REGULATION STATIONS

UWL18 Special Report #3: Disruptive regulations
Published 20 March 2018

Utilities regulation is designed to create stability and consistency, for the benefit of consumers and investors alike.

Changes to utilities’ regulatory regimes are therefore disruptive by nature, forcing companies to adapt work processes and reporting practices – often for myriad business activities – and update investor understanding of any implications for their returns. Meanwhile, regulators must ensure there is public confidence that changes to regulation will always maintain or improve the outcomes they receive from utilities services, without creating any counterproductive unintended consequences.

To protect the stability of utilities regulation, UK regulators have traditionally stood apart from the volatile political realm – creating a buffer zone between short-term populist policy making, (frequently designed to sway voting intentions and gather polling points), and the longer-term requirements of a sector that broadly requires either the confidence of patient capital or clarity of opportunity for shorter-term growth.

But today’s unique political narrative, combined with monumental macro-economic and environmental drivers for change, pose unprecedented challenges for the maintenance of regulatory stability, or even visibility of the direction of travel.

To ease the sector’s transition into an uncertain future, regulators across energy and water are testing the effectiveness of principles or risk-based approaches to regulation, which are more flexible alongside shifting consumer and policy

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expectations, as opposed to hard and fast rules that are eyed suspiciously for their ability to create cultures of compliance, rather than actually problem solving. Elsewhere, economic regulation for monopoly utilities is increasingly incorporating measures to drive innovation, proof of customer value and long-term thinking. It is seeking new ways to emulate competitive market conditions and ensure that utilities plan today for a world which may be radically different in a decade’s time.

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But some commentators are unconvinced that these new approaches to regulation are sufficient to answer the volume and importance of changes impacting the sector – from climate change through to digitisation.

Labour’s call for renationalisation, along with the fundamental systemic and institutional overhauls to utilities market structures put forward by the likes of Dieter Helm, mean there are options on the table for a complete redesign of utility regulation, and with it, the ways in which companies understand their roles, responsibilities and opportunities for profitability.

To understand the outlook of utilities professionals on these ongoing and potential influences over their regulatory regimes, Utility Week Live put the opinions and sentiments of its audience, and those of its sister brands Utility Week, WWT, WET News and Network, in the spotlight.

In a survey that asked about the disruptive impact sector changes are having on utility businesses, we found that within the next 15 years, respondents expect disruption on a significant scale, rating it at 7 out of a possible 10. And disruption arising from regulatory uncertainty is high in that mix.Commenting on the findings, John Parsons, networks portfolio manager at industry trade body Beama says: “What is very clear, and shown in the survey, is this is a time for government and the regulators to be very transparent about which path they are taking and create the levels of confidence the industry needs. It is not a time for kicking the can further down the road. Better to take a little longer over a good decision now than to fudge the situation.”


At Utility Week Live 2018 (22-23 May), disruption is the headline theme. Held at the NEC in Birmingham, the exhibition and seminar sessions will gather industry intelligence and spark debate on themes including the IoT and other game-changing technologies, utilities innovation and new solutions to serve customer interests and opportunities for applying new, collaborative ways of working in the sector in key areas such as streetworks.

Regulatory change will sit at the core of disruption debate and insight at the event, as well as in the build up to it. In the third of a five-part series detailing the responses of more than 700 utilities executives to our disruption survey, we reveal the top five ways in which respondents believe regulatory disruption is manifesting in the sector.

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THE DISRUPTION: BREXIT

What’s the deal: By this time next year, the UK will be on the verge of leaving the EU following last March’s triggering of the Article 50 withdrawal notice.

Brexit places a question mark over the UK’s continuing participation in the EU’s internal energy market (IEM), the Emissions Trading System and Euratom and has particular ramifications for the development of the all-Ireland single energy market.

Prime minister Theresa May said in her Mansion House speech this month that the government aims to protect the single energy market across Ireland and Northern Ireland, explore options for the UK’s continued participation in the EU’s IEM and maintain a ‘close association’ with Euratom.

Why it matters: A key reason why the complexity and far reaching impacts of Brexit may prove disruptive for utilities is that their overall demand on government time mean ministers are swamped with decision making requirements and the demands of lobby groups to prioritise their particular interests.

The sheer volume of work involved within a limited timescale runs the risk of key technical requirements and impacts on regulatory and market mechanisms being overlooked or brushed aside.

Top of the pile for utility concerns in the Brexit process is the future of its relationship with the IEM and the way in which the UK’s growing interdependence with wider European energy networks will be managed in future policy and regulatory approaches.

The UK’s connection to the IEM is physically manifested in the form of the 4GW of interconnectors that link the UK energy network with those of its EU neighbours.  Another 7.7GW of interconnector capacity is currently being developed, following Ofgem approval.

By facilitating trade in surplus generation, the interconnectors will enable the UK’s electricity grid to better cope with the peaks and troughs in output that will inevitably result from greater dependence on intermittent renewable power.

Experts agree that the interconnectors will continue to be used to trade electricity and gas post-Brexit. But there are doubts about investors’ willingness to invest in new projects amidst the regulatory uncertainty surrounding the future of the UK’s trading relationships with the rest of the EU.

In addition, departure from the IEM means that the UK will not benefit from reforms currently being developed, such as intra-day trading on the interconnectors between different EU member states, which will boost networks’ flexibility even further. As a result, experts predict that the UK will have to build more generating capacity than it would otherwise with knock on consequences for customers’ bills.

Furthermore, if regulations diverge between the EU and the UK, the UK’s ability to trade energy with the EU will be further complicated. Energy UK is keen for Britain to remain a participant in both the IEM and the EU’s Emissions Trading System, the world’s largest, for a period after Brexit.

Brexit also looks set to end the UK’s membership of Euratom, which currently governs the safeguarding of the UK’s nuclear industry as well as cross-border movement of atomic labour and materials.

Our survey found government and local authority actions are believed to be creating both positive and negative disruption – some respondents said there was a lack of focus due to Brexit, but others said the government would provide both the nudge factor and regulatory push to alter consumer behaviour and the usage and storage of electricity/launch of new business models.

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The disruption: political influence and intervention

What’s the deal: A surge in populist politics over the last five years has prompted a corresponding rise in political appetite for intervening in utilities markets.

The impacts of this urge to intervene on the behalf of consumers (and voters) have been most obvious and most heavily trailed in the energy retail market, where they have culminated in the introduction of price caps to protect vulnerable customers and legislation for wider price regulation. However, in the last twelve months, water companies and energy networks have also begun to feel the effects of political influence on the shape and tone of regulatory frameworks. PR19 has included a crack-down on investor returns, most notably via a tiny weighted average cost of capital. But Environment secretary Michael Gove wants to push further forward with such measures and has promised to give Ofwat special powers to enforce a new era of financial responsibility and transparency at water companies.

Meanwhile, John Penrose MP – who made a name championing a cap on default tariffs – has triggered a blast of political fury towards energy networks who he says have become “fat and lazy” under overly generous regulatory regimes. Ofgem’s draft framework for RIIO2 reflects an awareness of such views and includes an array of potential mechanisms for ensuring “fairer returns” are realised in the future.

Why it matters: In recent research, available exclusively to Utility Week members, industry chief executives were clear they felt that a rising appetite for political intervention in markets is significantly eroding the independence of economic regulators, with a potentially deleterious effect on investor confidence.

This view was most strongly expressed by leaders in the water and energy networks space, where the ire of public-spirited MPs and ministers is being most freshly felt. In the wake of suggestions that the RIIO mid-point review could re-open revenue settlements, one gas network leader told Utility Week Ofgem’s increasing susceptibility to political pressure to take rapid action against perceived market failures run the risk of damaging the largely positive and effective regulatory approach established under the framework.

Our survey found there is (marginally) more confidence in the RIIO regime (5.2 out of 10) to accommodate the scale of change facing networks in the next ten to five years, than there is in the PR19 framework (4.8 out of 10) to accommodate the scale of change facing water companies in the time period to 2025.

Meanwhile, other respondents to the CEO Insight research said their regulatory regimes are no longer fit for purpose because they have become “too politicised” or “increasingly intrusive, time consuming and lacking in confidence from politicians and media.”

Corroborating such worries, John Pettigrew, chief executive of Europe’s most valuable utility National Grid, recently told the Financial Times that US investors in particular are concerned about a cocktail of uncertainties including Brexit, government intervention in energy pricing and the Labour party’s renationalisation plans.

And even in the energy retail market, where politics has become a grudgingly accepted part of business as usual, the recent intensity of recent political interventionism has had some dramatic results. Announcing their mutual decision to hive off their energy retail arms into a merged business, SSE and Innogy cited uncertainty over the extent and reach of political intervention as a key motivation, to executive teams and investors.

The disruption: New regimes for monopoly networks

What’s the deal: With business plans for PR19 due this September and consultation on the RIIO2 framework underway, price controls are now dominating the thoughts and time of senior teams at regulated utilities across the UK.

Ofgem and Ofwat have both been clear that their next price controls will be tough – including higher expectations for customer focus, financial transparency and the delivery of innovative ideas into business as usual operations.

Why it matters: The final determinations monopoly utilities receive from their price controls definitively influence their ability to invest effectively for customers and deliver returns for shareholders over the following regulatory period.

Both PR19 and RIIO2 are set to challenge these interests, with Ofgem and Ofwat squeezing the allowed cost of capital and expressing in no uncertain terms that shareholders should expect lower returns over the next period. Ofwat has set the weighted average cost of capital for PR19 at an historic low of 2.4 per cent – furthermore, under pressure from government, chairman Jonson Cox has proposed reforms to dividend policy which could cause a further crunch on investor playback during AMP7.

But PR19 and RIIO2 are notable far beyond their impact on shareholder return – both frameworks seek to build on some seminal changes to regulatory approaches introduced in PR14 and RIIO1 respectively, especially with regards to regulatory expectations for customer engagement in the business planning process and for customer benefits-focussed innovation strategies.

There are also brand new elements included. For example, Ofwat has introduced Direct Procurement for Customers (see X), overhauled customer satisfaction metrics and put forward a new set of common performance measures to push companies to up their game on key operational and service factors. Over in energy, Ofgem’s RIIO2 consultation proposes to revert to the five-year time-scale used under the previous regulatory approach – DPCR – or possibly to introduce an even shorter period in appreciation of the level of uncertainty and radical change manifesting in the energy system.

Changes like these will mean organisational scrambles to ensure their impact on investment planning, risk exposure, operations, internal processes and reporting are fully understood and prepared for.

The disruption: Direct procurement

What’s the deal: Direct Procurement for Customers (DPC) is a new set of arrangements the water regulator Ofwat is introducing to the water sector as part of its next price review, PR19. The new approach will enable third parties to design, build, operate, and finance new large-scale projects that would otherwise have been delivered by the incumbent water company. (Ofwat defines a large-scale project as one with a totex value of more than £100 million.)
This model is already being used in the £4.2 billion Thames Tideway Tunnel, or “super-sewer” – London’s second biggest infrastructure project after Crossrail.
Projects Ofwat considers would have been suitable for the direct procurement method in previous price reviews include: the Severn Trent Birmingham resilience scheme (around £260 million), and the Wessex Water project to create an integrated supply grid (more than £100 million).
Ofwat intends the director procurement approach to help ensure the “efficient delivery” of large scale projects, and drive innovation by allowing new players to bring new ideas and approaches to the delivery of key projects, therefore delivering benefits to customers.

Why it matters: DPC is an exciting prospect for companies, as it creates the opportunity for new partnerships to deliver some of the country’s largest projects. However, there are those in the sector who have reservations about using DPC because the upfront costs attached to the tendering process are high, compared to more traditional procurement methods, and because there is uncertainty around how risk allocation will work in practice.
Partner at law firm Norton Rose Fulbright, Peter Hall, says that, in a post direct procurement world and with Ofwat now looking increasingly at totex rather than capex, “the incentives to focus on capital expenditure are diminishing and companies may find themselves delivering new assets, financed, built, and effectively treated as third party assets”. Roddy Adams, managing director of Atkins Acuity, says looking at projects in this way could indeed open up new and attractive propositions, and “we may even see a raft of inter-sector investment opportunities come to the forefront within a few years”.
He says DPC could clear a path to new entrants or outside investors exploiting the deregulation of the sludge market or abstraction market within the water industry. “There are early signs of significant change ahead and market participants need to be planning for these changes now. As Ofwat stated, delivering this vision relies on everyone in the sector working together and tackling long-term challenges.”

The disruption: New regimes for monopoly networks

What’s the deal: With business plans for PR19 due this September and consultation on the RIIO2 framework underway, price controls are now dominating the thoughts and time of senior teams at regulated utilities across the UK.

Ofgem and Ofwat have both been clear that their next price controls will be tough – including higher expectations for customer focus, financial transparency and the delivery of innovative ideas into business as usual operations.

Why it matters: The final determinations monopoly utilities receive from their price controls definitively influence their ability to invest effectively for customers and deliver returns for shareholders over the following regulatory period.

Both PR19 and RIIO2 are set to challenge these interests, with Ofgem and Ofwat squeezing the allowed cost of capital and expressing in no uncertain terms that shareholders should expect lower returns over the next period. Ofwat has set the weighted average cost of capital for PR19 at an historic low of 2.4 per cent – furthermore, under pressure from government, chairman Jonson Cox has proposed reforms to dividend policy which could cause a further crunch on investor playback during AMP7.

But PR19 and RIIO2 are notable far beyond their impact on shareholder return – both frameworks seek to build on some seminal changes to regulatory approaches introduced in PR14 and RIIO1 respectively, especially with regards to regulatory expectations for customer engagement in the business planning process and for customer benefits-focussed innovation strategies.

There are also brand new elements included. For example, Ofwat has introduced Direct Procurement for Customers (see X), overhauled customer satisfaction metrics and put forward a new set of common performance measures to push companies to up their game on key operational and service factors. Over in energy, Ofgem’s RIIO2 consultation proposes to revert to the five-year time-scale used under the previous regulatory approach – DPCR – or possibly to introduce an even shorter period in appreciation of the level of uncertainty and radical change manifesting in the energy system.

Changes like these will mean organisational scrambles to ensure their impact on investment planning, risk exposure, operations, internal processes and reporting are fully understood and prepared for.

The disruption: Principles-based regulation

What’s the deal: In 2014 at Utility Week’s Congress event in Birmingham, Ofgem chief executive Dermot Nolan announced that the regulator was embarking on a change process in its approach to regulation which would see prescriptive rules binned in favour of “principles-based” frameworks.

Setting out his stall, Nolan envisaged a smaller license for energy suppliers, gravitating around the idea of “treating customers fairly” rather than compliance with specific processes or requirements. He said, in the new world of principles-based regulation, the onus would be on companies to interpret whether their products, pricing and customer service arrangements lived up to the ideal of fair treatment.

Nolan’s vision was broadly welcomed by industry leaders and has since manifested in a number of key areas – such as changes to energy marketing rules. It has also been embraced at Ofwat, where the regulator has been clear it expects companies to operate in the spirit of transparency in order to build trust with their consumers.

But the transition to principles-based regulation is by no means complete and, more recently, has met with significant hurdles due to the rise of public and political concerns around the trustworthiness of utility organisations and the effectiveness of market mechanisms for protecting customers.

Why it matters: A complete transition to principles-based regulation would be a radical shift, with big implications for the risk exposure of utilities, enforcement measures and service diversification.

While most utilities are in favour of a move away from prescriptive rules and market interventions that can have unintended consequences – like the notorious four-tariff rule under RMR – leaving good practice open to interpretation potentially also increases the scope for disagreements between companies and their regulators. When the principles-based regulation was first kick-started, there were also concerns from consumer advocates that the shift might soften a regulator’s ability to penalise companies for mistreating customers or gaming the market.

Ofgem has been keen to counter such concerns and stand firm by its conviction that a principles-based approach is the best way forward. Recognising the concerns of critics however, it has also more recently emphasized that a blended approach is no doubt required, with hard rules to outlaw definitively negative behaviours and principles to encourage creative thinking about how to achieve positive consumer outcomes.

Even this ideal has arguably been cast into doubt, however, by political pressure to introduce a range of price caps in the energy retail market. Price regulation advocates argue that the caps are needed to prevent energy companies from treating the customers unfairly – a direct indictment of the idea that the market can be trusted to uphold the spirit of a fair treatment principle of its own accord.

Similarly, in the water sector, recent suggestions that Ofwat should be given enhanced powers to control water company financial arrangements undermine the idea that a core principle of transparency can be effectively regulated without a prescriptive rulebook.

Both Ofgem and Ofwat claim to stand by their principles-based, hands-off approach to regulatory evolution. But their ability to maintain this line against a political storm that demands heavy-handed intervention may become increasingly difficult to reconcile with this goal, once again casting a shadow of uncertainty over the direction of travel for utilities regulation and impacting the ability of companies to innovate and differentiate their offerings.

COMMENTARY

Laura Sandys, MP, entrepreneur, and CEO of Challenging Ideas:

“Disruption is the new norm and regulation and policy are having to face in two different directions at the moment. It has to look back and deal with the real legacy issues while also having to look forward ensuring that innovation and better consumer preferences are not squeezed out under the weight of managing the past mistakes of the sector.
We need a very different form of regulation as we move forward – one that drives a more optimised system reducing waste within the system. We need to allow the market to find better solutions that might blur some of the artificial boundaries created at privatisation, reducing the cost of the system thereby providing better value to consumers.

Much of the innovation will be driven by the range of people who could supply energy to the consumer – from their car company through to their white goods provider or their local authority or a home services company.  We must not stop this happening as this will truly shape better products and services to consumer however this “mixed” and “blurred” energy economy will pose new challenges to regulation to ensure that consumers are protected however they buy energy.  The next era of regulation needs to open up consumer preferences – not second guess what they are – but shape a system that allows drivers of cost reduction to put price pressure on the system.

In addition data flows and optimisation will have a radical impact on the cost and waste within the system. Data is revolutionary if it is allowed to play its role in reshaping how, what and at what cost energy is provided. It could not be a more exciting time for energy and more importantly for consumers of the product.” 

 

An Ofgem spokesperson:

“The energy system is in a time of huge transition – renewables, especially solar, are really coming to the fore –  deployment of small scale solar has been far above all expectations. 

We’re working towards a smarter, more flexible energy system, which will make the most out of new technologie, such as battery storage – we want regulation to break down barriers, not create them. Similarly for DSR, for businesses and individuals. We want regulations to be in place so that nothing stands in the way of this. With RIIO2, the clear message is that price controls will be tougher, but we also want to make sure that there is enough support for there to be high levels of innovation – higher than we’ve seen before.

What’s important to us is that we make sure the price controls provide strong incentives for companies to invest, but also that there are specific funding controls in place so companies are able to really innovate to the best of their ability. There are robots being developed to fix gas pipes, and smart tech being tested to squeeze more electricity out of the grid – we want innovation to be part of the everyday job for companies, and we want them to be less reliant on these specific funding methods to achieve that.

We have also questioned whether the supplier hub is fit for purpose – in future there will be new business models with new frameworks, such as peer-to-peer trading and blockchain, and regulation needs to be in place to allow that to happen and thrive, not restrict it.”

ALTERNATIVE OPTIONS

While many significant regulatory disruptions are today emanating from existing regulatory bodies and their evolving frameworks, it must be acknowledged that there is also increasing scope for these institutions themselves to be irrevocably disrupted in the near to mid-term future.

Labour’s pledge to renationalise utilities – including energy supply, energy networks and water networks – has created the scope for a radically different future for the sector. One which would unwind almost 30 years of work to make private ownership and competitive markets deliver cost effective and reliable utility services.

Details have so far been scant on how Labour's renationalisation plans would work in practice, but a January report on alternative models of ownership suggested a blend of national state, local and community ownership for the National Grid and other electricity and gas sector infrastructure. The boards running the companies would be split between state appointees, local and devolved administration government nominees, consumer, and employee representatives.

Despite the protestations of shadow Chancellor John McDonnell, it’s likely renationalisation would be a costly business and, as Scott Corfe, chief economist at the Social Market Foundation (SMF), says it is “pretty unclear” how existing owners would be compensated.The SMF published a report in February seeking to quantify how much Labour’s plans to take back control of water companies would cost and concluded that renationalising this utilities subsector alone could cost the government £90 billion.

KEY FINDINGS

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On top of that, the SMF estimates that the government would also have to pay out £100 billion in order to meet the industry’s investment needs over the next 25 years.

Much to the chagrin of utilities leaders however – who argue vehemently in favour of privatisation as a proven route to increased investment in utilities infrastructure and service improvement – polls and consumer surveys show strong public support for Labour’s renationalisation policy. In recent research conducted by Utility Week in partnership with Harris Interactive, over a third of respondents said they supported the concept for energy and a similar proportion advocated it for water.

Earlier research conducted by Conservative think tank Populus in September 2017 showed even stronger public support for renationalisation. According to the poll 83 per cent of consumers felt nationalising water utilities would be a positive step and 77 per cent supported the proposal to bring the national grid under public ownership and create a new set of regionally-focussed public energy supply companies.

With the popularity of the current government eroding, the likelihood that Labour will get a chance to make good on its promises is increasing – and credit ratings agencies such as Moodys and S&P Global have correspondingly issued statements warning of a negative impact on investor confidence in UK utilities as secure defensive stock.

It’s not only Labour that poses a threat to the utilities establishment however. Other bodies too are calling for industry reform agendas which allow for the overhaul of the institutional organisations which govern the sector and are challenging assumptions about the structure of the market.

Dieter Helm’s cost of energy review, Imperial College’s Reshaping Regulation report and the Future Power Systems Architecture project – run by the Institution for Engineering and Technology – all call for a fundamental re-think of energy system governance arrangements in order to open up distributed flexibility opportunities.

CONCLUSION

Utility Week Live’s survey shows that concerns about the impact of populist politics on regulatory stability abound. The apparent growing urge for politicians to intervene on behalf of consumers and voters is disrupting not only the energy retail market, (where it has resulted in price caps and legislation for wider price regulation), but also water companies and energy networks, which have traditionally been more sheltered from consumer-facing issues. Today however, questions over public trust and the legitimacy of monopoly utility finances mean political influence over the shape and tone of regulatory frameworks for these companies are being keenly felt.

Responses to the survey show that the confidence of utilities professionals in the effectiveness of new regulatory regimes, such as PR19 and RIIO, to continue delivering the outcomes the sector needs while responding to heightened political pressure, is not high (4.8 out of 10 on average). Though it is notable that there is (marginally) more confidence in the RIIO regime to accommodate the scale of change facing networks in the next ten to five years, than there is in the PR19 framework to accommodate the scale of change facing water companies in the time period to 2025.

In the face of this disruptive environment, the best course of action, says Richard Khaldi, water sector expert at PA Consulting Group, is not to resist change, but rather see this time of regulatory uncertainty as a call to arms: “Companies must focus on driving value from disruption and not be passive participants. They should push the regulator to adapt the regulatory regime to accommodate the new business models needed to deliver for customers going forward. Companies should be demanding of their regulator just as customers are demanding of the companies.”

Survey responses show many utilities are ready to answer this call, recognising the benefits of creating more agile business models and investing in innovation. At Utility Week Live, industry professionals with a zeal to successfully ride the wave of disruptive change sweeping over the sector will gather to share their strategies, express their concerns and catalyse thinking on potential solutions to transformation pain points.

Attend Utility Week Live 2018 to understand how these disruptive technologies can be best utilised in your business, and meet the organisations and innovators developing the next generation of tech and product solutions:

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Liked this report? Read more in the series of special reports:

SPECIAL REPORT #1: DISRUPTIVE COMPANIES
SPECIAL REPORT #2: DIRCUPTIVE TECHNOLOGIES
SPECIAL REPORT #3: DISRUPTIVE REGULATIONS
SPECIAL REPORT #4: DISRUPTION & THE SUPPLY CHAIN
SPECIAL REPORT #5: DISRUPTION & THE CUSTOMER

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