Don't Dismiss Dieter

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My Reflections on Dieter's Review.

Dieter has now published his much-heralded Cost of Energy Review which roves broadly across the electricity landscape and puts forward some radical proposals. There’s logic to much of what he says but inevitably he skirts over some of the practical implementation challenges. However that’s not a reason to ignore what he says.

One criticism that might be levied is that while branded an “Energy Review” it focuses almost entirely on electricity and gas / heat is out of scope. Given that one of the key messages from those looking at how to decarbonise heat is the need to take a whole system view, this seems a missed opportunity. Dieter does allude in passing to how heat could help provide flexibility to an electricity system but hydrogen doesn’t get a mention in the 200 + pages. One particular reason this is a missed opportunity is that Dieter strongly advocates a cross sector carbon price. That is widely seen as being a key part of the jigsaw for heat decarbonisation – albeit that it does then raise real affordability issues which would need creative solutions to resolve.

One potential solution is the idea that Dieter puts forward for how one might deal with legacy costs in the context of fuel poverty – rising block tariffs. The idea that some policy costs might only be levied on consumption above a certain “essential” level is one that I tried to get government to consider some years back and raised again in my report for the NEA on Heat Decarbonisation. It’s also the sort of idea that Ofgem should be considering in the context of its targeted charging review looking at the allocation of fixed and common costs. Dieter makes the point clearly that the allocation of such costs is essentially a political choice - you can opt for a Ramsey pricing style minimal distortion or you can choose to allocate these costs to meet wider social objectives.

I made all these points in my response to the targeted charging review but also picked up on the MIT comment that allocating fixed and sunk costs on the basis of some income proxy (such as rateable property value) might actually meet both objectives. Given the income constraints of those who are less well-off there is at least an argument that price increases for those customers would have a bigger impact on consumption than price increases for those who are well off.

Returning to electricity, Dieter looks in his review across the value chain at the implications of the shift to decarbonisation, decentralisation and digitalisation. He sets out clearly how these changes affect the fundamental economics of energy as you move to a demand side that is no longer fixed, the ability to store energy (removing the need for supply and demand to match at all times) and the shift to zero marginal cost electricity which undermines key concepts such as the merit curve. We have a whole set of market arrangements designed around a set of fundamental economic principles which are fast becoming outdated. Hence the whole set of market arrangements needs to change too.

That is all very persuasive and Dieter is able to talk at a high level about what the new arrangements should look like – but he skirts over the practical challenges of implementation.

On the wholesale market and the current incentives around security of supply and decarbonisation Dieter paints a compelling picture of the complexity of the current arrangements which developed in an ad hoc way, strongly influenced by technology specific lobby interests and what he calls the “sicking plaster” approach to policy development. His solution of a single mechanism of an equivalent firm power auction has a logic and apparent simplicity to it. However, it is based on using the de-rated capacity of the generation bid into the auction. As he acknowledges the de-rating factors for a technology will vary depending how much of that technology is on the system and individual plant can improve its de-rating factor by contracting with storage or DSR. Add on top of his proposal that the SO should be able to apply discretion to take account of cyber risks and the uncertainty inherent in nuclear – plus a two stage auction to deal with the carbon angle and you end up with something that will be pretty complex and not necessarily that transparent. It could still be the right way to go but it won’t be as simple (or immune from lobbying) as Dieter implies.

On the legacy costs of renewables Dieter draws out important points about the relative cost of finance at different stages with construction being high risk and demanding equity level returns while the ongoing operation is much lower risk and can be largely debt financed. This is the basis on which offshore transmission projects have been funded to date with generators funding the building though equity finance with the projects then put to competitive tender for the ongoing operation. It is this, probably more than the competitive tendering process itself, that has helped deliver the low cost of capital for these projects. Exploring how renewable projects could be re-financed to benefit consumers is an avenue worthy of exploration.

The other omission from the report which has particularly significant impacts for the wholesale market is on ancillary services. The shift away from fossil fuel generation creates various technical operational challenges for the SO in terms of reduced inertia on the system, levels of reactive power etc Renewable generators and storage can provide these services but only if they are rewarded for doing so as there is a cost involved. We saw two years ago how when some of the larger fossil fuel plant failed to get a capacity contract it was kept on the system by National Grid offering contracts for Black Start services. There isn’t a problem fitting such ancillary services into Dieter’s model and auctions – which he generally supports - have helped keep the costs down. My point is that this is another layer of complexity that Dieter has been able to skirt over but which will become increasingly important in the new world.

On networks Dieter proposes the creation of national and regional system operators – public bodies charged with overseeing the system operation and able to tender for storage and demand side response as alternatives to traditional reinforcement. There is a logic in such an approach but the disruption and practical challenges involved in stripping out and renationalising that part of the networks role can’t simply be skated over. The efforts to increase the independence of National Grid SO give a sense of the costs and issues involved. Moreover, DNOs are already starting to run tenders for these alternative solutions, driven by the totex mechanism in the RIIO price control. It is therefore far from clear that the additional disruption would be justified. What it does suggest though is that instead of talking about the transition from DNO to DSO we should be talking about the creation of a new DSO function – and thinking from the start about the level of separation required.

Dieter also argues that with increasing uncertainty and technology change traditional price reviews are impractical and unnecessary if you have a RSO who can tender for the DNO services. There’s certainly a strong case that 8 years is too long for a price control given the pace of change – and I’m on record advocating a return to 5 years. However, to suggest that you can simply do away with price controls ignores the bread and butter activity of running the distribution network where the RIIO regime has driven huge improvements in reliability and customer service.

Finally on networks, Dieter joins in the debate on excess returns, while noting that this is more of an issue on transmission where he rightly notes that the lack of comparators makes a regulator’s job harder. The RIIO-ED1 price control to date is showing a range of returns across the companies and lower levels of outperformance than on transmission or on gas. He talks about the options open to Ofgem including the problems with what he labels “Danegeld” (and I think of as the playground bully). I rather like this poem which explains the Danegeld concept and provide a riposte for any networks who get approached by Ofgem in this way:

http://www.kiplingsociety.co.uk/poems_danegeld.htm

When considering the options that Dieter sets out for intervention on networks, if Ofgem feels it can’t simply "do nothing" then it should behave like an economic regulator and not a political body and make a formal adjustment to the regime. That may still add to regulatory risk but less than the alternative.

The last part of the value chain which Dieter discusses is the retail sector. Dieter’s proposal here is for a default tariff with a regulated margin which is not really very different to a price cap. While he argues that this would be more transparent by focussing on the element of the price that actually varies between suppliers, he reveals a lack of appreciation as to how consumers actually think and respond which Ofgem and the CMA both focussed on. Consumers won’t understand the concept of a margin and won’t trust the companies to work out the rest of the price in line with a set of rules. There’s not an easy answer to this one but I don’t think Dieter’s ideas really provide much help here.

Where they do present a useful challenge is to the obsession with switching which he describes as a deadweight loss. Switching is not an end in itself – the key is to ensure customers get a fair price. Even there though I disagree with his vision of the future market as one more like broadband where there is only a fixed cost and hence little for suppliers to compete over. In a world where demand side is expected to play a bigger role, tariffs that encourage that engagement in innovative ways will be the hallmark of a successful player. As Ofgem have already flagged this may or may not be suppliers as we know them now but it will be an important element of a smarter market.

Bringing it all together then in thinking about the future transformation you really do need to look across the piece to ensure that policies are coherent. I was critical of Ofgem for looking at embedded benefits in isolation. Getting the big picture view is important. Inevitably that means that all issues cannot be considered in the sort of depth that is needed before taking a policy decision – but presenting a challenging and overarching vision is a vital step along the path. On that basis, it would be dangerous to simply do what Dieter says but foolish to ignore the fundamental issues he raises.