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How will Ofgem shape the future of electricity distribution in ED2?

Change comes fast but utility regulation risks slow motion. Since the RIIO2 process kicked off some two years back, government has legislated for a 2050 net zero green-house gas reduction target – and XR certainly knows how to focus minds. What's more, the wider politics of our utilities continues to pose a major challenge for economic regulation on how best to shape long-run national infrastructure and essential services through a period of profound change. Scrutiny of the draft five-year RIIO2 business and investment plans is well under way for electricity and gas transmission and gas distribution. But the ground continues to shift. For the electricity distribution networks, whose enabling role will be so fundamental in support of a smooth, cost-efficient and just energy transition, much is yet to play out.

For the ED2 process, Sustainability First would encourage Ofgem to first look to putting its own house in order. Ofgem must demonstrate concerted ambition in its approach to setting duties and incentives for electricity distribution in ED2 and beyond into ED3. A truly shape-shifting ED2 package is needed for a strongly future-facing and sustainable framework for electricity distribution going forward to support the transition. This must extend beyond a narrow focus on driving greater efficiency and value-for-money in today's networks, to give significant new weight to shifting the DNO role to become far more future-focused. Inter al, we see a need for Ofgem to adopt ambitious regulatory approaches to frame a proactive network role enabling plural pathways towards decarbonisation to net zero; integration of digital-control at every network-level; and clear recognition of a DNO / DSO regional leadership role to further the development of devolved, regional, community and local approaches to energy balancing and supply.

At the same time, as we accelerate towards 'smart' – including more forms of electric transport and heat – approaches to regulation must show a strong regard not just for the opportunity but also appropriate concern for the many customer groups at risk of being 'left behind' – be that businesses, communities, particular households or citizen groups. We would like to see a new DNO incentive for 'smart-inclusion'. This in turn poses the challenge – both for regulation and for the regulated companies – to find new and transparent approaches to addressing matters of fairness, including how best to bring forward key policy questions for decision by government.

In our submission to the ED2 Open Letter, Sustainability First singles out ten areas as important for a package of future-facing ED2 duties and incentives:

1.  Reshaping the DNO role to be future-facing – including for Ofgem to clarify its own approach on regulatory risk with respect to uncertainty and ED2 investment.

2.  DNO / DSO duty to facilitate outcomes for net zero delivery – so that responsibilities and incentives for DNOs in ED2 become aligned in practical terms with the statutory 2050 target. Including, potentially, reform of present non-discrimination duties to prefer low or zero carbon (connection, despatch).

3.  Successful customer-facing outcomes remain central to Sustainability First thinking. For ED2, critical outcomes include:

- Customers in vulnerable circumstances – to continue to stretch DNO ambition in this all-important area – including improved approaches to cross-utility and cross-agency coordination.

- Smart-inclusion – our proposal for a new incentive to identify and communicate about their customers at serious risk of being left behind in a smart, transactive energy world – be these businesses, households and / or communities.

- Regional, community and local energy – in recognition that DNO geographic assets are a major 'public good', DNOs to be incentivised to step-up to a clearer regional leadership role in support of others' efforts to deliver on smart and net zero.

4.  DSO/DNO development – to accommodate new forms of electric transport, heat and storage – and to promote appropriate non-build flexible responses – it is fundamental to 'get this right'. We agree with Ofgem that an evolutionary approach on respective DNO and DSO roles make sense for ED2. In particular, a network-wide overview and good coordination must be retained via well-integrated approaches – In both planning and operational timeframes. Competitive approaches may well promote and support innovation and efficiency. But, equally, without good coordination at the DSO- or DNO-level, undue fragmentation and atomisation could also pose a risk, both to efficiency and potentially to rapid progress on greenhouse gas reduction. We also agree that strong integration of the ED2 process with Ofgem's work on charging and settlement reform will be fundamental to ensuring efficient outcomes overall.

5.  Distribution losses – represent ~70% of total losses (26 TWh T&D) and ~1.5% of greenhouse gas emissions. Loss management is complex but ED2 should revisit to ensure appropriate regulatory responses – especially in light of increasing DNO/DSO separation.

6.  A broad and consistent environmental performance baseline – the 2030 UN Sustainable Development Goals provide a helpful environmental reporting framework. RIIO2 environmental reporting and action plans must align across all sectors (ET/GT/GD/ED) to allow consistent comparison and review, including on direct and indirect emissions, losses and SF6 reduction. As the carbon content of electricity supply decreases, the question of greenhouse gas impacts of SF6 in long-lived DNO assets will become ever-more pressing.

7.  Approaches to risk and reward Ofgem needs to address total expenditure and returns in the round – and consider the balance between base revenues and income available via incentives for output-related expenditure. The ED2 aim is surely to achieve a step-change in DNO facilitation of the energy transition, which may well mean an overall revenue package that looks significantly different from ED1. Also, in the future, base revenues may warrant lower returns. Riskier investments (high uncertainty, high complexity, high cost) may potentially attract higher returns (or uncertainty mechanisms). Customers should share in the upside of riskier investment (i.e. if they underwrite this) and companies should absorb down-side risk as appropriate.

8.  Digital & data – delivering the 'public good' aspects of DNO data – DNOs need to recognise the 'public good' aspect of the customer-side data they hold, both within their own geography and also as a potential national resource. ED2 should incentivise DNO collaboration to explore how customer-side data, suitably anonymised and aggregated via a trusted processor, could become available to serve the public interest as a regional and national resource.

9.  Enhanced engagement / demonstrating fairness – so far, enhanced engagement is a positive, albeit independent review will still be needed. The benefits are apparent: greater regulatory and company accountability; development of better regulatory methodologies; business plans subject to greater stakeholder input and scrutiny; and creation of a welcome cohort of better-informed energy sector stakeholders. Meaningful engagement and stakeholder challenge should not end however with the price control review process, and requires active integration into company and Ofgem business-as-usual. On fairness, in ED2 and more widely, Sustainability First would like to see a wide and inclusive stakeholder debate orchestrated by BEIS and Ofgem about trade-offs around what is fair in terms of cost and service for the energy transition[1].

10.  DNO culture and ambition – ED2 needs to considerably stretch DNO culture and prompt DNOs to adopt new approaches, including delivering on 'above and beyond' actions in support of the future. This includes approaches to net zero, integrating digital control, open approaches to data, to innovation, to resilience, and towards wide-scale collaboration and partnering. Investors in essential GB utility services need to fully understand the GB utility context and how ambitious approaches to ethical regulation and net zero will shape returns in ED2 and beyond.

The challenge of ED2 for economic regulation is therefore considerable. A narrow approach which risks playing it safe may indeed move us towards the future – but perhaps in relative slow motion. Conversely, it is open to Ofgem to recognise ED2 as a watershed: a key moment in which the distribution networks – and accordingly the nation as a whole – can be set on a more proactive path for a smart and inclusive transition, rooted in a better alignment with the UK net zero target.From our standpoint, Sustainability First would certainly urge Ofgem to err on the side of being bold in framing its strategy for ED2 – and in sowing the seeds for ED3. The opportunity to shape the coming decade is here and Ofgem must take it.

[1]  See 'What is Fair? How should we pay for the energy system of tomorrow?', Discussion Paper, Sustainability First. September 2019; and Sustainability First's Fair for the Future project to address the politics of fairness and the environment in energy and water.

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