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Network profits higher than necessary following Ofgem errors, NAO report finds

The average return for networks was 9.2%, compared to 5-6% for companies in the UK.Image: Andy Beecroft.

The average return for networks was 9.2%, compared to 5-6% for companies in the UK. Image: Andy Beecroft.

A new report, released today by the National Audit Office, looks at the state of the network now, and provides recommendations for Ofgem going forwards with the implementation of the second cost control period on the horizon.

Currently 20% of the average household bill goes to running, maintaining and upgrading networks, totalling around £130 annually, with a further £10 per household spent on balancing mechanisms. Combined, total regulated revenues of the UK’s transmission and distribution networks companies amounts to around £8 billion per year.

The report found that overall, customers in the UK suffer from fewer power cuts than most EU countries and that since the introduction of price controls under RIIO-1, network operators have met almost all of their targets.

But, the report finds, this comes at the expense of consumers, with network companies allowed to make profits higher than necessary.

The NAO’s report suggests that under RIIO-1, industry regulator Ofgem missed opportunities to reduce these costs by setting performance targets too low. Additionally, networks' cost budgets were too high, and Ofgem showed too much leeway, overestimating how much money it would take to incentivise shareholders to invest in the networks and expending regulatory periods by three years.

The price controls were designed to allow all networks to make a real-terms return on regulatory equity of between roughly 2.5% and 10.5%. It was originally expected that few would hit the higher end of this spectrum, however three out of nine network companies have forecast returns of 10%, and the average was 9.2%.

The average UK company registers a return of 5-6%, highlighting the above-average profit network operators stand to have made during the last price control period.

If the rate of risk was lower when RIIO-1 was created, consumers could have paid at least £800 million less, the report says.

Gareth Davies, the head of the NAO, said: “Ofgem’s regulation of electricity networks has delivered good service performance but higher than necessary costs for consumers. Its approach to price controls used insufficiently demanding targets and the eight-year price control period meant a longer wait before these targets could be reset.

“While Ofgem has encouraged networks’ innovative efforts to reduce carbon emissions, more needs to be done across government if the UK is going to reach net zero emissions at least cost to consumers. Tougher regulation of networks is part of the picture, but so is greater policy certainty and better coordination between the energy system’s many players.”

Ofgem has already highlighted its concerns over the legitimacy of some of the high returns, and four network operators have voluntarily returned some of the profits to their customers.

But heading into the next price control period, more needs to be done to avoid such a “windfall” again.

Dame Gillian Guy, chief executive of Citizens Advice, added: “Today’s report is more evidence that energy networks have enjoyed a major windfall at the expense of consumers. Our research in 2017 showed how gas and electricity networks have been able to overcharge consumers by £7.5bn during the current price control. This cannot happen again.

“Ofgem has made good progress towards a tougher settlement next time around. The regulator must hold its nerve, resist the efforts of networks to water down its proposals and deliver a price control that works for consumers.”

Ahead of the beginning of RIIO-2 in 2021, Ofgem is making a number of changes to balance network profit, including reducing the incentivisation estimate for shareholder investment and potentially adjusting network returns if they vary greatly from expectations.

The NAO’s report also suggests that in the run up to the UK’s net zero target , Ofgem must incentivise the networks to innovate to lower their carbon emissions. If the network does not transform itself, it could hamper broader efforts to decarbonise and add additional costs along the way.

For example, using flexibility sources such as batteries could help save between £17 billion and £40 billion cumulatively across the UKs network, according to the Department for Business, Energy and Industrial Strategy.

As such, “Strong pressure from government and Ofgem is needed to ensure network companies transform to support a low-cost, low-carbon energy system,” says the report.

Further coordination between BEIS and Ofgem could also help ensure the network transforms to a cleaner, more cost effective system.

Challenges remain however, with a recent report by the RIIO-2 Challenge Group finding no network operator to have been proactive enough in its efforts ahead of the new price control period.

Despite the criticism, the Energy Networks Association welcomed the report, with a spokesperson noting that network costs had come down by almost a fifth.

“We want to ensure the next price control period provides the right balance between creating value for money and an environment which supports the investment and innovation required to deliver cleaner, greener energy supplies to homes and businesses. We will continue to work with the regulator which decides the business plans for network companies.”

Since privatisation in 1990, an estimated £70 billion has been invested into the network. And since Ofgem introduced incentives for companies to improve reliability in 2002, the frequency of power cuts has halved.

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