Ofgem clarifies RIIO-2 pricing and methodologies

With the New Year heralding RIIO-2 T2, and ED2 just two more years away, Ofgem has laid out its final determinations and methodology decisions to focus on the drive for Net Zero.

As expected, Ofgem’s RIIO-2 energy delivery regulation and pricing controls focus on the drive for Net Zero energy across the UK by 2050, with the entire electricity system Net Zero capable by 2025.

On the positive side, there is more funding available for innovation than originally suggested, with a £30bn funding package (£5bn more than originally proposed) to support the industry’s Net Zero transition.  A further £10bn of additional funding is being set aside through ‘uncertainty mechanisms’ to allow for strategic network investments and flexibility, particularly as electric vehicle and heating demand/supply increases to meet the government’s recent 10 Point Plan. However, these mechanisms will not be automatic at this stage.

Innovation will also be backed by two allowances: the £450m+ Strategic Innovation and £209m Network Innovation Allowance. The latter has already spawned a number of projects including ENW’s QUEST voltage control initiative - for which Fundamentals has been appointed to deliver voltage control expertise - and UK Power Networks’ 5G connectivity trial.

Carrot and stick

But, there is also a price to pay for the network operators as the regulator looks to increase efficiency whilst lowering consumer costs and returns on equity.  As a result, an average 16% has been taken off the funding levels requested in DNO Business Plans as an “overall efficiency challenge…to do more for less”; 33-50% of network savings will have to be shared with consumers; and the cost of equity is reduced from the RIIO-1 7.8% to a new 4.55% (4.3% actual) level. Whilst the latter is higher than the 3.95% proposed in the July 2020 draft, it is still the lowest rate ever set.  

Good customer service and reliability standards will be incentivised (or penalised where necessary), with a small amount of funding (£13m) being made available for maintenance, repair and replacement of aged network assets.

Electric methods

Ofgem also released its methodology for the electricity distribution network price controls (RIIO-ED2) which run from 2023-2028. Again, the focus is on Net Zero and reflects the overall Determination document for RIIO-2. 

The regulator does highlight the challenges that will certainly be faced by the DNOs in overcoming generation and supply uncertainties – in particular from renewable energy and the increased demand from electricity-powered vehicles and heating – and states its clear expectation of the development of agile and flexible networks.   

In laying out these expectations, Ofgem states: “The challenge of Net Zero will require concerted effort over the coming three decades. This price control spans a critical period – network companies cannot wait for everything to become clear but must proactively manage those uncertainties.”

Ofgem also recognises the changing role of DNOs as they take on greater distribution system operation activities. However, it comments:  “there is a lack of consistency in how different DNOs carry out these activities. In RIIO-ED2, we are providing clarity on our expectations for these functions and putting in place an assessment framework with incentives on DNOs depending on how they perform.”

To assist with this, the regulator announced in the document a “strategic DSO work programme” to start in early 2021.  This aims to review the industry structure and needs as energy systems become increasingly decentralised.

In terms of keeping consumer prices as low as possible, through ED2 Ofgem plans to:

  • Scrutinise rigorously DNO’s business plans
  • Use its cost assessment toolkit to set “efficient” cost allowances
  • Retain strong incentives for companies to find cost efficiencies, flexibilities but ensure a higher share of generated savings are returned to consumers
  • Tailor a Business Plan Incentive for “ambitious” companies
  • Provide a toolkit of uncertainty mechanisms to allow flexible allowances to meet Net Zero targets
  • Increase the use of competition to drive efficiency
  • Introduce the Return Adjustment Mechanism (RAM) as a “backstop measure” to avoid excessive returns.