Three ways RIIO ED2 will impact flexibility markets
This blog takes a look at how the new RIIO ED2 price control period (2023-2028) starting this week will change flexibility markets in the UK moving forward.

The UK is renowned for being one of the leading markets for local flexibility services, the development of which has been possible due to the RIIO framework that determines the Distribution Network Operators (DNOs) activities, costs and incentives. This blog takes a look at how the new RIIO ED2 price control period (2023-2028) starting this week will change flexibility markets in the UK moving forward, across three key areas:

• new activities tied to the new DSO incentive

• the potential for lots more connections and

• the importance of more adaptability

Now, more than ever, the pressure is on to unlock the potential massive value from distributed flexibility. It will play an essential role in the UK’s target to have a decarbonised power grid in only 12 years' time, by 2035; as well as ensuring an energy-secure future by helping to accelerate the move away from gas. One key piece to this is the price control framework that sets out the activities, costs and incentives of UK Network Operators, for which this week marks the start of a new RIIO price control framework for DNOs - RIIO ED2.

Kicking off in 2015, the first RIIO-ED1 period helped ignite the development of DSO local flexibility markets and catapulted the UK to be seen as a leading force in this area, with over £57m worth of contracts awarded through Piclo Flex since 2018. A key enabler to this has been the Totex-based mechanism the RIIO framework centres at its core. Now, eight years later, the framework has been refreshed to reflect the growing need for an energy system that places flexibility at its heart. Even with the boost ED2 will give local flexibility services, the sector will need to take further steps to mature aspects such as market coordination, transparency, revenue stacking and streamlined access.

What is RIIO and why is it important for flexibility markets?

Price controls are in place to ensure networks earn a fair return on their activities for efficient operation while controlling end costs to consumers. Put simply, networks face a variety of different costs including investment in long-term network assets such as cables, substations and reinforcements (capex-based costs) as well as expenditure on operating and maintaining the network (opex-based costs), which can include inspections and system operation costs such as flexibility services.

Ofgem introduced the RIIO framework in 2013, which sets Revenue using Incentives to deliver Innovation and Outputs. Unlike many price controls or rate frameworks that treat capex and opex costs separately, a core feature of this multi-year framework is its Totex expenditure approach, which combines them. This, alongside the Totex Incentive Mechanism, encourages networks to think holistically when determining what the most efficient solution might be and has a number of benefits that are important to flexibility markets:

Reducing capex bias: traditionally, networks have been incentivised to spend on capex costs that earn a rate of return, over opex costs, which are passed through without a return. This skew is called capex bias and leads to networks prioritising network reinforcements over smarter, flexible (opex-based cost) solutions. By considering capex and opex costs together, the totex approach incentivises DNOs to think holistically and choose the most cost-effective solution to solve an issue, such as flexibility services.

Use of third parties: the approach also encourages networks to assess how a solution is best delivered, incentivising the use of third parties that can provide more cost-effective solutions than building something in-house. This drives costs down for consumers and enables networks to use existing services from third parties, such as flexibility marketplaces.

How will RIIO ED2 impact flexibility markets?

Since 2015 and the beginning of RIIO ED1, there has been a paradigm shift in the UK’s energy landscape. The role of a DNO has fundamentally changed to one that must rapidly digitalise its business, deal with thousands of EVs, solar and low-carbon technologies connections and procure and use flexibility services. The RIIO framework has had to be adapted to reflect this new reality in a myriad of ways.

New activities, new incentives?

Over ED2, the role of a DNO must continue to evolve into one that is smart, digitalised and flexible. To ensure this happens, Ofgem required DNOs to set out a DSO strategy as part of their business plan submission. The priority here is to ensure DNOs continue to develop their DSO capabilities in three areas: planning and network development, network operation and market development. These include specific activities  or “baseline expectations” that Ofgem will be assessing their performance on throughout the price control period, such as:

• Facilitate efficient dispatch of distribution flexibility services
• DNOs should also coordinate and engage with third-party platform providers, who can offer system value by providing new routes to market and driving whole system outcomes
• DNOs should identify the optimum combination of longer and shorter term lengths of markets and contract lengths reflecting the network need

To incentivise DNOs to more efficiently develop and use their network, taking into account flexible alternatives, Ofgem has introduced a specific DSO incentive value (+ 0.4% / -0.2% of RoRE per year). The DNOs’ performance will be assessed through a stakeholder survey, performance panel assessment and outturn performance metrics.

Lots more connections?

To bring ED2 changes and Ofgem’s Access Reforms into alignment, fundamental reforms to grid connections and asset access have also been implemented at the same time as the RIIO framework. Connection charges form a significant part of the costs facing the development of an asset, with these costs sometimes being prohibitively expensive. This is in part due to the fact that, up until now, the connection that caused network reinforcement to be triggered shouldered a significant proportion of the cost of this reinforcement. The changes that have been implemented since April 2023 alongside RIIO-ED2 change things significantly, by reducing or removing the contribution to reinforcement costs for new connections. This could have a profound effect on making previously uneconomical connection applications now possible and DNOs will have a job in terms of queue management of this set of new applications. These new connections will also impact network loads and make robust, scalable flexibility markets, which make use of these new assets' flexibility capability and have developed the enabling infrastructure such as open-APIs, all the more important.

Better adaptability?

Electricity has changed significantly over the past 5 years - and will continue to evolve during the ED2 period to 2028.  Many factors will have a significant impact on how costs and activities play out during ED2, including what constitutes the UK’s generation mix, the rollout of heat pumps and EVs, hydrogen development and the phase-out of gas and fossil fuels. Consequently, the ED2 framework needs to be much more adaptable than its predecessor.  To do so, the multi-year framework was reduced from 8 to 5 years and Ofgem introduced new uncertainty mechanisms and re-openers to cover situations such as cost changes, improved evidence or new government policies.  These include the Digitalisation Re-Opener to enable DNOs to apply for additional funding where a change in their responsibilities requires establishing or improving digital services and a DSO re-opener. DNOs can now access additional funding for flexibility through the secondary reinforcement volume driver if they need to spend more than was possible to forecast or evidence in their business plan.

Dynamic evolution

RIIO and the reforms introduced alongside are nudging the sector in the right way and ED2 will add to the momentum that has been building over the last few years - but it is still important to view them as one piece within a larger puzzle.  The effectiveness or impact that changes, such as new DSO incentives, will have will not be clear for at least a year - are they strong enough? Do they work?  Equally, the suitability of new re-openers and uncertainty mechanisms will need to be tried and tested.  Secondly, many fundamental questions on DSO flexibility remain, including who should be accountable for market facilitation and what is the best way to ensure markets and platforms are accessible and participation streamlined.  So given the pace that flexibility is evolving - and will need to evolve in the months and years ahead - the most important thing is to avoid a hiatus.  A dynamic relationship between the regulator, DNOs and tech companies, which can respond to different signals, stimuli and feedback, will ensure the sector can continue to evolve at the fast pace it needs to.