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Editor's Pick: NAO on networks: good service, but costs too high

Nick Palmer Nick Palmer Senior Writer
11th February 2020

This article was originally published in Energy Spectrum Issue 700 on 3 February 2020. For recent news and analysis on the energy market, find out more about our weekly publication, Energy Spectrum, here.

The National Audit Office (NAO) has concluded that electricity networks have provided a good service, but the costs for consumers have been too high.

In a report, published on 30 January, the NAO examined how effectively Ofgem has used price controls. The NAO found that consumers in GB experience fewer power cuts than in most other EU countries, and networks have met almost all their RIIO-1 targets.

However, the NAO criticised RIIO-1 for resulting in too high a rate of return for network companies. Ofgem designed RIIO-1 so that returns depended on performance, with the expectation that networks would make real-terms returns of between roughly 2.5% and 10.5%. It was expected that only the best-performing companies would hit the upper end of that range. The latest available information shows that three of the nine network companies are forecasting returns of around 10% and the average forecast return is 9.2%. In comparison, Ofgem estimated that FTSE-listed companies on average provide returns of 5.25%-5.75%.

When designing RIIO-1, Ofgem, estimated the level of risk for network companies’ shareholders as too high, the NAO found. As a result, it set the baseline rate of return too high. At the time of the decisions, other regulators had tended to adopt estimates that were high because it was thought to be necessary to provide additional certainty that the companies would not need rescuing. The NAO found that Ofgem placed too much weight on consistency with previous regulatory decisions, and not enough weight on up to date market evidence, which suggested that network company risk was lower. The NAO estimated that, if Ofgem had made better use of evidence, consumers could have paid £800mn less.

Of the average 9.2% returns forecast for network companies, 1.2 percentage points (pp) are a result of network companies spending less than their full allowances for costs, and 1.5pp from operational performance other than underspend. For electricity distribution companies, most of the rewards for operational performance come from exceeding targets under a power cut prevention scheme. The NAO concluded that targets for this scheme were fixed too far in advance, meaning network companies were already beating their targets before the price control started.

The NAO also criticised Ofgem’s “unusually long price control period” for locking consumers into paying higher costs for longer. Price controls usually last five years, the NAO said, but Ofgem set RIIO-1 to last eight years, “expecting this to encourage increased innovation and more long-term thinking”. Ofgem has now concluded that there is no evidence that longer network price controls create this benefit.

The report recommended Ofgem to:

  • Do more to demonstrate that regulation is working for consumers, by publishing summary indicators of the overall value for money of networks over time.
  • Improve the evidence base on the empirical impact of regulatory decisions on investor confidence and cost of capital.
  • Assess the extent to which cost targets set in RIIO-1 were too generous.
  • Ensure network companies make it clear to the public how much tax they pay; how executives are rewarded and how this links to quality of service for customers.

BEIS should:

  • Investigate the benefits of more strategic coordination in the energy system.
  • Action further heat decarbonisation policies.

Ofgem welcomed the findings, but acknowledged that costs to consumers “have turned out to be higher than they needed to be”. It said RIIO-2 will aim for “lower returns to save consumers money, while pushing companies to go further on decarbonisation” and energy security.

This report will make tough reading for the regulator. While it highlights some successes in RIIO-1, its principle criticism is that it did not use the best evidence available and was too long, leaving Ofgem unable to make corrections when flaws became apparent. Ofgem has already signalled that RIIO-2 will return to a five-year length and will be keen to ensure other learnings from RIIO-1 are incorporated.

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