Transmission network reliability incentives (1)

This entry was added to http://www.reckon.co.uk/headlines-franckblog on 26 October 2004.
Full blog table of contents available at Contents | viewpoint: Franck.

Ofgem has released on 15 October 2004 a consultation document entitled "Electricity transmission network reliability incentive schemes: Initial proposals":

http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/8968_24004.pdf (PDF file)

The final proposals have now been published (1 December 2004).
See Transmission incentives 2 | viewpoint: Franck.

Structure of the proposed scheme

The document proposes to introduce a financial incentive regime for NGC's operational performance as transmission network operator in England and Wales, with the following key features:

The measure of transmission network reliability exposed to incentives would be an estimate of unsupplied energy aggregated over a year.
Faults affecting fewer than three customers would be excluded (deemed to relate to low-grade connection assets rather than to infrastructure faults).
Faults on days on which there are more than 50 faults on the transmission system would be excluded (deemed to relate to extreme weather).
Interruptions "arising from a lack of generation capacity" would be excluded.
Interruptions on commercial grounds or at the user's request would naturally be excluded.
The target (perhaps more properly described as a benchmark) would be a fixed value, to be set by reference to NGC's historical performance (on a measure with the same exclusions as in the proposed incentive scheme).
The scheme would incorporate a deadband and a cap on NGC's loss, but have identical incentive rates in the gain and loss ranges.

Ofgem notes that corresponding arrangements have been designed through the "IIP" for distribution networks, and provides reasonable grounds for most of the differences between the IIP and the proposed transmission arrangements. However, there are some doubts about the quality of the incentives that would result from the proposed scheme.

Short-term problems

Potential problems in the short term include:

Calibration. There is no economic logic in the calibration of the scheme. The incentive rate is calculated as the ratio of an arbitrary 1 per cent of revenue (maximum benefit to NGC) to an arbitrary 90 per cent of a historical average level of unsupplied energy. The result is a whopping £39,000 per MWh, more than 10 times the old "value of lost load" figure under the Pool. In addition to this incentive, NGC is likely to be exposed to losses under the system operator incentive scheme as a result of most network faults. Conversely, any success in reducing transmission interruptions will provide substantial rewards to shareholders. Presumably Ofgem will claim credit in a few years' time, when NGC has suitably gold-plated its network and procedures and beaten the target by a comfortable margin. Do customers really want to pay on that scale for such improvements?

Deadband. Deadbands generally have an adverse effect on incentives (as recognised by Ofgem: see below), but it seems that in this case the deadband proposed by Ofgem is essentially pointless. It is so narrow that it probably does not provide a "comfort zone" to managers: there is always a risk that a single event could take performance well out of the deadband. This means that the deadband hardly reduces incentives for NGC to avoid every unit of unsupplied energy, except perhaps at the tail end of the year if performance looks almost certain to fall within the deadband.

Cap. Caps also distort incentives, even though they can sometimes be justified as ways of reallocating risk or as "backstop" provisions when using data that may not be fully tried-and-tested. However, Ofgem's choice of an annual cap on NGC's losses (rather than a cap applied to shorter periods or specific events) means that a major event or series of event risks cancelling all the incentive power of the scheme for the rest of the year, if it becomes clear that the cap will be hit anyway. This is potentially a much more significant distortion than the one arising from the deadband. (There is no corresponding problem with NGC's maximum gain of 1 per cent of revenue, since this is only reached at zero unsupplied energy, and unsupplied energy cannot be negative.)

Weather exclusion. Ofgem appears to propose that extreme weather should be excluded from the scheme altogether — so that an extreme-weather day would count as a day with no interruptions (or at least no interruption related to the weather event). This introduces discontinuities in the scheme (a day with 49 faults is extremely costly to NGC, whereas a days with 51 faults is actually more beneficial than a normal-weather day).

Connections exclusion. Excluding all faults which affect three or fewer customer seems a rather blunt way of addressing the issue of lower-grade connections. It is possible that data limitations may make it the only reasonable way, but Ofgem's paper does not demonstrate that this is so.

Generation shortage exclusion. There appears to be no specification of how the unsupplied energy attributable to generation shortages would be defined or measured.

Longer-term problems

In addition to these issues, there are some potential longer-term problems that Ofgem's paper fails to address altogether:

Target setting methodology. Ofgem does not set out any sensible way of re-setting the scheme's benchmark. There is therefore a risk that incentives may be blunted by a "ratchet effect": NGC may effectively "hold back" some improvements in order to avoid too steep a reduction in the benchmark amount of unsupplied energy. This problem can be addressed through a "rolling" system of incentives (more on this here soon).

Scotland. The paper acknowledges that further work will be required to adapt the scheme to the Scottish transmission networks, insofar as this is considered appropriate. More generally, Ofgem does not appear to have given due regard to the split between network operator and system operator that it is introducing as part of the BETTA programme. Incentives need to be designed within the framework of a well-understood industry structure with different businesses having clear areas of responsibility, and corresponding liabilities and profit opportunities. This has not yet been achieved.

It is only fair to point out that Ofgem's scheme is only intended as an interim arrangement, so it may be excusable that it should look in some respects more like sticking plaster than a thoughtful addition to the regulatory regime for electricity transmission networks.

However, this means that much more work will be required to develop a regime that can provide appropriate incentives over time, and can be adapted to the Scottish transmission networks.

If it ain't broke?

Despite the above concerns, Ofgem may argue that its approach to transmission network reliability incentives is similar to the way in which transmission services/system operator incentive schemes have been designed and developed in the past, which it claims have been a success.

To a point, this is a fair response.

But it is not quite enough. As noted above, it is quite easy to make a scheme look successful: replacing "backstop" licence obligations with very strong financial incentives is bound to lead to improvements in the performance measure subject to the incentives in question, and to the associated financial rewards for the company, to the satisfaction of Ofgem and shareholders alike.

The hard bit in regulation is not to improve performance. It is:

to improve the areas of performance that currently fall short of what customers want;
to improve them only insofar as the improvement represents value for money for customers; and
to maintain effective incentives for cost and for performance over an extended period of time.

Excessively high standards of operational performance can be a sign of lazy regulation and gold-plated management.

Consistency with system operator incentives

This earlier Ofgem consultation document (September 2004) entitled "NGC System Operator incentive scheme from April 2005" relates to the incentive scheme to be applied to NGC's performance as system operator in relation to the management of "balancing costs" (previously known as transmission services costs).

http://www.ofgem.gov.uk/temp/ofgem/cache/cmsattach/8762_22304.pdf (PDF file)

I missed my chance to review this fully at the time, but some general points are still worthy of mention:

Ofgem seems to think of a "deadband" as a way of mitigating the effects of uncertainty about future costs (paragraph 4.21, paragraph 4.22 second point). This sounds odd (see above).
Ofgem realises the problem that a deadband "creates a range of costs within which NGC has reduced incentives to manage costs" (paragraph 4.22 second point). True. But then it seems odd to suggest a deadband for transmission reliability schemes, especially such a narrow deadband that it does not even generate the few benefits that might be associated with deadbands (see above).
Ofgem appears to think that "evidence of asymmetric cost distributions" is a legitimate reason for an asymmetric cap/floor or asymmetric sharing factors (paragraph 4.22 third point); this is not obvious to me, and may be worth a comment at some point.