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British utility regulators are in the midst of a major change as they seek to spur £32 billion of upgrades to the country’s aging distribution networks by decade’s end. To achieve its goals, the government’s utility regulator, Ofgem, has put the responsibility squarely on the utilities, which need to develop robust business plans informed by engagement with their customers.
Since 2013, Ofgem has operated a performance-based regulatory model named RIIO (revenues = inputs + incentives + outcomes) that seeks to spur the country’s three transmission and 14 distribution operators to adopt business models that deliver a range of progressive goals spanning environmental and social impact, customer satisfaction, safety and reliability.
The RIIO framework includes incentives for distribution network operators that beat expectations on agreed-upon underlying metrics. Poor scores on RIIO’s underlying metrics -- such as low levels of customer satisfaction -- can have a negative impact on allowed revenues. Depending on the degree of “underachievement,” it is feasible that some investment has to be absorbed by shareholders, rather than being recovered through revenues.
The mandate to improve infrastructure and service quality -- while simultaneously preparing for a low-carbon, distributed electric system -- is a big ask for traditional utilities.
“All network companies have been conditioned to be risk-averse,” said Hannah Cook, an energy expert with PA Consulting in London.
“They were focused on costs rather than what they were getting for their money, and they were focused on the regulator rather than the customer,” Cook said. “Ofgem is trying to change their culture so they’re more innovative.”
Although certain elements of customer services were in existence prior to RIIO, the regulatory model represents a significant break from the status quo of the past. No longer can a utility simply cut costs to please regulators and justify its returns without showing clear regard for customer needs and requirements.
Companies that try innovative approaches to attaining environmental, customer service and other goals can exceed RIIO’s 6 percent baseline return on regulatory equity and earn a return in excess of 10 percent. RIIO offers an extra 2.5 percent of “totex” (the sum of capital and operating expenses) to companies that earn approval for their business plans in their first review by Ofgem. Just one distribution network operator earned this “fast-track” status for a high-quality plan as RIIO ramped up.
Critically, there’s a significant penalty to discourage utilities from reverting to the ways of old. Network companies that fail to meet their obligations can see return on equity fall as low as 2 percent, well below the cost of capital.
“RIIO is an outward-based incentive,” said Ljubomir Mitrasevic, a U.K. electricity industry expert with PA Consulting in London. “Ofgem doesn’t tell you how many transformers you need to replace or upgrade. Instead, it says you need to meet the relevant output measures such as safety, reliability, regulatory obligations and others.”
Synapse Energy Economics, Inc., sums up the impact of RIIO’s incentive structure in its recent Utility Performance Incentive Mechanisms: A Handbook:
The relatively large magnitude of incentives under RIIO not only helps to focus management attention on the attainment of the established targets, but may also help to provide the revenues necessary for innovating and implementing new technologies.
RIIO is in fact a set of bilateral contracts between each network operator and the regulator, where the utility sets its own plan of action rather than react to prescriptive regulation.
Each plan should detail inherently risky innovation around distributed resources, demand response and other technologies that might play a role in the U.K.’s attainment of a 40 percent reduction in greenhouse gases by 2030 under EU carbon-reduction rules. RIIO provides £60 million of competitive innovation funding each year to allow companies to explore innovative processes or technologies.
“It’s an asymmetrical incentive, as there’s no downside,” said Mitrasevic. “If you innovate, you can fail, and the regulatory framework allows you to do this. It’s a learning experience for the wider public.”
RIIO caps revenue using a metric known as totex, which is the total of capital and operating expenses. In the past, some utilities shifted certain capital expenses to the operating column to make their capital management appear more efficient to Ofgem.
The use of totex discourages inappropriate preference for capital expenditures over day-to-day operational expenditures. The eight-year duration of RIIO’s first phase (versus five years for the U.K.’s previous regulatory regime) encourages utilities to make investments that deliver longer-term benefits while simultaneously easing investor concerns over short-term financial penalties.
RIIO is still relatively new, but it nevertheless provides food for thought for regulators considering alternative price-control mechanisms. Some hurdles that could prevent similar frameworks appearing in the U.S. include inherent complexity and organizational inertia. RIIO is designed to reduce that burden by creating an eight-year framework rather than a five-year one -- but it’s unclear whether many regulators in America are willing to take such a leap.
“The RIIO business plans are around 1,000 pages each, so a regulator has to be able to review that with some economic engineering knowledge in order to meaningfully respond,” said Michael O’Boyle, a power industry expert with Energy Innovation: Policy and Technology LLC in San Francisco. “That’s not attractive to the states where the rate cases are already complicated and taking up a lot of resources.”
On the flip side, RIIO forces information to flow much more freely between regulators and utilities because the network operators reveal their entire capital and operating plans up front.
“Traditionally, utilities would make investments and the regulators would approve or disallow them after the investment was made,” said O’Boyle. “So one key aspect of RIIO is that it reduces this information asymmetry. By better defining what prudence is and what is in the public interest, the utility is held to a higher standard of accountability.”
In 2011, the state of Illinois adopted a similar accountability approach when it passed the Energy Infrastructure Modernization Act. The law gave ComEd and Ameren $3.2 billion to invest in infrastructure and smart grid upgrades. Tied to the money was the requirement that the utilities report reliability performance metrics. If performance lagged, the companies risked losing 5 basis points of profit.
Similarly, RIIO is shifting the focus of U.K. network operators to more closely consider responsiveness by tying customer service to regulatory returns. The framework gives utilities and their investors the chance to earn extra profit for innovating beyond business as usual, while making it safe to do so.
“It’s too early to say that RIIO concretely is a success or failure,” said O’Boyle. “But I think that what we do know from RIIO is that having something like 4 percent of revenue linked to performance is more than enough to make utilities change their attitude 180 degrees.”