Background

The transmission and distribution of gas and electricity are largely monopoly activities and are therefore subject to price control regulation. Following the privatisation of both industries (gas in 1986 and electricity in 1989), an incentive-based regulation regime known as RPI-X was implemented. Its main objective was to provide incentives for efficiency. It also aimed to support innovation and allow competition, while requiring a relatively low level of regulation.

Under RPI-X, a regulated network operator could retain financial benefits if it outperformed an allowed revenue calculation (which was fixed in advance for a defined period, typically five years), while being liable for at least part of the associated cost should it underperform. From the late 1980s, the various energy network operators each participated in around four price control reviews under RPI-X.

The framework changed over this time. In addition to the original efficiency incentives, new objectives were incorporated in respect of service quality and environmental targets, among others. Changes were also made to provide extra protection for the networks in relation to funding defined benefit pension schemes. As a result, the original framework became increasingly complex.

The RPI-X@20 review and the introduction of RIIO

In 2008, Ofgem began a review of the RPI-X framework, known as the RPI-X@20 review, which aimed to discover whether the framework was 'fit for purpose'. After two years of analysis and consultation with stakeholders, Ofgem published its decision document in October 2010.

This document proposed a new regulatory framework, known as the RIIO model (setting Revenue using Incentives to deliver Innovation and Outputs). Ofgem says that the RIIO model has "taken the elements of the old RPI-X framework that work well, adapted other elements to ensure they are focused on delivery of a sustainable energy sector and long-term value for money and added elements to encourage the radical measures needed in innovation and timely delivery".

The first application of the new model will be in the gas and electricity transmission and gas distribution price control reviews due in April 2013 (RIIO-T1 and RIIO-GD1 respectively), and then in the sixth electricity distribution price control review due in April 2015.

The implementation of RIIO

The RIIO model will be used by Ofgem to develop future price controls for electricity and gas transmission and distribution network companies. Ofgem has published a handbook which explains how the model will be applied in practice, although this is described as a 'living' document which is intended to be adapted over time.

The main theme of the handbook is that the framework is outcomes led; when implementing RIIO at price control reviews Ofgem will consider a number of core objectives :

  • Sustainable energy sector: meeting the needs of existing and future consumers.
  • Sustainable network services: safe, reliable and available, with a low carbon impact.
  • Play a full role: encouraging network companies to be proactive and open minded and to embrace innovation.
  • Long-term value for money: costs savings not to be made at the expense of outputs.
  • Long-term cost: balancing infrastructure and non-capital solutions on the basis of which is least cost.
  • Consumers: balancing the needs of network services as well as end consumers.
  • Stakeholders: including government, parties affected by decisions made by network companies and Ofgem.

To achieve these objectives, RIIO incorporates three main elements:

  • an upfront price control outlining the outputs that network companies are required to deliver and the corresponding revenue;
  • the option to give third parties a greater role; and
  • a time-limited innovation stimulus for both gas and electricity networks.

The price control period has also been extended to eight years, to encourage long-term focus.

Preparing for implementation

To give effect to RIIO, the licences of the electricity and gas transmission and gas distribution companies will need to be modified ahead of RIIO-T1 and RIIO-GD1, and, in July 2012, Ofgem published the first of two informal consultation papers on the proposed changes.

This paper outlines the proposed amendments to the licences of the transmission and distribution companies. Responses to the amendment proposals are invited and will be incorporated into the next informal consultation in the autumn, with the final proposal for statutory consultation being planned for December 2012.

The impact of RIIO on infrastructure investment

Ofgem believes that RIIO will provide better value for money for consumers, by encouraging network companies to engage with stakeholders so that infrastructure investment is carefully targeted. National Grid and others networks have expressed concern at the level of funding commitment proposed by Ofgem. Even allowing for spending cuts it has been estimated that implementation of the RIIO model will result in a gradual increase in household bills.

On a positive note the infrastructure proposals could create significant numbers of jobs mainly in the construction supply chain, according to Ofgem.

What next?

Both the funding proposals and the proposed licence amendments are open for consultation until 21 September 2012. The final proposals are expected in December 2012, for implementation in April 2013