25/04/18 – “Is regulation of utility networks effective at controlling costs?”

Speakers: Paul Bircham, Director of Strategy at Electricity North-West; Jeremy Nicholson of the Energy Intensive Users Group; Jonathan Brearley, Ofgem’s Senior Partner for Networks

25 April 2018

All-Party Parliamentary Group on Energy Costs

“Is regulation of utility networks effective at controlling costs?”

Chair: Alan Brown MP

Speakers: Paul Bircham, Director of Strategy at Electricity North-West; Jeremy Nicholson of the Energy Intensive Users Group; Jonathan Brearley, Ofgem’s Senior Partner for Networks

Chair’s Opening remarks

I’d like to extend a warm welcome to you all to this, the 42nd meeting of the All-Party Parliamentary Group on Energy Costs.

I am Alan Brown, the MP for Kilmarnock and Loudoun and the Scottish Nationalist Party’s energy spokesperson.

This afternoon we are addressing the question “Is regulation of utility networks effective at controlling costs?”

The Helm review suggested that customers have been getting a bad deal from the way that Ofgem regulates how much monopoly utilities can charge.

Certainly, the way that the revenues are calculated is complex, and there are a series of incentives given to companies that can increase charges.

It is difficult for consumers to know if they are getting value for money. However, consistently higher than inflation increases may leave customers wondering where the money is going and whether the approved investments are really required?

Are higher charges an inexorable consequence of government policy, necessary investment or a failure of regulation?

We have three excellent and very pertinent speakers I have asked them each for 5-7 minutes opening remarks after which we will go on to our normal Q&A.

Paul Bircham, Director of Strategy at Electricity North-West and Director Energy Networks Association

I have three broad points

  1. The purpose of network companies is to build an efficient, smarter, cleaner energy system fit for Britain’s homes and businesses, and this involves making substantial investment to build that network and reduce costs to customers, continuing to improve reliability (over the past 15 years we have halved the number of power cuts and 90% of customers are now satisfied with both gas and electricity). More than a quarter of all electricity generation is now connected to the distribution networks and most of that is renewable generation. It’s been a quiet transition as the networks have connected almost 30 GW in the last five years, and they continue to find ways to innovate in order to reduce the cost of decarbonisation. They are laying the foundations for a smart grid where we will deliver in a more dynamic way using more advanced technology.
  2. We think that the current regulatory system delivers cost benefits for customers and is a flexible system that can continue to evolve to suit our changing needs. Costs to customers are down – they have come down by 17% since 1990 and going forward network costs will be flat or falling for the next decade. The cost for energy networks for the average dual-fuel user is 69p per day. These are very capital-intensive businesses: we’ve invested £100bn since privatisation in 1990 and we have planned to spend another £45bn over the period of the coming price reviews up to 2023. That is all the network companies, both gas and electricity. Ofgem do set tough price reviews and do learn from the latest market information. The current price review set tighter returns and the effect of that over the RIIO 1 period is a reduction in revenue for companies of about £9bn. We’re in a dynamic market place and there is changing data and that changing data does need to be reflected into the regulatory process. At the last price review Ofgem did put in place a mechanism to ensure that every year the cost of debt that they allow is changed to track that market data.
  3. All over the country our members are devising and pioneering new techniques to support the communities that they serve and provide energy as reliably and cheaply as possible. We’ve been encouraged to do that and enabled to do that by the regulatory regime that Ofgem have put in place. The second ‘I’ in RIIO stands for innovation, and it really works: we have fantastic innovation going on in our energy networks and we are a world leader in many of those technologies and lots of countries look to the UK for its leadership in both innovative technology and regulation. Smart networks that we’ve developed are already saving about £1bn for customers since 2015 and forecasts are that there’ll be another £1.7bn worth of savings to 2030. When successful technologies are rolled out across all companies, there’s an £8bn opportunity for us in technology that we’ve already developed. The innovation stimulus has enabled the UK to develop a hinterland behind all the energy network companies, with new companies, start-ups, academics able to move into the energy network field, and to link together a wide range of different leading technologies to bring this about. We have such a capability now in the UK that we have a competitive edge against the rest of the world. The innovation works at many different levels: from the high-tech of the smart grid down to simple expansion of networks to help vulnerable customers. The gas network companies have a network extension scheme to connect vulnerable, fuel-poor customers and they will be connecting 91,000 households to the gas supply by 2021.

In conclusion I would say that the regulation of utility networks has been very effective at controlling costs. It’s an ongoing dynamic process to drive down bills for customers both in the short term and the long term, and it is enabling the UK to achieve the decarbonisation of our supply in a cost-effective manner.

Jeremy Nicholson of the Energy Intensive Users Group

Our brief is to campaign and lobby on behalf of our members, all of whom depend on secure and internationally-competitive energy supply to stay in business. Security of supply is obviously very important and any short-term economies that result in reduction of supply have a critical impact on our members. We do not believe in security of supply at any cost though, and we recognise that efficiency gains are possible.

We very much championed a liberalised marketplace model, recognising that there are natural monopolies of networks which will require independent regulation, and I think that in general that has served the UK consumer well, although it has worked better for domestic customers than for industrial ones if you look at comparison across the rest of Europe. It’s not so much about whether network companies are spending more here to provide electricity or gas, but how those costs are distributed and balanced between domestic and industrial users.

The network companies have made cost efficiencies, but one never finishes on this road and there is always more to be done. One of the risks that was taken in this price control period, which has extended over 8 years, is that the number of things that can be different from original assumptions made by regulators, investors and even politicians increases over that period of time 8 years. I don’t think there’s a perfect length of time for a price control review but 8 years is challenging, particularly as we are going through the transition to decarbonisation and decentralisation. When that also coincides with turmoil in financial markets and a flight to relative safety of networks and a drop in the cost of debt, it’s not surprising that profits are larger than anticipated. Defenders of Ofgem would say that there is a chance to claw that back at the next review and I’m sure we’ll see something of that – we will wait to see.

But waiting 8 years is not good enough and the suggestion that we may be moving back to 5 year reviews seem sensible.

Industrial consumers can have wide variety of load profiles, some with very constant loads on the network and others more flexible and variable. Consumers who can be flexible help keep network costs down for others, and are rewarded through the charging systems for doing so. Some are also generating their own energy as well as making use of private networks that are connected through to the transmission system or are transmission connectors themselves and not part of distribution. So there’s any number of them: there’s no such thing as a typical industrial consumer. This has a profound effect on the level of their network charges, which are typically a smaller proportion of the bill for industrial users than they are for domestic users. At a time when UK industry faces highest electricity prices in Europe, we are facing high network costs as well – partly due to overall costs and partly due to the way those costs are distributed – and that is a real threat to our manufacturing competitiveness, particularly for energy-intensive industries exposed to international competition.

That’s not specifically Ofgem’s concern, but more a matter for the network companies. It ought to be BEIS’s and MPs’ concern, and anyone who wants to see a thriving manufacturing sector.  No one is asking for subsidised network costs but they should be as efficiently incurred as they can be, and that there is a proportionate and fair distribution of those costs between users.

A recent report looked at the ratio of industrial to domestic costs and found a very steep profile in most of the rest of Europe and a much shallower one in the UK. Regardless of which is right, we’re in the minority in the UK and we have to compete with everyone else.

I’m not suggesting that we solve the problem of high network costs by dumping them all on domestic consumers as that would have very negative social consequences and would be morally indefensible, but nonetheless that’s the world we are operating in.

I would say that we are very sympathetic to some of Helm’s points and recognise the criticisms – although we’re not necessarily wedded to his particular solutions. Network regulation needs to step up a gear and has been found wanting to some degree in the recent price control. So if you don’t accept all Helm’s proposals (some of them are probably more radical than is necessary to cure the problem) one could at least accept that extending competition makes sense and is least problematic. It’s worked well for example with offshore and some new developments and there’s scope for doing more. That would help a regulator and deliver benefits for consumers.

I think stakeholder engagement is key to this as well, but I have a caveat about that. It’s a good idea and who would be against it, but resourcing is challenging for industrial users  – getting the balance right in the forthcoming price review will be important for Ofgem and a challenge for the network companies.

To conclude, people often say you need predictability in price control periods, just as they say with Government policy and other things, but you never get complete predictability in life and I think it’s a mistake to aim for that. That doesn’t mean you can’t seek to reduce unnecessary uncertainty and have a degree of clarity which is sufficient to finance the functions of network industries and give consumers reassurances about where we’re heading.

Therefore it is perhaps better to concentrate on being relatively adaptable, mindful that there are all sorts of changes that we know will take place, but we don’t know how many of them, how fast, or over what time period. We need to keep it simple and perhaps we’ve tested the boundaries of price control in RIIO 1 and learned a lesson or two from that.

Jonathan Brearley, Ofgem’s Senior Partner for Networks

I agree with a lot of what Jeremy said, and I’d like to start by talking a bit about history of network regulation. It’s not for Ofgem to judge how this compares to other systems, but let me talk about some of the things I think we’ve achieved.

There are three dimensions

  1. What has the scale of investment been?
  2. What has the service been like?
  3. What is the cost as a result?

If we go back 20/25 years there was a consensus that the networks themselves were under-invested, service levels were relatively low and costs were where they were. When you look at the system now, we’ve had over £100bn invested in the network as a whole, service levels have gone up and in particularly when you look at the fact that power cuts have halved since 2002, you see something that all of us care about and that is a big step forward.

In terms of productivity, the cost of transporting energy has gone down by about 17% compared to RPI in that time.

So overall I think there is a very strong record but that said, when you look at this price control there are some lessons we can learn. The good news is that those price controls were designed specifically to target things that customers really care about: they were very output-focused and very target-focused, and that part has worked. So we have seen customer satisfaction going up and we have seen more connections for the fuel-poor and we’ve seen fewer power cuts. But as we have said publicly, the returns are at the high end of what we expected: when we designed these price controls we expected some companies to do very well but what we have seen is a large number of companies at the high end of our original expectations. There are a number of reasons: when you look over 8 years the scale of change wasn’t foreseen. That’s not to say that Ofgem aren’t doing anything about this.

It’s not true that we set them and then forgot them – there’s a lot of change in that. For example, during this period we have taken back about £5bn. Some of that figure has been from companies coming forward and accepting that there is a legitimacy underpinning the regulation that needs to be respected and they have come forward with their own voluntary change.

However, that does mean that there are lessons for the future. We’re in the process of designing the next set of price controls and we have set out our early ideas. I want to talk a bit more about the energy system before coming back to the financing etc. I’ve been in the energy field for about 10/15 years now and I’ve never seen the scale and pace of change that we’re seeing now. Talking about predictions and actuals, 10 years ago my boss said solar would never take off in the UK because it’s just too cloudy, and many of us thought that offshore wind was always going to be more expensive than onshore wind because you had to put a turbine out at sea. All of these things were common sense at the time but they are being unpicked by the innovation that we are seeing in the market and by the scale and pace of change.

So in that context of change we need to make sure that when we design this next set of agreements, which run until 2021, we need to make sure that they can adapt to the very different worlds that quite frankly we can’t predict from where we are now. To pick up on Jeremy’s early point, that means we have to be more adaptable, both in the face of change – so that means indexing more of what we do – but also financially: Paul mentioned the debt index for example which has been successful in tracking down the reduced cost of debt and making sure that consumers feel that benefit.

So those things are definitely going to be part of how we structure the agreements, but equally we need to think hard about what the decarbonisation transition is going to bring and make sure that networks are working together to bring forward some of these new solutions, e.g. the role of low-carbon gas and hydrogen, where over time we’re going to have to ensure the networks are doing the necessary testing to make sure those options are right.

So there’s a lot there we need to do in supporting the wider system and making sure that these price controls can change as the world changes. But equally we are thinking hard about the structure and the financial structure that underpins it. So we have come forward and said that on balance, given this scale of change, we need to move back to 5 years. In addition to that we have set out our view from market evidence, that investors will accept a lower return than they used to. Network assets in stable regulatory regimes are highly prized by investors at the moment, because of the changes we are seeing globally. Ofgem has 25/30 year record now of preserving a stable regime. We need to make sure that is maintained and that the benefits are going back to consumers. So we’re moving from a baseline that was roughly 6½-7%, down to something that looks around 3 to 5%.

We are also making sure that when we refine the cost of debt we are keeping up with market changes there. In addition to that, one of the issues we are exploring is in the world where financial returns do move away from expectations, can we build in something upfront (we call it a failsafe mechanism) that says if things are strategically moving away from what we thought they were, can we design something upfront that investors can see and know about, that gets them back to where they were before. All of those things together we think will lead to savings of around £15-£25 per household per year and ultimately a total of about £5bn savings compared to the price control today.

The long-term record is there: each price control will result in lessons being learned for the next one, and our job now delivers that value for money and adapts to that new role in 2021.

Questions and Comments – taken in groups

Mark Todd, Energy Helpline: When the National Grid can make a 40% profit margin and customers are paying £250 year in network costs, isn’t it a fairly simple equation that £100 of profit is going from every customer’s bill effectively to the network companies?

Andrew Bainbridge, Major Energy Users Council: You’ve all given a fairly clean bill of health to regulation. I seem to remember that the Energy Networks Association spokesman said that the regulation was a bit harsh – do you agree?

Jonathan Brearley: In answer to the first point simply looking at the margin doesn’t take into account the investment that has gone in there previously. What needs to be looked at is the return on investment: for National Grid this is around 9½-10%. I’m not saying that there isn’t more we can do to derive greater value next time, but we need to be sure that we have the right matrix to process this. On the other point, I don’t accept what the ENA say.

Paul Bircham: I’ve been part of four price reviews and now I’m going into a fifth. At the start of every price review, the energy network companies say “this looks really harsh” but by the end, they’ve performed well, and looking back they say that it wasn’t as bad as they thought it was. So there is a truth that we need to learn – generally, it is that necessity is the mother of invention. If you’re faced with a very tough price review, you take some tough decisions and face challenges that, initially, management teams really don’t know how they will get out of. Quite often the first couple of years are quite tough before the effects of the changes start to take effect.  Price reviews are set in a way that everyone sucks their teeth and tightens their belts, but they’re not set in a way that everyone goes to the wall.

As for the point about profits, the profit margin for my company is about 30% and I’m not ashamed of that because the money we invest every year in our network is larger than what we take out. For every £1 taken out, we put back in £1.40, and it’s only through generating what accountants called “profit” that you can satisfy your lenders that you are a sound business. Profit is seen as a dirty word but in fact these companies make a small return because money is being recycled as investment: the accountants ignore that capital re-investment and calculate profit purely on operating costs, which is only a partial picture.

Alan Brown MP: Can you explain a little more? Are you saying it’s not a true profit?

Paul Bircham: The profit number is smaller than the capital investment, but when accountants using their internationally acknowledged accountancy standards to calculate the number that is called “profit”, capital investment is ignored, so all the money that is taken out is considered to be taken out as profit, but actually it is profit before re-investment.

Jeremy Nicholson: That’s an important point. Firstly on the ENA, if I was a member of that association I would expect them to say that price controls are tough, and if I was in Ofgem’s position I’d be worried if they weren’t saying that.

On the point about margins and profits, there is scope for confusion here. I am perfectly happy to criticise network companies and their regulators if excess profits are being made, but that’s rather different from looking at the gross margins.

It’s important to recognise that this isn’t like a retail business where you buy or make something and then sell it on for a margin – there’s an awful lot of kit that goes in the ground and elsewhere that makes this happen and it takes investment to finance improvement programmes and the like. It’s good to keep the pressure up on behalf of consumers, but be careful at how the media portray these figures.

Damir Ahmovic, Alfa Energy: What are your thoughts on peer-to-peer energy and its likely impact on network costs?

Jonathan Brearley: One of the fundamental issues we have in this next set of price controls is that we don’t have the old world of a generator over here and a customer over there, etc. with the different systems to deal with them. Peer-to-peer energy is one example where things could be more cost-effective for everyone if we had the right systems for that, and I’m optimistic about peer-to-peer trading and also about peer-to-peer storage. I’m optimistic too about other things we can do that avoid the need for networks and traditional companies. The challenge for us when we set these price controls is how we get people who do this into the discussion at the consultation stage to ensure that all this is taken into account. Part of the design of the new price controls is going to be a very intensive consultation and we welcome anyone with input: the more people we can get into the room, the better sense we will have of the new forms of competition as well as the traditional ones.

Paul Bircham: I am excited by the prospect of peer-to-peer trading. We have more than a big enough challenge ahead as we seek to decarbonise our transport system and some of our heating. As an electricity network, we need to maximise the utilisation of our existing assets before we build anything new. To do that we need our customers to offer up some flexibility in their use of energy, and things like peer-to-peer trading can put a real value on that flexibility.  Flexibility of demand and generation will enable us to get the most out of our network before we need to upgrade it.

Peer-to-peer will be beneficial in stimulating that market of participation that will enable consumers to reveal their flexibility. We have just issued first piece of information where as a network company we are calling for market-based responses to some of the capacity challenges we have on our network. We’ve issued press releases in last few weeks saying “these are the areas where our network is likely to be constrained in the future”, and rather than build additional infrastructure we are seeing whether the market will come back to us and offer a response that will enable us to avoid that infrastructure cost.

Damir Ahmovic, Alfa Energy: Do you think it will put upward pressure on network costs?

Paul Bircham: Not necessarily, no. I think it will keep network costs down because we can avoid the cost of building new infrastructure. It’s always cheaper to get customers to move the time of day at which they consume their energy than to build new infrastructure.

Alan Brown MP: Looking at next price control and the range of things you have to take into consideration, how do you take account of what regulation changes might come in?

Jonathan Brearley: When we run the process we run a whole range of scenarios, and we will be looking at the different changes that might be out there. In some areas (for example, the regulatory area) we may say if we’re not sure that (whatever it is) is going to happen yet, we may keep the price control flexible and not change the revenue until that change occurs. In other areas we might have to take a view even though we’re not sure. There are a huge number of start-ups nowadays offering services that network companies could offer, in competition with them in effect, and we need to design a price control that brings out those effective alternatives. That’s partly through calculating figures but also maybe we start driving competition for these services more into the framework that we’ve got, and that might mean saying “this could go to a network operator, or it could go to someone else” and we need to find a way of allowing that competition to happen.

Ashutosh Shastri, Enerstrat Consulting: What changes are we likely to see in RIIO2?

Alan Brown MP: Helm said RIIO was not fit for purpose because of the vast technological changes that were going on. Was he wrong?

Jonathan Brearley: On innovation, in the last set of agreements we set aside a lot of funding for network companies to bid in for big innovative changes. Around this time last year we ran a detailed review to see whether that delivered and we found that the benefits were about eight times the cost of the funding.  The reflection we have when looking at the new price controls is that some of those things were quite operational: they were about doing things more efficiently, and for next time we’ll say that things like that (e.g. a robot fixing a pipeline) really should just be part of business as usual and something the business should be doing to drive down costs. So we’re making two changes in focus, although we haven’t got the details yet. One change is that we want this funding to focus on the areas where we need big collaboration, e.g. low carbon heat where gas networks will need to work together to face the challenge. Equally in a world where we have peer-to-peer trading, we will need some kind of distribution system where the district networks will be playing a much more active role in making sure the system works. So those are the sort of areas where we can imagine focusing the innovation funding. The other thing is that we will open it to everybody and not just to network companies. So if someone comes up with an idea that they think needs to be developed and will produce benefit for everybody, they will be able to bid for funding to get the early stages off the ground. I think that will give us more diversity in terms of what we will see, and will stimulate things that perhaps would be harder to bring forward without it.

Coming onto Helm, what he said was that we need one more of these, but in his view we should then move to a system where that central body tenders out for services. We are still looking at the Helm report so it’s too early to say what we will conclude but I do think the market is changing radically and things will need to change significantly. Where I absolutely agree with him is that whatever we do, we have to build in that sense of competition. The question is how to get that competition into the system and how does it align with the parties that are already there.

Jeremy Nicholson: As suggested earlier, you don’t have to agree with every one of Helm’s suggested solutions but you do have to have a response for all his criticisms. He makes some fair criticisms to which the Government needs to respond. In yesterday’s debate the point was raised: if there are cheaper ways, whether on security of supply or other aspects of energy, why wouldn’t we want to pursue them? We can argue about the precise means of doing that but where I think there are grounds for optimism, I think some of what Ofgem’s been saying about simplicity, engagement and so on, is a step in the right direction.

Paul Bircham: What we have seen in the nature of regulation and the price review framework is that it continually evolves and it flexes to address the challenges of the day and the market situation of the day. If RIIO was to be completely inflexible it would not be fit for purpose, but if RIIO can be flexible I see no reason why it shouldn’t work. Fundamentally in RIIO, and Helm has published something else more recently on this, is the fact that RIIO is an incentive-based framework which challenges companies to go out and find ways to reduce their costs, and to innovate and improve things for their customers. That seems to me to be a fundamental principle that should be continued in our regulatory framework, whatever shape it is. Incentive-based regulation drives companies to respond to the harsh realities, to do things differently and to get better.

At this point, Alan Brown MP left the meeting.

Georgina Bailey, Policy Connect: A question about the relationship between the fuel-poor and energy companies.

Jonathan Brearley: This is something we are beginning to think hard about in RIIO2. There’s a set of questions about how we apply the fuel-poor extension targets and there’s a question around the fuel-poor and the wider energy transition. Frankly, it is something that we need to do more work on, particularly having had feedback to that effect. We need to ensure that we are targeting price controls and benefits more effectively at the fuel-poor.

Jeremy Nicholson: One thing you don’t want to be doing is closing off options for reducing problems (whether in the industrial sector or the domestic sector). Whilst recognising we have carbon capture etc. to meet, if you look at the cost of a unit of heat from gas compared with electricity, electricity costs are is going up for environmental reasons at the moment. I’m not saying that gas is the solution to everything but if you want affordable heating in some parts of the country, extending gas networks is a relatively cheap option compared with some of the alternatives. It’s not a universal solution but certainly removing access to gas supplies in areas of social deprivation, in the name of greenery, is not a good idea.

Paul Bircham: That’s an important point, and the move to cheaper decarbonisation targets by 2050 gives two opportunities to replace everyone’s boiler. Gas boilers will continue to have a massive role to play and we should not necessarily be rushing all consumers to fit heat pumps: there is a gas role in the transition and the extension of gas networks is a good way to address fuel poverty. Also, look at how the network costs are shared. We’ve seen with the Government subsidy of solar that those who get the biggest benefits are usually the more affluent, so bear in mind that if some affluent consumers avoid network costs, the burden will fall on the less able to pay.

George Major, Ardour Energy: Question about RTS tariffs in the Scottish Highlands.

Jonathan Brearley: We look hard at the way we arrange network charges and we clearly had a big debate about how we allocate this and how cost-reflective it is, and although ultimately it is for the Government to decide because they’re the ones who set the framework within which we operate, the cost-reflective system we have is better for more vulnerable consumers.

George Major, Ardour Energy: In the work I’ve been doing I’ve been speaking to around 1000 customers on RTS tariffs where there is no competition and therefore it is quite challenging to switch. This goes against the general theme of competition in everything.

Tim Lines, Fuellers: Has the idea of district heat died a death? A nuclear power station, e.g. Hinckley, could heat the whole of Bristol and Portishead.

Jonathan Brearley: Responsibility for this is primarily BEIS’s but there is quite a lot of funding going into district heating and they are looking at the issue now of how to regulate it, and we’re awaiting the outcome of that. Clearly it is growing fast enough that we regulators want to be sure that we have the right regime to go with it.

Jeremy Nicholson: It’s always seemed difficult to me to see how some of the wide-scale district heating schemes would stack up against of reducing thermal loads on the system in the first place. You have to have some kind of heat to do this with. Frankly I don’t think anyone knows where we’re going to be by 2050, but I suspect in dense urban areas there is still potential for increasing heat networks. In industrial sites where there are multiple companies co-located, making use of waste heat is normal and there’s more CHP in the industrial sector than anywhere else. It’s easy when you have stable and predictable demand but it’s more complicated to do this in a domestic setting.

Tim Lines, Fuellers: How effective has the smart metering rollout been?

Paul Bircham: Electricity and gas has been rolled out at the same time. My personal view is that it has been an abject failure because it’s been delivered against artificial deadlines which have led to damaging compromises. We are currently rolling out millions of smart meters that when a customer switches supplier, revert to being dumb meters. Smart meters do not provide useful data to network companies and my personal view is that all the potential benefits of the programme have been lost.

Tim Lines, Fuellers: Does that apply to SMETS2 meters?

Paul Bircham: No, they’re better. In the North West of England, 600,000 meters have been installed but only 2 of them are SMETS2 meters. We’re missing a huge opportunity.

Jonathan Brearley: There is an upgrade being worked on to allow the meters to be transferred to new suppliers. There’s a lot of work going on as to how we manage this problem but the meters are a fundamental part of the transition to the new world.

 

 

The meeting closed at 5.50pm