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Economics Division School of Social Sciences University of Southampton Southampton SO17 1BJ

Understanding the economics of running a health service

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University tuition feesUp-to-date information linked to the article in this issue

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2 Economics of the health sectorMaksymilian Kwiek

5 Getting started Opportunity costPeter Smith

8 Price discrimination: university tuition feesWilliam Bohanna

12 Question and answer Questions on economic conceptsPeter Smith

14 Who’s who in economics James TobinJohn Aldrich

16 Fiscal policy Why do people make bad decisions?Wenchao Jin

19 The history of the public debtHelen Julia Paul

22 The energy industry: new regulation for new challengesChris Watts

28 Question and answer AnswersPeter Smith

32 Student’s corner A student’s viewBen Sorrell

34 Development profile Country XPeter Smith

Volume 29 Number 1 September 2011

Exam questions to practise, with comments and answers

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Behavioural economics: how do we make decisions?

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TEbn

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/FO

TOli

A

22 Economic Review

Ensuring reliable and sustainable delivery of energy to business and

households is crucial for the economy. However, the gas and electricity transmis-sion networks are seen to be natural monop-olies, so there is a need for regulation to avoid the potential market failure that could hamper the efficient allocation of resources in the sector.

Gas and electricity businesses were pri-vatised in 1986 and 1989 respectively, and a regulatory framework was put in place under the aegis of Ofgem. This agency has applied price control regulation to the networks, and provided incentives for firms, initially to improve cost efficiency, but later encom-passing other objectives covering aspects of service standards.

The RPI-X framework has been success-ful in delivering benefits to consumers. Since privatisation, the cost to consumers for network services has fallen by around 60% in electricity distribution and 30% in electricity transmission. It fell by around 41% for the gas networks between 1995 and 2007 but has been increasing more recently, reflecting increased investment.

The framework has delivered a better quality of service and over £35 billion in network investment.

The energy industry now faces major new challenges and Ofgem needs to make sure that the regulatory framework steps up to support these, while continuing to protect consumers. The sector plays a key role in moving to a low-carbon economy. The government has set a target of an 80% reduction in greenhouse gas emissions by 2050 and decarbonised electricity genera-tion by 2030, while maintaining security of supply. The networks need to adapt to connect new energy sources such as onshore and offshore wind generation, biofuel gen-eration and fossil fuels with carbon capture. It is estimated that the networks will need to invest in excess of £30 billion leading up to 2020, at least doubling the rate of investment.

Ofgem has put in place a new regula-tory framework to support this. This is the RIIO model — Revenue set to deliver strong Incentives, Innovation and Outputs. It builds on the existing RPI-X regulatory framework, refining the approach and

building in a number of exciting new ele-ments. It focuses on two key outcomes: delivering a sustainable energy sector in a timely manner and value for money for con-sumers. Ofgem is carrying out the current transmission and gas distribution reviews using this approach (RIIO-T1 and GD1).

This article provides an insight into the energy networks, the RPI-X framework, the changes facing the industry and the new regulatory regime, and also provides some examples of new developments.

Structure of the energy industryFigure 1 shows the structure of the gas industry in Britain. Gas is brought into Britain through several sources, including production on the UK Continental Shelf, imports from Europe and liquefied natural gas (LNG) brought in by tanker. This is a competitive activity. Gas is then trans-ported from the relevant entry terminal to the network across the country through high-pressure pipes on the National Transmission System (NTS). It is distrib-uted to the majority of end consumers by the eight local Gas Distribution Networks

The energy industry

Chris Watts provides an insight into the regulation of the gas and electricity industries and the new challenges facing the energy sector

Newregulationfornewchallenges

Metering

NGET operates the system of high voltage pylons and wires in Great Britain

Metering Suppliers transport the electricity to final consumers

Distribution companies operate the medium voltageregional electricity distribution networks

NGET owns the highvoltage pylons and wires

in England and Wales

SHETL owns the highvoltage pylons and wiresin the Scottish Hydro area

SPTL owns the highvoltage pylons and wiresin the Scottish Power area

Generationfrom coal

Transport of electricity via IndependentDistribution Network Operators (IDNOs)

Generationfrom gas

Nucleargeneration

Renewablegeneration

Combinedheat and power

Electricityimports

Distributedgeneration

= Competitive

= Monopoly

Source: Ofgem

Figure 2 The structure of the electricity industry in britain

23September 2011

(GDNs), which operate at lower pressures. These networks are owned by four compa-nies and are regional natural monopolies. The shippers and suppliers that arrange for the delivery and sale of gas to end customers

are competitive businesses. There is a similar structure for electricity (Figure 2).

The networks have the key character-istics of natural monopolies. They have high levels of sunk costs, provide essential

services, serve large markets and have large economies of scale, which means a large minimum efficient scale.

In the absence of regulation, profit-max-imising network companies would look to

Production from the UKContinental Shelf (UKCS)

Transport of gas via IndependentGas Transporters (IGTs)

Metering

Metering Transport of gas to consumers by suppliers

Transportation of gas on mediumpressure distribution networks

Transportation on high pressure National TransmissionSystem (NTS) by National Grid Gas (NGG)

Imports from Europethrough interconnectors

Worldwide imports ofliquefied natural gas (LNG)

Shippersarrange fordelivery ofgas on the

transmissionsystem

and fromdistribution

companies tosuppliers

Gas storage(not possiblein electricity)

= Competitive

= Monopoly

Source: Ofgem

Figure 1 The structure of the gas industry in britain

Maintaining the electricity distribution network

Y1 Y2 Y3 Y4

Additionalprofits forcompany

Y5First pricecontrol review

Second price control review

Allowed revenuesCompany’s actual cost

Lower costsfor consumers

Figure 3 Price control reviews

SCO

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SO

uTh

ERn

ElE

CTRi

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24 Economic Review

set prices and quantities at a point at which marginal revenues are equal to marginal costs, significantly pushing up prices and reducing consumer welfare. Ofgem applies price controls to protect the interests of consumers.

RPI-X frameworkSince privatisation, Ofgem has applied RPI-X incentives to the networks. This sets allowed revenue that the companies can charge for a fixed period (typically 5 years). It is adjusted for inflation, which is captured by the Retail Price Index (RPI) less a speci-fied ‘X-factor’. The idea was originally devel-oped by Stephen Littlechild in the context of the regulation of British Telecom. The

X-factor was intended to represent improve-ments in productivity over and above the economy as a whole.

As price controls have developed further, the RPI-X framework has become more focused on the key building blocks of com-panies’ costs and the X-factor represents the profile of those costs over time includ-ing efficiency improvements, but capturing other factors such as changes in input prices.

Ofgem sets allowed revenue based on an estimate of efficient costs for the 5-year period (Figure 3). Companies have a strong incentive to outperform. If they can achieve lower costs, they retain the benefit until the end of the 5-year period and earn a higher return. If they have higher costs, they

underperform. At the end of the period, the companies’ actual performance has revealed additional information about their costs, which can be used to set lower prices in the next period and pass on benefits to customers.

Building blocksThere are a number of building blocks that Ofgem assesses for a price control. These are as follows:1 Operating expenditure The day-to-day costs of running a network. Examples of these include staff salaries, costs of carrying out repairs to the network and tree cutting.2 Capital expenditure This covers invest-ments in assets such as overhead lines and pipes. The benefits of these assets are realised over time and costs are recovered gradually through an allowance for depre-ciation and financing costs.3 Regulatory asset value (RAV) The RAV is calculated by determining the opening value of the companies’ assets at the start of the price control and rolling this forward for capital expenditure minus depreciation. 4 Depreciation A depreciation charge is calculated by making an assumption on the average life of an asset and then applying this to the RAV. For example, under straight line depreciation, based on an asset life of 40 years, the depreciation charge for a RAV of £800 million would be £20 million.5 Allowed return Investors require a return that reflects the opportunity costs of holding network assets rather than other forms of investment. This is based on an estimate of the weighted average cost of capital (WACC), which is the average cost of debt and equity finance with an assumed (or notional) level of gearing. This is applied to the RAV.

The overall revenue allowances are calcu-lated by bringing together operating expend-iture, depreciation and the allowed return and making allowance for other incentive income and costs outside the companies’ control.

Challenges facing the sectorAfter a stable period of around 20 years since privatisation, the energy sector faces significant new challenges in responding to a low-carbon economy. In December 2008, the Climate Change Committee (CCC) rec-ommended that UK greenhouse gas emis-sions should be reduced by 26% by 2020 and 80% by 2050. To deliver this target, the

Source: Ofgem

= ++

Specification of outputs to be delivered

Upfront efficiencyincentives

Combined effect determines financial risks faced under price control

Expected efficientexpenditure

Allowance for taxation

WACC

RAV, capitalisationand depreciation

Rewards/penaltiesfor delivery of

outputs

Indexation

Other uncertaintymechanisms

(e.g. volume drivers,revenue triggers)

Rules to adjustrevenues for otherfactors (uncertainty

mechanisms)

Rules to adjustrevenues in light

of company’sperformance

Baseline revenueallowance £m

(includingfinancing costs)

Revenuecommitmentunder price

control

RAV carriedforward fromprevious pricecontrol period

Figure 4 building blocks of output-led price controls

Customers expect a reliable energy supply

AlE

X yE

un

G/F

OTO

liA

25September 2011

CCC recommends that electricity should be almost completely decarbonised by 2030. The move to a low-carbon economy could see some significant changes in the use of the gas network, as a large proportion of carbon dioxide (CO

2) emissions come from domestic premises and gas central heating, and there is a large proportion of gas turbine generation.

The electricity networks need to adapt to a range of challenges including connec-tion of increased volumes of offshore gener-ation, greater renewable generation onshore, more generation connected to the distribu-tion networks, use of electric vehicles and increased use of electric space heating. This will have a significant impact in terms of how the electricity networks are managed, requiring more active management to deal with changing energy flows and smarter grids to deal with changing patterns of supply and demand. There will need to be greater focus on energy efficiency and demand-side management to address peaks in demand. For the gas networks there will be significant uncertainties over demand with a greater variety of gas sources, includ-ing the use of LNG and opportunities for connection of renewable gas.

All of this points to significant changes in the use of the networks, the need to invest in new assets and operating solu-tions to meet the challenges of changing customer requirements and the energy mix. It is important to consider new technical and commercial solutions and to focus on the longer term to meet the 2030 and 2050 targets.

RIIO regulationOfgem has developed the RIIO model of price control regulation to address these challenges. The price controls will now be output rather than input led. To assess the efficiency of companies and set an appro-priate regulatory settlement, it is essential to understand what they are proposing to deliver as well as the costs associated with this (Figure 4).

This puts customers, network users and other stakeholders at the heart of the price control process. Ofgem has identified a number of key types of outputs that must be targeted:

■■ Environmental impact both in terms of their contribution to broader government environmental targets and networks’ efforts to reduce their own carbon emissions.

■■ Safety — networks should be maintained and operated in a safe manner with regard to both staff and members of the public.

■■ Customer satisfaction for a wide range of network users, including domestic custom-ers, small and large businesses, generators, and suppliers.

■■ Reliability of supply — customers expect to have a reliable energy supply and for issues to be dealt with rapidly when there are problems with the networks.

■■ New connections — there should be a timely and high quality process for new con-nections to the networks, both for smaller scale and larger users.

■■ Social obligations — these include pro-visions of services to vulnerable customers and the fuel poor.

Ofgem is putting into place enhanced incentives for the delivery of these outputs.

For example, in transmission ±1% of allowed revenue will depend on a survey of customer satisfaction and companies’ per-formance in engaging stakeholders. Ofgem is applying a marginal incentive on compa-nies’ performance in managing the level of energy not supplied due to supply interrup-tions. It is also introducing a reputational incentive and considering a financial incen-tive on transmission companies’ perfor-mance in promoting low-carbon energy flows.

A key element of the new price control process is placing greater focus on the longer term. Companies will be required to produce their plans in the context of how they will contribute to longer-term environ-mental objectives. Ofgem has decided to lengthen price controls from 5 to 8 years, giving companies greater certainty over their

Num

ber

of s

ubst

atio

ns

40

3 4 51 2

60

80

100

120

20

0

Load index

Year 5 load index profile — with investment Year 5 percentage of customers suppliedsplit by load index — with investment

LI1–3 LI4 LI5

70%

10%

20%

Figure 5 load index

Some gas is brought into the uK from the north Sea

Source: Ofgem

bP P

lC

26 Economic Review

future allowances but placing the onus on them to look further into the future and consider how to manage uncertainties.

Ofgem is encouraging companies to work with partners to develop innovative ways of meeting future challenges. It is also apply-ing a proportionate approach for assessing the companies’ price control forecasts with the level of analysis dependent on the justi-fication within the companies’ plans, their track record for delivery and benchmarking across companies. Below are three examples of how Ofgem is developing this approach.

Network output measuresIn the past, Ofgem has set allowances for capital investment based on its view of efficient expenditure but has not defined associated outputs. It has been difficult to distinguish between a company that has acted efficiently in terms of deferring invest-ment without impacting on the network and another company that has simply chosen not to invest to improve its returns at the expense of the robustness of the network. In

this case the economic incentives to manage costs potentially lead to perverse outcomes.

It is not always easy to observe the network deterioration in terms of how the networks are performing on a day-to-day basis. This is why Ofgem is introducing network output measures for the gas distri-bution and transmission businesses, which provide leading indicators of asset condition and loading.

The output measures capture the condi-tion of the companies’ assets and their criti-cality in terms of safety, environmental and reliability consequences. For example, an asset may be considered to be high critical-ity if failure would pose a danger of injury to staff or to the public. These two factors are combined to determine a replacement prior-ity. Ofgem is capturing similar information on the loading of the networks and how this changes over time.

Figure 5 illustrates the distribution of how substations are loaded on an elec-tricity distribution network. For example, load-category 1 indicates a low level of

loading. Category 5 indicates that the level of demand is exceeding capacity of the substation and that additional capacity is needed. By setting output measures tied to the investment on the network, it can be established whether a company is effi-ciently deferring expenditure or causing the network to deteriorate, and ensure that only efficient improvements in costs and outputs are rewarded.

Equalised incentivesIn past price controls there have been signifi-cant differences in the strength of incentives between operating and capital expenditure. For example, if companies made a £100 one-off saving in operating costs they would have received the full benefit of this. By contrast, if they saved £100 worth of capital expenditure they would have retained the benefit in terms of lower depreciation and financing costs until the end of the price control period. There was a 100% incentive strength on operating costs but a much lower incentive strength for capital expenditure. This provided incentives for companies to focus on more capital solutions and to look to reclassify costs as capital expenditure.

Ofgem has now addressed this by ensur-ing that companies face the same incen-tive strength for all activities and there is a level playing field. This is important in the context of a low-carbon economy, as the costs of innovative operating solutions such as demand-side management are treated equivalently to the costs of building new assets to meet growth in demand.

Innovation One of the difficulties that Ofgem faces in setting price controls and mimicking how a competitive market works is encour-aging appropriate levels of research and

27September 2011

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Review notes

1 The gas and electricity industries have the key characteristics of natural monopolies. They have high levels of sunk costs, provide essential services, serve large markets and have large economies of scale, which means a large minimum efficient scale.2 In the absence of regulation, profit-maximising network companies would look to set prices and quantities at a point at which marginal revenues are equal to marginal costs, significantly pushing up prices and reducing consumer welfare. 3 Ofgem, the regulatory agency covering both the gas and electricity industries, applies price controls to protect the interests of consumers. It has applied RPI-X price controls, which set the revenue that the companies can earn for a fixed period and provide incentives to improve cost efficiency. 4 The energy sector is facing significant new challenges in responding to a low-carbon economy. Ofgem has developed the RIIO model to address these challenges. RIIO stands for Revenue set to deliver strong Incentives, Innovation and Outputs. It builds on the existing RPI-X regulatory framework, refining the approach and building in a number of exciting new elements such as more emphasis on the longer term, outputs that stakeholders want and providing funding for new innovation.

development and trialling. Ofgem looks to pass through efficiencies to customers when a price control is reset and this potentially puts companies off speculative research and trials. Ofgem has introduced a number of elements as part of the RIIO model to encourage innovation.

Ofgem will be providing innovation funding of £240 million over the price control period for electricity transmission and £160 million for gas transmission and

gas distribution. Ofgem is setting longer price controls over 8 years rather than 5 years, which gives companies greater cer-tainty and potentially greater retention of benefits from innovation. There is a greater focus on outputs, which gives companies an incentive to seek innovative ways of meeting a change in the demand and supply balance, delivering capacity and new connections to the network. Companies will be given the opportunity to present the case for new

technology that only pays off in the longer term, up front in their business plans.

ConclusionAfter years of stability, the energy industry and energy networks are facing major new challenges with the move to a low-carbon economy, needing to facilitate the connec-tion of a new generation, manage changing demand and supply patterns and innovate to offer new solutions. Ofgem’s RIIO frame-work for price controls provides stronger incentives and opportunities to address this with a focus on sustainability, outputs and value for money. The price controls focus more on the longer term and on outputs that stakeholders want, and provide funding for new innovation. £

Further informationFor further information, see: www.ofgem.gov.uk

Some explanation of the problems caused by a natural monopoly can be

found on EconomicReviewOnline.

Dr Chris Watts is head of networks, costs and outputs at Ofgem.