Electricity network companies have provided a good service under Ofgem’s regulation. However, the cost to consumers has been greater than it should have been.
Today’s report by the National Audit Office (NAO) finds that strong price controls and greater coordination across the energy system are needed to ensure electricity networks transform to support a low-carbon energy system at the least cost to consumers.
Each year around 20% (£130 on average) of the typical household’s annual electricity bill goes towards running, maintaining and upgrading the networks which take electricity from power plants into homes and businesses.1
These networks are privately owned, and their earnings are regulated by Ofgem through price controls, which provide networks with budgets and performance targets. Since 2013, a price control framework known as RIIO2 has aimed to ensure consumers are provided with a reliable service, prevent them from being overcharged and encourage networks to innovate and enable the transition to low-carbon energy.
The NAO has found that networks provide a good service. Consumers in Great Britain experience fewer power cuts than in most other EU countries, and networks have met almost all their RIIO-1 targets, which cover safety, environment, reliability, providing timely connections, customer services, and assisting vulnerable consumers.
However, consumers have paid more than they should have under RIIO-1. This is because:
- networks’ performance targets were set too low;
- their cost budgets were set too high;
- Ofgem overestimated how much money shareholders would need to incentivise them to invest in network companies; and
- Ofgem set a regulatory period of eight years instead of the usual five, delaying the opportunity for improvements.
Networks expect to deliver shareholder returns of 9% in real terms, compared to a UK company average of around 5%-6%. This is higher than Ofgem anticipated and has increased consumer costs. Of the 9% returns, 1.5% points came from rewards for exceeding performance targets, including a scheme to prevent power cuts. Targets for this scheme were fixed too far in advance, meaning networks were already exceeding their targets before RIIO-1 started. The NAO 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 £800 million less in total.
Ofgem has highlighted concerns about the legitimacy of network companies making such high returns. Four out of the nine network companies have voluntarily returned some money to consumers.
By setting price controls for eight years rather than the usual five years, Ofgem has locked consumers into paying higher costs for longer. Ofgem expected this to encourage innovation and better outcomes for consumers and the environment, but has concluded that it didn’t provide this additional benefit.
Ofgem is currently designing the next set of price controls (RIIO-2), which will start to apply from 2021. It is making changes which are aimed at ensuring network companies only earn a fair return. These include reducing its estimate of the money shareholders require to incentivise them to invest in network companies. It is also proposing to adjust networks’ returns if they vary greatly from its expectations.
Ofgem’s regulation also aims to encourage networks to innovate. By 2050, the amount of electricity flowing through networks may need to double to support electric vehicles and electric heating. If networks do not transform their businesses in an intelligent way, this expansion in the electricity system could add significantly to network costs. Strong pressure from government and Ofgem is needed to encourage this because these changes will not necessarily be in networks’ financial interests.
The Department for Business, Energy and Industrial Strategy (BEIS) and other government departments have important roles to play in ensuring networks support the achievement of net zero emissions. BEIS has not yet introduced a fully-fledged strategy for low-carbon heat. Policy uncertainty creates a risk of too little network infrastructure being built, endangering the net zero target, or too much being built, at added cost to consumers.
The NAO recommends that BEIS consider the benefits of more strategic coordination in the energy system; keeping network costs to a minimum while the wider economy undergoes a mass transition to low-carbon power may necessitate more joined up thinking than the current system allows. Ofgem must also do more work to show in clear and simple terms that network regulation is working for consumers.