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Electricity Distribution Regulation in the UK

Supplying electricity across the UK involves four key activities: generation, transmission, distribution and retail sales. The largest part of the generated energy comes from large scale power stations connected directly to the national transmission grid[1]. Electricity is transported over long distances at high voltages, with National Grid being the firm responsible for such activity. In the following stage, the Distribution Network Operators (DNOs) transfer the electricity from the substations (transmission) to homes and businesses. Finally, there is a competitive market in which firms compete to sell the electricity to the final consumer.

In reality, the UK was one of the first European countries to privatize the electricity distribution companies which required the implementation of a mechanism of incentives. In particular, they introduced an innovation regarding price regulation: the RPI-X mechanism. This restrains the prices charged by distribution network operators to a annual growth rate of no more than the rate of inflation (Rate of Price Index) minus a productivity improvement factor. This system has two particular features: it means that consumers will be better off since the prices of electricity will go down in real terms, while also working as an incentive, since the DNOs have to improve their efficiency if they do not want to see their revenues going down, in real terms.

This regulatory scheme was quite successful at the time, spreading to several countries and persisting until the present days in the UK. However, it may also create some distortions, such as loss of quality resulting from firms wanting to reduce costs being, therefore, additional incentives needed.

Currently, in the UK, there are 14 electric distribution companies (owned by six different groups). Each distribution network operator (DNOs) must have a license and it is responsible to provide the distribution service in a certain regional area.

The distribution companies themselves provide only delivery services and don’t contract nor buy or produce electricity for resale to final customers – a competitive function referred to as “electricity supply” – though they may have functionally separated or “ring fenced” supply affiliates that do so. Their activities, prices and revenues are subjected to the regulation framework set out by the UK Office of Gas and Electricity (Ofgem). In addition to the DNOs, there are also smaller distributions network operators which are known as Independent Distribution Operators (IDNOs) operating within the regions covered by the DNOs.

Every five years, there is an Electricity Distribution Price Control Review (DPCR) which involves a review of the entire regulatory framework concerning electricity distribution. The main purpose of these reviews is to ensure that the mechanism provides the proper incentives to the DNOs. Therefore, such reviews include the basic information regarding the way in which DNOs are regulated and get their revenue. Ultimately, it aims at “encouraging the type of behavior that will deliver the services that DNOs’ customers want at reasonable prices over the next five-year period” (Ofgem 2009c). Furthermore, Ofgem has also other objectives and it has created incentive mechanisms to deal with them. Particularly, it wants to promote the UK transition to a low carbon economy.

The main conclusion one can make of this report is that Ofgem did not settle for setting the leading RPI-X regulatory framework, but rather keeps on applying to real life economics the main breakthroughs in regulatory theory. In DPCR rules, one can easily identify the Laffont-Tirole model of a linear menu of contracts, complemented by monetary performance-based incentives (using yardstick regulation) to develop quality of service and green investments. All of this is done while keeping in mind that regulatory risk should be kept low.

 

[1] The number and the type of power stations are an individual decision of each company, which have to respect the current government policies.

 

Filipe Silvério 617

João Garcia 618

Samuel Cardoso 624

Rita Azevedo 625

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Author: studentnovasbe

Master student in Nova Sbe

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