Innovation in energy market highlights case for principles-based regulation, says expert

Out-Law Analysis | 31 Jul 2015 | 11:41 am | 3 min. read

FOCUS: Innovation in the energy market is challenging the existing regulatory regime, highlighting the case for industry supervisor Ofgem to set new principles-based rules.

Principles-based regulation can help support core Ofgem goals of safeguarding the UK's energy supply, protecting consumers and enabling innovation in the market.

The current regulatory system was developed to regulate a centralised electricity and gas system focussed on large-scale fossil fuel generation. However, the market has evolved to become more decentralised and accommodating of new renewable power sources with changes in technology.

Technological advancements have also had an impact at the retail level, with the increasing connectivity of 'home hub' devices and mobile apps, and the associated proliferation of data, helping companies to help home owners control their energy consumption better than ever before. New energy storage technologies, such as the Tesla battery, promises further innovation in the market.

The 'big six' energy companies have been presented with new opportunities to connect with and service customers, with British Gas' 'Hive' product and npower's tie-up with Google-owned Nest among the examples of connected home technologies in use in the energy market.

There are opportunities too for smaller energy providers and new entrants to the market, with technology companies and third party intermediaries, such as aggregators like Kiwi Power, likely to play a growing role in the industry. Local authorities are also increasingly involved in supplying and generating heat and power for local residents in new municipal energy schemes.

Ofgem faces a challenge in regulating such a fast-moving market, particularly where it has to balance support for innovation with other, sometimes competing, demands, from ensuring adequate protection for consumers to managing the so-called ‘energy trilemma’ – the need to ensure there is security of supply, and that that supply is both affordable and sustainable.

Ofgem has tried to be positive in embracing innovation. It has developed a 'Licence Lite' regime to encourage new entrants to the market and, with a consultation earlier this year, recognised the growth of "non-traditional business models" (34-page / 567KB PDF) and its intention to support "transformative change" in the energy sector.

The regulator has already issued a large number of 'derogation' decisions granting new suppliers offering new products and services the right to temporarily go about their business even if those innovations do not fall squarely within the regulatory regime.

It has also launched a number of regulatory initiatives to react to market changes. Its Retail Market Review prompted reforms aimed at making "the retail energy market simpler, clearer and fairer for consumers". Some of the reforms delivered so far include the simplification of tariffs and greater transparency in consumer communications.

Its Smarter Markets Programme (SMP), aimed at making the energy market more efficient, dynamic and competitive to increase customer engagement, included measures to improve switching between suppliers, as well as new incentives for suppliers to buy energy based on half-hourly demand to encourage consumers to reduce their energy consumption more flexibly.

However, both the incumbents and disruptors in the market have complained about the regulatory regime. An example of regulation that has prompted criticism is the way in which the Energy Companies Obligation (ECO) is implemented. ECO requires the largest suppliers in the market to contribute to overall energy efficiency targets set by the government by introducing energy efficiency measures into homes in the UK.

The particular ECO requirements imposed on suppliers are determined by their relative share of the domestic gas and electricity market.

However, only energy companies with more than 250,000 domestic customers and which provide more than 400 gigawatt hours (GW/h) of electricity or more than 2,000GW/h of gas are subject to the ECO rules.

Some of the big providers have argued recently that ECO rules are unfair, because they create a two-tiered system of regulation. They argue that their funding and administration of energy efficiency schemes under the ECO regime presents them with a burden which smaller providers in the market do not face, and makes it easier for the smaller companies to undercut them on price.

From the alternative perspective, it might be argued that having thresholds set the way they are currently, actually serves as a disincentive to the growth of smaller suppliers that would face additional compliance challenges if they were subject to the ECO regime.

In a recent open letter (2-page / 51KB PDF) to the Competition and Markets Authority (CMA), Ovo Energy chief executive and founder Stephen Fitzpatrick said regulation of the energy market should be "based on clear principles, with the priority being to avoid customer harm".

Alongside the letter, Ovo published separate recommendations for energy market reform (23-page / 1.40MB PDF) which criticised "quantity and complexity of regulation" in the industry. It said that "much of the existing regulation is overly complex, nonsensical and burdensome to the point of inhibiting entry and expansion" and that "ever-more detailed and prescriptive" rules had "stifled innovation".

Ovo's comments echo similar calls made by trade association Energy UK in May.

Ofgem has already introduced overarching Standards of Conduct in the energy market, and in doing so showed an appetite for principles-led regulation. Expanding on this approach further to simplify the regulatory regime could help businesses develop new corporate structures, collaborations and business models, adopt new technologies and develop new sources of income, whilst delivering good outcomes for consumers and safeguarding the future of the UK's energy supply.

Peter Feehan and Lindsay Edwards are experts in energy industry commercial contracts at Pinsent Masons, the law firm behind Out-Law.com