On 7 March 2018 Ofgem released a major consultation on the framework for RIIO-2 (“Revenues = Incentives + Innovation + Outcomes”), the second framework period for setting price controls for the gas and electricity network in Great Britain.
5 key principles underpin Ofgem’s RIIO-2 proposals
Ofgem has proposed a number of important changes to its approach to price control in comparison to RIIO-1. Ofgem has also promised that RIIO-2 will be “a tougher price control for network companies. We will set targets that reward those that deliver great customer service at lower cost, and penalise those that do not”. As part of that promise, Ofgem has identified five core principles which will underpin the price control:
- Introducing different models for enhanced stakeholder engagement for the distribution and transmission sectors in RIIO-2. This will entail Consumer Engagement Groups (for distribution companies) and User Groups (for transmission companies).
- Responding to how networks are used, including by reducing the length of the price control from the current 8 year period, to a default period of 5 years. Ofgem will then challenge companies to “make a compelling case for some allowances to be set for longer if this could deliver benefits for consumers”. Ofgem is also proposing to separate the electricity System Operator’s (SO) price control from National Grid Electricity Transmission’s (NGET’s) Transmission Owner (TO) control.
- Increased use of innovation incentive mechanisms and competitive procurement. This will involve Ofgem revising the current incentive mechanisms to reward companies for introducing innovation to the benefit of consumers. Ofgem will also extend competition across the sectors (electricity and gas, transmission and distribution), where it is appropriate and provides better value for consumers.
- Reducing the complexity of the price controls, including by reforming incentives for companies to produce high-quality and less complex business plans.
- Fair returns and financeability, which will result in tougher economic settlements for companies and their investors.
The consultation comes at a time of challenge for the energy sector (and network utilities in general). The recent winter cold snap raised challenges of supply resilience as gas reserves dropped sharply. Ofgem, as with peer utility regulators, is also under political pressure to “get tough” with the companies it regulates. The RIIO-2 proposals seek to deliver a robust and sustainable price control, which reflects the changing use of the gas and electricity transmission and distribution networks, whilst protecting consumers and ensuring a fair return for industry participants.
Competition in network development – progress on direct procurement?
Ofgem has stated in the framework consultation that “we also want to see competition more widely where this can deliver benefits”. This “direct procurement” – where competitive tenders are used for the design, build, financing and/or operation of projects which would previously have been carried out by the regulated companies themselves – is intended to contribute to efficiency and value for money asset procurement in these sectors.
Ofgem believes that direct procurement has a potentially key role to play in delivering these benefits, and it is not an outlier in this regard. Direct procurement has been used successfully in the water and rail industries, and the energy sector has also seen various forms of competitive procurement in recent years (see Direct Procurement: the story so far).
The potential expansion of the current competitive procurement model would build on, for example, the current framework’s use of direct procurement, including OFTOs (competition for offshore transmission asset procurement and operation, with up to £1.2 billion of savings to be made through the use of competition in the first three tender rounds).
The extension of the direct procurement OFTO regime to onshore infrastructure (through, for example, competitively appointed electricity transmission operators – ‘CATOs’), and potentially also further extending direct procurement to gas infrastructure, has been delayed by the lack of a successful ‘test’ project.
However, whilst the previous candidate project - the North West Coast Connections/Moorside project – has fallen away, Ofgem has recently announced that it intends to run a competitive market proxy mechanism (referred to as ‘Competition Proxy’) for the funding of National Grid’s construction of the Hinkley-Seabank project (connecting the proposed Hinkley Point C nuclear power station to the electricity transmission network).
This, coupled with the Ofgem’s statements in the framework consultation, suggests that competitive procurement for major new development projects – whether badged as “direct procurement” or not – is still at the forefront of Ofgem’s considerations. In particular, Ofgem sees direct procurement as an effective way to deliver value for money to energy consumers in Great Britain.
There remain a number of uncertainties with the proposals as put forward. For example, it is not clear how effective the “competition proxy” approach would be in comparison to a normal regulatory review of new development proposals and costs that Ofgem would do under a traditional procurement model.
Nonetheless, while further detail will emerge at the RIIO-2 framework progresses, the likely expansion of some form of direct procurement offers investors and new entrants the ability to compete to deliver high value projects, while ensuring that system operation is delivered by an independent operator (National Grid Electricity System Operator).
Get in touch
If you would like to discuss the future role of direct procurement in the delivery of infrastructure in regulated industries, please get in touch with James Marshall, Julia Joseph or Kenneth Addly.