adjusted every year by the rate of inflation and
target rate of productivity growth. The TSO is
constrained in exaggerating its costs by the regulator conducting benchmark analysis and
detailed studies of the TSO’s historical accounts.
The TSO has some incentive to lower its costs
because it can retain the difference between the
price cap and its actual cost as profit.
Performance-based regulation is still evolving
and there is no consensus on the optimal practice.
Several forms of performance-based regulation
have been adopted, which continue to evolve. An
example of their evolution is the introduction in
the UK of the RPI-X (retail price index minus X)
mechanism in 1992, and its eventual replacement
by the RIIO (revenue = incentives + innovation + outputs) mechanism in 2013, as described
below. A key challenge in performance-based
regulation is its high information burden. The
regulator has to review the TSO’s accounts and
business plans and undertake benchmark
analysis.
Performance-based regulation in the UK
The UK introduced performance-based regulation in electricity networks in 1992 with the
RPI-X mechanism, later replacing it with the
more sophisticated RIIO mechanism in 2013:
• RPI-X mechanism. Ofgem and its predecessors, the electricity market regulator in the
UK, used the RPI-X mechanism until 2013.
Under this mechanism, Ofgem carried out
cost forecasts to determine the base revenue
required by the TSO to recover its costs.
Based on this base revenue, Ofgem set a price
cap and adjusted it each year for retail price
inflation (RPI) and an assumed target rate of
productivity growth calculated by statistical
benchmark analysis. Ofgem reset the price
cap at the end of the five-year price control
period to ensure that the TSO’s cost savings
are passed on to end consumers. Under the
RPI-X mechanism, the TSO had incentives to
reduce its costs because it was able to retain
the margin between the price cap and its own
actual cost as profit, as shown in Fig. 31.
However, the RPI-X mechanism did not
adequately incentivise service quality or
innovation. It allowed cost savings to be
achieved through decline in quality of service, and the five-year price control periods
did not provide sufficient incentives to
develop new technologies (such as smart
meters) with longer investment cycles and the
potential to provide cost savings over the
longer term.
• RIIO mechanism. In 2013, Ofgem introduced
the RIIO mechanism to address its concerns
with RPI-X. The RIIO mechanism takes the
elements of RPI-X that work well, such as
determining base revenue, and adds extensive
innovation and output targets to them.
The RIIO mechanism determines the base
revenue from output-led business plans with
greater use of option analysis and scenario
planning. In their business plans, companies
compare the costs and benefits of options for
delivering long-term outputs under various
scenarios and assess the value of keeping
these options open. Moreover, financial and
reputational incentives strengthen the incentive structure. Ofgem rewards or penalises
companies when they achieve or miss their
output targets. Reputational incentives do not
have a financial element, but they affect
Ofgem’s evaluation of base revenue in the
next review periods. A longer control period,
of eight years, encourages the TSO to focus
on longer term investments, such as smart
meters. RIIO provides a wider set of performance incentives than RPI-X, but at the cost
of greater complexity and reduced
transparency.
(2) Independent system operator
An independent system operator (ISO) is fully
separated from ownership of all network
resources. The ISO performs all system operation
functions, including allocating network capacity
among generators and consumers to respect the
physical characteristics of the network, carrying
out residual balancing to ensure electricity is
delivered to where it is most valued, and maintaining the stability of the electricity system. In
an ISO model, the transmission network
Special Report 1: A Study of China’s Energy Supply Revolution
91
target rate of productivity growth. The TSO is
constrained in exaggerating its costs by the regulator conducting benchmark analysis and
detailed studies of the TSO’s historical accounts.
The TSO has some incentive to lower its costs
because it can retain the difference between the
price cap and its actual cost as profit.
Performance-based regulation is still evolving
and there is no consensus on the optimal practice.
Several forms of performance-based regulation
have been adopted, which continue to evolve. An
example of their evolution is the introduction in
the UK of the RPI-X (retail price index minus X)
mechanism in 1992, and its eventual replacement
by the RIIO (revenue = incentives + innovation + outputs) mechanism in 2013, as described
below. A key challenge in performance-based
regulation is its high information burden. The
regulator has to review the TSO’s accounts and
business plans and undertake benchmark
analysis.
Performance-based regulation in the UK
The UK introduced performance-based regulation in electricity networks in 1992 with the
RPI-X mechanism, later replacing it with the
more sophisticated RIIO mechanism in 2013:
• RPI-X mechanism. Ofgem and its predecessors, the electricity market regulator in the
UK, used the RPI-X mechanism until 2013.
Under this mechanism, Ofgem carried out
cost forecasts to determine the base revenue
required by the TSO to recover its costs.
Based on this base revenue, Ofgem set a price
cap and adjusted it each year for retail price
inflation (RPI) and an assumed target rate of
productivity growth calculated by statistical
benchmark analysis. Ofgem reset the price
cap at the end of the five-year price control
period to ensure that the TSO’s cost savings
are passed on to end consumers. Under the
RPI-X mechanism, the TSO had incentives to
reduce its costs because it was able to retain
the margin between the price cap and its own
actual cost as profit, as shown in Fig. 31.
However, the RPI-X mechanism did not
adequately incentivise service quality or
innovation. It allowed cost savings to be
achieved through decline in quality of service, and the five-year price control periods
did not provide sufficient incentives to
develop new technologies (such as smart
meters) with longer investment cycles and the
potential to provide cost savings over the
longer term.
• RIIO mechanism. In 2013, Ofgem introduced
the RIIO mechanism to address its concerns
with RPI-X. The RIIO mechanism takes the
elements of RPI-X that work well, such as
determining base revenue, and adds extensive
innovation and output targets to them.
The RIIO mechanism determines the base
revenue from output-led business plans with
greater use of option analysis and scenario
planning. In their business plans, companies
compare the costs and benefits of options for
delivering long-term outputs under various
scenarios and assess the value of keeping
these options open. Moreover, financial and
reputational incentives strengthen the incentive structure. Ofgem rewards or penalises
companies when they achieve or miss their
output targets. Reputational incentives do not
have a financial element, but they affect
Ofgem’s evaluation of base revenue in the
next review periods. A longer control period,
of eight years, encourages the TSO to focus
on longer term investments, such as smart
meters. RIIO provides a wider set of performance incentives than RPI-X, but at the cost
of greater complexity and reduced
transparency.
(2) Independent system operator
An independent system operator (ISO) is fully
separated from ownership of all network
resources. The ISO performs all system operation
functions, including allocating network capacity
among generators and consumers to respect the
physical characteristics of the network, carrying
out residual balancing to ensure electricity is
delivered to where it is most valued, and maintaining the stability of the electricity system. In
an ISO model, the transmission network
Special Report 1: A Study of China’s Energy Supply Revolution
91