Low carbon incentives for network? Yes! But will they work in the current wider governance context?
Matthew Lockwood, IGov Team, 23rd May 2018
Sustainability First have produced an interesting discussion paper proposing a low carbon incentive for inclusion in the next round of regulation for networks (RIIO2). The paper, written by regulatory experts Maxine Frerk (ex-Ofgem), Judith Ward (who is – full disclosure – on the advisory group of IGov2) and Sharon Darcy, argues for the introduction of a specific low carbon incentive that would work in three areas:
- Low carbon energy sources: incentivising network companies to facilitate the connection of low carbon energy sources (for example distributed renewable generation in electricity, or biogas in the gas network) and increasing the level of output from those sources
- Low carbon network operation: incentivising network companies to reduce their own carbon footprint (and that of contractors), including via losses and leakage
- De-carbonising demand: incentivising companies to facilitate reductions in demand for energy (for example via energy efficiency measures), as well as the use of lower carbon energy sources in other sector (e.g. heat and transport).
Part of the argument for such a move is that it would bring together a number of existing relatively small incentives for network companies impacting on carbon emissions reduction in a single incentive, raising its profile and giving a ‘clearer and more coherent focus on an important outcome for the entire sector’. However, this is not just an exercise in consolidation; the paper is proposing incentives in new areas – for example, as the paper points out, existing incentives for low carbon generation connections focus purely on stakeholder engagements aspects, not on the level of connections delivered. There is also no incentive for networks to minimise the constraining off of low carbon distributed generation once connected. The paper goes on to give serious consideration to how such an incentive might be operationalised in practice.
Overall, IGov very much welcomes this contribution, certainly we are in favour of much clearer incentives for network companies to facilitate the decarbonisation of the energy system in Britain. But the paper throws up three important challenges for making this kind of reform work, both of which the authors themselves recognise. The first is to do with the current goals of regulation, the second to do with coordination between regulation and policy, and the third to do with what we want network companies to actually do. In all these areas, other aspects of the energy governance system may need to change to make a low carbon incentive work effectively.
The first issue is that while decarbonisation of the energy system is a clear policy goal, driven indirectly via the carbon budgets set under the 2008 Climate Change Act, it is not always so clear an imperative at the regulatory level. This state of affairs reflects both ambiguity in Ofgem’s remit, and the limited nature of the code objectives.
Ofgem’s remit includes the promotion of interests of current and future consumers; the latter seen as being about delivering efficiency through competition wherever possible and the latter as being about sustainability, including decarbonisation. Thus, while decarbonisation is on Ofgem’s agenda, it is always within the context of potential trade-offs, and the regulator has to make its own judgements about how to handle those trade-offs. With a history of being an economic regulator, (and also being subject to an ever-present implicit threat of legal action by companies), it is not surprising that it has in the past tended to err on the side of caution, which has often meant on the side of promoting competition (despite the complete absence elsewhere in the system of anything resembling first-best markets).
The SF paper itself provides an interesting example of how this works. In an appendix the paper notes a debate held at the time of RPI-X@20 in which the possibility of stronger environmental incentives were raised, including an incentive for maximising the volume of local carbon flows on networks. However, this idea was seen as conflicting with non-discrimination obligations under the aegis of ensuring competition, and the idea was rejected in favour of incentives linked to generic reliability and connections outputs. It may be that seven years on, the regulator is more minded to prioritise increasing low-carbon energy production over competition, but this kind of loose governance arrangement, subject to the changing whims of regulator (and subject to legal challenge) is no substitute for a clearer mandate for decarbonisation throughout the policy and regulatory governance system. An effective low carbon incentive would specifically be about treating some forms of energy production more favourably than others, and until such an approach is given sufficient cover by the governance system, it is perhaps unlikely to be taken up.
At the same time, at the level of codes governance, decarbonisation is not (with the exception of the Smart Energy Code) a code governance objective. This means that it remains impossible to modify a code on the grounds that a modification would lead to carbon reduction. Perhaps more importantly for the current context, this aspect of codes governance is presently also influencing thinking about the reform of network access going on in the Charging Futures Forum Access Task Force. This is the early stages of a major review of the rules for network access going on outside the usual codes governance process. It will set the terms for connections, including by low carbon energy production and storage for years to come. The Task Force has just produced an admirably thorough consideration and assessment of different options for access, but that assessment is based wholly on the objectives for the CUSC and DCUSA, i.e. the network codes for transmission and distribution respectively, which as outlined above, do not include consideration of decarbonisation. If they were working under a low carbon incentive in RIIO2, network companies would still have to work within the access rules that will be set in the review that is now under way. It would make sense for that review to include an assessment of different options for network access that does include impacts on decarbonisation.
The second challenge facing a low carbon incentive, and again one that the SF paper acknowledges and engages with, is that in many of the areas the proposal covers, the outcomes are not directly under the control of network companies, for example on the level of connections, which depends on the number of developers in low carbon energy who come forward, or on the level of energy efficiency activity. Trying to assess fairly how actions by the network companies would make a difference in these areas, and therefore how much of a reward they should receive, is also one of the reasons why the SF paper argues against quantitative targets as the basis for the incentive, and instead recommends a qualitative assessment (underpinned by some metrics).
This problem can be seen as applying not only to the SF proposal but to other ideas trying to achieve the same overall outcome. For example, in his recent cost review, Dieter Helm argued for ‘regional system operators’ (RSOs), who would assume responsibility for the development of electricity systems at sub-national level (as discussed below the IGov approach for this is somewhat different). He sees ‘public duties’ being placed on these bodies, and while these are mostly familiar elements such as system reliability, he does mention, for example, that RSOs would be tasked with maximising the scope for the use of flexibility and networks so as best to incorporate electric vehicles. However, for such an arrangement to be meaningful, the RSOs would have to be suitably incentivised, which raises the question of measuring outcomes (in this, case, presumably something like the number of EVs charged).
The underlying issue here, as implied in the SF paper, is whether it is fair and workable to require or reward a network company with delivering an outcome that lies outside of its control. This approach would appear to go against the oft-cited principle in energy governance that risk should be allocated to those parties best able to manage it.
However, in practice, energy outcome incentives and obligations have quite successfully been placed on actors which do not have control over the outcome. An example is the obligations placed on suppliers on the UK over many years to promote energy efficiency measures by households. Another, more relevant perhaps, is the obligation placed on distribution network companies (electricity, gas and district heating) for delivering energy efficiency in Denmark. In both cases, the actors on whom the obligations were put sought to achieve outcomes (largely successfully) through influencing those actors who did have direct control, largely via third parties (in the Danish case only by third parties). As the SF paper notes, distribution companies could become ‘place shapers’, seeking to attract low carbon investment in the form of different technologies to their areas, and competing to do so. This may involve network companies developing new capabilities, but it is not necessarily impossible.
But it will be a lot easier to task or incentivise network companies with bringing about an outcome that they have at best limited control over if other factors, especially policy, are also aligned with that outcome. In other words, it makes sense to put a low carbon incentive on network companies (i.e. that incentive is likely to be effective) if it complements effective policy aiming at expanding, for example, renewable distributed generation, or storage. This is the principle that underlies incentives for combined network and supply utilities in the New York Reforming the Energy Vision programme in the form of ‘earnings adjusted mechanisms’, for example, i.e. they align network efforts with State goals for the growth of renewables and energy efficiency. For such an arrangement to work well, a clear sense of direction for both policy and regulation is needed, with good adaptive governance mechanisms to ensure a reasonable fit between them. In the absence of this, if policy is defined only by inputs, and is fixed, there is a danger that outcomes will end up being a long way away from the expectations that regulation was based on, as was the case with solar PV in the period 2011 to 2015. In other words, having a clear sense of direction in policy, with staging posts along the way, and having mechanisms to reach those staging posts, will help network companies play a meaningful part in helping to facilitate the outcomes desired.
From this point of view, the larger problem in Britain at the moment is a lack of specified direction (beyond high level decarbonisation and the idea that we need ‘more’ flexibility) and ways of guiding the associated path. Thus if a quantitative low carbon incentive were to be chosen, or indeed a qualitative incentive but with supporting metrics, the question is what one would base numbers for desired outcomes on? Again, a low carbon incentive will be more likely to be effective if the wider governance approach were giving a clearer sense of direction.
Building on this point, a third issue for a low carbon incentive as suggested by SF is that it would appear to have been developed largely with the existing model of a network company in mind. Thinking especially about electricity distribution network operators (DNOs), these are companies that can currently offer connections and to a very limited degree manage the flow of low carbon electricity across their networks. There is a general expectation that DNOs will evolve into distribution system operators (DSOs), developing greater observability, monitoring and active control of power on their networks, allowing more opportunities for maximising the use of low carbon resources. However, it is important to note that there is still no agreement on exactly what DSOs will look like or do, and how they will interact with the transmission level or indeed with national system operation. Government and Ofgem are looking to the network companies to come up with some answers, and their different efforts – see here and here – are still in process. The IGov model involves these companies being transformed into distribution service providers (DSPs) which not only manage power flows on networks, but also coordinate local markets for distributed energy resources and balance energy below the grid supply point through distribution platforms. Such an entity would have much greater array of potential relationships with low carbon resources than simply through connections. It would also be incentivised in a radically different way from conventional price-control regulation, and this would include incentives for maximising the use of local carbon generation. The overall point is that it is hard to develop a regulatory incentive for an actor until it is clear what that actor is and what it is being asked to do. Again, a clearer sense of direction is needed in order to construct effective regulation.
Posted by: rhoggett
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