Innovation funding under RIIO: “Money left on the table?”
Just over one month into RIIO ED-1, DNOs are dealing with the outcome of their review process, which means looking into ways of cutting costs. In our previous blog, we proposed that DNOs will need to adopt a holistic approach to managing networks and consider that the answer lies in optimizing the mix of ‘traditional’ network investments and the deployment of smart grid and non-network technologies, subject to operational standards and quality of service requirements.
Of these factors, developments in smart grid technologies  and non-network technologies  are arguably the most promising (or challenging), given the pace and variety of technological developments. The previous (DPCR5) and current (RIIO) price controls contain innovation funding packages, allowing DNOs to explore the potential of such technologies.
The innovation incentive package in RIIO-ED1 consists of three components: the Network Innovation Competition (NIC), the Network Innovation Allowance (NIA), and the Innovation Roll-out Mechanism (IRM). Of these three, the NIA and the NIC are effectively updated incarnations of the Tier 1 and Tier 2 funding mechanisms in the Low Carbon Network Fund (LCNF). Of these mechanisms, the NIC/Tier 2 mechanisms require DNOs to compete for funds, whereas the NIA/Tier 1 mechanisms involve a use-it-or-lose-it allowance, where spending must meet a number of requirements, but individual projects are not formally approved in advance by Ofgem.
In the absence of formal approval, use-it-or-lose it funding should be fairly readily available to DNOs. However, a simple analysis of Tier 1 funding allocation shows that DNOs have so far mostly been ‘losing it’.
Table 1 includes the value for projects registered for Tier 1 funding up to and including March 2014, meaning that by the end of the 4th of 5 years, DNOs had on average tapped into only 29% of potentially available funds in DPCR5. Depending on how much of their £15.8m annual allowance DNOs managed to consume between April 2014 and March 2015, they have left between £40m and £56m of funds on the table.
It is fair to say that DNOs have, for whatever reason, largely foregone the opportunity to undertake paid research & development into new technology, operating and commercial arrangements that could result in long-term efficiencies. Looking at the rigorous cost savings required from the RIIO-ED1 review, this missed opportunity may come at a considerable cost: In addition to £728m of ‘general efficiencies’, Ofgem considered that slow-track DNOs underestimated potential savings from smart technologies and other innovations by around £322m, an amount that is largely meant to reflect anticipated benefits of LCNF-funded innovation efforts. Had DNOs made better use of Tier 1 funding, this amount might have been smaller, or at least easier to realize.
But this is not all. In addition to the benefits that might emerge from R&D into innovation, the very process of undertaking the R&D, especially under an Ofgem-endorsed funding mechanism, can be a major benefit to a DNO as a way of evidencing the legitimacy of its network costs. The RIIO-ED1 outcome does not necessarily mean that DNOs’ costs are too high, just that Ofgem believes them to be too high, and it’s up to DNOs to demonstrate that Ofgem is wrong. The only way to do that is to investigate the merits of alternative processes and technologies to determine which are feasible and lead to long-term efficiencies, and which are infeasible or whose costs outweigh their benefits, and use these results as the basis for future business plans.
In the past, DNOs might not have undertaken this kind of analysis for lack of dedicated resources, a perceived lack of regulatory incentives (after all, there’s no defined penalty associated with under-consuming subsidies) or an underestimation of the true opportunity costs of failure to innovate in the RIIO environment. However, the RIIO-ED1 review outcome negates these considerations. NIA funding in RIIO-ED1 is between 0.5% and 1% of base revenues, meaning that individual distribution licensees have somewhere between £1m and £3m annually to spend – and they should put these funds to good use to.
The options are myriad and need not stray far from “business-as-usual” questions. We believe, for instance, that DNOs’ asset management systems are in great need of an innovative overhaul to adopt a more risk-based approach, allowing DNOs to inform the timing of investments to enhance the safety, the performance, and the overall (cost) efficiency of operating and maintaining network assets. Lowering the cost of asset management, or evidencing why a certain (higher) level of spend is justified, has an immediate effect on any DNO’s bottom line – but finding out ‘how’ does require an investment. The point is that DNOs need to spend money to gain money, failure to spend has an immediate opportunity cost, and is likely to carry an even greater cost at the next RIIO price control review.
 Including the deployment of smart meters.
 Including, for instance, demand side response, distributed generation, and energy storage.
 Source: https://www.ofgem.gov.uk/ofgem-publications/90854/tier1fundingallowanceandregistrationlog.xlsx