Energy network costs: transparent and fair? Contents

3Complexity and volatility

20.In this chapter, we explore the complexity of the broader network costs landscape, including legacy issues from the pre-privatisation era and the impact that this complexity has on transparency of network costs, and market behaviour in the energy sector.

Are network costs too complex?

21.Network charges for gas and electricity vary regionally. There are 14 regions (excluding independent DNOs) in Great Britain for electricity transmission and distribution, for the purposes of charging consumers. Northern Ireland operates a separate wholesale electricity market, the Single Electricity Market (SEM), which is integrated with the wholesale electricity market in the Republic of Ireland.36 These 14 areas represent the legacy of pre-privatisation supply areas (12 in England and Wales and two in Scotland). For gas networks, Great Britain is split into 12 local distribution zones (LDZs) which mirror the pre-privatisation gas board areas. Northern Ireland is not part of the National Transmission System (for Great Britain) per se, but since 1996 has received natural gas via the Scotland to Northern Ireland gas pipeline.37 Network companies pass their charges onto suppliers who in turn pass them onto customers.

Figure 1:1 Maps of the charging regions for electricity transmission and distribution

Maps of the charging regions for electricity transmission and distribution

Source Energy Networks Association

Figure 1.2 Maps of the charging regions for gas transmissions and distribution

Maps of the charging regions for gas transmission and distribution

Source Energy Networks Association

22.Charges are calculated on the basis of network charging methodologies, which are set out in the following regulated codes:

23.This combination of codes and regional charges has led to a complex system of network costs, which we heard is making it difficult to compare price and performance across different network companies.38 The complex methodologies also result in volatility in charges within regions on a year-on-year basis. John Pettigrew, Executive Director, National Grid, explained the reasons for maintaining regional variations for charges:

We have 14 zones and charges vary across those zones. The principle is to try to give to customers an indication of the cost that they are imposing on the transmission system. If you move to a standardised charge then of course there will be winners and losers and whenever we have done a consultation on charging you get people at both ends of the spectrum, both very passionate about what is the right solution. Historically, we have tried to stick to those principles, which have resulted in a tariff structure that is reflective of the costs in the transmission system rather than a standardised one.39

24.The Minister told us that RIIO had “significantly flattened” the regional variations on distribution costs, exemplified by a £27 reduction in average annual charge in the north of Scotland and a £4 increase in the south of Scotland.40 We questioned the necessity for maintaining different regional charges and explored whether a national tariff, akin to Royal Mail’s where the price of one stamp pays for delivery of a letter anywhere in the country, would be fairer and less complex. Dermot Nolan, CEO of Ofgem, said:

We are looking at that and we will look at it further. As I said, I think it can be done but it would be a very, very major change. It would be essentially a change that would be not delivered but decided upon by policymakers, or so it seems to me. There would also be administrative costs, but it might be considered fairer. I absolutely take the point. The mail service is nationally priced. The distribution service is not. That does seem to me to be a societal choice.41

25.Tointroduce a national tariff for gas and electricity transmission and distribution would require major changes to the existing charging system for network costs. For this change to be considered, further evidence must be gathered and a robust analysis undertaken. We recommend that the Government and Ofgem publish an evidence-based analysis of the advantages and disadvantages of introducing national tariffs for transmission and distribution network charges. These national and regional charges should include data on the costs for connecting different energy types, such as renewable energy sources.

Standardised reporting

26.We also heard that there is further scope to reduce complexity by standardising the reporting between network companies, to enable more ‘like-with-like’ comparisons. British Gas wrote that some network companies provide information sporadically, and delay publishing information on their performance by up to two years.42 This lack of information makes it more complex to assess whether or not the price controls are providing value for money. Maxine Frerk, Interim Senior Partner for Smarter Grids and Governance, Ofgem, explained Ofgem’s approach:

At the minute they [transmission and distribution companies] all have to produce an annual report, and at the minute the information that is required in it is the standard information that they provide to us. We make sure it is on a comparable basis, but the actual reports may look different. We have a new section of our website where we bring those reports together and over time we will be looking to make sure that that kind of comparable information is available.43

27.Ofgem announced on 10 October 2014 that it would launch reforms in 2015 which would require companies to report network costs under a common set of categories.44 Greater openness of information would help demystify the complexity of network costs. We heard that one aim of the RIIO framework is to lead network companies to have a more direct relationship with the end consumer in order to encourage greater accountability.45 We also heard that Ofgem is encouraging network companies to engage directly with local communities.46

28.A standard form of reporting would bring clarity to the performance of the network companies and the impact of the RIIO price framework. We welcome Ofgem’s approach to ensure that network companies provide comparable information at fixed, regular times. We would like Ofgem to provide a clear timetable to phase in this standard form of reporting, and more information on the interim arrangements. We also recommend that Ofgem continues to encourage network companies to engage more directly with consumers and include qualitative and quantitative information on consumer engagement in their reports.

Volatility

29.The physical infrastructure for UK energy networks has been in place for many years. There are predictable patterns of customer usage throughout the year. Despite this stability, we heard that price volatility in network costs was common. This potentially has a detrimental effect, particularly on suppliers, who incur extra costs. Peter Bennell, CEO, Haven Power, said:

I think we are making things far too complicated. Here, when we talk about distribution, we have a long-lived asset: 40 years, 50 years, 60 years and some of it has been in the ground 100 years. We have a very stable, predictable usage pattern among most customers, but from my perspective we have very volatile network charges….. If you look in my evidence, you will see how prices have gone up one year, down the next, and up again the year after and that is unnecessary. It is not reflective of the nature of the asset. It is not reflective of the costs that are there and it adds costs for business.47

30.Jeremy Nicholson, Director, Energy Intensive Users Group, confirmed that volatility was also adversely affecting large industrial consumers:

It’s not just the absolute level of network charges, but the volatility, and the changes in the distribution of where those charges fall, and that has affected our members in what should be a relatively stable part of the bill48

31.Jonathan Smith, Head of Trading & Pricing, First Utility, told us about the extra costs caused by volatility, the impact of complexity and the current 40 day notice period for price changes:

Volatility means that suppliers have to put a risk premium on their tariffs. If you think about other costs in the electricity bill, the wholesale electricity is about half of the bill. It is a volatile number, but I can go into the market and I can buy a hedging product to lock in the cost of that for my customers. With network charges there is no equivalent hedging product you can go into the market and lock in. You are exposed to the price that is set sometimes only 40 days before it starts being charged. Then when you think about the retailer, I am selling to domestic customers who, under retail market reform, are moving increasingly to one-year, two-year, three-year fixed tariffs where there is no lever. If there is a cost shock on the distribution or transmission charges, I cannot pass that through to my customers. You have complexity you can’t manage on one side and a revenue stream you can’t adjust on the other side. It is very difficult to compete in that market 49

32.The Minister acknowledged that uncertainty on network costs created a cost premium and the importance of using stability to bring down costs for consumers:

There is a cost premium to uncertainty and that, again, has to be balanced on the speed with which benefits accrue to consumers. If we can get the cost to everybody down by having a period of certainty then ultimately, over the longer term and over the period of most people’s lives, that will benefit consumers. 50

33.Maxine Frerk, Interim Senior Partner for Smarter Grids and Governance, Ofgem confirmed that volatility needed tackling:

It is an issue that we are aware of and have been trying to take steps to address by making those charges more predictable in the first instance. We are minded to approve a modification that would give companies 15 months’ notice instead of three months’ notice of the changes. The volatility tends to come as a result of there having been a few major changes to the methodology for how you allocate those costs between different categories of customer….the overall revenues that the companies get are stable over time, but sometimes you can get what are quite big swings as a result of how they are allocated between different categories of customers.51

34.The levels of volatility of network costs are unnecessary. The risk premiums that suppliers are compelled to add to mitigate the costs of volatility raise consumer prices. We recommend that Ofgem adopts the proposal to provide suppliers with 15 months’ notice of network price changes. Network companies must also provide clearer explanations for the reasons behind such changes.

37 Department of Enterprise, Trade and Investment, Consultation on the potential for extending the natural gas network in Northern Ireland, June 2011

38 Haven Power (NTC0035)

39 Q163 (John Pettigrew)

40 Q295 (Matthew Hancock)

41 Q245 (Dermot Nolan)

42 British Gas (NTC0030)

43 Qq242 - Q243 (Maxine Frerk)

45 Q240 (Dermot Nolan)

46 Q242 (Maxine Frerk)

47 Q67 (Peter Bennell)

48 Q128 (Jeremy Nicholson)

49 Q67 (Jonathan Smith)

50 Q279 (Matthew Hancock)

51 Q224 (Maxine Frerk)