Governance of network transformation

Long-term transformation tends to be neglected within the debate on incentive regulation. For example, Frontier Economics (2003), in a report for Ofgem discussing regulatory mechanisms for dealing with uncertainty, recognises that DG can cause additional uncertainty in the short term. As a new phenomenon, its network costs are more uncertain and diverse than those of 'traditional' generators. However, according to this report, 'DG is likely to become a more 'normal' part of what DNOs do ... as the network develops towards a transmission role, in which its function is to connect generation to load'. How this long-term network transformation will come about, and how it can be influenced, are not discussed. This is surprising, given that it would mean a far-reaching change with repercussions on the business model of distribution network operators, their network control paradigm, the relationship between distribution and transmission system operators and the overall commercial framework.

The more we move from the connection of DG to system transformation (Table 9.1) the more the focus shifts from short-term operating efficiency to long-term structural change. While connecting DG to the existing system is more or less a well-defined problem (although connection costs can be uncertain and diverse), long-term transformation entails increasing uncertainty about future development paths and how these may be shaped by specific actions taken today. The general problem of regulation thus becomes more severe in the context of network transformation: the regulated company may respond to the economic incentives given by the regulator in unexpected ways, making the transformation path less controllable and predictable.

In this context it becomes insufficient for network regulation to emulate the price mechanism of the competitive parts of the electricity market. Financial incentives to individual network companies to change their parts of the system (as they see fit to maximise profits) over five-year regulatory periods look increasingly inadequate. It is doubtful that such changes could lead to a system transformation that is in line with political objectives to increase the share of DG and make the energy system more sustainable.

In order to promote a long-term transformation of the network, revenue incentives that mimic market forces need to be complemented by instruments that: (i) go beyond one regulatory period, (ii) enable the regulatory process to deal with future structural changes and future uncertainty and (iii) provide coordination mechanisms for the stakeholders involved.

When it comes to transforming the system rather than renewing it, there is also more scope for conflicting interests. The regulator may therefore need to adopt an active, problem-solving role in mediating among the various actors. For this process to work in favour of DG it is crucial to include new actors with different values and beliefs who will question dominant system cultures around the centralised provision of electricity.

While fixed regulatory periods give the regulator opportunities to adapt to new developments, objectives and insights (Crouch, 2006), these adaptations need to be guided by an understanding of potential longer-term developments and their implications. Joint development of long-term visions between various stakeholders is an important and promising means to achieve this. Such a process and vision can help coordinate activities and innovations, and guide regulatory decisions to make these consistent with long-term aims.

Network regulation has often been considered as a mainly technical task, one that can and should be separated from the political process. The fear is that political influence could favour certain economic actors, and that it could increase the 'time inconsistency problem'. Helm (2004b, p. 15) explains this problem as follows: 'government might ex ante encourage investors to sink money into new assets, and then ex post renege on their side of the deal, pushing down prices'. This is one of the main reasons why (more or less) independent authorities were put in charge of regulating networks. Regulation is seen as an instrument to achieve clear-cut goals, among which economic efficiency is typically paramount.

As long as the focus is on (short-term) efficiency, the regulator's role is relatively clear and uncontroversial. With the goal of network transformation, however, matters necessarily become more political. Ultimately the key questions then revolve around what kind of electricity system society wants, taking into consideration trade-offs with other policy objectives such as climate change or energy security (SEG, 2007b). These are essentially political questions, making it more difficult to separate policy and regulation (or the definition of objectives and their delivery), requiring more iteration between the two.

This links up with more general discussions (Helm, 2004b, 2005b; Owen, 2004; Green, 2004) about extending the objectives of regulation beyond the promotion of short-term efficiency and competition. This could lead to a redefinition and broader understanding of network regulation, pertaining to: (1) the relationship between policy and regulation, (2) the objectives of regulation (beyond economic efficiency), (3) the regulatory remit and (4) the institutional set-up.

The Electricity Network Strategy Group set up in the UK by the DTI and Ofgem can be seen as a first attempt to tackle long-term network transformation in a liberalised market. Ofgem's role in this process clearly goes beyond implementing political objectives defined by others. It has a dominant role in the process of defining the future development of the network. DG incentives are complemented by coordination mechanisms based on cooperation and joint vision building, encompassing a broad range of actors and oriented towards long-term network development.

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