Energy network costs: transparent and fair? Contents

2The RIIO price control framework

RIIO vs RPI-X

8.Until 2013, Ofgem regulated energy transmission and distribution companies’ network cost pricing policies on a five-yearly basis. Charges were linked to inflation through a formula known as RPI-X, where RPI was the Retail Price Index and X was an efficiency savings target. However, Ofgem concluded that the RPI-X price control would not meet Britain’s £30bn energy infrastructure shortfall.15

9.In 2013, Ofgem replaced the price control RPI-X with RIIO (Revenue = Incentives + Innovation + Outputs) which set targets to encourage more innovation in energy networks to benefit consumers. The more innovative energy networks would receive more financial rewards, while those that failed to innovate sufficiently would face financial penalties and further regulatory scrutiny. Ofgem also designed RIIO to attract more investment into Britain’s energy infrastructure by increasing the price framework period from typically five years (under RPI-X) to eight years, the current period started in 2013 and ends in 2021. This stability over a longer period aims to increase investor confidence. Ofgem estimated that £1bn savings for consumers could be achieved through the eight-year period.16

10.We heard that RIIO has been better at consulting stakeholders than the RPI-X process.17 The success of RIIO for the public hinges on setting targets, so that prices and profits rise no more than necessary. Ofgem reported that under RPI-X, all gas distribution networks and gas transmission companies generated greater than expected returns.18 Thus RIIO was intended to have more stretching targets with explicit outputs for network companies.

11.However, we heard from British Gas that Ofgem’s targets for the 2013 RIIO price controls were set too low, with 38 out of 40 targets reached by network companies in the first year. This enabled most, rather than just the best-performing, energy network companies to make higher than expected profits.19 National Grid confirmed in May 2014 that they had increased their assets by £1.1bn in the first year of RIIO and their performance had exceeded the targets set by Ofgem.20 Andy Manning, Head of Network Regulation, British Gas told us:

What we see is particularly the networks are making higher returns than were allowed when Ofgem set their allowances… the best performing networks should be able to receive higher returns. It is just that we are seeing that all networks are able to enjoy those high returns.21

12.Dermot Nolan, Chief Executive Office, Ofgem, agreed that the network companies’ initial profits under RIIO were higher than Ofgem forecast:

I have looked at the first year returns and I will say they are somewhat higher than expected…I do think that in any price control [period] it is always far too early to judge how effective the price control is at this point. I would say that if at the end of eight years everybody is earning higher returns, then it is probably indicative that perhaps something has gone wrong.22

We do not think it is in the public interest to wait until the eight-year period is over before determining whether the RIIO framework has met its objectives, and if the price targets have been too lenient.

13.The RIIO-Electricity Distribution (RIIO-ED1) is due in April 2015 and will set the outputs that the electricity distribution network operators need to deliver for their customers, as well as the associated revenues they are allowed to collect between 2015 and 2023. In November 2013, Ofgem “fast-tracked” Western Power Distribution (WPD)’s settlement as it was satisfied that its assessment showed value for money for consumers. In July 2014, Ofgem asked the remaining five network companies to reduce their draft RIIO-ED1 cost plans for April 2015 by £2.1bn.23 Ofgem considered that the network companies could find more efficiencies, particularly from smart grids. These preventative steps to control excessive profits are encouraging. The Minister confirmed his support for the potential benefits of smart grids in reducing network costs.24 However, there could be an £860m difference between Western Power Distribution (WPD)’s ‘fast-track’ RIIO-ED1 assessment, approved by Ofgem and Ofgem’s subsequent view of efficient costs in October 2014.25 If this is an Ofgem miscalculation caused by fast-tracking, WPD customers may have to fund the £860m difference over the eight-year price control period.

14.The Citizens Advice Bureau also told us that other network targets were set too low. They questioned whether the target set by Ofgem to connect 80,000 off-grid gas customers to the network over the 8-year RIIO period was stretching enough at 10,000 customers per year, as it is identical to the target under RPI-X, which had been achieved straightforwardly.26

Connecting small generators onto the network

15.The Government has announced that it wants to turn ‘the Big Six [energy companies] into the big 60,000’ by connecting small community generators to [distribution] grids through network improvements.27 The Government’s ‘connect and manage’ programme aims to connect new generation energy to transmission networks but there appeared to be no comparable policy at the distribution level.28 We heard from UK Power Networks (UKPN) that there was a lengthy backlog of new generators around the country waiting to connect to the network, especially at the distribution level with some small generating companies expected to wait until 2018 for connection.29 Basil Scarsella, CEO of UKPN, explained:

Distributed generation is a very quickly developing market, as we all know. From a UK Power Networks perspective, over the last three or four years we have connected in excess of 50,000 customers, ranging from a very small domestic wind or solar generator to a very large solar farm or wind farm. What has happened in the market over the last three or four years is that there has been so much demand that the level of offers that are around in the market and not accepted is now getting to the stage where some of the networks, including ours, especially in the eastern network, are getting pretty much full to capacity.30

16.We heard a similar view from Northern Powergrid, suggesting that subsidies for energy generation had over-stimulated demand for connection, resulting in lengthy delays for connection times for new energy providers.31 These delays prevent new competitors from entering the market. The Minister told us that the Government had made progress in increasing the market share of other companies to 9%, but accepted that it had not set a target date by which to achieve the ‘Big 60,000’.32 This lack of a clear deadline risks reducing the Government’s objective to rhetoric.

17.We also heard that government bureaucracy inhibits the pace of connections of energy providers. John Pettigrew, Executive Director, National Grid said:

The challenge is the planning process. We are very supportive of the new Planning Act, but it is a long process. I will take a specific example, just to give you the sense of it—the Hinkley nuclear station down in the south-west. We have been consulting following the steps that the Planning Act has set out now for four years, and we have just made our application to the planning inspectorate. That is to ensure that all the environmental and engineering studies are done, but, most importantly, that we consult with all the stakeholders locally to ensure that they understand the rationale for what we are doing and we can take on board their interest. It is quite a long process. I think there is the opportunity to put some flexibility in that when it is perhaps a less major project that there could be a fast track way of getting through the Planning Act. That is the long lead time with regard to a lot of the development projects of connecting generators. 33

18.The Minister told us that the Government recognised the importance of speeding up planning decisions and had a “huge amount of work on to try and improve that”.34 The Minister also said that from April 2015 there would be commercial incentives in RIIO to ensure that distributors connected providers more quickly.35

19.Ofgem has agreed price control settlements with the gas and electricity transmission companies and gas distribution companies until 2021 and with electricity distribution until 2023. We believe that the price controls are too generous and the targets are too low. We want Ofgem to utilise the RIIO price control frameworks to put more pressure on the networks to limit their costs and provide better value for consumers, for example through a mid-term review, ideally supported by an independent auditor to enable more accurate calculations of future price controls. We also recommend that DECC and Ofgem introduce an effective “connect and manage” policy for distribution-connected generation to clear the backlog and enable more connections. We recommend that the Government and Ofgem submit data on the number and regional variation of the backlog of connections, an analysis of the reasons behind it, and proposed solutions with a clear timeframe for network companies to address the backlog.

15 Utility Week, Ofgem’s new model to RPI-X, 6 October 2010

17 Q159 (Jeremy Nicholson)

19 British Gas (NTC0030); referring to Ofgem, End of period review of the first gas distribution price control (GDPCR1), 21 March 2014

20 National Grid, Results for the year ended 31 March 2014, 15 May 2014

21 Qq1-2 (Andy Manning)

22 Q215 (Dermot Nolan)

24 Q310 (Matthew Hancock)

26 Q26 (Richard Hall)

28 Department of Energy and Climate Change & Ofgem, Electricity network delivery and access, 22 July 2014

29 Q10 (Basil Scarsella)

30 Q10 (Basil Scarsella)

31 Q193 (Phil Jones)

32 Q280 (Matthew Hancock, John Fiennes)

33 Q151 (John Pettigrew)

34 Q289 (Matthew Hancock)

35 Q284 (Matthew Hancock)