DNO Losses Incentive- Summary

1. DNO Losses Incentive- Summary

2. Minded-to position, with restated losses, makes outcome far more extreme, with nearly £500m in rewards

3. Ofgem’s IA focuses on the ‘close-out’ term, PPL, but this number has no meaning in itself • The PPL is simply a ‘true-up’: it is not a reward or penalty • It is the difference between the Total Incentive (LRRM) and Incentive Revenue received to date1 • It is not the same as LRRM as stated in the Ofgem consultation2 • close out (PPL)= total incentive (LRRM) - Σ incentive over DPCR4 • Even when compared to published DNO expectations3, the PPL terms proposed by Ofgem are significantly more (£224m) generous:

4. DNOs have publicly stated that they believe they can have little or no impact on the Losses Incentive One further option would be to close out DPR4 by merely reversing gains/losses to DNOs, in effect leaving DPR4 losses at a neutral position. This would seem to be the right thing to do for customers; in the absence of hard evidence that DNOs investment plans have been altered by the losses incentive, it would seem perverse that DNOs have gained or lost financially as a result of the incentive. Western Power4 The mechanism depends on data that is dominated by the behaviour of suppliers and has almost nothing to do with the steps taken by Distributors. Northern Powergrid5 Ofgem proposal for Losses Incentive value (LRRM) for Western Power: £19m Reward Ofgem proposal for Losses Incentive value (LRRM) for Northern Powergrid: £55m Reward However, we do not believe that the DPCR5 Distribution Losses Incentive Mechanism will meet its objectives of encouraging DNOs to achieve an efficient level of losses on their distribution networks since the outcome is largely outside of their influence. ENW6 We do not believe that the existing losses mechanism is effectively incentivising DNOs to reduce losses. It is clear that even in the normal course of settlement, reported losses vary much more as a result of settlement effects than would be possible through the influence of DNOs’ loss reduction measures. SP Energy Networks7 Ofgem proposal for Losses Incentive value (LRRM) for SP: £65m Penalty Ofgem proposal for Losses Incentive value (LRRM) for ENW: £43m Reward

5. We are now seeking to establish what has gone wrong in the process to arrive at this outcome • We understand that Ofgem may not have applied a credibility test to consider whether performance against targets is realistic • Ofgem committed to ‘reported losses performance during the normal period must be credible’8 further noting that this was to ensure that DNOs were not unduly rewarded or penalised. • For ED1, Ofgem has stated that they believe an incentive value of £32m (for an 8-year control) is appropriate to incentivise behaviour9 • Critical elements of DPCR5 Final Proposals seem to have been interpreted in 2 different, and contradictory, ways (Adjustments arising from settlement corrections and provision accounts10) • Different DNOs selecting different interpretations of how to apply • DNOs seem to have driven the process of testing for normality, allowing them to select their own periods of normality • The process of applying reconciliations from other years to correct an ‘abnormal’ year may simply be incapable of producing a sensible answer

6. Appendix: References • From DPCR5 Final Proposals: ‘7.5. In DPCR4 the incentive mechanism was created so that the LRRM retains each year’s incentive amount earned on the incremental change in outturn losses for five years. In discussions with the DNOs we have explored the algebra behind the LRRM and have explained that the LRRM equates to five times the final year losses performance against the target. We consider this property to be appropriate as the purpose of the incentive is to reward sustainable changes in losses, and therefore the final year should reflect the cumulative efforts over the entire price control period.’ • Also from DPCR5 Final Proposals: ‘4.26. In calculating the remaining amount owed to/by the DNOs (the 'close out' amount) we will then subtract the loss incentive amounts already included in the DPCR4 allowed revenues: • close out = corrected net LRRM incentive – Σ incentive over DPCR4’ • From Document G: Consultation on restatement of 2009-10 data and closing out the DPCR4 losses incentive mechanism: ‘1.31. The PPL term is simply the result of the LRRM calculation. Its total value is the same as the LRRM, but recovery of the PPL term may be split over more than one year, as PPLt.’ • From DCUSA Schedule 15 forecasts for November 2012 (all amounts relating to close out of DPCR4 converted to 2009/10 prices): http://www.dcusa.co.uk/Public/Documents.aspx?t=10 • From WPD response to Ofgem Consultation on “Whether to activate the Distribution Losses Incentive Mechanism in the Fifth Distribution Price Control Ref 87/12” http://www.ofgem.gov.uk/Networks/ElecDist/Policy/losses-incentive-mechanism/Documents1/WPD%20Response%20to%20DPCR5%20Losses%20Consultation.pdf • From Northern PowerGrid response to Ofgem Consultation on “Whether to activate the Distribution Losses Incentive Mechanism in the Fifth Distribution Price Control” • http://www.ofgem.gov.uk/Networks/ElecDist/Policy/losses-incentive-mechanism/Documents1/NPG%20Cover%20Letter%20to%20DPCR5%20Losses%20Consultation.pdf • From ENW response to Ofgem Consultation on “Whether to activate the Distribution Losses Incentive Mechanism in the Fifth Distribution Price Control Ref 87/12” http://www.ofgem.gov.uk/Networks/ElecDist/Policy/losses-incentive-mechanism/Documents1/ENWL%20Response%20to%20DPCR5%20Losses%20Consultation.pdf • From SP Energy Networks response to Ofgem Consultation on “Whether to activate the Distribution Losses Incentive Mechanism in the Fifth Distribution Price Controll” • http://www.ofgem.gov.uk/Networks/ElecDist/Policy/losses-incentive-mechanism/Documents1/SPEN%20Response%20to%20DPCR5%20Losses%20Consultation.pdf • From Document G: Consultation on restatement of 2009-10 data and closing out the DPCR4 losses incentive mechanism: ‘2.7 In addition to relatively stable reconciliation levels, reported losses performance during the normal period must be credible, eg the normal period should not include historically low, one-off, losses levels17 • 17 This is to ensure that a DNO is not unduly rewarded or penalised by a year where there is a known reason for abnormal losses.’ • From RIIO ED1 Strategy Consultation, Outputs, Incentives and Innovation: ‘5.25. We have concluded that a sufficiently strong incentive is required to ensure that DNOs place an appropriate level of focus on losses reduction activities, and to highlight the importance that we place on the contribution of losses reduction to carbon emissions as well as the implicit impact of losses on customer bills. At the same time we have to balance this by considering our inability to accurately measure the outputs and benefits of any losses reduction measures at this time. We consider that a DR of £32m will achieve the desired result.’ • DPCR5 Final Proposals – Financial Methodologies: p.25, paragraphs 4.19 – 4.21, Section on ‘Adjustments arising from settlement corrections and provision accounts’