Essential Services, Essential Oversight: The one thing that has to change to ensure the grid we need is delivered

Delivering net zero will need billions of investment in our electricity grid. This should allow consumers to benefit from cheaper renewables, reducing energy bills overall. The network companies that own the grids will get the work done, but it’s really consumers making the investment so we need to be confident that they’re getting value for money. There’s currently a risk that network companies will be over-rewarded for managing this investment on behalf of consumers. Seeing companies make unjustified profits damages public confidence. Without public confidence, long-term certainty over the regulatory regime is damaged and net zero targets are put at risk.

So far in this series, we have explored the importance of regulation in protecting those who need it most and how to go about this. Here, we look at how the interests of consumers can be better represented when issues can feel more remote but will still have a big impact.

The status quo is reasserting itself

There’s been a near consensus among independent observers that energy network companies find it too easy to make money. Following Citizens Advice’s landmark report in 2017 that identified that consumers had overpaid by billions, the National Audit Office reached a similar conclusion in 2020. The National Infrastructure Commission recommended that regulators should reduce how much money can be made by using the lower end of estimates of what return on investment is needed (known as ‘aiming off’). Ofgem sought to reduce returns, by applying an ‘outperformance wedge’. This was to adjust for the fact that network companies will earn extra money because incentive targets will be too easy to beat.

But then Ofgem abandoned its attempts to address outperformance and the NIC’s recommendation has been quietly ignored. Ofgem is now even considering a notion of ensuring ‘investability’ on top of its statutory duty to ensure network companies are financeable. And there is a risk unrelated issues in other sectors could add to this narrative.

Regulatory appeals cast a long shadow

Regulating these monopoly providers is always going to be challenging — the companies are on the right side of some structural asymmetries. The companies will always have more information, have more resources to throw at regulatory discussions and have a clear and unambiguous commercial incentive to get the best result for shareholders. The regulatory process should be designed to address this but instead makes it worse.

Currently, it’s effectively just the companies who can appeal the decisions by Ofgem about how much money they receive. They also can choose which aspects of the decisions are subject to appeal (known as ‘cherry picking’). This can only lead to outcomes that are too generous to the network companies. Even if you assumed that the original decision was well-balanced to begin with, ‘cherry picking’ means looking only at issues which seek additional money which will lead to an unbalanced position in favour of the network companies. In reality, due to all the structural advantages the network companies enjoy, the network companies are already winning by the time Ofgem makes decisions and so a successful appeal simply skews the result further against consumers.

But the true impact of the appeals regime is likely to be bigger than the effect of the appeal decisions themselves. Decision-makers will naturally and reasonably seek to understand the likelihood of their decisions being challenged, in this case by appealing to the Competitions and Markets Authority (CMA). This leads to decisions that are designed to reduce the risk of a successful appeal — and if you know only network companies can appeal, this inevitably leads to outcomes that are generous.

A recent example of this was when Ofgem decided how much consumers should fund electricity distribution companies to cover the return on investment. Ofgem relied on the approach that it had taken for gas distribution because that had already withstood an appeal to the CMA. However, the original Ofgem proposals for gas distribution also included the 0.25% ‘outperformance wedge’ reduction — but that was rejected by the CMA on appeal. By applying the rest of the package, but without this reduction, Ofgem adopted an approach which is inconsistent with precedent and knowingly generous — all in order to reduce the risk of networks successfully appealing. The impacts of being generous here are massive. We estimate it could be up to £1.5bn for electricity distribution alone. This number will rise as more investment is required to deliver net zero, and with it the risk to public confidence and net zero.

Reform is needed or investment will be put at risk

So, a poorly designed appeals process casts a shadow over the whole regulatory regime. There are a range of options for reform, which we’ve explored, but all need to level the playing field. Parties other than the network companies need to be able to bring issues for the CMA to consider when hearing appeals to address ‘cherry-picking’. The government proposals for reforming the appeals process need to be much more ambitious. If we don’t get these reforms right, consumers will continue to fund excess profits, potentially in the £billions, and the lack of consumer trust this brings will put the grid investments needed to deliver net zero at risk.

This blog is part of a series by Citizens Advice, “Essential Services, Essential Oversight” looking at the role of regulators and exploring ideas which aim to put the consumer at the heart of markets.