*In such uncertain times, how can Ofgem ensure network firms are incentivised to appropriately trade-off investment and active management? ask Dan Roberts and Sarah Deasley.*

When thinking about the changes the energy sector is about to face, and the challenges this may have for the future of network regulation, as unlikely as it may seem, it is helpful to turn to erstwhile US defence chief Donald Rumsfeld for guidance. He said: "There are known knowns - things we know we know. We also know there are known unknowns - that is to say, we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know."

The known knowns in the electricity sector include the need to gear up the network for intermittent renewable generation and decarbonised electricity for transport and heat.

There are also some known unknowns. How quickly will electric cars take off? Will people charge them at their homes? How many houses will switch to electric space heating? What volume of distributed generation could we see if the new feed-in tariff regime is successful?

Then there are the unknown unknowns.

*Distributed generation and electric cars*

Given what we know, we can expect there will need to be changes in the way networks are planned. Distributed renewable generation will mean that flows will be difficult to predict and may no longer be unidirectional. New technology will provide the option to control load more effectively. Electric car take-up could mean that there is a lot more load the customer is happy to have controlled, and be a big source of distributed storage to balance intermittent generation. So the models of historic load growth, and the implications of that growth for new investment, look like they might break down.

These changes should result in more options for network companies to optimise network investment by considering alternatives such as active management of supply and demand. But uncertainty about the magnitude and timing of these changes creates a problem for utility managers and regulators because it increases the risk of wasted long-term investment.

Working out the right thing to do at any given time will therefore become more difficult. The regulatory challenge is ensuring companies face the correct incentives to trade-off between network investment and active management options when the future is so uncertain.

*Adapting regulation*

Ofgem recognises this challenge and has taken it on board as part of its RPI-X@20 . As part of this wide-ranging review, the regulator has been thinking about what impact industry developments have on the way regulation should look. And it seems clear that today's regulatory framework may lead to a bias towards investment. The root of the problem lies in the additional risk network companies may think they face if

they substitute active management for network investment.

First, while it is true that contracting for additional generation or for interruption of load can be a substitute for network investment, it can be a lot less certain. This is a problem given that planning standards mean you need to be sure there will always be sufficient controllable load available. It is also commercially more risky. Any individual contract is not likely to last as long as a network investment, so there is almost certainly more price risk, and such contracts would have to be justified at every price review.

*Held to ransom*

Second, the nature of the trade-offs between contracting for generation or load and network investment may be very local in nature. If electric vehicles take off, these trade-offs may be at the individual street level. If this is the case, there is a risk that those offering active management options might have a degree of market power. While there will always be the backstop option of making the investment, this still means there is a short-term risk of the network company being held to ransom.

Third, there also may be problems in contracting for interruption of load, given that suppliers (rather than distribution companies) manage the customer relationship and given that customers can change supplier on 28 days' notice.

Therefore, unless something changes, there may be a continuing bias towards long-term investments and a significant bill for the customer to pick up at the end of it all. Unfortunately, the potential solutions are far from straightforward.

*Storage ownership?*

For example, network companies could be allowed to own distributed generation or energy storage, to avoid the risk of being held to ransom by third-party supply-side solutions. This would in some ways be analogous to gas network companies owning gas holders. But the risk with this option is that it may well encourage the network companies to invest too much in assets that would more properly be part of a competitive market.

Another solution would be to allow the network companies to contract directly with small customers to avoid the issues associated with frequent change of supplier. However, customers move house almost as often as they change supplier. It would risk customer confusion and increase billing costs because network companies would also have to develop a billing function.

Alternatively, new suppliers could be required to take on the contractual commitments made to old suppliers in respect of demand-side response. However, this risks further complicating the change of supplier process.

*Equalising incentives*

From the point of view of Ofgem's RPI-X@20 project, perhaps the most important area to look at is how to equalise incentives over time, given the very different durations associated with network investments and contracts for active management.

There are two broad approaches that could be used: either an ex ante one, based on evaluating whether an investment appears appropriate at the moment at which it is made, or an ex post approach, based on remunerating asset owners depending on the actual use that is made of investments in future.

The current regulatory framework is closer to the ex ante approach. Once an investment has been allowed into the regulated asset base, asset owners do not expect the investment to be removed for the remainder of its life. If this approach is to be continued, it would rely on Ofgem being satisfied that the investments were appropriate. Since distribution investments tend to be small in scale and numerous, it may be impractical for Ofgem to review them all.

*Out of control*

It would be appropriate to move to an ex post approach only if network owners were well placed to manage the risks associated with predicting where assets were likely to be used and useful. Making them bear risks that they are not best placed to manage will raise the cost of capital without delivering customer benefits. It seems unlikely that they have much control over the pace of developments, since these will be driven by technological progress and government policy.

However, they will have the best information about the steps that can be taken now to build networks that are robust in a range of different development scenarios. It may be that the regulatory focus should be on ensuring that distribution network operators plan appropriately for future uncertainty, rather than rewarding or penalising them based on outcomes they are not well placed to predict.

Dan Roberts is director and Sarah Deasley a manager at Frontier Economics.