RIIO-2 Business Plans Draft

Guidance Document

Publication Date 21 December

2018

Contact: RIIO Team

Team: Network Price Controls

Tel: 020 7901 000

Email: RIIO2@ofgem.gov.uk

This is an updated guidance document directed at gas and electricity network companies

and their stakeholders, which sets out the information we expect to see in companies’

business plans for RIIO-2.

This is a live document which we will update periodically, as and when appropriate.

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Contents

1. Introduction 4

Context 4

Purpose of this document 4

Cross-sector workshops 5

Electricty distribution 5

2. Proposed Content of Business Plans 6

Track-record 6

Business Plan commitment 6

A consistent view of the future 6

Outputs and incentives 7

Ensuring future resilience 8

Enabling whole system solutions 10

Innovation 11

Competition 11

Enhanced engagement 12

3. Costs and Finance information 13

Cost information 13

Cost drivers 13

Consideration of options 13

Cost justification 13

Business plan data templates 14

Cost benefit analysis (CBA) 15

Financial information 15

4. Managing Uncertainty 16

Uncertainty mechanisms 16

Proposed approach for new assets 17

Anticipatory investment 17

Real Price Effects (RPEs) 17

5. Business plan incentive 19

Proposed Minimum requirements 19

Proposed characteristics of a poor plan 19

Proposed characteristics of a good plan 20

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6. Next steps 21

Gas distribution, gas and electricity transmission networks 21

Electricity distribution 22

7. Appendix 1- Summary of proposed outputs in each sector 23

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1. Introduction

Context

1.1. In RIIO-2, we will set revenues for gas and electricity network companies. In

order to set these revenues, we need information from the companies on the

activities that they intend to undertake in RIIO-2 and their associated costs.

Companies will provide this information to us in the form of a Business Plan,

which we will then assess. The gas distribution, gas and electricity transmission

network companies will submit their final Business Plans to us in December 2019.

Their next price control will start in April 2021.1

1.2. In developing their plans, it is essential that companies carry out robust and high

quality engagement with their stakeholders2. Through the enhanced stakeholder

engagement framework,3 companies should also engage with the RIIO-2

Challenge Group and the User Group/Customer Engagement Group that each

company has established.

1.3. Companies should submit full drafts of their Business Plans to the RIIO-2

Challenge Group twice, before the plans are submitted to Ofgem in December

2019:

The companies are expected to submit a first draft of their full plans on 1

July 2019.

Following the first round of challenge, a second draft of their full plans is to

be submitted on 1 October 2019.

Purpose of this document

1.4. We are publishing this Draft Guidance Document to give network companies and

their stakeholders an indication of the kind of information that we are likely to

expect in their Business Plans.

1.5. This Guidance is based on our sector methodology proposals for RIIO-2, which we

are currently consulting on. This consultation closes on 14 March 2019, and we

expect to issue our decision in May 2019. Therefore, this Guidance – including the

type of information we may require and how we might assess it – may be

updated in light of this decision. We are aiming to update this Guidance prior to

the companies submitting the first draft Business Plans in July 2019.

1.6. There are a number of Sections in this Guidance:

Section 2 describes the content that we expect to receive in the Business Plans

and provides guidance on the issues we expect companies to have considered in

preparing their plans.

Section 3 describes the cost and financial information that we may require4.

Section 4 describes our proposed approach to managing uncertainty.

Section 5 describes our initial thinking on the characteristics of a Business Plan

that could determine whether it is of good, standard or poor quality. This would

1 The electricity system operator is also subject to a RIIO-2 price control, however this guidance does not apply to the ESO. 2 By stakeholders, we mean individuals, organisations or communities that are impacted by the activities of the network company. This includes existing and future consumers. 3 Please see Ofgem, RIIO-2 Framework Decision, July 2018. 4 Please see Ofgem, RIIO 2-RIIO-2 Sector Specific Methodology and RIIO-2 Framework Decision, July 2018.

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inform our assessment of the plan as part of the proposed business plan incentive

we have described in our December RIIO-2 Sector Specific Methodology

consultation, subject to responses to that consultation.5

Section 6 describes next steps.

1.7. We recognise that network companies require guidance in order to prepare their

Business Plan. We are interested in your views on this guidance document, in

particular on the following questions:

Q1. What further detail on the proposed content of the Business Plan do you

think network companies require?

Q2. Is there other information that we should be requesting in order to

assess a network company’s Business Plan?

Q3. What further information do network companies require on the

characteristics of a Business Plan that we need to consider in assessing its

quality?

Q4. Are there other characteristics that we should consider in assessing the

quality of a Business Plan?

1.8. We ask for responses by 15 February 2019, to allow us to update this Guidance

as necessary in sufficient time for network companies to be able to prepare their

plans in line within the RIIO-2 timetable.

Cross-sector workshops6

1.9. We recognise that network companies and stakeholders may require further

information in addition to that provided in this draft Guidance. We will be hosting

a series of cross-sector workshops between January and March 2019 to discuss

our thinking on the type of outputs companies could be expected to deliver, how

their plans may be assessed (including potential reward or penalty), and the

proposed specific format of financial and costs data submissions.

Electricty distribution

1.10. The next electricity distribution (RIIO-ED2) price control starts in April 2023.

1.11. We will consult separately on the sector methodology for electricity distribution

during 2020. This will include consideration of the applicability of the approach

taken for other sectors and the specific features of electricity distribution that

may warrant a different approach.

1.12. Subject to that process and full consideration of any further developments in the

interim period, the content of this draft guidance may, in principle, be broadly

applicable to the Distribution Network Operators (DNOs). An updated version of

this draft Guidance will be issued alongside the sector methodology consultation

for electricity distribution, taking into account any learning from the other sectors.

5 https://www.ofgem.gov.uk/publications-and-updates/riio-2-sector-specific-methodology-consultation 6 Further details on these cross-sector and sector-specific workshops, including arrangements for attendance,

will be published on our webpage in due course. https://www.ofgem.gov.uk/network-regulation-riio-

model/network-price-controls-2021-riio-2/riio-2-events-seminars-and-working-groups

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2. Proposed Content of Business Plans

Track-record

2.1. In assessing the credibility of the Business Plan being proposed, we propose to

consider how companies have performed and behaved in the RIIO-1 period.

Therefore, in their RIIO-2 Business Plan, we expect companies to explain:

their delivery against RIIO-1 output targets and their performance against

the incentive mechanisms available

what level of service has been provided to the average customer and to the

worst served customers in RIIO-1, and what steps they took within the

period to improve the service to the worst-served

how well different groups of customers have been served over the RIIO-1

period – e.g. customer in particual regions/circumstances

what additional value they have provided to consumers outside of the price

control/licence mechanisms (e.g. voluntary returns, voluntary additional

Guaranteed Standards of Performance payments, etc.)

how their expenditure has differed against allowances provided at the outset

of RIIO-1

what factors contributed to any differences between allowances, and how

these factors have been considered in the RIIO-2 Business Plans

the returns companies earned over the RIIO-1 period, and key drivers

behind this

the level of profit payment they distributed to investors over the RIIO-1

period.

Business Plan commitment

2.2. In assessing the credibility of the Business Plan being proposed, we propose to

take into account the level of commitment companies give to their RIIO-2

Business Plan. Therefore, in their RIIO-2 Business Plan, we would expect

companies to explain:

how they intend to align the structure of pay and reward within the

organisation to the delivery of commitments set out in their Business Plans,

including on accuracy of data provided

what level of assurance is provided by sufficiently independent directors that

the plan and associated costs have been tested for accuracy, ambition and

efficiency.

A consistent view of the future

2.3. In preparing their Business Plans, network companies should consider a range of

future outcomes and the different investments and activities they may need to

undertake. We want to ensure that the price control is sufficiently flexible to meet

changing circumstances. We have asked the networks to jointly develop a

‘consistent view of the future’ across all five regulated sectors (gas, electricity,

and the ESO).

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2.4. The consistent view of the future should also incorporate a view on the primary

drivers of investment, including relevant government policy,7 and a range of

plausible future scenarios associated with each.

2.5. Having a consistent view of the future will require some consideration of the

regional variations which will inevitably occur across the networks, and

differences in opinion on 'most likely' outcomes. Where networks believe their

plans will need to deviate from the common view, then they should provide

evidence for this and the most appropriate mechanism to allow expenditure

allowances to adjust.

2.6. We will work with network companies in early 2019 to ensure that a consistent

view of the future has been formed in the interests of consumers. While we

believe best practice dictates that networks should undertake this process, if

necessary, we will form our own view on some of the primary drivers of

expenditure and ask networks to implement these as a reference case.

Outputs and incentives

2.7. In the RIIO-2 December Sector Specific Methodology consultation, we set out our

proposal to specify outputs as a set of consumer-facing outcomes.

Figure 1: Output categories in RIIO-2

2.8. We also set out our proposed overarching framework for outputs and incentives

to deliver these outcomes.

We propose to set mimimum standards of performance which we will impose

through the introduction of Licence Obligations (LOs).

We propose to capture outputs directly associated with baseline funding

through Price Control Deliverables (PCDs). We will clarify consequences for

non-delivery or delivery to a lower than expected standard as appropriate,

including for example the use of uncertainty mechanisms.

We propose to apply Output Delivery Incentives (ODIs) where service quality

improvements beyond the minimum standard may be in the interests of

consumers and other network users.

7 For example we expect GDNs to set out in their Business Plan how they are preparing for Government decisions on the future of heat. This should include consideration of decarbonisation scenarios in which gas distribution plays a significant role, and scenarios in which their role is considerably diminished. Consideration of these scenarios should include a description of the potential impact of Government decisions during RIIO-GD2 on their investment plans, which we would consider when developing a heat policy reopener.

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2.9. As set out in the sector-specific methodology consultation, network operators will

have the opportunity to propose bespoke outputs in collaboration with their

stakeholders and Customer Challenge Group/User Groups. This could include

bespoke PCDs or ODIs.

2.10. Network company proposals should:

reflect the network services that existing and future consumers/network

users require/will require

be as complete as possible in capturing the activities of the network operator

focus on simpler output categories of value to consumers/network users

allow comparison of performance across companies where there is sufficient

commonality

capture the long-term nature of outputs.

2.11. In assessing proposals, we are likely to consider, amongst other things:

whether the output reflects a service that consumers expect to receive from

a network company that cannot be funded through the base revenues

provided in the price control settlement

whether the activity in question is best dealt with through the price control,

rather than through a government body responsible for the public interest in

that area (e.g. Highways Authorities for matters relating to the occupation of

the highway)

whether proposals are backed by robust evidence and justification (such as

cost-benefit analyses8) and demonstrate value for money for existing and

future consumers

the value that consumers will receive from a proposed new service level, and

by extension the potential associated reward and/ or penalty, and the extent

to which these are symmetrical, in terms of value and likelihood of outcome

the extent to which an independent measure of the existing level of service

that consumers receive is available, and the degree to which the target level

being proposed represents an improvement on this

the level of service provided by other companies/comparators (where

available)

the activities (and indicative cost) associated with achieving the targeted

level of service

proposals for licence conditions and/or penalties if performance falls below

existing service levels.

2.12. In the annexes that accompany the sector-specific methodology consultation, we

provide more information on the type of outputs that may be applicable in each

sector. If these are taken forward, then to support the design of these outputs,

we may require companies to submit output-specific information in their Business

Plans. Appendix 1 provides a summary of the proposed outputs in each sector.

The sector-specific methodology annexes should be referred to for more detail.

Ensuring future resilience

Asset resiliance

2.13. Network Asset Risk relates to the risk of asset failure and to the network

companies’ asset management activities that are aimed at maintaining this risk at

8 Please see our requirements for cost-benefit analysis in Section 2 of this guidance.

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levels which are acceptable to consumers. We expect companies to provide us

with the following information in their Business Plan submissions:

Monetised Risk objectives that are informed by stakeholder engagement,

including appropriate understanding of consumers’ willingness to pay

cost-benefit analysis (CBA), according to the guidelines specified in Section 3

of this document, to demonstrate that selected investment options efficiently

meet their stakeholder-driven objectives and deliver sufficient net benefit for

existing and future consumers.

Workforce resilience

2.14. We are currently consulting on whether network companies should be submitting

a sustainable workforce strategy as part of their RIIO-2 Business Plans. If this

proposal is taken forward then we would expect these plans to set out how

companies would ensure that their workforce better reflects the diversity of the

communities they serve. Specifically such plans should:

demonstrate where attracting and retaining skilled personnel is becoming

increasingly challenging, including areas of uncertainty outside the control of

the companies

demonstrate how existing approaches to recruitment and retention in these

areas need to be improved to address this challenge, including:

o where this involves changes to pay and benefits, this would need to be

justified against historical benchmarks supported by robust evidence of

market trends for these skills going forward

o where this involves recruiting increased numbers over and above those

required to operate efficiently in the shorter term (e.g. additional

apprenticeships / technical graduates), the longer-term benefits of such

recruitment should be clearly evidenced

not only cover the RIIO-2 period, but extend out at least another 10 years to

consider workforce resilience over the longer term.

Cyber resilience

2.15. As discussed in the RIIO-2 Sector Specific Methodology, under the Network and

Information Systems Regulations 2018 (“NIS Regulations”), network companies

must take appropriate and proportionate technical and organisational cyber

security measures to manage risks posed to the security of the network and

information systems on which their essential service depends, and to prevent and

minimise the impact of incidents on these essential services.

2.16. The National Cyber Security Centre (“NCSC”) has developed a sector-agnostic

Cyber Assessment Framework (“CAF”) to assist operators covered by the NIS

Regulations.

2.17. Each network company is expected to perform a self-assessment against the CAF

in the coming months and propose what short-to-medium term cyber-security

measures they consider proportionate and appropriate to manage risks identified.

These will form part of an improvement plan to be submitted to Ofgem for

approval in its role as the CA. We intend to establish a comprehensive audit and

inspection regime to monitor the delivery of these improvement plans.

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2.18. In addition, we require network companies in all sectors (including electricity

distribution) to develop and submit strategic investment plans for cyber

resilience. As the CA, we plan to publish guidance by June 2019 to inform the

development of these longer-term plans.These plans:

must consider the cost of additional security measures against the consumer

must consider the economic and societal impacts of a cyber-incident

provide all of the necessary information to allow us to take a view on the

proposed security measures, including the needs case, the range of options

considered and the efficient costs of delivery.

Where possible, we expect these strategic investment plans to form part of

the RIIO-2 Business Plan submissions. These plans must allow us to assess

and take a view on the how the proposed investments meet the

requirements set out in the detailed guidance.

2.19. We will assess these plans considering whether the measures proposed to meet

the security requirements of the Directive are appropriate, proportionate and

efficient. Any allowances provided under RIIO-2 will be based on this assessment.

For RIIO-2, we propose to consider cyber security resilience costs which are (1)

efficiently incurred as a direct result of the introduction of the NIS Regulations,

and (2) above ‘business-as-usual’ activities.

Physical security

2.20. As discussed in our RIIO-2 Sector Specific Methodology we expect network

companies to submit costs relating to Physical Security Upgrade Programme

(PSUP) as part of their business plans, as a (confidential) Price Control

Deliverable.

2.21. Changes in Government policy during the price control could result in changes to

the investment required for PSUP. Therefore, for RIIO-2, we are considering to

include a reopener to adjust allowed revenue (either upwards or downwards) if

Government mandates changes to the scope of the enhanced physical site

security work required during the period. These costs would be subject to the

normal cost assessment process (see Section 3). Companies would not need to

provide CBAs or assessment of needs case.

Enabling whole system solutions

2.22. Greater whole system thinking and coordination should increase the number of

options networks have at their disposal when seeking to provide services and help

ensure network companies’ actions are efficient overall. We expect companies to

provide information on their approach to enabling whole system solutions in their

Business Plan. We propose that this should include:

plans and processes for joint planning with other network companies / the

ESO

effective consideration of whole system solutions to network planning and

constraints in their cost benefit analyses, as well as reflecting how they have

taken account of the wider impacts and opportunities of their actions,

including identification of uncertainties and their mitigation

long term whole system thinking and value for money, including

identification of uncertainties and mitigation.

2.23. Any specific expenditure that network companies propose for enabling whole

system solutions should be clearly identified. We would expect to see supporting

information demonstrating:

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any costs that they anticipate incurring by implementing these projects or

activities

the benefits that they expect to flow as a result of the projects and what

may be the indicators of these

the level of coordination that has already been undertaken to support these

proposals

how uncertainty mechanisms, including reopeners, should be used or

triggered to support the project

what arrangements they will put in place to ensure these measures are

operating effectively, or can be revised accordingly

why this project or activity cannot already be undertaken through a totex

allowance, and why a market solution cannot be utilised to produce this

result, where applicable.

Innovation

2.24. Our expectation for RIIO-2 is that companies will undertake more innovation

through their business as usual (BAU) activities, especially lower-risk operational

and maintenance innovation projects. We also want greater third party

involvement in network innovation.

2.25. To support this, we would expect companies’ Business Plans to explain:

what steps companies are taking to ensure that previously proven innovation

is rolled out into BAU

what innovation activities companies are planning for RIIO-2 using their

totex allowance

how the benefits of previously proven and proposed innovation is reflected in

the company's proposed expenditure for RIIO-2

what arrangements companies will take to secure third party involvement

and colloborate with other network companies as part of their innovation

activities.

2.26. As the composition of the RIIO-2 innovation stimulus and level of funding

available is not yet confirmed, we only expect companies to include plans for

innovation projects funded via their totex allowance within their Business Plans.

Once details of the RIIO-2 innovation stimulus are confirmed, we may then ask

companies to set out more detailed plans regarding innovation projects funded

via the RIIO-2 innovation stimulus.

Competition

2.27. We are currently consulting on our plans for competition in RIIO-2, and further

information on our proposals is available in the RIIO-2 Sector Specific

Methodology consultation. Broadly, our consultation covers three areas: early

competition, late competition, and native competition.

2.28. We provide early sight of our thinking in relation to the information that

companies migh need to provide for late and native competition below. We do not

address early competition here. We may update this information after considering

stakeholder responses to the RIIO-2 Sector Specific Methodology consultation.

Late competition

2.29. Under our current proposals, in their Business Plan submissions, companies may

be expected to provide us with the best information available to allow us to

identify projects that may be eligible for late competition.

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2.30. We are currently consulting on the extension of our existing criteria for electricity

transmission (new, separable, high-value) to both gas sectors and electricity

distribution. We intend to update stakeholders on our view of the criteria for late

competition in each sector following the close of the RIIO2 sector methodology

consultation.

Native competition

2.31. Under our consultation proposals, in their Business Plan submissions, companies

may expect to provide us with information on how they intend to use competition

to drive efficiencies. Each company’s competition strategy would be expected to

be in line with the proposed principles outlined in our December RIIO-2 Sector

Specific Methodology consultation. The type of information we might expect to

receive could include:

clear governance processes for the competitions (such as annual public

reporting of their performance against their proposed procedures) the type of metrics and tangible audit methods by which Ofgem and

stakeholders can assess their performance throughout the price control.

Enhanced engagement

2.32. The enhanced stakeholder engagement process for RIIO-2 has now been

established.9 We expect network companies to work with the Customer

Engagement Groups in Distribution, User Groups in Transmission, and the RIIO-2

Challenge Group to challenge and scrutinise their Business Plan proposals.

2.33. We would expect network companies to provide in their Business Plans:

evidence of appointment of company specific groups - timely appointment of

groups, governance arrangements at appointment and on an ongoing basis,

amongst other things as described in the enhanced engagement guidance

document issues in April 2018

evidence of effective engagement with User Groups , Customer Enagement

Groups and the RIIO-2 Challenge Group. We will also ask these groups to

provide us with evidence that the level of engagement was sufficient to help

them reach views on each part of the business plan.

Evidence of robust and high quality engagement with stakeholders by the

company in designing the plan.

Proposals in the plans on how companies will maintain a process of robust

and high quality engagement with stakeholders on an ongoing basis within

RIIO-2. This might include consideration of:

o how they will incorporate best practice from RIIO-1 into their activities.

o what commitments they will give to support engagement (including

what will be the consequences for non-delivery)

o whether KPIs and targets could be used to monitor within-period

performance10

o needs of existing and future customers and consumers.

9 Electricity distribution companies have started to set up their Consumer Engagement Groups. We welcome this with a view to the companies being prepared for the publication of our open letter for RIIO-ED2 in Q3 July 2019 10 As set out in the RIIO-2 sector methodology document we are currently consulting on whether to retain an ODI for stakeholder engagement for RIIO-2. Depending on the outcome of this consultation we might require additional information on KPIs and targets.

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3. Costs and Finance information

Cost information

3.1. In proposing costs for operating and developing their networks, we expect

companies to explain their costs/workload forecasts, particularly where these

diverge from historical trends. In particular we expect network companies to

provide information in their Business Plans on:

cost drivers

consideration of options

justification of costs.

Cost drivers

3.2. We expect companies to clearly set out:

the key drivers of expenditure for the RIIO-2 period - for example growth in

demand, conditions of assets/utilisation, legislative requirement, and any

other relevant drivers.

which categories of expenditure are uncertain and cannot be forecasted

using historical/independent benchmarks. Where this is the case we expect

companies to consider uncertainty mechanisms that mitigate risk associated

with uncertainty, and/or other evidence to justify their costs.

Consideration of options

3.3. We expect companies to clearly demonstrate the need for new investment

including:

The different options considered for meeting future network requirements,

including the cost of “doing nothing” and of “deferral” options and the

associated cost benefit analysis (CBA). Options discounted at this stage

should be accompanied by full reasoning, detailing key assumptions and

selection criteria given for exclusion. We expect CBAs to meet the criteria

described below.

The reasons for the timing of investment under the different options

considered, including expected outputs (eg the delivery of an increment in

boundary capacity transfer, the delivery of an electricity link, a gas pipeline)

related to the investment and year of delivery.

Cost justification

3.4. We expect companies to provide:

a justification of the efficiency of their costs, for example as compared to

historical benchmarks and/or benchmarking with national and international

comparators

details of assumptions and justification for projected changes in the efficient

levels of unit costs over time (i.e. ongoing efficiencies) caused by

improvements in project delivery, technological innovation, procurement

efficiencies

clear justification for any associated assumptions they consider we should

use when assessing costs. For example, robust and transparent justification

for the extent to which regional and company-specific factors determine

material (higher and lower) cost variations.

Details of the activities and indicative cost that are directly funded through

totex allowances and are associated with achieving service levels.

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For discrete projects, we expect companies to provide:

For high value, discrete projects, a detailed breakdown of costs that allows

individual cost elements to be benchmarked against relevant comparators.

A clear explanation of how they will account for the costs of projects that

straddle price control time periods.

A clear explanation of how they will deal with projects where the deliverable

changes, or the project itself is no longer needed (for example through the

use of PCDs).

Details of the activities and indicative costs associated with delivering PCDs

and ODIs.

3.5. We expect detailed information on costs and workloads during RIIO-2 to be

provided in the Business Plan data templates. We discuss these below.

Business plan data templates

3.6. Business plan data templates (BPDTs) enable the collection of business plan data

from all network companies on a consistent basis. We will work with the network

companies in each sector over the next few weeks to develop draft sector-specific

BPDTs and associated instructions. We expect to issue these draft BPDTs in March

2019. These draft BPDTs will identify the price terms (mindful of our proposed

move to away from RPI to CPIH) in which companies should present financial

information.

3.7. We expect network companies to use these draft BPDTs when submitting their

draft Business Plans to the RIIO-2 Challenge Group on 1 July 2019 and in October

2019.

3.8. We will use the draft Business Plan data, collected from the draft BPDTs, to test

whether we have all the information we require for our cost assessment and to

enable us to further develop our approach to assessing efficient costs.

3.9. Following the sector-specific methodology decision in May 2019 and our review of

draft Business Plan data, we will then develop the final RIIO-2 BPDTs. We intend

to issue final BPDTs in autumn 2019 for use in the December 2019 Business Plan

submission.

3.10. In large part, we expect the BPDTs for RIIO-2 to be very similar to the BPDTs

used in RIIO-1 and to RIIO-1 annual reporting templates. Some areas that we

currently think may change or develop from RIIO-1 are set out below:

• where we think the level of uncertainty has changed from RIIO-1 to RIIO-2

with consequences on what data we need in order to assess costs

• data that helps inform policy, for example to enable us to assess costs

associated with proposed PCDs, to determine output targets and to

implement indexation for Real Price Effects, if this is what we decide

• to adapt to Network Asset Risk Metric reporting requirements. This will be

driven by the development of our approach to assessing the NARM in

RIIO-2 at both cross-sector and sector-specific levels

• to inform how we develop our cost assessment approach, for example to

link outputs to costs and ensure transparency

• where we require a greater level of granularity, for example for specific

investment projects

• where useful, to reflect a multi-period approach to provide greater

transparency on investment cycles beyond RIIO-2 in recognition of the fact

that price controls are artificial boundaries.

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Cost benefit analysis (CBA)

3.11. CBA is an important decision support tool as part of the justification for

investment needs in RIIO-2. In demonstrating due diligence has been followed in

the appraisal of potential investment decisions by network companies, we

propose CBAs should:

be consistent with published guidance and recognised best practice, for

example the Green book and the Spackman discounting approach

demonstrate evidence of structured options development, including

consideration of whole system options and non-network options, where

applicable

demonstrate the value of projects across different scenarios, and include an

explicit consideration of (quasi) option values11 of deferring the investment

be clearly linked to the Business Plan, where applicable, with sensitivity to

changes in input parameters assessed, for example future energy scenarios

act as a robust decision support tool, open to scrutiny and challenge in

conjunction with other appropriate means of justification for investment

decisions

be transparent about which risks, costs and benefits have not been

considered and non-monetised as part of the analysis.

Be transparent about assumptions, inputs and rationale for decisions,

calculations and results.

3.12. We will work with the network companies on a sector-specific basis to agree the

scope for the application of CBA and develop detailed guidance and templates for

CBA submission. We expect to publish updated guidance and templates by March

2019.

Financial information

3.13. For business planning purposes, we will provide a business plan financial model

(BPFM) for network companies to complete, this will include additional financial

tables, for example for taxation, pensions and asset disposals. We intend to

provide more detailed guidance on the BPFM in early 2019.

3.14. The BPFM will be pre-populated with all the parameters set out in the finance

section of the December RIIO-2 sector-specific methodology and forecast closing

RIIO-1 price control financial model (PCFM) data, for example regulatory asset

value (RAV). It will allow network companies to populate with their plans to

calculate expected allowed revenues. It will also be used for assessing the

financeability of the plan and will include a suite of commonly used financial

metrics.

11 Guidance on this option value from Ofgem can be found in our Strengthening strategic and sustainability considerations in Ofgem decision making, and Real Options and Investment Decision Making papers and annexes.

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4. Managing Uncertainty

Uncertainty mechanisms

4.1. Forecasting costs for the duration of a price control is challenging. Uncertainty in

cost forecasts can arise for several reasons, including whether a network

company needs to conduct an activity or make an investment, the amount of an

activity they need to conduct, as well as the cost of the activity. Uncertainty

mechanisms allow changes to a network company's allowed revenues to be made

in light of what happens during the price control period.

4.2. In the December Sector Methodology consultation, we have set out our thinking

on some of the uncertainty mechanisms that we propose for RIIO-2.

4.3. As part of their Business Plans, network companies can propose, with suitable

justification, the inclusion of additional uncertainty mechanisms. The table below

gives an illustration of the type of material we may expect to see to support any

such company proposals.

Table 1: Information we may expect for additional uncertainty mechanisms

Issue Information

What is the issue/risk that the proposed mechanism addresses?

Set out the uncertainty identified and why an uncertainty mechanism might be appropriate.

Is the issue/risk regionally specific or industry wide?

Where does the ownership of risk lie in relation to the uncertainty?

Clearly set out where the risks lie with regard to customer/network company/both.

Materiality of issue Quantification of the materiality of the issue (ie what is the expenditure exposure of the issue) – we will not prescribe a specific methodology for the quantification of materiality.

Frequency and probability of issue over the price control period

What is the expected frequency and probability of the issue during the price control period?

What is the proposed mechanism?

A description of what the mechanism is and how it works. This needs to be detailed enough to allow for potential implementation. If there is a materiality threshold, this would need to be set out as a percentage of allowed revenue. If there is a specific trigger event this should be defined.

What are the justifications for the mechanism?

Set out the benefits of the mechanism.

What are the drawbacks from the proposed mechanism?

Set out the drawbacks of the mechanism. Again, where possible, the materiality of these drawbacks need to be set out (e.g. the impact on charging volatility).

Can the drawbacks be reduced? Explain why the drawbacks cannot be mitigated through alternative mechanism designs (eg by using a volume driver instead of logging-up or cost pass through).

Explanation of how on balance, the mechanism delivers value for money while protecting the ability to finance efficient delivery.

Explanation of why the benefits of the mechanism outweigh

the drawbacks.

We also expect the quantification of how the proposed mechanism delivers value for money whilst ensuring efficient delivery.

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Proposed approach for new assets

4.4. To address the risk of stranding/under utilisation, we will be setting higher

evidentiary hurdles before approving new investment. We expect to see network

companies provide this evidence in their Business Plans.

4.5. We expect companies to provide probabilistic CBAs that explicitly consider

different scenarios, meet the requirements set out in cost benefit analysis set out

above, but also describe a number of elements, including:

with respect to the core scenarios and sensitivities mentioned in section 2,

the level of risk that new investments/existing assets could pose a stranding

risk in the future

the mitigation they will put in place to reduce the risk of stranding

what monitoring they will undertake to ensure a continuous assessment of

risk levels

availability of potential market solutions, and whether any ‘whole system’

solutions are available

a “least worst regrets” assessement.

Anticipatory investment

4.6. Where potential investments by gas and electricity networks are justified on the

basis of being in the interests of energy consumers, it may be consistent with our

principal objective and other statutory duties to support the delivery of these.

However, there may be circumstances where expenditure is justified on the basis

of policy objectives beyond our remit or whole economy implications.

4.7. In their Business Plan, we propose that companies describe these types of

investment in a separate section from their ‘core’ Business Plan proposals.

4.8. To support these proposals for anticipatory investment, we ask companies to

demonstrate:

the benefits to network consumers that may flow from earlier investment

the consequences of not making anticipatory investment

the other options they have considered to address the relevant need

the level of risk surrounding their assumptions on future demand, including

clarity on government policy

the justification for why network consumers should fund this work, including

an examination of which other parties (including local authorities, national

governments, and third parties) could fund the investment

the balance of risk that is to be shared between consumers, the network

company and any third party.

Real Price Effects (RPEs)

4.9. In RIIO-1, we provided companies with fixed, ex ante allowances for real price

effects (RPEs). These RPE allowances were for the forecast increase of certain

input prices (such as labour and materials) over and above the forecast increase

in the Retail Price Index (RPI). So far during RIIO-1, input price inflation has been

lower than forecast and this has had a material impact on companies’ costs and

returns.

4.10. To enable us to implement RPEs appropriately, we expect network companies to

provide us with the following information in their Business Plans:

proposed input prices indices

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justification for their choice (e.g. why an RPE is needed for a particular cost

and why the proposed index/indices are appropriate)

the costs to which they might apply

ongoing efficiency assumptions.

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5. Business plan incentive

5.1. In Chapter 9 of the December RIIO-2 Sector Specific Methodology, we describe

our proposal for a new business plan incentive for the gas distribution, gas and

electricity transmission sector.

5.2. The Business Plan incentive is intended to encourage companies to provide us

with information that enables us to set a better price control. This information

may come in many forms but could include more stretching cost or outputs than

we may otherwise set.

5.3. Our proposal for a Business Plan incentive includes the following elements.

A four stage assessment process of Business Plans. We propose that this

process would consider the level of ambition that is reflected in cost

forecasts and on qualitative elements. These qualitative elements may

include elements such as output delivery commitments, quality of

stakeholder engagement, effective proposals on dealing with uncertainty,

approach to enabling whole system solutions, competition and innovation.

We are proposing to assign a score based on our assessment of their costs

and a score based on the qualitative elements of their Business Plans.

We are proposing an upfront penalty regime for companies that submit

Business Plans that do not meet our minimum requirements or are of poor

quality. We describe the proposed minimum requirements below.

We are also proposing to allow network companies that submit a Business

Plan that offers additional value to consumers to earn an upfront reward.

5.4. Our assessment of the quality of the plan, if this proposal is taken forward, would

take into account the reports we receive from the various engagement groups, as

discussed above.

Proposed Minimum requirements

5.5. As part of the assessment of whether the Business Plan has met our minimum

requirements, we may consider, for example, whether:

the company submitted all the information detailed in this guidance in a clear

and understandable manner

the plan has been subject to a robust and auditable quality assurance process

to prevent inaccuracies and mistakes

the plan meets our formatting requirements, such as obligatory cross-

referencing

the plan is no longer than 200 pages excluding BPDTs and CBAs and business

plan financial model

the plan ensures the company can comply with relevant legislation, such as

for safety

the company used the enhanced engagement process to test and challenge

the plan, in line with our guidelines

the company provided the necessary information in line with our Business Plan

guidance and timetable for submission.

Proposed characteristics of a poor plan

5.6. A network company may submit a Business Plan that meets minimum

requirements but may still be of poor quality. This may be because, for example:

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limited commitments are offered to assure the credibility of the Business

Plan

proposed uncertainty mechanisms are overly biased on risks to companies

Little/no consideration has been given to non-network solutions and/or

whole system solutions, the whole system impacts of their actions or

benefits they could offer

PCDs and/or ODIs are proposed without credible justification, targets are at

too low a level, incentives are requested where baseline funding is already

provided.

potential projects/system needs that could be potentially competed are not

clearly presented

insufficient engagement in developing the plan and going forward – limited

stakeholder access to information, resource, personnel, time to properly

input to and challenge the plan

Proposed characteristics of a good plan

5.7. A network company may submit a Business Plan that provides more information

than the minimum required and in doing so, offers additional value to consumers.

This may be because, for example:

companies propose uncertainty mechanisms that highlight risks to consumers

we are not aware of

companies make well-evidenced proposals of more stretching targets for PCDs

and/or ODIs

companies have demonstrated consideration of non-network solutions and

whole system approaches that are likely to deliver demonstrable benefits to

consumers.

5.8. In addition to the above, information to support the design of sector-specific

outputs (as set out in appendix 1) may contribute to the categorisation of a plan

as being of either good or poor quality.

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6. Next steps

Gas distribution, gas and electricity transmission networks

6.1. The gas distribution companies, gas and electricity transmission network

companies will make the formal submission of their Business Plans to us in

December 2019.

6.2. Prior to this, the companies should submit a complete draft of their plans,

including submission of BPDTs, to the RIIO-2 Challenge Group on 1st July 2019

and then a second draft on 1st October 2019. This is to ensure there are at least

two rounds of challenge before the final Business Plan is submitted to us in

December 2019.

6.3. We will hold open hearings prior to our initial determination, to focus on areas of

disagreement or contention raised by the various groups and to invite any other

evidence in support of, or against, company Business Plans.

6.4. The full timescales for Business Plan submission is detailed in Figure 2 below. As

discussed in section 3, we expect to issue draft RIIO-2 BPDTs at a sectoral level

in March 2019. We expect network companies to use these draft BPDTs when

submitting draft Business Plans on 1 July 2019.

6.5. We will develop the RIIO-BPDTs following the sector-specific methodology

decision in May 2019 and our review of draft business plan data. We intend to

issue the final BPDTs in autumn 2019.

Figure 2: High-level milestones for developing price controls for electricity

transmission, gas transmission, gas distribution and electricity system operator

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Electricity distribution

6.6. The next electricity distribution (RIIO-ED2) price control starts in April 2023 - two

years after the other sectors. As part of the RIIO-ED2 process for electricity

distribution, network companies will also be expected to submit both draft and

final Business Plans to the Challenge Group. Our suggested forward workplan for

RIIO-ED2 is below in Table 2. The final timescales will depend on whether we

retain fast-tracking for electricity distribution companes. We intend to start the

consultation process on this as part of our open letter for RIIO-ED2, due to be

issued in 2019.

Table 2: Indicative high-level milestones for electricity distribution price

control

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7. Appendix 1- Summary of proposed outputs in each

sector

Gas distribution Reference in RIIO-2 Sector Specific Methodology - Gas Distribution Annex (paragraph)

Consumer vulnerability and carbon monoxide safety awareness use-it-or-lose-it allowance

3.24, 3.31, 3.42

Fuel Poor Network Extension Scheme 3.47

Average restoration time incentive for total unplanned interruptions 3.170

Shrinkage 4.11

Decarbonisation of heat - Low and no regrets heat decarbonisation projects

4.30

Decarbonisation of heat - heat policy re-opener 4.41

Repex 5.35

GDN record keeping 5.64

Gas holder demolitions 5.70

Smart Meters rollout costs 7.8

Xoserve costs 7.41

Gas Transmission Reference in RIIO-2 Sector

Specific Methodology - Gas

Transmission Annex

(paragraph)

Stakeholder engagement incentive and customer satisfaction 3.9 & 3.21

Quality of demand forecast 3.33

Maintenance 3.42

Capacity constraint management 3.62

Residual balancing 3.73

Compressor emissions 4.6

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NTS shrinkage 4.46

BCF reporting 4.53

Low carbon energy systems and decarbonisation of heat 4.63

Network capability assessment and target 5.10

Xoserve costs 7.47

Electricity Transmission Reference in RIIO-2 Sector

Specific Methodology -

Electricity Transmission

Annex (paragraph)

Stakeholder engagement 3.7, 3.15, 3.25, 3.32

Stakeholder satisfaction survey 3.37

Timely connections output 3.57

Energy Not Supplied 3.132

Environmental considerations embedded in Business Plans 4.4, 4.7, 4.9, 4.16, 4.19, 4.27

Annual environmental performance reporting (incl. BCF and losses) 4.22, 4.83

Sulphur hexafluoride (SF6) and other IIG leakage 4.65

Additional contribution to low carbon transition 4.34, 4.43

Mitigating visual amenity impacts in designated areas 4.113

Network Access Policy 5.28

Successful delivery of large capital investment projects 5.33

Cost Assessment 6.11, 6.19, 6.23, 6.33, 6.39

Uncertainty Mechanisms 7.8, 7.11