Earlier this month, the House of Lords Industry & Regulators Committee published its report on its Ofgem and net zero enquiry. Although the terms of the enquiry centred around the role of Ofgem, the report’s focus is more on the role of Government and the need for greater clarity in the following policy areas:

  • a business model to support the development of long-duration storage technologies;
  • the overall funding envelope and business model for carbon capture, usage and storage;
  • the funding mechanism for the deployment of small modular reactors;
  • business models and financial support for hydrogen conversion;
  • an accelerated decision on the role of hydrogen in heating;
  • the future role of the gas distribution network;
  • funding incentives to deliver heat pumps;
  • funding to support the energy efficiency of homes; and
  • a review of the non-financial barriers to the deployment of 40 GW of offshore wind by 2030.

Ofgem and net zero The Committee also states that the Government should set the out roadmap by which it will deliver the energy mix it envisages for achieving net zero in a secure way by the end of 2024 setting out the funding structures for any new technologies it expects to rely on. The Government should also set out the role it intends gas to play in the future system and how this will be sourced given security of supply and price volatility concerns in international markets.

The Committee also states that the Government “must take all steps to facilitate the exploration and exploitation of our own resources.” The Committee expressed concerns over the costs of the energy transition and that lower-income groups pay a disproportionate share. It would like the Government to explain how the transition is to be funded and believes government borrowing should be one of the options considered, given considerations of intergenerational fairness.

The Committee believes current market and governance arrangements are not sufficient for delivery of net zero targets, and states that the Government should address this immediately.

“To provide the necessary political and policy leadership across Whitehall, an Energy Transformation Taskforce within government responsible for co-ordination, strategic planning and delivery monitoring—reporting directly to the Prime Minister through a Cabinet sub-committee—should be established. Any delay is highly likely to lead to failure to meet the net zero target given the lead time for complex infrastructure projects and the lifespan of any assets put in place now.”

In terms of the role Ofgem, the Committee believes Ofgem will play a significant role but its responsibilities should be reviewed “to ensure it is not a barrier to a net zero energy system”. It does not believe Ofgem should have a co-ordinating or political role in the transition; but should maintain its existing responsibilities for economic regulation and consumer protection. An explicit reference to “having due regard to net zero” should be added to its duties, bringing it in line with other regulators. The Government should provide guidance to Ofgem on how to manage any political or distributional trade-offs in meeting its objectives, by issuing the promised but long-delayed Strategy and Policy Statement, something other regulators have received for their own sectors.

The Committee states that consumer protection should remain central to Ofgem’s work, and cites the failure of so many suppliers over the past year as evidence of a regulatory failure to protect consumers by an excessive focus on customer switching as one narrow measure of competition in the sector. This led to short-term price competition that, combined with a lack of regulation over the sustainability of new entrants created greater cost and uncertainty for consumers. It goes on to say that Ofgem must implement a robust approach to the licensing and supervision of suppliers, along the lines of financial services regulation, including capital requirements and a fit and proper persons test, “while remaining open to new business models that benefit consumers”.

“The governance of the energy system is the product of a previously more settled era and needs to become more responsive to the dynamic transformation required to implement the transition to net zero.”

In addition to highlighting regulatory failures in the retail segment, the Committee also believes that Ofgem is generally too cautious in its approach to allowing new business models into the retail market and that network price controls can potential to stifle investment at the exact moment it is most needed. It wants Ofgem to be more open to innovative new approaches and to enabling investment.

Key themes in the Committee’s report

Who should pay for the energy transition?

The Committee found that witnesses nearly all agreed that bills are unjustly regressive as a primary source of funding for the energy transition, taking proportionately larger amounts from those with the fewest resources. For example, Ofgem has proposed that the costs for the EV charging infrastructure should be recovered from all energy billpayers despite much lower levels of car ownership among those on lower incomes, meaning that spreading network reinforcement costs across all consumers hits those on low incomes hardest.

The Committee also identified a risk that consumer support for net zero could be lost – the majority of witnesses called for a greater role for general taxation (although no witness said the entire costs of the transition should come from taxation). While the Government opposes using more government borrowing due to concerns over intergenerational unfairness, the Committee takes a different view because future generations will be the main beneficiaries of net zero investment.

Either way, the Committee strongly urges the Government to set out how the transition will be funded setting out explicitly the distributional consequences of any funding proposals.

Policy co-ordination

The Committee found that there is insufficient co-ordination within Government on net zero, as well as evidence of insufficient bandwidth in BEIS to tackle the full range of issues associated with the transition. To support efficient delivery of the transition and the necessary policy clarity, the Committee proposes the immediate creation of an expert taskforce, along the lines of the Vaccine Taskforce, but on a longer term footing, which would be responsible for economy-wide strategic planning, cross-departmental co- ordination, implementation of agreed policies and monitoring operational delivery by all departments and agencies.

This model should provide the agility necessary to adapt to the uncertainties inherent in the transition. As such a taskforce would need to address politically sensitive policy issues, including public spending commitments, it cannot be independent of Government and should report directly to a Cabinet Committee chaired by the Prime Minister which would agree the strategy and key policy components and authorise any Government financing. The Committee also believes that the Future System Operator should not have a wider role in co-ordinating the net zero transition since political trade-offs are the remit if the Government.

Role of Ofgem in net zero

Although the Committee believes that Ofgem has an important role to play in enabling the transition it thinks Ofgem’s primary focus should remain on its supplier regulation, economic regulation and consumer protection. It does not believe that Ofgem needs to be given a more strategic role in planning the energy system, which should be the responsibility of the Future System Operator.

Ofgem and net zero system architecture

Ofgem’s primary duty, laid out in statute, is to “protect the interests of existing and future consumers in relation to gas conveyed through pipes and electricity conveyed by distribution or transmission systems”. This objective is to protect these interests “taken as a whole, including their interests in the reduction of greenhouse gases and in the security of the supply of gas and electricity to them”

Some witnesses argued that Ofgem has been given an overly long and complex set of duties., and that they have expanded to a degree where they cannot all be met simultaneously. Others noted that net zero will require “a wide range of trade-offs” that technocrats are not well-placed to make.

There was also consensus among witnesses that Ofgem’s current objectives incline it to focus on short-term costs, and that without an explicit reference to net zero, the long-term costs of not achieving net zero could be neglected. For this reason. The Committee believes that Ofgem’s duties should be amended to include explicit reference to “having due regard to the net zero target”.

The Committee would also like to see a simplification of the system of governance in the energy markets, particularly licences and industry codes, to make them more adaptable to a fast-changing market environment. The Government is considering extending Ofgem’s remit to include code management, and the Committee would like to see the necessary legislation being brought forward swiftly.

Planning for net zero

There was extensive evidence from witnesses, particularly network companies, that Ofgem is overly cautious when allowing the “anticipatory” investments in networks that may be needed to enable the transition, particularly in light of the projected demand changes resulting from the electrification of heating and transport, but for which there is not a direct, immediate requirement at present. Allowing such anticipatory investment and adapting price controls could reduce long-term costs to consumers, and avoid a situation where more expensive actions are needed on short notice. Comparisons were made with the water sector, which was seen to be less restrictive. Darryl Murphy, Head of Infrastructure at Aviva Investors, said the relationship between private investors and Ofgem has “been a little strained”, and that to mobilise capital, “the regulator has to be supportive of encouraging that long-term investment”.

Others were more supportive of the current framework pointing to National Grid’s acquisition of the Western Power Distribution at a premium as evidence of investor appetite despite a tougher price control environment. that “people are prepared to invest … even with tougher price controls from Ofgem”.

Several witnesses raised concerns about the new uncertainty mechanisms in RIIO-2, which are designed to allow a re-opening of the price control in response to market change. Five main reasons for re-openers have been defined but stakeholders worry that Ofgem’s processes may be too slow and / or the evidential hurdles too high for them to be effective. On the other hand, they also risk sub-dividing the price control into much shorter periods.

The Committee believes the price control regime has “the potential to discourage investment at exactly the point when it is needed most”, and that Ofgem needs to ensure price controls allow the appropriate level of investment ahead of need and do not restrict investments that are necessary to enable the transition. It recommends that Ofgem carries out a review of its use of uncertainty mechanisms, their effectiveness, the regulatory burden they have placed on energy networks and their impact on investment in time for any conclusions to be reflected in the next price control period.

Need for new retail business models

Many witnesses informed the Committee that to new business models are needed in the retail sector to enable flexibility and help consumers de-carbonise their energy use, for example by offering service-oriented models that remove the complexity of flexible use of low-carbon energy from consumers. Josh Buckland of Flint Global said that “the current regulatory environment does not necessarily outlaw” new supplier models, such as energy-as-a-service, “but it makes it much harder, because the ability for regulation to adapt in the timeframe that is required is not currently there.”

Some witnesses raised concerns about the readiness of consumers themselves for new models since there will consumers groups who will not want to engage with energy markets. A regulated baseline tariff was proposed by some stakeholders to support consumers that were either unable or unwilling to engage. Others noted that consumer trust in the sector will need to improve in order to support such new models – many consumers have been reluctant to receive smart meters and are likely to be similarly reluctant to have companies being involved in the operation of their domestic appliances.

“Becoming a more adaptive regulator must not come at the expense of consumer protection. The recent collapse of a large number of suppliers has highlighted substantial failings on the part of Ofgem…The promotion of switching and short-term price competition without adequate financial oversight contributed to energy supplier failures…New business models may require longer-term relationships between customers and suppliers and this must be based partly on greater trust in those firms,”
– House of Lords Industry & Regulators Committee

The Committee agreed that without acceptance by consumers the energy transition will not be possible, but that they need greater clarity, information and guidance in order to play their part and realise the benefits of the transition. It believes the Government should take the lead in clearly setting out the actions consumers should take, as well as providing incentives to de-carbonise energy use. This will allow Ofgem to set out its expectations for energy suppliers who can then adapt their consumer offerings, with Ofgem regulating to ensure that consumers who are unable to engage with the energy market are not unduly penalised.

In addition, the Government and Ofgem should set out their expectation that companies should compete on their overall service and value to customers and not just on price, saying that the use of switching as the singular metric of competition should be abandoned. The Committee’s view is that it is the ease of switching rather than actual switching which supports competition, and that high switching may be an adverse measure of customer service rather than something to be encouraged. Furthermore it is likely that long-term relationships including longer-term contracts may be needed to build the trust and deliver the services needed to support the transition. For example, the capital costs of new energy assets could be recovered from a consumer over multiple years in a model similar to current mobile phone contracts.

Lack of accountability and questions over Ofgem’s competence

Two further themes emerged from the evidence presented to the Committee, which were not reflected in the Committee’s report: concerns over Ofgem’s lack of accountability and its competence.

Lack of accountability

Time and again respondents raised the issue of accountability and a lack of clarity on the various roles of Ofgem, BEIS, Parliament and the Energy Ombudsman, and that there was often book passing between Ofgem and BEIS. Technically, Ofgem is accountable to Parliament, but it was pointed out in the evidence that Ofgem’s management is not called to explain its actions, or the trade-offs involved in its decision-making by any Parliamentary committees.

In their submission, Phil Burns and Mike Huggins, directors of Frontier Economics point out that RIIO-2 is a radical departure from the approach to network price controls taken since privatisation, significantly reducing the incentives and increasing regulatory micro-management, which in their view will result in higher prices to consumers. This “significant policy shift” has not, in their view, been adequately scrutinised from a public policy perspective and they call for the Competition & Markets Authority to have some oversight role on the basis that it is possibly the only agency with the necessary expertise.

“Under Ofgem’s new approach, large swathes of the networks’ plans will be locked down for the duration of the price control, with little scope for reward if they depart from them efficiently, and material risk of clawback and further penalty…This approach carries high risks of creeping inefficiency pushing cup customers’ bills over the next 30 years. Even if the inefficiency cost is “only” 10%, that is still £40 billion that customers will have to pay for,”
– Phil Burns and Mike Huggins, directors of Frontier Economics

Electricity North West suggested that Ofgem should produce an annual transparency report outlining how it has gone about discharging its duties and powers, which would include discussion of how conflicts and trade-offs have been managed.

Centrica agreed that regulatory decisions should be open to robust scrutiny by bodies with the expertise and resources to review them. It also expresses concerns that in practice BEIS has increasingly interfered in competition issues that should be the remit of Ofgem, and that the large number of joint BEIS/Ofgem reviews make it unclear how regulatory policy is being developed and where responsibility lies. The now withdrawn collective switching proposals were cited as an example of the Government usurping role of economic regulator. The Global Warming Policy Forum believes that Ofgem is tying itself too closely to Government policy and is losing its ability to remain politically neutral and protect consumers.

Many respondents complained that the relationship between Ofgem / BEIS / Parliament is not clear. The Energy Intensive Users Group stated that accountability is “opaque at best” and that while Ofgem presents an Annual Statement to Parliament there does not seem to be any Select Committee hearing or similar where MPs question Ofgem on the rationale and impact of the choices made in the delivery of its duties. SSE said that at times it is unclear which of BEIS and Ofgem is responsible for a specific area of policy development and that there is a blurring of responsibilities. This was echoed by Sustainability First which pointed to a lack of clarity on the responsibilities of Ofgem and BEIS for example on affordability issues in network charging, where Ofgem said mitigation actions were for the Government while the Government said Ofgem was responsible for network charging.

The Mineral Products Association believes that Ofgem and BEIS fail to consider how new policies add to the cumulative burden of energy and climate policy costs faced by energy intensive industries, and the potential for carbon leakage. It believes there should be greater scrutiny and transparency in Ofgem’s decisions including Parliamentary scrutiny; “the process regarding Ofgem’s accountability is very unclear and MPA is unsure how or who ensures that Ofgem is conducting all its duties appropriately and meeting its responsibilities”. Wales & West Utilities said that it is difficult for affected parties to understand how Ofgem’s duties have been balanced which makes it hard to challenge its decisions.

Lack of competence

Several respondents were also critical of Ofgem’s approach to carrying out its duties. The Committee identified regulatory failures in its approach to the retail market, but evidence was presented of failings in other areas.

The Independent Renewable Energy Generators Group expressed concerns over Ofgem’s abilities to carry out its duties effectively, particularly in relation to assessing the impact its reforms have on investor confidence saying its “modelling is based on unrealistic assumptions about future technology mixes, which do not represent reasonable outcomes based on the current GB policy mix. Furthermore, their modelling does not factor in additional system balancing costs that their reforms will incur, meaning that the overall impact of their reforms is a significantly negative on a system-wide basis and consumer benefits will be lower that claimed [sic].”

Solar Energy UK raised concerns over Ofgem’s approach to administration of the Renewables Obligation (“RO”) and Feed-in-Tariff (“FiT”) schemes, saying its members complain of “a vague, inconsistent and protracted [RO/FiT] auditing process which, in some circumstances, has resulted in the suspension of payments based on the absence of evidence, which is either unsuitable for the given site, or is in no way related to determining whether a site was “commissioned” or “capable of export” under scheme guidance”. It said its members have reported a significant increase in number of Ofgem audits and time and cost of compliance with audit requests: on average Ofgem’s auditing process costs over £50,000 per site and 2 full-time equivalent staff over an 18-month period. The average time taken is 89 weeks from receipt of audit letter to confirmation of completion.

“The combination of costs, delays, lack of transparency and inconsistency has caused considerable uncertainty for the industry and could make it more difficult to secure finance and complete future transactions. The audits process as it stands has a profound impact on the confidence that shareholders and investors have in the renewables sector,”
– Solar Energy UK

Southern Gas Networks stated that Ofgem’s regression-based approach to assessing costs is flawed in that it only considers costs on a comparable basis according to workload which disincentivises activities outside the workloads in the model, and discourages higher quality but higher cost actions since that deviate from the industry from the average. It also believes Ofgem should strengthen its in-house technical capabilities to reduce reliance on external advisors.

There were also concerns over the reduced importance of incentives in RIIO-2. Scottish Power describes this as “unfortunate” saying that Ofgem’s focus on “introducing new and untested competition models into offshore networks, with limited evidence of consumer benefits, is creating additional regulatory uncertainty and weakening incentives for the large amount of network and generation investment required”. Several network operators also complained about a lack of clarity on consumer inputs to the price control, with consumer evidence from network companies often being disregarded. Wales & West Utilities suggested that Ofgem should do its own consumer engagement since it currently carries out very limited direct consumer feedback exercises.

Several respondents criticised the network charging reforms, both in terms of the slow pace and the content with extensive criticisms of TNUoS particularly from renewable generators. RenewableUK claims that the Targeted Charging Review impact assessment was flawed as it did not take into account the costs of carbon and need to meet net zero. Had these been properly included, the impact on consumers would go from savings of £113 million under Ofgem’s analysis to costs of up to £333 million. Of Ofgem’s review into forward-looking charging, Fred Olsen said:

“the supporting quantitative assessment contains some notable flaws: assumes a fixed exogenous deployment of generation, that government support will be exactly regionally and technologically tailored to offset generators’ revenue losses, and misapplies the existing network charging methodology to claim a carbon emissions reduction. The result is a proposed decision which may be in fact a net systemic disbenefit, and increase net carbon emissions, but does offer a distributional albeit short-term gain for consumers at the expense of generators.”

Several respondents say Ofgem fails to understand the different needs of different customers, and different types of vulnerability both for domestic users and energy intensive industries (“EIIs”). The Mineral Products Association complained that Ofgem has been unable to provide the analysis EIIs need to understand the impact of regulatory proposals preventing them from engaging fully with proposals until changes are finalised. The Energy Intensive Users Group said that EIIs are not given enough attention in regulatory policy and decision making and that “the current regulatory approach may help partly explain why UK EIIs have faced the highest energy prices in Europe for several years. The price disparity provides evidence that Ofgem has to date not addressed the needs of UK EIIs to remain competitive against near neighbour economies”.  Sustainability First complained that Ofgem’s impact assessment on EV charging connections failed to explore the impact on fuel poor consumers who will pay disproportionately for the proposed changes – those in fuel poverty have lower levels of car ownership and are therefore less likely to benefit from charging infrastructure although they will still have to pay for it.

Multiple respondents also complained that Ofgem’s regulatory processes are too slow. EDF states that the regulatory framework has not always kept pace with changes in technology and markets, and that Ofgem will need more resources and more effective prioritisation going forwards. The Energy Intensive Users Group says that the time taken for decision making is “incompatible with the speed of change required” citing the Significant Code Review which was launched in December 2018 and is still not completed. At the same time, there was criticism over a lack of complete and thorough impact assessments in some areas. SSE said that new policies are being introduced without enough consideration of the impact on security of supply and reliability.

There was extensive criticism of Ofgem’s approach to retail market regulation. Energy UK says that the retail market in need of reform – average profits in recent years of -1.4% undermine the viability of investment in research and development, and that Ofgem must develop a robust competitive market. Ofgem also needs to apply learnings from sandboxes to rest of market to reduce barriers to changes in business models. It also criticised Ofgem’s reluctance to deliver full and considered impact assessments relating to some decisions which further undermines investor confidence. Centrica echoed these concerns, saying that retail regulation had created a structurally loss-making situation that inhibits the delivery of net zero.

“The quality of Ofgem’s decision making and effectiveness is mixed, especially where is [sic] comes to consideration of the needs of future customers, as opposed to current. Because of this, Ofgem has notably failed to address the structural lack of profitability in the retail market. Also slow pace of policy development has led to prolonged uncertainty, leading cautious investors to bide their time until uncertainty reduces. Ofgem has been slow to address irresponsible business practices…the market is littered with business failures,”
– Centrica

Citizens Advice recently published a critical report that highlighted failures of both regulation and supervision. In its evidence to the enquiry the consumer group said that Ofgem needs to properly resource its compliance and enforcement teams to be effective saying that in the recent past it has been slow to tackle issues, not been transparent enough and not prioritised appropriately, leading to greater customer detriment. It also believes Ofgem could be more proactive but is too afraid of legal challenge, saying that Ofgem could have capped energy prices without legislation but was reluctant to, something the Government acknowledged when it brought forth the cap legislation.

“Given the much higher barriers to passing new legislation compared to altering energy licences, it will be important that Ofgem is quick to act and culturally willing to take difficult decisions rather than deferring them to Parliament, as we transition to net zero,”
– Citizens Advice

Regulatory reform is needed

It will come as no surprise to regular readers that I would like to see fundamental reforms, particularly in retail regulation which I believe should be moved to the Financial Conduct Authority. This would also help to reduce Ofgem’s scope – evidence was presented to the Committee about Ofgem’s large size compared with energy regulators elsewhere and large headcount: In 2020-21, Ofgem’s operational income was £109.1 million, and its operational expenditure was £121.1 million. The main source of income is from licence fees paid by market participants, while the main costs are staffing costs. Ofgem’s headcount in 2020-21 was 1,187.

I also agree with the Committee that a Strategy and Policy Statement is urgently needed to help Ofgem to manage the various trade-offs inherent in its responsibilities. This should also clarify the division of responsibilities between Ofgem, BEIS and other relevant bodies. And I support the suggestions made by various stakeholders that Ofgem should produce an annual account of its decision-making which should be routinely scrutinised by Select Committee. Ofgem’s current lack of accountability is a significant cause for concern, and it should be noted that while a judicial review of decisions taken by the regulator can be sought, there is no mechanism for challenging its failure to act in any given area. The Select Committee could also hear evidence from market participants giving them a forum for expressing the types of concerns highlighted above, and an opportunity for Ofgem to be held to account, and required to make improvements where necessary.

This would help to restore confidence in the regulator. I have noted before that retail market participants have largely lost confidence in Ofgem’s abilities to regulate the market fairly and effectively, and its hostility to suppliers has helped to undermine public trust in the sector. The evidence presented to the Industry & Regulators Committee shows a lack of confidence in Ofgem’s abilities extending across the energy value chain. Complaints such as those raised by Solar Energy UK are very much echoed by suppliers, particularly among those that exited the market last year, who pointed out that Ofgem’s burdensome requests for information had failed to prevent those closures, and in some cases contributed to the difficulties faced by suppliers who had to recruit staff just to comply with them.

Ofgem’s change in tack on network price controls could very well be the next major point of failure in the regulatory regime. As many stakeholders raised concerns over an excessive focus on short-term cost minimisation and a reduction in incentives, which are likely to combine to inhibit the infrastructure investments that will be needed to support the energy transition. This is a seriously backward step, which appears to be a reaction to the levels of profits earned by network companies under RIIO-1, ignoring the fact that consumers also benefitted. If this notion that energy companies should not be profitable persists, then investors are unlikely to find the sector attractive.

If the Government acts on the Committee’s recommendations, there will be a review of Ofgem’s duties, which will provide another forum for these concerns to be aired. But at some point we need to stop with the endless reviews of various aspects of the energy market and actually implement change. Energy policy in recent years has been all talk and no action, and while the current crisis may actually prompt some concrete decisions to be taken by the Government, it should not take a war for policymakers to stop kicking the energy can down the road. The problems are well understood – now is the time for solutions.

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