OFGEM Case Study 2 – Energy Price Control Appeal

OFGEM Case Study 2

Energy price control appeal: British Gas Trading

British Gas Trading v Gas and Electricity Markets Authority; Northern Powergrid v Gas and Electricity Markets Authority

 CMA (2015): ‘Northern Powergrid (Northeast) Limited and Northern Powergrid (Yorkshire) plc v the Gas and Electricity Markets Authority – Final Determination

https://www.gov.uk/cma-cases/energy-price-control-appeal-british-gas-trading

Competition & Markets Authority (29 September 2015)

The appeals were made under section 11C of the Electricity Act 1989 and relate to price controls made for the 8-year period from 1 April 2015 to 31 March 2023. NPg is an electricity DNO. BGT is an electricity supplier which pays charges to each of the DNOs for use of their respective electricity distribution networks. Ofgem announced the details of the price controls in November 2014 (https://www.ofgem.gov.uk/publications-and-updates/ofgemannounces-%C2%A317-billion-new-investment-package-and-reduces-pressure-customer-bills) and published its final decision (https://www.ofgem.gov.uk/sites/default/files/docs/2015/02/slow_track_crcs_modification_notice_feb2015.pdf) on 3 February 2015.

The final determinations and all other information relating to the appeals are available on the Northern Powergrid (https://www.gov.uk/cma-cases/energy-price-control-appeal-northern-powergrid) and British Gas Trading (https://www.gov.uk/cma-cases/energy-price-control-appeal-british-gas-trading) case pages.

Ofgem new statutory licence modification appeal process- determination of the applicable price controls for electricity distribution for the next eight years.

In its determination on NPg’s appeal, the CMA dismissed 2 of the 3 grounds of appeal. It upheld one ground in relation to Ofgem’s adjustments to reflect potential savings available from the introduction of smart grids and other technological innovations. The CMA’s determination will increase NPg’s allowable revenue over the price control period by around £11 million.

In its determination on the BGT appeal, the CMA dismissed 4 of the 5 grounds of appeal. The CMA upheld, in part, one ground which sought to challenge the adjustment that Ofgem made to the up-front rewards and penalties for DNOs in its Information Quality Incentive scheme. The CMA’s determination increases the net penalty across the 10 ‘slow-track’ DNOs (those which did not reach an early settlement with Ofgem). After taking into account tax, the effect of the increase in the penalty is to reduce the amount of revenue DNOs are allowed to recover through charges by around £105 million over the price control period.

RRIO < Revenue = Incentives + Innovation + Outputs

  • Incentive-based regulation
  • RIIO-ED1 is the first price control conducted for electricity DNOs under Ofgem’s new incentive-based regulatory model: Revenue using Incentives to deliver Innovation and Outputs (RIIO).

Ofgem’s principal duty: In the interest of consumers that efficient network companies can secure finance in a timely way and at reasonable cost to facilitate their regulatory obligations

  • No bail-out if financial distress is due to own behaviour
  • No reward of inefficiency or unwarranted returns
  • Capital structure remains the responsibility of network companies‟ management

RRIO-T1 = The need for significant investment in the networks. Challenge of facilitating required investment while ensuing that both existing and future consumers get value for money.

Addressing uncertainty: Significant uncertainty over basis on which some investment would come forward and the associated costs. The need to put in place mechanisms that allow for flexibility to address the uncertainty during the RIIO-T1 period.

RRIO-D1= Fundamentally changed behaviour and Board discussions at companies

  • Significant step-up in stakeholder engagement to present well thought-out, detailed and better justified business plans
  • Ofgem staying true to RIIO principles:
  • Framework and key parameters clearly set out early on
  • Transparency of approach from early on– No „black box‟ dates
  • Increased stakeholder engagement – including investors
  • Proportionate treatment
  • Higher level of scrutiny focused on areas not well justified
  • Two Scottish TOs fast-tracked
  • Flexibility in allowed costs ensure customers pay only for necessary expenditure
  • Financeability not compromised – transition where needed

British Gas and Northern Powergrid brought appeals against Ofgem’s determination of the applicable price controls for electricity distribution for the next eight years. These are the first appeals brought under the new statutory procedure set out in section 11 of the Electricity Act 1989, so the CMA’s determinations are now the leading authority on the conduct of such licence modification appeals and the standard of review to be applied by the CMA.

CMA determination: In respect of British Gas’ appeal, the CMA rejected all but one of the six grounds of appeal advanced by British Gas, almost entirely upholding the price control determination applied by Ofgem to distributors.

On the one ground that the CMA partially upheld, the CMA determined that Ofgem had been entitled to recalibrate one of the incentives (the Information Quality Incentive), but that the quantum of the recalibration made was, on the facts, excessive. The CMA made a small consequential adjustment to that recalibration.

In respect of Northern Powergrid’s appeal, the CMA dismissed two of the three grounds of appeal in respect of real price and regional labour adjustments; and upheld one ground of appeal in respect of savings relating to smart technology. The CMA’s decision gives guidance as to the ambit of a sectoral regulator’s expert judgment in the context of a complex price control.

CMA (2015): ‘Northern Powergrid (Northeast) Limited and Northern Powergrid (Yorkshire) plc v the Gas and Electricity Markets Authority – Final Determination/

Whilst the CMA recognised the importance of smart grid solutions, SGBs and the role they are likely to play during RIIO-ED1, it concluded that neither the evidence, nor the reasons put forward by GEMA, were sufficient to justify its proposed SGBs adjustment for NPg.

In competitive industries, pressure to adopt disruptive and innovative technologies can normally be expected to take place through new entry and competition tension within the market. In network sectors, the incentive for innovation and delivery of savings for consumers is far more reliant on the revenue control regime applied by the regulator.

 

Smart grid technologies and solutions are expected to play an increasingly important role in the future delivery of energy network services. The CMA’s final determination – and indeed, the RIIO-ED1 review process more generally – raises some important questions for how SGBs, smart grid solutions and perhaps innovation more generally should be accommodated in cost assessment and industry business plan treatment looking forward.

In competitive industries, pressure to adopt disruptive and innovative technologies can normally be expected to take place through new entry and competition tension within the market. The natural monopoly nature of network services, however, makes adoption of new technologies, and their delivery of savings for consumers, much more reliant on the incentives and scrutiny processes applied by the regulator through the revenue control regime.

The CMA in its final determination, has placed significant emphasis on the role of efficiency incentives under RIIO-ED1 for DNOs to adopt and propose solutions with benefits for consumers, rather than requiring intervention from the regulator. The longer term question is can these incentives be considered sufficient to drive the scale and pace of change in industry thinking and delivery in consumers’ best interests?

Privatised network companies and their management which operate under incentive regulation, face a range of corporate objectives and incentives, alongside their price control cost efficiency targets. The business planning process at the time of the price review has to consider a range of balancing factors and, therefore, the clarity of financial incentives for innovation when considered through an efficiency incentive “lense” is important.

The CMA’s view on how SGBs were assessed by GEMA also highlights the challenges for the regulator of accommodating the impacts of new technologies and processes within industry benchmarking and cost assessment processes. Benchmarking tools – particularly in the distribution sector – can provide confidence of the relative efficiency of network companies under current industry processes and solutions, but have perhaps been less successful in helping to justify whether the scale and the pace of innovation and proposed ongoing efficiency targets are sufficiently challenging for the control period. Technological change and its impact on ongoing efficiency is also normally captured through methodologies used to establish targets for frontier shift / ongoing efficiency.

The RIIO-ED1 review process is perhaps testament to the challenges that face regulated sectors that have large potential opportunities for innovation with adoption of new technologies. Viewed collectively the issues would suggest that the CMA is right to place its emphasis and trust in the role of incentive based regulation to deliver such innovation. The challenge is ensuring the structure, clarity and strength of incentives is sufficient to drive good long term outcomes for consumers, particularly given the investment that has been made in early pilot innovation funding schemes such as the low carbon networks fund.

The appeal to the CMA however, perhaps raises the question, are the two ‘Is’ in RIIO – incentives and innovation – sufficiently calibrated and aligned for network companies to drive good long term outcomes for consumers in their delivery choices, particularly in the presence of business process and technology change such as smart grid solutions?

Finally the appeal process on SGBs itself also provides potentially important precedent for making price review referrals to the CMA.

In this case, the CMA’s task was to assess whether the decision appealed by NPg was ‘wrong’ on the available grounds for appeal including but not limited to, the decision being based wholly or partially on an error of fact, or that GEMA had failed to give proper regard, or appropriate weight, to matters it should have given regard to in carrying out its principal duties and objectives.9 In the case of SGBs, the CMA agreed with NPg that GEMA had been ‘wrong’ as NPg was able to demonstrate to the CMA that the principles and approach which GEMA had followed had not been consistent with earlier guidance in the price review process and the CMA was not convinced GEMA was able to justify its change in approach, given the technical challenges with treatment of SGBs discussed above.

On 29 September 2015, the UK Competition and Markets Authority (CMA) published its final determinations on two appeals against elements of the 2015–23 electricity distribution price control review (RIIO-ED1) by Ofgem, the GB energy regulator. One appeal argued that Ofgem had been too stringent in setting allowed revenues; the other that it had been too generous to the distribution network operators (DNOs). What were the CMA’s findings, and what are the implications of its decisions for these appeals?

 

The first appeal came from Northern Powergrid (NPg), an electricity DNO. The second came from British Gas Trading Limited (BGT), a buyer of DNO services, and is the first example of an appeal by a network user against an Ofgem price control. In its determination on the BGT appeal, the CMA dismissed four of its five grounds, but partly upheld one ground that challenged the adjustment that Ofgem made to the upfront rewards and penalties for DNOs in its Information Quality Incentive (IQI) scheme. The CMA’s determination reduces the amount of revenue that the

DNOs can recover by around £105m in total over the

RIIO-ED1 price control period (a reduction of less than 0.4%).1 In its determination on NPg’s appeal, the CMA dismissed two of the three grounds of appeal, but upheld

one in relation to Ofgem’s adjustments to reflect potential savings available from the introduction of smart grids. The CMA’s determination increases NPg’s allowable revenue by around £11m in total (an increase of less than 0.3%).2 The various areas of appeal are shown in the box.

Notably, the regime in electricity distribution is one of appeal against specific areas of a price control, which differs somewhat from a regulatory-reference approach where all areas of a price control may be re-examined—as happens, for example, in the water sector. The standard applied is also of interest—the CMA may uphold an appeal only where the particular decision appealed was ‘wrong’ (although the legal wording around ‘wrong’, as specified in the Electricity Act, covers a number of issues).3 However, the CMA interprets this as meaning that it is not just limited to conventional ‘judicial review’ grounds; rather, it must consider the ‘merits’ of the decision appealed (albeit by reference to the specific grounds of appeal laid down in law).4

This article focuses on cost assessment and IQI issues. However, BGT’s appeal also covered two finance issues. First, BGT challenged Ofgem’s decision to introduce a transition regime for depreciation on new assets, which

BGT considered provided more depreciation upfront (than otherwise) to deal with financeability issues.5 Second, while BGT did not challenge the principle of using an index for the allowed cost of debt, it did question Ofgem’s decision on how to calculate this index. Both of these challenges were dismissed by the CMA.

Cost assessment

As shown in the box, NPg’s appeal centred on three issues around cost assessment. Of these, SGBs was the main area of contention—and the only area of appeal granted to NPg.

The RIIO-ED1 appeals

The issues covered by the CMA in the RIIO-ED1 cases (and the results of the appeals) were as follows.

NPg appeal (DNO)—exclusively cost assessment issues

  • Smart grid benefits (SGBs)—upheld
  • Real price effects (RPEs)—rejected
  • Regional labour cost adjustments (RLCAs)—rejected

BGT appeal (DNO purchaser)—exclusively incentive and finance issues

  • Double recovery allegation—rejected
  • Incentive targets—rejected
  • Information Quality Incentive—partially upheld
  • Asset life policy change—rejected
  • Change in cost of debt indexation—rejected

 

SGBs are the forecast cost savings that result from the application of smart grid technologies. Ofgem changed its approach to the assessment of SGBs between its March 2013 Strategy Decision and its July 2014 Draft Determinations (DDs). This was because, in its view, companies had materially underestimated SGBs in their business plans—to the extent that separate adjustments were required, over and above Ofgem’s more general cost benchmarking exercise. In the DDs, Ofgem applied a downward adjustment to DNOs’ total expenditure (TOTEX), based on the difference between SGBs identified by DNOs in their business plans (‘embedded SGBs’) and the level of SGBs that Ofgem thought DNOs should achieve (‘potential SGBs’). The latter had been based on a combination of external evidence and industry modelling.

Ofgem also altered its approach to assessing embedded SGBs and potential SGBs between its Draft and Final Determinations (FDs). The scale of embedded SGBs increased markedly, as Ofgem broadened the definition of what constituted a ‘smart’ solution.6 However, Ofgem also altered the approach it used to derive potential SGBs, following industry criticism regarding the use of external evidence. In its FDs, the assessment was based solely on comparative benchmarking of the business plan data submitted by the DNOs. In one area, Ofgem set the benchmark at the upper quartile (UQ), or 75% of the highest identified level of DNO SGBs. In another area, the benchmark was set at the frontier (the highest level of SGBs identified by a DNO).

NPg argued that there were a number of methodological, conceptual and implementation issues with Ofgem’s approach.7

However, the CMA considered that Ofgem erred on the second point. Given the significant change of definition of smart solutions between DDs and FDs,10 and the resultant increase in embedded SGBs, the CMA considered that Ofgem should have reassessed its original judgement of an underestimation of SGBs in the DNOs’ business plans. The absence of such a reassessment did not give the CMA confidence in the new level of savings identified at FDs.11 Taking all the evidence into consideration, NPg’s appeal on SGBs was upheld.

In reaching this judgement, the CMA also provided some specific views on the SGB benchmarking undertaken at FDs. Some of these views also have implications for other sectors. In particular:

  • the use of benchmarks based on single observations. The CMA questioned the appropriateness of Ofgem’s approach to determining the level of SGB adjustment for fault-level reinforcement costs,12 noting that the benchmark was based on a single data point, which it considered to be clearly an outlier. The CMA further noted that this method was not ‘adequately tested’,13 and might not truly reflect a shortfall in cost savings;
  • introducing new approaches during the process. The CMA also highlighted that the benchmarking exercise was a ‘novel’ introduction to the price review process undertaken after companies submitted their business plans; that Ofgem had altered the definition of what comprised a ‘smart’ cost saving at FDs; and that there was an absence of established reporting rules. The CMA concluded that Ofgem should have exercised more care in concluding that this method reflected a true shortfall in savings.14

In contrast, the appeals on RPEs and RCLAs were disallowed.

RPEs refer to the increase in input prices over a price control period, over and above general inflation. Several regulators take account of real input price inflation in their determinations. Broadly, NPg argued that Ofgem should have used data on DNOs’ actual pay settlements to calculate RPEs, rather than external indices. However, the CMA shared Ofgem’s view that the purpose of estimating RPEs is not to accurately reflect the costs faced by DNOs, but to reflect costs faced by companies in the wider economy. As such, the CMA considered that there was no need to use actual DNO pay settlements data. This also aligns with regulators’ approaches in other sectors. Indeed, the CMA ‘found no evidence, and none was put to [it], of any sector regulators using the actual wage settlements of the regulated companies subject to the price control to construct RPE forecasts for those companies’.

 

 

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