A change of direction for utility regulation in the UK

What you need to know

• The Government has launched a review of economic regulation in the utilities sector – downstream gas and electricity, water and telecoms.
• The review is not looking to "reinvent the wheel" but rather to achieve greater clarity and consistency in areas such as the statutory duties of regulators and the price control methodologies applied by them.
• The regulators are already working together to align their approach to price controls, and a consultation on changes to the statutory duties of the regulators will be published in 2022.

Background

The UK is currently going through a period of significant regulatory change and reform. There are a number of factors driving this change, including the UK leaving the European Union (Brexit) and the UK's Net Zero objectives. The UK has a well developed regime of utility regulation, having had a privatised utilities sector for over three decades. The system of economic regulation of monopolies in the key utilities – energy, water and telecoms – has evolved over time, but arguably that evolution has taken place in a slightly piecemeal fashion, leading to some areas of inconsistency and lack of clarity. Recognising the scale of investment required in utility infrastructure in the coming years, in October 2018 the UK Government asked the National Infrastructure Commission (NIC) to conduct a study into the regulation of the UK’s energy, telecoms and water industries. The NIC's overarching conclusion was that while the current system of regulation of utilities does not need to be redesigned, it does need to be "updated to achieve a well regulated market economy which can respond to the coming challenges".

The BEIS policy paper has been published partly in response to the NIC's recommendations, with the Government agreeing that the existing regulatory regime has functioned well but was not designed to address challenges such as reaching Net Zero, protecting and enhancing the environment, and increasing digitalisation. While not expressly discussed in the BEIS policy paper, it is also a fact that a lot has happened since the Government originally asked the NIC to review utility regulation, making this review even more pertinent. In particular, the pathway towards Net Zero has been accelerated, with an ambitious roadmap of investment in decarbonisation set out in the Energy White Paper of December 2020. This will have an impact on utility regulation as new areas – such as carbon capture transport and storage infrastructure, heat networks and new build nuclear - come within the ambit of economic regulation.

The key areas being reviewed

The BEIS policy paper identifies four main areas that are being targeted in the review of utility regulation: duties of the regulators; the need for a clear strategic direction; greater competition in strategic investment; and transparency and consistency.

Duties of the regulators

The duties of the three utility regulators – Ofgem for gas and electricity markets, Ofwat for water; and Ofcom for communications – are set out in legislation and, as mentioned above, have evolved over time. It is noted that the statutory duties of Ofgem under the Gas Act 1986, for example, have risen over time from eight to twenty-one. Similar trends have been identified in the statutory duties of the other two utility regulators. The key challenges arising from this evolution of the statutory duties of the regulators, as set out in the policy paper, are as follows:

• The increasing complexity of existing duties may stifle regulatory decision making and limit the effectiveness of new duties where they are introduced.
• The transparency and predictability of the current framework could be improved. In this context it is noted that ensuring that duties are clear and coherent will enable regulators to assess and articulate the challenges associated with balancing their duties, promoting both greater transparency and consistency in decision-making, and providing greater clarity to stakeholders.
• The growth in duties as they have evolved has also been accompanied by divergence across the utilities sectors. It is acknowledged that whilst a certain degree of variation in duties is necessary to account for the different dynamics in each sector, greater consistency between regulators’ duties would enable them to collaborate and support performance on vital common, long-term priorities, such as the Net Zero target and interim carbon budgets, investment in climate adaptation, and the environment, thereby helping to support predictable regulation over the long-term.

To address these challenges, the Government will launch a review of utilities regulators’ statutory duties in 2022.

Clear strategic direction

The policy paper notes that since 2013, strategy and policy statements have been introduced for some individual regulators. In particular, the Government published a statement for the water sector in 2017, a statement for the telecoms sector in 2019, and the Government has committed to consult on a statement for the energy sector in 2022. However, the Government considers that it would be desirable to set high-level national policy objectives and reflect these in a vision for the utilities sectors, including where the Government expects greater cross-sector collaboration between regulators.

As an immediate response, alongside its policy paper, the Government published a letter of strategic guidance to the utilities regulators. One of the issues discussed in the guidance letter is the role of the UK Regulators Network (UKRN) in facilitating co-operation between the three regulators and increasing consistency via their newly established Weighted Average Cost of Capital (WACC) Taskforce. The Government notes in the letter that it expects the regulators, via the UKRN Taskforce, to work towards alignment where clear benefits can be identified.

The question of whether future strategic guidance to the regulators will be provided is being further considered by the Government.

Greater competition in strategic investment

The policy paper notes that increased competition in strategic investments could facilitate more efficient delivery of major projects to tackle long-term challenges. This is an area where a lot of progress has already been made, but the Government wants utility regulators to be able to implement competition further, drawing on the success of existing projects and initiatives.

In the electricity sector, the electricity offshore transmission owner (OFTO) regime is noted for its success in reducing the cost of offshore transmission through the OFTO competitive tendering process. More recently the Government has also consulted on a new approach to competition in onshore electricity transmission and distribution, and the Government and Ofgem have also consulted on a new, independent Future System Operator (FSO) to drive further competition in energy networks.

In the water sector, the Thames Tideway project is cited as an example of where competition was able to deliver major water and wastewater infrastructure. The Government has now asked Ofwat to produce a bespoke review of competition for the provision of infrastructure in the water sector.

The Government will work closely with the three regulators in the coming months to identify possible opportunities where Government action would facilitate enhanced competition for investment into strategic projects.

Transparency and consistency

The policy paper states that there are two priority areas where the Government believes that greater regulatory consistency may promote greater transparency for consumers, business and investors:

• The Government believes that the methodology that regulators use to control prices should be easy for companies to navigate, to create a fair and effective process that also balances the interests of investors and consumers. As noted above, the sector regulators, via the UKRN, are taking forward work to align methodologies where viable and the Government expects that this will quickly deliver greater consistency in approaches.
• The paper also notes that Government believes that the process by which regulator decisions can be appealed should provide appropriate checks and balances to support the right outcome for consumers and the wider public interest. While it is acknowledged that each sector has unique characteristics, the Government will explore whether greater alignment of these processes between sectors could reduce investor uncertainty and achieve better outcomes for consumers.

A welcome development

The main theme of the proposals – greater clarity and consistency in the regulatory regimes applied by the three economic regulators – is clearly a welcome development. As mentioned above, the landscape within which regulators are currently working is very different to that which existed at the time when they were first established. Questions around how duties relating to the Net Zero objective will be balanced with other statutory duties is just one area where no doubt investors and regulators alike will welcome greater clarity. Moreover, the expanding remit of the utility regulators also means that a more consistent approach to economic regulation is desirable, to avoid an inconsistent approach to different types of infrastructure where a different approach is not merited.