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on Nov 20, 14 • posted by rhoggett •

New Thinking: Bringing International and Local Together – Decentralising Energy Regulation

Bringing International and Local Together – Decentralising Energy Regulation (Starting the Discussion)

Catherine Mitchell, Bridget Woodman and Caroline Kuzemko

DECC has recently consulted on a Strategy and Policy Statement (SPS), which is intended to fulfil some of the recommendations made in the DECC Review of Ofgem in 2011, including replacing the past Social and Environmental Guidances from DECC to Ofgem. Unfortunately, the SPS has scarcely moved on from the Social and Environmental Guidance it is meant to replace. The EPG submission to the consultation discusses this in detail.

A fundamental problem of the Draft SPS is that it accepts without question that the current model of regulation in place in GB – set up in late 1980s / early 1990s with very different goals – is the right one to enable a transformation to a sustainable, secure and affordable energy system.

It assumes that the tension between ‘independent’ regulation (ie arms-length from Government) and need for a longer term, strategic and flexible framework to move towards a decarbonised energy system in a time of rapid technological and economic change can be addressed simply by adding sustainability as an aim to the remit of an institution that was created to reduce costs.

We argue that the goal of transformation implies not just a changing role for companies and customers but also a new role for regulation, and a different set of institutions more suited to the complex technological, social (including trust, satisfaction, affordability, choice etc), environmental and economic demands of enabling the necessary shift in our energy systems. In the face of these developments, the traditional, independent CEO-led model of energy regulation is no longer fit for purpose.

Bringing International and Local Together

The IGov project is investigating the links between innovation and governance for a sustainable economy – with energy as a particular case study, and the demand side as a particular focus within that. We are investigating this from an inter-disciplinary, whole system point of view. The political system (eg whether first past the post as in GB; proportional representation; federal versus regional etc) which is in place is critical to the governance process. Regulation is one key aspect of energy governance and is bounded to some extent by the broader political system.

This blog discusses decentralised regulation within the energy sector, and it uses the term decentralised to (1) reflect a move from the current GB energy regulatory system (with a few powerful bodies) to a system with a number of smaller, more focused institutions; and (2) to reflect a move from a fundamentally economic focus to one which includes a greater number of dimensions, such as transparency, direction, integration and so on. However, another decentralised aspect relates to political devolution and devolved regulatory powers ie some sort of NI/Welsh/Scottish regulatory process, as occurs in Germany for example.

Energy is only one of several sectors which make up GB’s economy; and the GB economy exists within Europe and globally, and somehow all governance systems of these different sectors and different levels have to fit seamlessly together.

This blog is written with the specific intention of kicking off a discussion about the needs of energy system regulation, and we argue a more decentralised regulatory process – which brings local and international together – better suits the needs and realities of the current energy system. In GB, it would better

increase, speed / nimbleness, transparency and trust;
fit the increasing ICT basis of energy system operation and management, which includes more decentralised electricity / heat production and use; but also
ensure appropriate political responsibility is taken and a more directional approach is managed so that the energy policy objectives of security, affordability and environment are met.

It seems to us that Denmark has many hallmarks of a decentralised energy regulatory system. It has several regulatory institutions focused on specific areas; it has an overseeing body to give direction; its economic regulator is small and primarily provides analysis and ensures compliance; and it has a state-owned system operator responsible for the technical transition to a secure and sustainable energy system.

IGov will shortly publish a more in depth Working Paper fleshing out this blog as well as discussing the broader governance issues of bringing international, European and GB energy regulation together; the complementarity or not of various political systems; a discussion about devolved regulatory powers; and a discussion of Danish energy regulation.

However, this blog only introduces the idea of a more decentralised energy regulatory system.

Bringing oil and gas production regulation into the energy regulatory system

The UK is setting up a new regulatory body – the Oil and Gas Authority (OGA). It seems to us that whatever the rights or wrongs of setting up such an institution – which is charged with maximising the economic recovery of our oil and gas resources – it should have been set up as part of a well thought out strategic regulatory process for meeting all our energy policy goals. The aim of OGA seems to be to make the North Sea ‘work’ for the UK as a whole – by ensuring greater indigenous oil/gas supply (i.e. security) and longer-term (albeit reduced) tax receipts for the Treasury. Thus, while Government does seem to be thinking to an extent about how to re-regulate energy such that energy companies deliver certain public outcomes for the UK it is unfortunate that the OGA has not been set up within an over-arching energy regulatory framework that has greater strategic foresight for the direction, and trade-offs necessary, for an environmentally sustainable, affordable AND secure energy system.

Energy in GB: Current Centralised Regulatory System No Longer Fit for Purpose

A recent EPG blog by Bridget Woodman provided a map of the GB institutional framework for electricity: what organisation is responsible for what; and what the links between them are. This powerfully illuminates how important, and how centralised, Ofgem and National Grid are within current energy system regulation. We argue that the current regulatory system for gas and electricity is no longer appropriate for the following reasons:

The distributional impacts of different technology paths taken are so great for different sections of society that it is no longer acceptable that DECC, Government and Parliament pass these decisions over to the Regulator; (in practice those impacts are forcing politicians to intervene directly in any case, by-passing the idea of independence completely)
Change is happening so quickly within the energy system that the normal way of undertaking regulatory decisions is too slow and prescriptive. Historically, the ‘Regulator’ has been separate from the market and network actors. Every few years, the regulated network companies send in their plans for the next regulatory period to the Regulator, and the Regulator then comes to a decision about what they, the Regulated, are allowed to spend money on and how they recoup those costs. Similarly, with respect to the markets, there is a process for changing the rules of the market via the BSC Panel at arms length from the Regulator, although the Regulator still has the power of veto. Both processes are cumbersome, interventionist, prescriptive and constraining in a time of huge and rapid technological development and change. The Regulator has always had a battle to keep up with the level of knowledge held by the regulated companies but it is even harder for the Regulator because of new IT possibilities in both markets and networks;
The model of a large, centralised economic regulator, which brings all dimensions of regulation together under one roof, is too unwieldy to manage. There are many reasons for this: We would argue that it has its own institutional momentum to keep following the same course; it finds it difficult to come to agreements internally, slowing down decision-making; because it is meant to be an economic organisation, the short term is favoured over the longer term, and non-economic issues receive less attention or understanding than economic ones; it is not as nimble as it should be when faced with issues such as transfer pricing or customer dissatisfaction, or when it is trying to keep up with issues in other countries which may have a major impact on the GB energy system;
An ‘independent’ economic regulator, such as Ofgem, de facto applies narrow technical /economic analysis to make momentous societal decisions which have major distributional impacts. Currently, Ofgem is then evaluated in a narrow legal sense of meeting its Duties, including ensuring the financial stability of the system. There is no wider evaluation of ensuring an energy system suitable for the longer term needs of society – beyond that of customers – nor does Ofgem have any incentive to act in that way, or face a penalty if it does not.

In contrast, we believe that appropriate regulation to move to a sustainable, secure and affordable energy system would:

Accept the hugely distributional impacts of regulatory decisions, and the need for political responsibility for those decisions;
Try to increase customer (all sizes) involvement, with a key aim of increasing trust, both between customers and suppliers in general but also as a way to increase investment and involvement in the energy system whether as prosumers or community investors. Legitimacy and transparency have to be incorporated in all processes of decision-making;
Accept that, because of technological change, regulatory decisions have got to be made quickly, and that new services may appear from, for example, new entrants or because of customer wishes and these would have to be valued and incorporated rapidly;
Accept that because of the needs of climate change, there is a desired rate of change towards decarbonisation and in order to do this as cost effectively as is possible, given legitimacy concerns, that some sort of system and market architect is needed to get there; and
For all this to occur there needs to be some sort of regulatory overseer with clearly defined boundaries, given to it by, and answerable to, Parliament.

This blog is intended to introduce a longer, forthcoming Working Paper (WP) on the topic of decentralised regulation. For more details, please go to that WP but, in brief, we argue that a more decentralised regulatory model would be based on a number of smaller agencies with more limited remits (see Figure 1 below), as compared to the current GB model which fundamentally has two central institutions, which oversees the majority of key decisions. The WP sets out a discussion of the arguments generally put forward in favour of the current, more centralised approach (for example, overcoming silos; bringing all decisions under one roof; stopping squabbling between smaller entities). However, we believe that a decentralised regulatory model is able to ensure cohesion while at the same time has the following benefits:

A regulatory body, which undertakes economic analysis, is one aspect of a functioning regulatory system but it should not be the dominant part.
Regulatory independence of government is fine when the desired outcomes are based on price and a functioning competitive market can be installed as the de facto, non-political means of choice. But if price is not the only factor – and other issues such as legitimacy, climate, affordability, trust, flexibility, speed have to be taken into account – then markets, and their rules and incentives, themselves become as suspect as direct political intervention.
Energy systems are changing rapidly because of the arrival of new technologies, including IT which enables a new operation and control of energy systems. Thus regulatory systems have to make decisions quickly, and they have to be very knowledgeable about technologies and business models to ensure that barriers to take-up are removed.
In order to ensure competitive practices, there needs to be an ‘independent’ and transparent market monitor so that any market participant is able to understand the value of different services at any one time and in any one place.
Customers and supplier relationships are changing, and these shifting relationships need to be accommodated in a flexible regulatory framework.
Energy infrastructure is long lived, so it is important that when infrastructural decisions are made they are made to enable flexibility towards a number of options. Currently, network regulation and markets are managed separately – market outcomes occur unrelated to potential network efficiencies, or more importantly, system efficiencies. Market outcomes should complement system operation in order to maximise integration and to provide value for different services. Separation of networks and markets is overly complicated.

The move to a sustainable, secure and affordable energy system is inherently broad and complex and not only an economic issue. The issues currently shaping energy systems will require more than short-term economic analysis, and as such an economic regulator setting the conditions which govern current and future investment in both generation and infrastructure is no longer appropriate. Energy policy requires a number of essentially political decisions because different technological pathways and different timescales for decarbonisation have major distributional consequences for British society. These decisions should explicitly be in the hands of politicians who are (albeit imperfectly) answerable to the electorate. This may not always lead to an ideal outcome, but at least there would be the opportunity for debate and scrutiny not always apparent in the ‘black box’ of Ofgem.

The Figure below is a tentative first stab at what a decentralised regulatory system might look like, as opposed to the current institutional structure shown elsewhere. Again, please see the forthcoming Working Paper for full details.