Reviewing RIIO

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Reflections on Ofgem's Open Letter.

Last week Ofgem published its consultation on the framework for RIIO-2. The good news is that they are clearly building on the RIIO concept – not trying to recreate a new regime from scratch. And their open letter represents a genuinely open consultation on how RIIO might be improved. As such it is of as much importance to the DNOs as it is to GDNs and transmission – indeed one might observe that Ofgem seems more interested in the questions around development of the electricity system than gas. It was ever thus, but the DNOs are only 2 years into their existing control and Ofgem should not be trying to design the detail of their control at this stage – while recognising of course that many of the broader principles will read across so DNOs will have to engage in this debate to some extent.

It's good to see a strong focus on bringing the consumer voice into the debate and the letter picks up on some of the angles explored more fully in my paper that is on the Ofgem website (which gets a footnote reference). One of my lines in that paper is that something closer to full negotiated settlement might work in transmission where (as in airports) the users of the system are actually industry players with whom some deeper dialogue on future requirements might be possible and valuable. For the distribution networks the real question is for Ofgem. How far is it willing to let end consumers define different standards in different regions reflecting different local priorities – or does it want to stick with a set of national incentives which facilitates benchmarking? Ofwat has historically allowed different incentives in different regions but for PR19 is moving to standardise the metrics while still allowing companies to set their target level based on consumer feedback.

The other obvious thread in the paper is a concern that companies have been earning excessive and unjustified returns. The concept of “legitimacy” is a new and helpful one – high returns can be justified if they are the result of efficiency and innovation (and I would argue exceptional customer service). They are a problem if they result from mis-forecasting or windfall gains as a result of falling interest rates for example. But the misconception that continues to be promulgated is that this means there will be a “natural dispersion” of returns. That might be a reasonable expectation but there is no reason in principle why all companies couldn’t earn at the top end if they were all strong performers. Or indeed why they shouldn’t all see low returns if they let things slip. This should be about absolute not relative performance. There shouldn’t be prizes for winning the fat boys race and an arrangement that encourages sharing of ideas and knowledge (so that all can excel) must be in consumers' interests in this sector.

Most of the questions Ofgem raises are the obvious ones that have been trailed around the industry over the last few months (including in my Utility Week article) – a move away from 8 years, alignment of T and D controls, the future of fast track, sharing factors and indexation to name a few.

The one novel idea in the paper is that Ofgem would determine the level of costs at the beginning of the process with companies then required to justify any deviations from that in their plans. It has some appeal – and if you are looking to stronger consumer engagement in the price control then stakeholders will need that sort of input. But it rather begs the question of how Ofgem propose to do this. If it was that easy we wouldn’t need the whole protracted price control process and the top down and bottom up benchmarking (which Ofgem seemingly still plans to do). The idea behind fast tracking and IQI is to try to get companies to reveal what they really can do – with the stretch target of the most ambitious then used to set allowances for the others. There still needs to be a strong incentive for companies to submit plans that outshoot whatever Ofgem may initially be thinking. So while it would be odd for Ofgem to “determine” the costs upfront, the idea that it could provide guidance on an expected upper bound is worth exploring. Most regulators could – at the beginning of the process and simply looking at high level trends form a view of where they might expect to land. And the fact that under RIIO companies have to provide a rolling forecast each year will help. But Ofgem does keep emphasising the extent of change anticipated over the RIIO-2 period which means that information asymmetry will as ever be a major problem.

Companies and stakeholders now have the summer to come up with views on the 37 questions Ofgem has raised. While Ofgem have stuck with the core principles of RIIO, there is still a lot to play for in this far-reaching review. The companies (and other stakeholders) have a busy summer ahead.