RIIO performance-based ratemaking

RIIO (the name is taken from the equation Revenues = Incentives + Innovation + Outputs) is a form of performance-based regulation applied to energy network companies in the United Kingdom (U.K.) by the national utility regulator the Office of Gas and Electricity Markets (Ofgem). Energy network companies include gas pipeline, gas distribution, electric transmission, and electric distribution companies. The methodology is applied to rates for gas and electric transmission and distribution, but not to supply since supply has been deregulated and is provided by retail marketers in the U.K. 

Under RIIO, base rates were initially set for an eight-year period beginning in 2013. The rates were set through a process whereby the network companies filed business plans with proposed costs and rates that were reviewed and approved by Ofgem. Costs include expenses and return on capital based on a proposed capital spending plan. Revenue requirements and rates were then set based on the approved total expenditures (totex) for the eight-year period. 

Initial rates are adjusted up or down annually based on a formula for calculating approved annual revenues. The approved annual revenues are determined by a model that calculates the adjustment based on a limited number of updated variables:

• The annual cost of corporate debt and inflation

• Uncontrollable expenses such as pension variables, tax variables, and legacy adjustments

• Overall cost performance relative to the approved totex amount (if costs come in below approved totex, savings are split between customers and shareholders)

Revenues are further adjusted based on company performance measured against output metrics in the following areas:

• Customer satisfaction

• Reliability and availability

• Safety

• Speed of new customer connections

• Environmental impact

• Social obligations

Revenue can be further increased by implementing innovation projects. 

How annual allowed revenues are determined under RIIO-1

According to Ofgem, the regulation is designed to encourage network companies to:

• Put stakeholders at the heart of decision making

• Invest efficiently to ensure continued safe and reliable service

• Innovate to reduce network costs for customers

• Play a full role in delivering a low-carbon economy and wider environmental objectives

Utility management is given the flexibility to determine spending levels for both expenses and capital since both are included in the totex category. There is no rate of return on capital spending determined beyond the initial setting of rates, so utilities are no longer incented to favor capital over expense spending. 

The original RIIO mechanism is now called RIIO-1 and will expire in 2021. As of mid-2020, Ofgem is working with the network companies and various stakeholders to develop the new RIIO-2 that will replace the initial mechanism. Under the initial mechanism, typical utility returns on equity averaged in the mid-9% range, which is within the typical range for utilities in various parts of the world. 

Source: Ofgem RIIO Annual Report 2018-2019