Written evidence submitted by Ofgem
ABOUT OFGEM
Ofgem welcomes the opportunity to provide evidence
to your inquiry on the Government's proposals for a Green Investment
Bank. We are the Office of the Gas and Electricity Markets. Protecting
consumers is our first priority. We do this by promoting competition,
wherever appropriate, and regulating the monopoly companies which
run the gas and electricity networks. The interests of gas and
electricity consumers are their interests taken as a whole, including
their interests in the reduction of greenhouse gas emissions and
in the security of the supply of gas and electricity to them.
OUR RESPONSE
Ofgem considers the main components of the inquiry
to be outside of the scope of our remit and to be the responsibility
of the Government. Correspondingly Ofgem cannot comment on the
requirement for a Green Investment Bank, its objectives, priorities
or funding and governance structures. However, we feel that we
have some relevant information to provide to the Committee in
relation to the inquiry. This includes:
- Some of the findings of our Project Discovery
assessment of how the energy market can deliver secure and sustainable
energy supplies. This work looked at some of the significant financing
challenges faced by the industry.
- Our role in creating and administering the Low
Carbon Networks Fund, which is designed to encourage innovation
in network delivery. This fund was wrongly identified in the Report
by the Green Investment Bank Commission as a cash fund for innovation
trials. In fact it is part of the regulated company revenues and
is funded through electricity network operators raising charges
to consumers to fund the selected projects. If good projects are
not found, consumers will not be charged.
- Our experience and role in administering mechanisms
for ensuring investment in the electricity and gas networks. Ofgem
has recently introduced a new regulatory framework ("RIIO")
which will form the basis for securing £32 billion of
network investment by 2020.
- Our role in creating (with the Government) the
successful tender regime for encouraging new investment in offshore
cables which attracted almost £4 billion of investment appetite
for the first nine transmission links worth around £1.1 billion.
PART 1: PROJECT
DISCOVERY WORK:
COST AND
AVAILABILITY OF
FINANCE
As part of our year-long study into whether the current
arrangements in GB are adequate for delivering secure and sustainable
electricity and gas supplies over the next 10-15 years, Ofgem
found that around £200 billion worth of investment would
be needed by 2020. The work from Discovery has now fed in to,
and been taken over by, the Government's Electricity Market Reform
process.
The "Discovery" investigation (published
February 2010) highlighted that while investor confidence appeared
to be recovering from the global financial crisis, there was still
a question as to whether the high levels of investment needed
in the UK energy sector over the next decade will be available
at a reasonable cost given the riskiness of the investment environment.
Discovery concluded that the markets' willingness
to lend or invest and the associated cost of funding will be determined
by the perceived risks in the GB energy sector relative to other
sectors and markets. Low forward liquidity in power markets and
uncertainty surrounding future carbon prices and subsidy levels
were key risk factors facing investors. It also found that any
perception of heightened policy and regulatory uncertainty, particularly
given the long term nature of the investments required, may also
push up the costs of financing them.
Discovery assessed that the bulk of the investment
required in the GB market is likely to be focussed on riskier
activities such as generation (especially renewables), gas storage
and smart meters. Raising debt for these types of investment looked
challenging, implying that a higher degree of equity finance may
be required to meet funding requirements. The primary sources
of such funding remain pension and infrastructure funds, other
private sources of equity and sovereign wealth funds.
Companies can expand their balance sheets to fund
new investment through borrowing, equity and bond issuances, but
we assessed that they may start to face the constraint of limited
market demand for further issuances should the companies become
over-borrowed. Management teams may well proceed cautiously and
multi-national players may prioritise investments in markets with
a higher degree of confidence in achieving good returns.
However, Ofgem would add that while Discovery did
find the above, Ofgem has not concluded whether a Green Investment
Bank is or is not the solution. There are a number of ways to
improve financing, both involving and not involving the creation
of such an institution. Ultimately, it is for Government to decide
how it best wants to tackle the financing challenge.
PART 2: THE
LOW CARBON
NETWORKS FUND
Rationale for a fund
The future use of the electricity distribution networks
will change considerably with the increased take-up of low carbon
initiatives such as distributed generation (DG), demand side management
(DSM), electric space heating, electric vehicles and electricity
storage. This could require significant changes to the way these
networks are designed and operated, and the commercial role the
network operators (DNOs) play. For example, they may need to introduce
more intelligence onto the networks to make sure they can adapt
quickly to the changing pattern of network use and connect new
users promptly without having to wait for new transformers or
lines to be installed.
DNOs will need to better manage energy flows on their
networks. Advances in technology, as well as the new data that
will become available through smart meters could enable the DNOs
to run the networks more efficiently, by directing energy around
the grid in a more flexible way. More efficient movement of energy
will allow the grid to better manage peaks in demand.
Network companies will need to innovate in the way
they design, build, operate and charge for usage of their networks
to deliver smarter networks and encourage customers to change
their behaviour. The DNOs also need to anticipate and explore
how they can ensure that the significant investments required
in the future are cost effective and fit for purpose.
During the last electricty Distribution Price Control
Review (DPCR5), Ofgem recognised that the regulatory framework
whilst successful in incentivising efficiency and customer service,
has not operated to encourage the companies to trial and innovate,
since the companies believed they would gain little benefit and
bear all the risk. Ofgem therefore decided to introduce a mechanism
to incentivise network innovation.
Introduction to the fund
In the Final Proposals of DPCR5, we proposed a £500 million
Low Carbon Networks Fund (LCN Fund) to encourage the electricity
distribution network operators (DNOs) to use the price control
period (1 April 2010 to 31 March 2015) to try out new technology,
operating and commercial arrangements.
The LCN Fund will enable the DNOs to run trials to
explore which technologies and commercial and operating arrangements
are likely to provide best value for money for network users while
helping to tackle climate change. We anticipate that the projects
may highlight the technical, regulatory, commercial and legal
changes that may be needed to ensure that the networks can meet
the needs of users into the future. We also anticipate that the
trials may reveal information about the way that consumers respond
to the deployment of new technology. We expect these trials will
help to inform the business plans that the DNOs submit to us at
the time of the next price control review.
A key feature of the LCN Fund is the requirement
that learning gained from projects can be disseminated, to maximise
the benefits of the trials so that customers get value for money
for their "investment" and receive the subsequent network
cost savings and/or carbon benefits.
How the fund actually works
Currently electricity distribution network operators
have price controls which are set every five years. These controls
determine what expenditure is needed on each of the regional monopoly
networks and what amount the network operator can recover from
customers. The costs are passed onto energy suppliers in the form
of distribution charges, the cost of which they reflect in the
energy bills paid by their customers.
Although described as a "fund", the LCN
Fund is actually part of the price control mechanism. There is
no available pot of money to be used like a Government grant
or a Carbon Trust loan, rather the costs of the selected projects
are passed on to consumers via distribution charges as outlined
above. We consider this makes it very different to the other
funding mechanisms mentioned in the Report by the GIB Commission.
More specifically, the LCN Fund consists of two tiers.
DNOs will be able to use the First Tier to recover a proportion
of expenditure incurred on small scale projects and to recover
expenditure incurred to put in place the people, resources and
processes to progress small innovative projects. The total expenditure
that a DNO can recover from the First Tier is subject to an annual
limit, amounting to £20 million across all DNOs per annum.
The Second Tier provides total funding of up to £320 million
over the five years (£64 million a year) for a small number
of significant "flagship"
projects. Ofgem will hold an annual competition for project funding
and the DNOs will compete against each other for an allocation
of the funds. The annual process involves DNOs putting forward
outline project proposals for Ofgem to assess whether they meet
the eligibility criteria. This is then followed by an annual call
for, and submission of, full proposals. Ofgem (advised by a panel
of independent experts) will decide which projects (if any) are
to be awarded funding, against a predefined set of criteria.
If a project is selected, costs will be spread across
all of the DNOs (and therefore socialised across consumers).
DNOs will transfer their share of the funding to the DNO with
the winning project over the first year of the project implementation.
Just as the costs are socialised, so too must be the benefits.
Successful bidders have to demonstrate how they will pass on information
to other companies so that the benefits are realised for all consumers.
Ofgem is part of the way through the first round
of Second Tier Project evaluations. We have been encouraged by
the projects received, which involve a wide range of partners
and collaborators, and cover a broad range of areas including
three "smart cities" and a range of projects aimed
at investigating accommodating electric vehicles, distributed
generation and wind energy intermittency. Ofgem will publish its
decision by the end of the year.
In addition, a discretionary reward worth £100 million
over the five year period enables Ofgem to reward successful delivery
and projects that bring particular value in helping the DNOs understand
what investment, commercial arrangements and operating strategies
they should be putting in place to provide security of supply
at value for money for future network users, while doing all they
can to tackle climate change. We will seek to use the discretionary
reward to imitate the commercial benefits of innovation through
rewarding DNOs for successful innovation by relating these rewards
to the risks that their shareholders have borne (relative to customers)
and the benefits associated with that innovation, as well as any
learning arising from it. This will not, typically, give rise
to the same level of rewards that unregulated companies enjoy
with successful innovation because under the LCN Fund DNOs will
typically only fund 10% of the expected costs with customers funding
the other 90%.
PART 3: REGULATING
THE NETWORKS
AND ENCOURAGING
INVESTMENT
Of the £200 billion of investment needed by
2020 highlighted by Project Discovery, about £32 billion
will be spent ungrading the electricity. This includes investment
in the onshore and offshore grids. The diagram below illustrates
some of the key onshore investments.
In order to ensure the necessary investment, as well
as ensure that ths investment is underpinned by innovation and
delivers security of supply, Ofgem has fundamentally changed the
way in which it regulates networks. Following a comprehensive
two-year review, we have scrapped the old RPI-X regime, which
set each of the regional network companies' regulated performance
over each five year "price control" period. While RPI-X
was very successful in securing £35 billion of investment
over its lifetime, Ofgem did not think it provided the flexibility
needed to meet the challenges that the industry now faces.
The solution: "RIIO"
RIIO (Revenue=Incentives+Innovation+Outputs) is the
successor to RPI-X and Ofgem's solution to the challenge. The
RIIO model takes the best from RPI-X, but places far more emphasis
on the delivery of specific outputs (eg network reliability) through
a framework which heavily encourages innovation. This will support
the delivery of environmental outputs and the delivery of smarter
grids. It will protect consumers by rewarding those companies
that innovate and invest efficiently, meeting their outputs, but
will penalise those companies which perform badly for consumers
with lower returns on their investment.
RIIO is designed to ensure that companies can operate
economically and will be able to raise finance effectively through
the regulated asset base. However, there will be no bailout for
companies that make mistakes and get into financial trouble.
Each price control will continue to be set ahead
of the period of activity. Targets will be set in advance, which
continue to provide companies with the incentive to minimise costs.
Costs will be passed on to consumers more in line
with the benefits incurred. If the benefits of a certain project
will last over 20 years then it is reasonable to expect the costs
to be spread over that time. Asset values will also be depreciated
more in line with actual their lifetimes.
Innovation funding will be embedded in the RIIO framework
through fund for Gas Distribution and Transmission which operate
in similar way to the Low Carbon Innovation Fund. Whilst there
will be a separate "virtual pot" of funding for gas
trials and for electricity trials, both transmission and distribution
companies will be competing for the same funding. In addition,
third parties will also be able to compete to run trials.
Investment in the offshore grid
The offshore regulatory regime for licensing offshore
electricity transmission, introduced in 2009 by the Department
of Energy and Climate Change and Ofgem, uses competitive tendering
to ensure the cable connections are delivered on time and at reasonable
cost. Essentially, any company can bid for the right to own and
operate offshore transmission links in return for a 20-year regulated
revenue stream. The aim is to encourage competitive bids and new
entry into an area that was the preserve of National Grid, Scottish
Power and SSE (the existing network operators).
The early signs from this process are positive. The
first round of tenders was very successful, attracting almost
£4 billion of investment appetite for all nine transmission
links worth around £1.1 billion. It has resulted in overall
forecast savings of £350 million for offshore wind farms
and ultimately consumers, and attracted new entry for firms like
Balfour Beatty.
The key features of the offshore regime for investors
are:
- A 20 year RPI-linked revenue stream under a licence.
This provides offshore transmission operators and investors with
long-term regulatory certainty.
- Bidders wishing to become Offshore Transmission
Owners (OFTOs) have to bid their required revenue as part of the
competitive tendering process.
- Strong incentive regime which is availability-based
and with no energy volume/price risk or stranding risk for the
OFTOs.
Ofgem will commence a second transitional round of
tenders later this year for assets for around 2GW of capacity,
with a potential asset value of around £1.8 billion. In total
high voltage cable links worth over £20 billion will be needed
to connect a potential of around 50 GW of offshore wind over the
coming years.
I hope that you consider this information useful
and that it forms the basis for an interesting discussion at the
evidence session.
Office of the Gas and Electricity Markets (Ofgem)
15 October 2010
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