There is no way the transition to net zero for the power sector can be completed without networks being in a good shape to achieve this objective and at the same time ensure security of supply.
Electricity transmission and distribution need not only to support the current and growing demands for electricity, but also to meet the new requirements, for electric transport, decentralised generation (including households feeding into the grid), the ability to handle lots of intermittent small-scale renewable generation, air conditioning, and heat pumps, and the growing demand to support the digital economy.
Neither the grid nor the distribution networks were designed to handle any of these demands. On the contrary, they were built on the assumption of ever-larger coal and nuclear power stations in the post-Second World War era, and to take this electricity from these stations, located either close to coal mines or, in the nuclear case, on the coast, to the main sources of demand – notably in the south, and down through the distribution networks. This generation would be driven off baseload power, with the system matching movements in demand from older stations further up the merit order. The assumptions were that electricity could not be stored at scale and that the demand side would be passive. Finally, the location of power generation was coordinated and planned in an integrated way with the grid and distribution networks, with the Central Electricity Generating Board (CEGB) and the Electricity Council ensuring that it all added up.
The 1990s RPI-X model
Network regulation post-privatisation in 1990 was designed primarily around this “old model”. It was widely assumed that the CEGB and the Area Boards had gold-plated the systems, and that there was a lot of inefficient “fat” which strong efficiency incentives would drive out, thereby reducing costs and prices. RPI-X regulation was designed precisely with this in mind. Fixed-price, fixed-period contracts provided high-powered incentives to maximise profits by minimising costs.
The model did not play out as intended. The privatised companies certainly focused on profit maximisation, but the way they did it gradually degraded the networks, and OFFER and then OFGEM unintentionally encouraged the massive financial engineering that took place from the mid-1990s onwards. The companies discovered that the best way to make lots of money was to exploit the way OFFER and OFGEM set the cost of capital. These regulators set a weighted average cost of capital (WACC) that was too high for the cost of debt and too low for the cost of equity. It was a financial no-brainer to leverage up the networks, in effect mortgaging the assets, and extracting the upside through special dividends, buy-backs and inflated profits. This was true even before the collapse of interest rates spawned an economy-wide dash-for-debt.
The mistake in using the WACC rather than a split cost of capital was compounded by the failure of the regulators to hold the companies to the use of the balance sheet for investment only in the switch from pay-as-you-go in the public sector to pay-when-delivered. The balance sheet should have been used to pay only for enhancement investment that was not being paid for by the current customers. Instead the regulators let the companies choose whatever gearing they thought appropriate, and not surprisingly that was the gearing that maximised the exploitation of the WACC. The result was the crazy boom in mergers and acquisitions (M&As), each time around coming with yet more ambitious gearing. The sheer number of takeovers is listed out in the Cost of Energy Review.[1]
Nobody at privatisation would have thought that the way to run and develop the networks would be through a major M&A boom, ludicrously supported by the idea that this meant that inefficient management would be replaced by ever better managers. Nobody would seriously claim that the current crop of CEOs are better than their predecessors.
The regulators made one further mistake. They held off for a long time indexing the cost of debt, and since interest rates were on the way down, in every single periodic review since 1990, OFFER and OFGEM overestimated the interest rate for the next five years. The cash tills were ringing repeatedly as a result.
Two further regulatory mistakes followed. The regulators set an historical-cost depreciation rather than a current-cost one, so that the assets were depreciated, and the depreciation provided cash to support profits. Instead there should have been capital maintenance to keep the assets in good shape. The regulatory asset base (RAB) should be in perpetuity, not paid back. The regulators allowed all sorts of obviously operational activities – which should have been capital maintenance – to be capitalised. Tree felling and even telephone calls were early ridiculous examples, and it is interesting that tree-felling failures were a significant contribution to the recent Storm Arwen major network failure.
Two major structural mistakes
To these mistakes in carrying out the periodic reviews and setting a proper and prudential regulatory framework, there were at least two very big structural mistakes that haunt the systems now and are a major obstacle to achieving the 2035 net zero target. These are the separation out of metering from distribution to supply, and the failure to develop an integrated offshore network for wind.
The placing of metering in supply came as a response to intense lobbying by incumbent suppliers, and most notably British Gas. The argument confused two things: on the one hand, the supply business of both billing and debt collection, and the contracting directly with generators, and, on the other, the energy services business and its innovation.
Almost all other countries kept meters in distribution as a core system asset, and then opened up the market to competition among energy service companies and for the billing. There is no obvious reason why suppliers have to control the meters in order to deliver energy services, as all the other countries have demonstrated.
The suppliers, with the meters, became responsible for the roll-out of smart meters. This helped them sell their specific services, like British Gas’s boilers and home services. It also incentivised them to carry on fitting meters that would go dumb if the customer tried to switch supplier. Instead of a smooth street-by-street conversion into properly smart meters – which lots of other countries have achieved –the UK has been slow and incredibly expensive. It is a massive regulatory mistake that has led to this outcome, spurred on by an OFFER–OFGEM strategy of trying to unbundle as much as possible of the core network utilities. No one has been held to account for the costs of this mistake and the consequences for moving towards net zero.
This strategy went much further when it came to the offshore wind farms. Instead of setting about the development of an offshore integrated network, the mantra was that the grid should be passive, responding to requests to connect, but having no say over where and how these connections occurred. In its zeal to push National Grid aside, OFGEM actively promoted offshore transmission owners (OFTOs), essentially a series of binary links to the shore by competitors to National Grid. The result is not only the inefficiency of the network that results, but also all the separate transformer sites being developed along the east coast of the UK. The OFTOs are another major regulatory mistake.
The current periodic review
Given the above, you might think that OFGEM would have had a radical rethink of its regulatory model, and that the current periodic review might have started with the 2035 objective, and set out a route map to get from here to there. But not a bit of it, despite the rhetoric on the opening pages of the final determinations of RIIO-ED2.[2]
OFGEM effectively starts with “more-for-less” , and the objective of resisting real price increases. Whatever is to be done to get from here to 2035, it must not lead to higher real bills.
The politics of this is understandable, but then it is not the politics that should drive a periodic review; rather, it is the statutory duties of OFGEM, and the surrounding legal framework on net zero and the Environment Act statutory targets. In order to get from here to there in 2035, in just 12 years, the electricity system needs to cope with rising demand (the digital economy), rising population, rising air-conditioning demand, increasing demand for charging electric cars and other vehicles, own-generation surpluses and deficits, intermittent renewable generation, smart active demand, and much else. Business plans should have this net zero 2035 target at the core, and the period should be 12 years.
There should be a proper reassessment of the RABs, the capital maintenance and the gearing levels to prevent a financial disaster, as OFGEM allowed to happen in supply. Instead, OFGEM does this by first setting a price cap below the level of current prices (no real price increase) and then adds in three dozen or more “uncertainty measures”. What the periodic review actually says is that the business plans add up to a fall in real prices by excluding much of the stuff that will increase prices. It is smoke and mirrors, and no customer should be deluded in thinking that the actual price cap is going to insulate them from the price consequences of the investments to get to net zero. OFGEM might be able to play with the financials and kick the can down the road to the next periodic review, but there are no free lunches in the net zero transition when it comes to networks.
The need to add in so many uncertainty mechanisms has a possibly unintended consequence. What OFGEM envisages is that the companies will come up with more investment in these categories, and then OFGEM will sit in judgement on each and every application. It is as though OFGEM has become the investment committee of the companies, taking over the proper functions of the boards.
Worse, OFGEM thinks it knows what the categories are, as if the network systems can be unbundled into precisely these categories. But they are systems, and systems do not neatly disaggregate. If the systems are not up to scratch in 2028, then with just seven years left to 2035, OFGEM opens itself up to be held responsible for the failures that may result.
In the face of such a huge challenge in 12 years, and with all the uncertainty associated with heating, transport, digital services, and intermittency, you might think that OFGEM would want to encourage a whole system planning and the building of assets in advance. The consequences of too few networks are much, much worse than having too many; the balance is asymmetric. If the networks are not sufficiently developed, there will be no net zero. If they are slightly over-invested, the costs across the whole customer base are small, and in any event the assets will in due course probably be needed.
The Future System Operator
OFGEM has been largely pushed out of the regulation of generation. The government became a central buyer with the electricity market reform (EMR) in the early 2010s. Contracts for new generation were ultimately with government, not suppliers, shopping around for the best deals. Contracts for differences (CfDs) and capacity contracts are auctioned, and the contracts are ultimately backed by the government. Planning the generation side – and in particular offshore wind, solar and nuclear – has become a matter outside the practical control of OFGEM. Planning has returned, which is anathema to the OFFER–OFGEM mindset.
This is taking a step forward with the creation of an independent public Future System Operator (FSO). It is the right direction to go in, but it is being weakened by three related decisions about its design. The Department for Business, Energy and Industrial Strategy (BEIS) proposes: that the FSO should be a “big” model, incorporating not just the strategic planning role, but the day-to-day operations of the networks as well; that the FSO should be a public corporation rather than a government agency; and that the FSO should be regulated by OFGEM.
The first “big FSO” model choice is a big mistake. It combines operational activities with strategic planning and auctioning, and risks repeating the errors made when the Environment Agency (EA) was set up not only to do environmental regulation and enforcement, but also to have a large workforce doing the operational flood defences. The result in the EA’s case is that the day-to-day crises dominate its board and it spends a great deal of time on running a large workforce. The medium-term-focused public regulation and enforcement activities must take second place, notably as crisis (floods and droughts, for example) happen. The FSO will be similarly steered towards the day-to-day balancing of the systems, and as and when there are tight market conditions (for example when it is cold and still), the strategic planning will take second place. Combining operations with the broader public roles will almost always default to the operational issues.
To these institutional bias considerations need to be added the intimate relationships between operations and the management of the grid, notably at a time when the grid and distribution networks are going to need large-scale investment to cope with the 2035 target for net zero for the power sector.
The public corporation model has been chosen as a consequence of the above mistakes and for reasons associated with the desire to escape public sector pay constraints. The error in choosing a big FSO is compounded. That in turn dictates the final error: regulation of the public corporation by OFGEM through its licence.
It is a classic case, following the smart meter example, of making the wrong structural choice, and then having to make lots of knock-on decisions which make matters worse.
Giving OFGEM a role in overseeing the system planning is the opposite of what is required. Instead, OFGEM should be excluded, as it is from the CfD processes, and be confined to its core technical regulatory functions only. It should not be in the business of deciding what should be done, but rather the narrower tack of working out whether it is being done efficiently. Mission creep for OFFER and OFGEM since 1990, and especially in the last decade, should be put into a sharp reverse.
Prudential regulation and the coming financial crisis among the distribution network operators
The massive OFGEM failures over supply – and in particular the prudential financial regulation – would, for most regulators, lead to a wider search to see whether there are any other lurking financial disasters out there. In the OFGEM case, prudent regulators, in the latest periodic review, would be looking at the distribution companies, and focusing on their robustness (or lack thereof).
These often very highly geared companies, often with opaque ownership structures, might be thought to be prima facie potential victims of a sharp rise in interest rates, and especially so if and when there is another financial crisis. What happens if they are squeezed and if they start to struggle to pay the interest on their debt piles?
Instead of asking this question, OFGEM defers to the special administration protections – don’t worry, because we can always step in and take control. And since the companies and their owners would want to avoid being put into special administration, the assumption might be that they will act prudently to avoid this possibility.
They didn’t in the case of supply: over 30 supply companies went bust, and the one case of special administration, Bulb, has proved a financial disaster. Again, you might think that OFGEM would sit up and wonder whether special administration is quite as good a protection as it might seem. OFGEM could look across at OFWAT, and the inability of OFWAT to use special administration for the failures at Thames Water and Southern Water. And OFGEM might take a look at previous examples of how utilities, when distressed, prioritise short-term interest payments.
Special administration is important, it needs to be beefed up, and if regulators want to rely upon it to be able to relax about the companies’ financial state, special administration must be a credible threat. Regulators have to be seen to be capable of implementing special administration in a practical and cost-contained way.
With this in mind, OFGEM should be focused on avoiding network companies getting in a mess in the first place. The source of financial distress will come from the gearing, and it was a choice by OFFER to allow the companies to choose their own gearing and play the massive financial games, arbitraging on the WACC, as discussed above. Instead, OFGEM could push for a gearing level that is consistent with the enhancements (but not capital maintenance) which have not been paid for by current customers, and (given it is historic-cost accounting) have not yet been depreciated out of the RAB and hence paid back by current customers. OFGEM should make sure balance sheets are used for the intended purposes at privatisation – to support real investment, and not financial engineering.
Notional gearing relies on the simplistic idea that an arbitrary number (such as 60%) is the hurdle for investment-grade credit ratings. Even if this was a good idea (which it was not), regulators might look at the failures of the UK Financial Services Authority in the great financial crisis in 2007/08 and in particular the banking failures, and ask how good the credit rating agencies were at assigning financial risk.
The net zero 2035 target and network regulation
Government has set the objective, and the gap between where we are (and all the current regulatory failings) and where the power sector needs to be in 12 years’ time is enormous. It is a no-brainer that there needs to be an integrated system plan to get from here to there, and that the networks are core to achieving this.
The idea that carrying on with the OFGEM model is going to close this gap is one that has little evidence to support it, and much to suggest an inevitable and muddled failure. It is not a job that OFGEM is designed to achieve, and, not surprisingly, it is not fit for purpose.
Carving out the FSO is a step in the right direction, but it should be designed properly from the outset. The lesson from the smart meter debacle should be a salutary warning, and the evidence from the management and regulatory failures at the EA should deter the government from combining major operational functions with system planning and auctioning.
It is not difficult to get all this right. Institutional design needs to follow the objective and be kept simple. Adding yet another body on top of the existing ones, and then muddling the responsibilities between them, is not the way to go. Instead, the FSO should be small, a public agency and answerable to the Secretary of State, not OFGEM. OFGEM’s role (and its model) belongs to the 1990s and early 2000s. OFGEM should be returned to its technical role and combined with the other economic regulators, and it should then focus on avoiding the major mistakes of the past – the WACC, the 60% gearing, and the failure to do proper prudential regulation, being the most notable.
Get this institutional architecture right, assign the responsibilities clearly, and get on with system planning, and there is then an outside chance that, in 12 years’ time, the power sector will be net zero. It cannot be done with the old OFGEM model. Probably even with the right structures, the target will be missed, but at least by then the networks will be on an integrated path towards the development of smart networks, the integration of intermittent wind and solar, starting to link up nuclear and hydrogen, and developing the active demand and storage options. This is what the FSO should concentrate on, whilst OFGEM should be slimmed down, merged with the other residual economic regulators, back to the former insignificance that Stephen Littlechild had in mind for economic regulators.
[1] Helm, D. (2017), “Cost of Energy Review”, 25th October.
[2] OFGEM (2022), “RIIO-ED2 Final Determinations”.
