Adaptive regulation and planning in utility regulation

Over the last couple of years, Ofwat, Ofgem and Defra have all been thinking hard about how to make decisions now which are faithful to the various potential pathways to the long term ends of net zero, climate adaptation, and biodiversity. As we have argued elsewhere, a Beis strategic policy statement to Ofgem would be a logical companion.

A major issue in planning for these long-term objectives is the great uncertainty around how things will turn out and what will be required. We don’t know how rapidly emissions will be controlled and the extent of temperature and sea level increase. The resultant UK projections for climate change (UKCP18), for example, give a range of summer rainfall change from today of between a 49% fall and a 2% increase! The pace of technological development on issues such as energy storage is unclear. And the government has not yet made important policy choices on the future of heat.

Recent Defra guidance has made it clear under these circumstances that conventional ‘green book’ economic analysis, based around analysis of ‘net present value’ and assuming a symmetric distribution of risks, is insufficient. It offers a range of tools including scenario analysis and real option analysis which should be used to complement traditional appraisal. Defra’s recent draft strategic policy statement to Ofwat reinforces this.

For the regulators and the industry there is as well as the details of project appraisal a more practical issue: the tension between planning for the worst and avoiding unnecessary short- term costs and excessive redundant/stranded assets. This requires two things:  

First flexibility; and,

Second, a framework enabling them to judge where to spend now to buy time, and what to do now because delay would rule out important options or render them much more expensive, while avoiding the risk of nugatory spend.

Fixed 5-year price  reviews are (as we have pointed out before) not well tailored to these challenges: waiting another 5 years to respond to changes in science or technology could be very costly - as Ofgem have accepted - and systems changes, and mega projects, require wholly different time periods.

The issues across the sectors are of course different.

For water, while the industry are major energy users and need greater flood resilience, the main challenges are ensuring there is sufficient water in a potentially much more drought prone future and playing their part in achieving the target in the 25-year environment plan of achieving 75 per cent of water bodies in good condition (up from perhaps 14% now) – the latter would be easier to plan for if Defra had set a target date!

For electricity, the main challenge is how to provide enough power at the right time and in the right place, in a decarbonised future where transport and heating are much more electricity dependent than at present, but where local solutions may be more prevalent. However, importantly, the recent climate change risk assessment makes it clear that the industry (and therefore Ofgem) has also fallen behind on resilience to climatic events – notably wind/storm and floods.

For gas, the challenge may even be existential: decarbonising heat pathways are not yet clear but at best there seems likely to be a sharp reduction in gas demand, and/or a significant cost to make existing networks hydrogen ready.

Partly reflecting the different challenges, the approaches of Ofwat and Ofgem are different.

Ofgem have started with the likelihood of major policy changes on net zero within the RIIO2 period and/or emerging clarity on network solutions. Their main approach can be characterised as ‘adaptive regulation’: building on existing within price control flexibility – such as volume drivers - with new reopener mechanisms. They would propose changes, say 2 years into the price review period, which would entail increased investment, and higher bills, than set out in their final determinations.

There is however already some important longer-term flexibility (storage, demand side response etc) in the electricity system to allow decisions on investment to await better information. Ofgem are also using medium to long term scenarios, have required the adoption of science-based targets, have commissioned thinking on real options analysis and have set up working groups to think more widely. But while we would give them 8/10 on within price review flexibility, they probably score only 5/10 for really working back from the end points of net zero and climate resilience to optimise today’s actions.

Ofwat by contrast have concentrated on working back from the longer term (‘adaptive planning’). This reflects the fact that things happen more slowly in water – there are no seismic changes of the kind which may impact on gas. They have stressed in their PR24 material that the long term is one of the major challenges for them and the sector. In the RAPID workstream they have made a good start on long term planning and the WINEP consultation suggests moving to 10-year planning for aquatic biodiversity. But there remains a suspicion that when push comes to shove there may still be a tendency to delay spend, particularly given the competing pressures of long term water resources and the aquatic environment and for spend on combined sewer overflows and more help for the financially vulnerable.

Both sectors are looking at, but have a lot more work to do on, solutions outside the price review and even more on working between the sectors.

All this is the subject of a set of slides we have published today, one of the final outputs from our Fair for the Future workstream. After setting out the issues and the current approaches, the slides offer a possible checklist for adaptive regulation/within PR flexibility work (for example, in balancing the need for speed/lower bureaucracy with proper customer engagement and protection) and offer a series of questions for adaptive planning (working back from the long-term net zero and climate resilience objectives).

Watch this space: this seems set to be a major working area for regulators over the next few years.

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