​​Ofgem’s RIIO-3 SSMC​

On 13 December 2023, Ofgem published its Sector Specific Methodology Consultation (SSMC) for its forthcoming RIIO-3 price control for electricity transmission, gas transmission and gas distribution networks. Oxera summarises some of the key themes emerging from the consultation, ahead of the final methodology decisions expected in Spring 2024.

Introduction

The ongoing RIIO-2 price control period for energy networks in Great Britain is expected to end in March 2026. In anticipation of this, earlier this year Ofgem consulted on an overall regulatory framework, the Future Systems and Network Regulation (FSNR), and published its decision in October 2023.¹ As per that decision, the next price control period for electricity transmission (ET), gas transmission (GT) and gas distribution (GD) networks, together GD&T, will last for five years from April 2026 to March 2031.² The next stage in the development of the regulatory regime is the Sector Specific Methodology Consultation (SSMC), which Ofgem published on 13 December 2023,³ and which is the focus of this article.

The UK’s plans to decarbonise the power system by 2035 and achieve a net zero economy by 2050 have led to a significant push for electrification. The pace of investment in electricity network expansion is unprecedented, while gas networks are facing uncertainty around the phase-out of natural gas and how existing networks will be utilised for other fuels. In this context, it is important to note that a net zero duty was added to Ofgem’s remit as recently as this year.⁴ We look at the highlights of Ofgem’s proposals on how to address the challenges of energy transition.

Ofgem needs to set a RIIO-3 price control that provides sufficient certainty to companies, investors, customers and other stakeholders. However, this settlement also needs to be sufficiently flexible to support the decarbonisation pathway that Great Britain will take up to 2031, when RIIO-3 ends for GD&T networks. In terms of investment, this is likely to mean a settlement that supports:

• the pre-emptive construction of new infrastructure. There is a risk that some of this will subsequently prove to be unnecessary, underutilised, of the wrong technology or in the wrong location—depending on how decarbonisation priorities and technologies (as well as their costs to deploy) evolve in the coming decade;
• the construction of a framework that helps companies to respond dynamically to new information without undue regulatory burden (for example, in terms of choosing which parts of the gas network might be repurposed to use hydrogen);
• consumer interests, which could encompass multiple areas such as affordability, the protection of vulnerable customers, intergenerational equity, and networks being fit for purpose in meeting future net zero targets.

In particular, we observe that, while some specific issues and approaches to implementation differ across gas and electricity, there are many commonalities. Ofgem has structured its SSMC for GD&T around four common outcomes:

• infrastructure fit for a low-cost transition to net zero;
• secure and resilient supplies;
• high quality of service from regulated firms;
• system efficiency and long-term value for money.

There is scope for tension among these objectives—in particular, between the need to ensure that network underinvestment is not constraining the delivery of decarbonisation and minimising network costs. RIIO-3 will need to strike the right balance between regulatory control and company flexibility; between pre-emptive spending and cost minimisation; between providing certainty and retaining optionality; and between allowing companies to attract capital and keeping bills low.

The future system operator’s (FSO) development of a Centralised Strategic Network Plan (CSNP) will provide an independent, coordinated and longer-term approach to wider network planning in Great Britain to help meet the government’s net zero ambitions.⁵ While this is intended to support Ofgem’s approach to making these trade-offs, the first CSNP is scheduled for 2026—relative to an indicative date for the RIIO-3 final determination in late 2025. This will require networks and Ofgem to finalise the business planning and approval process under considerable uncertainty.

Electricity transmission

In the ET sector, a post-RIIO-T2 status quo has already arguably emerged over the past few years through Ofgem’s introduction of the Accelerating Strategic Transmission Investment (ASTI) framework.⁶ Ofgem is proposing to introduce a RIIO-3 framework for ET that retains the broad structure of the RIIO-T2 + ASTI arrangements.

Ofgem’s framework for new strategic investment will draw heavily from the regulator’s experience of setting up the ASTI framework in terms of aiming to reduce the regulatory burden and streamline the development process. It will involve:

• relying on the FSO to establish the needs case for new projects, with Ofgem’s role refined to regulating delivery;
• automatic funding for early development costs;
• an expedited cost assessment process, supported by an independent technical adviser;
• a strong financial incentive to promote timely and high-quality delivery;
• the development of a model for competitive tendering, but only deploying it where this will not delay project delivery.

A source of tension with the existing portfolio of ASTI projects has been the two incentives that were introduced to promote timely and high-quality delivery—(i) an output delivery incentive (ODI) that applies an automatic penalty for late delivery of up to 10% of project expenditure; and (ii) a licence obligation (LO) to deliver before a certain date with an unconstrained level of penalty. Some stakeholders have commented that these mechanisms expose networks to high levels of risk, particularly as the timelines that the target is calibrated against is outside of transmission operators’ (TO) control (as the FSO defines the delivery date, and Ofgem defines the financial incentive regime). Therefore, a question remains around whether the return will be sufficient to compensate for this risk and for new capital to enter the sector—and if not, whether this will delay delivery.

This relates to the financing challenges associated with the large net inflows of equity that are required to fund new transmission, which Ofgem positioned as part of its FSNR decision as ‘investability’, describing it as considering ‘whether the allowed return on equity is sufficient to retain and attract the equity capital that the sector requires’.⁷ Ofgem has proposed some ways to develop the standard financeability framework to incorporate the investability concept, and is seeking input to develop it further.

In terms of smaller projects, Ofgem intends to extend its reliance on the assessment by the FSO—funding lower-value works that are identified by the CSNP through a combination of uncertainty mechanisms (UMs). For investment that is not identified through the CSNP, Ofgem will rely on its RIIO-2 suite of regulatory tools—ex ante allowances and re-openers.

Gas transmission and distribution

In the GT and GD sectors, networks face different sources of uncertainty relative to the ET sector. Specifically, gas networks face uncertainty around the extent and pace at which the pathway to decarbonisation will affect existing and new/enhanced network assets. The pace at which the GB energy system decarbonises, and the pathway that it takes, will affect when and whether assets are retained, repurposed or decommissioned.

Ofgem’s starting point for RIIO-3 is that it does not currently anticipate that there will be large-scale, systematic changes to the gas networks during the RIIO-3 price control period,⁸ and it is therefore proposing a fairly unchanged price control process from RIIO-2. In several policy areas that could significantly affect the future of the gas network,⁹ the sector is awaiting a number of government decisions.

Ofgem highlights the longer-term risk of gas network asset stranding if gas demand falls before the existing regulatory asset value (RAV) is paid down. Ofgem notes that exposing investors in gas networks to stranding risk ‘could undermine regulatory stability and predictability and is likely not in the consumer interest’,¹⁰ and is explicit about not favouring an increase in the return on capital allowance as compensation for the asset stranding risk perception.

Ofgem outlines two main policy aims in relation to a diminishing user base:

• that consumers tomorrow do not pay a significantly higher charge than consumers today for their use of the gas network;
• that consumers today pay no more than is necessary.

It aims to achieve these with an alternative depreciation profile for gas networks. Ofgem has undertaken RAV and bills development modelling and found that, if the existing depreciation policy is followed, gas networks’ RAVs will not fully depreciate by 2050 and the charges per user will increase substantially from the 2030s onwards. It also highlights some complications in the process of setting a new depreciation profile—in particular, in terms of how to account for the cost of decommissioning, the uncertainty relating to the expected utilisation of gas networks, and the uncertainty around the potentially high residual value of the assets if they are repurposed for hydrogen and carbon capture, utilisation and storage (CCUS) applications.

Below we cover the building blocks of the proposed RIIO-3 regime, efficiency assessment, and finance topics.

Building blocks of the proposed RIIO-3 regime

Building on the framework decision, Ofgem has started to consider the practical tools that it will use in RIIO-3 in the SSMC. The building blocks of the price control design are the same as in RIIO-2 and are discussed in turn below.

The output framework

The output framework will still consist of LOs, price control deliverables (PCDs),¹¹ and ODIs.¹²

While the intention is to keep cross-sectoral, sector-specific and company-specific incentives, Ofgem is planning to standardise these as far as possible. Parallels can be drawn with Ofwat’s PR24 approach, in which it has sought to move to an incentive framework based around common ODIs and PCDs, relative to its historical framework, which placed a greater emphasis on bespoke ODIs for incentivising company-specific output delivery and investments.

There is significant uncertainty in the volume required, and in the cost to deliver certain outputs over the RIIO-3 period. Ofgem is proposing to retain its approach to addressing uncertainty via five types of UM: re-openers, use-it-or-lose-it allowances (UIOLI), volume drivers, indexation, and pass-through items. Ofgem takes RIIO-2 as a starting point and comments on whether to retain, modify or remove certain UMs.

Information and efficiency incentives

For the information (or, in Ofgem’s words, ‘truth telling’) and cost efficiency incentives, Ofgem uses the business plan incentive (BPI) and the TOTEX incentive mechanism (TIM).¹³ In RIIO-2, within the structure of the BPI, all cost forecasts were split into those in which Ofgem had high or low confidence (defined by, for example, the quality of the justification provided by networks). The proportion of high-confidence costs was then used to set incentive rates for the TIM—i.e. percentages of cost out- and underperformance that networks would keep when actual costs deviated from forecast.

For RIIO-3, Ofgem is minded to move away from the high/low confidence cost approach and move closer to the ‘in the round’ ambition assessment, similar to those used in RIIO-1 and in the latest PR24 methodology in water.

Incentivising innovation

In RIIO-2, two innovation funding mechanisms were available to networks: the Network Innovation Allowance (NIA) and the Strategic Innovation Fund (SIF). However, having identified several reasons for change, Ofgem is proposing improvements for stakeholders’ consideration—examples of which are provided below.

• To increase third-party involvement, instead of limiting innovation stimulus to networks, Ofgem is considering establishing an accelerator to support early-stage innovators.
• Regulatory sandboxes, i.e. changing or relaxing current regulatory rules for innovative projects, are considered to be potentially helpful to stimulate transformational innovation. In proposing this measure, Ofgem refers to successful implementation of such mechanisms by regulators internationally.
• Ofgem is also concerned that only a small number of projects that receive innovation funding are being rolled out at all, or are being rolled out quickly. The options that Ofgem are considering to address this challenge are success incentives, conditional roll-out allowances, penalties for non-delivery, and impact-based incentives.

Efficiency assessment

To respond to the uncertainty over the future of gas and macroeconomic challenges within the relative cost assessment framework for RIIO-GD3, Ofgem is exploring options for the timeframe (given that the changes in the nature of activities potentially makes historical costs less suitable for assessing the efficiency of forecast costs) and cost drivers in use.

It is also consulting on whether the market volatility and supply chain challenges resulting from changes in the macroeconomic environment, and leading to cost pressures, could be sufficiently addressed via the existing real price effects (RPEs) mechanism. RPEs allow Ofgem to adequately capture the cost developments that networks face beyond movements in a generic inflation index such as CPIH.

Return on capital allowance

As previously outlined in the FSNR, Ofgem is planning to keep a single rate of return allowance for all types of investment. It is also planning for the methodology to be consistent with the guidance by the UK Regulators Network.

For the cost of debt, a change that Ofgem is proposing to its existing trailing average indexation methodology (based on the iBoxx GBP Utilities 10+ index) is to introduce an annual RAV weighting for all companies.¹⁴ Ofgem explains that the RAV weighting would allow it to compensate ET networks for high expected RAV growth (which they will need to finance at the current high rates), while keeping the structure of the trailing average relatively stable.

On the cost of equity, Ofgem uses the RIIO-2 methodology as a starting point and keeps it unchanged as far as possible. One change that relates to the energy transition is Ofgem’s indication that it may set sector-specific betas if sufficient evidence is provided that systematic risks are different for different sectors. Moreover, Ofgem acknowledges that beta estimates based on historical data may not accurately reflect systematic risks on a forward-looking basis.

As in RIIO-2, Ofgem is planning to cross-check the adequacy of the capital asset pricing model (CAPM)-based allowed return on equity with other available evidence. In addition, Ofgem is acknowledging that it will need to account for the expected outcome of the entire price control and adjust the return on equity allowance up or down, if that is required to ensure that the expected return matches the best estimate of the cost of equity.

Treatment of inflation

Given that the RAV under Ofgem’s regime is indexed to inflation, networks’ allowances are higher at times of high inflation. To avoid inflation double-counting, Ofgem sets the return allowance in real terms. However, it is concerned that debt financing costs would typically be fixed in nominal terms and not change with inflation—as a result, equity holders would receive an even higher inflation remuneration when inflation is high (and lower when inflation is low).

Ofgem has previously considered making an adjustment to networks’ allowances to retrospectively remove this extra effect on equity holders’ remuneration, but decided against it, explaining that the predictability and stability of the regime is valuable for consumers, as it keeps the cost of capital down.¹⁵ Instead, Ofgem is considering making a forward-looking adjustment to the RAV indexation or to the cost of debt allowance deflation mechanisms. In some of Ofgem’s options, it proposes to make changes only to the part of the debt portfolio that is assumed to be fixed-rate rather than linked to inflation.

Next steps

Stakeholders have until 6 March 2024 to respond to Ofgem’s SSMC, in terms of commenting on Ofgem’s proposals and contributing to its thinking. Ofgem will then finalise its Sector Specific Methodology Decision (SSMD) and issue its business planning guidance. In the SSMD, we expect to see more details about how Ofgem is planning to ensure ‘investability’ in the networks; how it intends to address the uncertainty that gas networks face in planning for their decreasing user base via accelerated depreciation and/or other mechanisms; whether Ofgem achieves a streamlining of the regulatory regime as it intended in the FSNR; and what balance it achieves as regards the trade-offs that the industry and Ofgem face as part of the energy transition.

1 Ofgem (2023), ‘Decision on frameworks for future systems and network regulation’, 26 October, https://www.ofgem.gov.uk/publications/decision-frameworks-future-systems-and-network-regulation, accessed 13 December 2023.

2 Ibid., para. 4.35.

3 Ofgem (2023), ‘RIIO-3 Sector Specific Methodology for the Gas Distribution, Gas Transmission and Electricity Transmission Sectors’, 13 December, https://www.ofgem.gov.uk/publications/riio-3-sector-specific-methodology-gas-distribution-gas-transmission-and-electricity-transmission-sectors, accessed 13 December 2023.

4 Ofgem (2023), ‘Ofgem welcomes proposed legal mandate to prioritise the UK’s 2050 net zero target’, 7 June, https://www.ofgem.gov.uk/publications/ofgem-welcomes-proposed-legal-mandate-prioritise-uks-2050-net-zero-target, accessed 20 December 2023.

5 Ofgem (2023), ‘Decision on the framework for the Future System Operator’s Centralised Strategic Network Plan’, 13 December.

6 This has largely replaced the Large Onshore Transmission Investment (LOTI) reopener introduced at RIIO-T2, which in turn replaced the strategic wider works (SWW) reopener from RIIO-T1.

7 Ofgem (2023), ‘RIIO-3 Sector Specific Methodology Consultation – Finance Annex‘, 13 December, para. 5.9.

8 Consistent with Ofgem’s Open Letter on Future of Gas Price Controls. See Ofgem (2023), ‘Open Letter Decision on Future of Gas Price Controls’, 26 July, p. 8.

9 For example, in relation to (details of) blending hydrogen and methane, hydrogen transport infrastructure, and the role for hydrogen in domestic heating.

10 Ofgem (2023), ‘Consultation – RIIO-3 Sector Specific Methodology Consultation – GD Annex’, 13 December, para. 10.7.

11 PCDs may be evaluative or mechanistic.

12 ODIs may be financial or reputational.

13 For details on these mechanisms in RIIO-2, see Oxera (2020), ‘RIIO-2 Final Determinations: how final?’, 14 December, https://www.oxera.com/insights/agenda/articles/riio-2-final-determinations-how-final/, accessed 19 December 2023; and Oxera (2020), ‘RIIO-2 Draft Determinations: what next?’, 20 July, https://www.oxera.com/insights/agenda/articles/riio-2-draft-determinations-what-next/, accessed 19 December 2023.

14 The proposed approach would be similar to that applied to Scottish Hydro Electric Transmission (SHET) in RIIO-2, with some mechanical improvements.

15 Ofgem (2023), ‘Call For Input – Impact of high inflation on the network price control operation – Conclusion and Next Steps’, para. 3.7, https://www.ofgem.gov.uk/sites/default/files/2023-12/Call%20for%20Input%20-%20Next%20Steps%20-%20Final.pdf, accessed 20 December 2023.