2014 features pollitt littlechild heatingupregulation

Heating up regulation

10 February 2014

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Research from Cambridge Judge Business School has been instrumental in developing a new system of energy market regulation Research from Cambridge Judge …

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Research from Cambridge Judge Business School has been instrumental in developing a new system of energy market regulation

2014_features_pollitt_littlechild_heatingupregulationResearch from Cambridge Judge Business School’s Dr Michael Pollitt, Reader in Business Economics, and Dr Stephen Littlechild, Fellow in Privatisation, Regulation & Competition, has been instrumental in developing a new system of regulation which encourages engagement with customers, say energy regulators.

Cambridge Judge Business School’s regulatory unit is respected internationally as possibly the leading institution in economic regulation,” says former Ofgem CEO Alistair Buchanan. “Their views and models are sought across the globe.

Dr Michael Pollitt
Dr Michael Pollitt

He adds that Dr Pollitt and Dr Littlechild’s involvement provided credibility to Ofgem’s ‘very significant’ RPI-X@20 review of network prices. Energy network charges make up around 20 per cent of the total charges that a typical householder pays.

Dr Pollitt and Dr Littlechild’s body of research, carried out between 2006 and 2009, aimed to improve upon the then current system of controlling annual price changes within energy networks, which used a formula known as RPI -X (retail price index, or simply the rate of inflation, minus X, in which X is the efficiency factor) and dated from the early 1980s.

However, by 2005, energy networks had been price cap regulated for 15 years since privatisation. A new system was needed as prices began to rise.

“RPI -X was coming to the end of its useful life,” says Dr Pollitt. “We had a long period during which, in many network industries, prices had been falling relative to inflation which was which was what RPI -X price cap regulation was about.

“But with the elimination of the inefficiencies which existed under state ownership, and the beginning of increasing investment requirements, the formula was no longer going to be RPI -X, it was going to be RPI +X. Prices started to go up.

And the emphasis then switched to: how do we make sure that we are making the right investments for the network; and how do we ensure these investments are being supplied at least cost?

Dr Stephen Littlechild
Dr Stephen Littlechild

Dr Pollitt and Dr Littlechild’s research introduced a new way of thinking about regulation, which focused on the process by which regulatory targets were set, rather than simply the size of the X-factor.

It demonstrated that UK regulation relied far too much on the interaction between the regulator and the regulatee, and did not use the information held by users of network services.

“Dr Littlechild and I were emphasising the need for customer engagement, so that the customers should say what networks actually want,” says Dr Pollitt. ‘We emphasised the importance of transparently identifying the need for investment and we focused on how we make sure that these investments are competitively provided.

“And we pointed out that since no one is actually sure how the networks will develop in the future, and there is a need for some large scale experimentation around which assets we might deliver to the network and what benefit we might get from them. That was another aspect of this future-proofing of the network regulation.”

This new way of thinking – consumer engagement and competition – informed Ofgem’s RPI-X@20 review of regulation between 2008 and 2010, and fed into the new system, known as RIIO – Revenue = Incentives+Innovation+Outputs.

Companies will now need to consult with consumers and network users to set performance targets. If these targets aren’t reached, the company will be penalised, while high-performing companies will result in higher returns.

The new framework sets longer eight-year price controls, offers incentives focused on delivering results, and expands the Low Carbon Network Fund by £500 million, to encourage the growth of ‘smart’ grids, which use information gathered from customers to inform efficiency.

It is currently being implemented by Ofgem. However, its principles are not exclusive to the energy industry, and UK water regulators are also now adopting aspects of RIIO.

As a result of his research, Dr Pollitt has advised the English and Welsh water regulator Ofwat, and is advising the Office of Rail Regulation (ORR), while Dr Littlechild is now advising the Water Industry Commission for Scotland (WICS).

The research into constructive engagement and negotiated settlements carried out by Professor Stephen Littlechild was compelling,” says Alan Sutherland, Chief Executive of WICS. “As a direct result of Stephen’s research and his unstinting support, we have agreed a role for a Customer Forum in Scotland. Customers are already benefiting from the interaction between Scottish Water and the Customer Forum.