Ofgem’s RIIO-1 electricity framework too lax, says NAO
Consumers paid too much for their electricity during the RIIO-1 price control period after Ofgem set performance targets for the network companies too low and allowed them over-generous cost budgets, according to the National Audit Office (NAO).
30th January 2020 by Networks
The NAO’s Electricity Networks report described how the distribution and transmission companies had achieved market-beating returns, delivering shareholder around 9% in real terms compared to a UK company average of around 5%-6%.
The report also criticised Ofgem for allowing the RIIO-1 rules to prevail for eight years, rather than five, delaying the opportunity to correct the course, and locking consumers into paying higher costs for longer.
But the report also found several areas to credit Ofgem’s work, including the low level of power cuts experienced in the UK compared to the EU average – the frequency of power cuts has declined since Ofgem introduced incentives on reliability in 2002.
Ofgem’s regulation of electricity networks has delivered good service performance but higher than necessary costs for consumers
Gareth Davies, chief executive, NAO
It also found that the three transmission and six distribution companies have met almost all their RIIO-1 targets on safety, environment, reliability, providing timely connections, customer services, and assisting vulnerable consumers.
The spending and public services watchdog is now urging Ofgem to tighten the rules governing the network companies in the forthcoming RIIO-2 price control period, and to foster more coordination in the energy system to ensure that the low carbon transition carries the least possible cost to consumers.
Gareth Davies, the head of the NAO, said: “Ofgem’s regulation of electricity networks has delivered good service performance but higher than necessary costs for consumers. Its approach to price controls used insufficiently demanding targets and the eight-year price control period meant a longer wait before these targets could be reset.
“While Ofgem has encouraged networks’ innovative efforts to reduce carbon emissions, more needs to be done across government if the UK is going to reach net zero emissions at least cost to consumers. Tougher regulation of networks is part of the picture, but so is greater policy certainty and better coordination between the energy system’s many players.”
According to the NAO, transmission and distribution network costs made up around 20% (£130) of the typical household’s annual electricity bill in 2019. Overall, they amount to £8 billion a year.
The RIIO price control framework aimed to ensure that consumers receive a reliable service, and are not overcharged, while encouraging the networks to innovate and enable the transition to low-carbon energy.
However, consumers’ interests were not adequately protected under RIIO-1, the NAO says, because the networks’ performance targets were set too low, and their cost budgets were set too high.
In addition, Ofgem overestimated how much money shareholders and investors would need to incentivise them to invest in network companies.
Ofgem had expected real-terms return on regulatory equity of between 2.5% and 10.5%, with only the best-performing companies reaching the high end of the range.
In practice, the NAO says, three of the nine network companies are forecasting returns of around 10%, and the average forecast return is 9.2%.
Of the 9% returns typically achieved by network companies, 1.5 percentage points came from rewards for exceeding performance targets, including a scheme to prevent power cuts, and 1.2 percentage points come from network companies spending less than their full allowances for costs, the report says.
But the NAO found that Ofgem had fixed targets for the power cut avoidance scheme too far in advance, meaning networks were already exceeding their targets before RIIO-1 started.
It estimates that if Ofgem had placed greater weight on the most up-to-date evidence on network company risk, consumers could have paid at least £800m less in total.
Ahead of the net-zero imperative, which could mean that the amount of electricity flowing through networks may need to double to support electric vehicles and electric heating, the NAO warns that this expansion should not add significantly to consumers’ bills.
The spending watchdog says that strong pressure from government and Ofgem will be needed to protect consumers, as the changes ahead will not necessarily be in networks’ financial interests.
The NAO points out that continued policy uncertainty – where BEIS has not yet introduced a fully-fledged strategy for low-carbon heat – creates a risk of either too little network infrastructure being built (endangering the net zero target), or too much being built (adding cost to consumers).
It is therefore calling on BEIS to consider the benefits of more strategic coordination in the energy system, to help keep network costs to a minimum while the wider economy undergoes a mass transition to low-carbon power.
Citizens Advice, in its role as the official consumer watchdog for energy, gave its response to the report. Dame Gillian Guy, its chief executive, said: “Today’s report is more evidence that energy networks have enjoyed a major windfall at the expense of consumers. Our research in 2017 showed how gas and electricity networks have been able to overcharge consumers by £7.5bn during the current price control. This cannot happen again.
“Ofgem has made good progress towards a tougher settlement next time around. The regulator must hold its nerve, resist the efforts of networks to water down its proposals and deliver a price control that works for consumers.”
In Ofgem’s response to the report, Akshay Kaul, director of network price controls said: “We welcome the NAO’s findings that Ofgem’s regulation has delivered consumers a good service, increasing customer satisfaction and sharply reducing power cuts to half the European average, whilst attracting £70 billion investment to connect record levels of renewable power.
“We acknowledge that the overall costs to consumers to date have turned out to be higher than they needed to be. That’s why our tough new round of price controls will lower returns to save consumers money, whilst pushing companies to go further on decarbonisation and ensuring we retain one of the world’s most reliable energy systems.
“Under our regulation, companies must share any savings they’ve made during the price control period with consumers. So far, over £6 billion has been clawed back across all networks through reduced revenues or voluntary contributions.”
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