electricity Transmission and Gas Distribution and Water

(Source: Guidehouse)

Are Network Companies Being Punished for the Past?

Ofgem has previously been criticised for allowing gas and electricity network companies to give high returns to their shareholders. The decision to set a record-breaking low rate of return may partly reflect current market conditions as well as show the regulator’s tendency to tighten the rules governing the network companies in the upcoming price control periods. This approach may be seen as punishing companies for excessive returns of the past. It comes at a time when the UK needs significant new investment in gas and electricity infrastructure to meet the challenges of decarbonisation. The August announcement by PPL Corporation of its proposed sale of Western Power Distribution may indeed be a sign that low equity returns, capital demands, and questions around risk for UK energy network businesses require a different set of expectations, and possibly a fresh set of owners.

Are These Plans Enough to Achieve Net-Zero Targets?

Ofgem’s new spending framework has also raised questions over whether it sufficiently incentivises the required investment in the sector. According to the UK Climate Change Committee's Sixth Carbon Budget report, by 2030, more than 40% of UK passenger vehicles will likely have to be electric, compared with today’s 1%-2%. This likelihood will have significant implications for electricity network investment requirements, for which the Business Energy and Industrial Strategy Energy White Paper proposes a £950 million (~$1,282 million) investment impact. 

Similarly, the massive shift to create a hydrogen economy in the UK will require further investment from all stakeholders, from homeowners to gas distribution and transmission networks. The Guidehouse-supported Energy Networks Association Pathways to Net-Zero project highlights the need for many immediate actions if the transport, industry, and heat sectors are to decarbonise before 2050. Energy networks find themselves in a situation where urgent investment may be required; however, in regulatory terms, this investment is subject to a number of business plan re-openers, especially those related to heat policy and net-zero.

What Signal Does This Send to Investors?

Investing in gas and electricity networks has become more complex over the past few years with the emergence of decarbonisation targets and technologies that must be in the mix if these targets are to be met. For example, according to the UK Government Ten Point Plan, 5 GW of low carbon hydrogen production capacity will be needed by 2030. It is uncertain how this capacity would be split among industry, heating, and transport applications, with different implications for gas and electricity networks. 

Investments in times of great uncertainty should be supported by a regulatory framework that fully acknowledges the risks companies have to take and the challenges being faced. The ongoing commitment to supporting innovation is commendable and relatively rare in the world of regulated energy networks. The softening of Ofgem’s position since the draft determination is also a helpful signal and, despite critics of the RIIO regime, the position steers clear of overt input-based regulation and the vast compliance cost witnessed in markets such as the US. 

What Is Yet to Come for Electricity Distribution Networks?

This final determination excludes electricity distribution, which has a couple of years in its regulatory cycle. Many are hopeful that RIIO-ED2 will prioritise investment to electrify transport during the next decade, which will, in turn, be a huge factor in business plans. Likewise, the questions around heat decarbonisation and balancing electricity and low carbon gas in the system deserve full attention and could benefit from a regional whole-system view (such as the recent decarbonisation pathways project with Cadent Gas and Electricity Northwest in Greater Manchester). Although Ofgem has advanced the cause and provided some clarity with this set of final regulatory determinations, the situation is expected to continue to shift as we look toward a net-zero future with a new set of rules and differing investment expectations as energy business models fundamentally change.