Innovation and economic regulation of energy utility assets are not the easiest of bedfellows. But, despite the fact that economic regulation has typically entrenched long term thinking, innovation – challenging the assumptions underpinning such models – has the potential to deliver more for less.

That is particularly relevant in an era of new efficient technology coming to the market that will make us rethink how we use networks and infrastructure through innovative supply and demand approaches – for example "smart" metering that allows consumers to optimise their use to a flexible pricing model from the utility and captive (behind the meter) generation and storage models. 

Assuming you accept the premise that investment in long term infrastructure is most efficiently achieved through appropriate funding models to allow optimal financing of investment, how do you leave space in that model for innovation? To put the point another way, any environment where the cost of provision is largely agreed and embedded upfront on an industry wide basis, risks leaving little flexibility to allow for innovators to enter and disrupt.

Unsurprisingly at a time when significant change to network use is expected, policy makers and regulators are focussed on this conundrum. Many hours and days have been spent reimagining regulatory shape and considering how regulation can incubate technological, operational and financial innovation to ensure that the industry is able to respond to change and implement it.

Regulatory shape

In the UK at least, a large amount of the regulatory activity in the utility sector since privatisation could be characterised as incentivising incremental innovation in the context of a regional monopoly provider.
By stimulating competition between providers and permitting investors to share in the benefit of outperformance, regulators have driven efficiency in the delivery of capital investment (capex). That structure has also promoted information exchange with the regulator promoting a symbiotic relationship.

But the traditional approaches have been felt to be a bit blunt – the perception being that metrics applied across a utility business did not distinguish sufficiently between spheres of activity nor did they sufficiently support significant investment in network change and operating (opex) efficiency. The regulator could not demand rapid innovation – merely assess how incremental improvements have been made.

So policy makers and regulators have increasingly looked beyond this incremental approach to look at more proactively managed regulatory models such as The Independent Infrastructure Provider framework used for Thames Tideway, unbundling of customer facing services, OFTOs, CATOs and the broader RIIO programme. In effect, these new models bring regulatory innovation, which helps drive inputs as well as measuring outputs on the traditional regulatory basis – albeit with a general move towards total cost (totex) as a metric, recognising both capex and opex efficiency.

Regulatory distinction and unbundling
An area of common focus for policy makers and regulators has been to increase the contestable opportunities in each sector through carving-out standalone projects. This has allowed them to:

  • achieve specific outcomes
  • address the historic concerns with the past inefficiency in the promotion of new infrastructure by providing for a more focussed regulation; and
  • drive efficiency though competition – in turn driving innovation and better value for money for customers.

Facilitating consumer choice
At the same time as looking to stimulate competition amongst providers within those aspects of any network that are supported through economic regulation, policy makers and regulators are increasingly looking to areas of the industry that can be broken apart from the core of the utility business that benefits from regulatory support. So, to take an example, customer facing activities can be exposed to consumer choice and real market innovation as the costs that underpin these do not justify any particular economic support.

Technological innovation

As mentioned earlier, in the traditional geographic monopoly model, technical innovation has largely been supported by the reward for doing something cheaper. To take an example from another utility, ice pigging in a novel way can bring efficiencies in cost to network owners in the cleaning of water pipes. The regulatory model allows the utility and its investors to take the benefit of the early cost saving compared to the basis allowed for in the regulatory settlement whilst allowing the consumer to ultimately take the long term benefit of the efficiency by resetting the long term operational expectation. But the technology has its limits - it does not uprate the pipe capacity.

What about technology that responds to changes to the network's need? How should regulation help support that, and the short term risks of developing new technology before it is certain to be a deliverable solution? Whilst regulators want to facilitate innovation, they are likely to want to, as far as possible in a complex system context, be technology neutral: avoiding the regulatory regime effectively subsidising a particular technological solution or, in extremis, back a technological dead end or unfairly block the best solution.

One example of regulatory thinking on how to help address the concern in the UK is Ofgem's introduction of the network incentive arrangements to support the development of technologies to address the new demands to be placed on the network in the foreseeable future. Efficiency and network redesign were clearly uppermost in Ofgem's thinking once we saw the successful bidders for 2015.

Taking this to the next level

So what about new technology that does away with the need for the network or a part of it or reduces demand? To repeat the example, how should the regulator react to the impact of smart metering and distributed/captive generation and storage?

Where the network owner has accepted usage risk, the regulator's job is comparatively easy, the market will decide between the regulatory supported cost of provision using the existing technology and the market price of the new technology. That is to some extent already being tested with users looking to take part of their demand off grid through captive generation and storage or modifying demand through adopting smart metering.

Where the network owner is funded on an availability basis, policy makers and regulators may have a harder question to assess: will the adoption of the new technology prior to the end of that support period be sufficiently beneficial to justify the costs of bringing to an early end the regulated provision (or allowing it to carry on potentially unused and running in parallel)?

Where does the benefit and cost of innovation flow

If the benefits of efficiency on the network are socialised into reductions in wholesale or consumer cost distributed across all users, the question of who benefits is comparatively easy to answer but what about innovation that benefits a small section of a community?

It's not news that differentials in the provision of essential services are not politically popular, particularly where it is acknowledged that, as in most of the utilities industry, returns are supported by explicit or implicit public sector support as a provider of last resort. Having developed a new regulatory regime that embraces innovation, the next headache for policy makers and regulators will be to ensure that the benefits are appropriately shared.