Reforming distribution networks: the DNO to FSO Transition?

Demand and supply side complexity is increasing, as we outlined in our first blog of this series.
Here are the facts:

• Greater renewable penetration is leading to a more decentralised and more distributed supply.
• More electrification and greater levels of engagement from the public in their energy consumption and in owning energy assets themselves is leading to less predictable demand.
• If we are to meet our net-zero ambitions in the UK, this trend needs to accelerate.

In the face of these drivers, centrally managed balancing of electricity supply and demand cannot meet our needs much longer. System balancing at local scale is needed, to be performed by Distribution System Operators (DSOs).

The critical question is: who is best placed to perform this role and how they will be set up?

What options are being considered for establishing DSOs?

Ofgem is considering four frameworks:

1. Internal separation of DSO roles within existing Distribution Network Operators (DNOs)
2. Independent distribution system operators (IDSO), separate from existing DNOs
3. Regional system planner & operator, separate from the DNO, that covers electricity and gas system operation and planning remits
4. Interacting organisations (combinations of other models, e.g., a regional system planner covering gas and electricity planning and an IDSO covering electricity system operation)

In March, Ofgem proposed that Framework 4 is the most suitable option for future arrangements, segmenting three core functions as follows:

• Energy system planning: introducing new Regional System Planners (RSP(s)) with accountability for regional energy system planning
• Market facilitation: assigning a singular market facilitator role to deliver more accessible, transparent, and coordinated flexibility markets for the distribution network
• Real time operations: keeping real time operations with DNOs, ensuring clear accountability for network reliability and safety.

Ofgem went further. They proposed that Regional System Planner and market facilitator roles should be taken on by the Future System Operator (once established from the nationalisation of National Grid Electricity System Operator (ESO)) as they have strong synergies to the FSO’s national functions and would support greater local and national consistency and coordination.

So, what is our view? In short, we believe the reforms could deliver the key outcomes needed but the devil will be in the detail whether those outcomes are enabled or eroded by the complexity of the framework. Before unpacking why we feel this way, we should first outline what we think matters most with the reforms and how we assessed them against a set of key criteria.

How did we critique the frameworks?

We wanted to provide a broad, holistic assessment on the efficacy, benefit, and feasibility of the proposed reforms. To this effect we reframed some of the governance criteria used by Ofgem but also considered the impact of the reforms on the outcomes needed to enable the energy transition and deliver a sustainable and affordable power system. We then also looked at the risks and costs associated with these outcomes.

Our 9 criteria were as follows:

Outcomes:

1. Operability – Will the reforms protect or risk operability of the GB energy system? How quickly can they be implemented? Once established, will operations and security be maintained to the same level as today?

2. Regional investment – Driving investment into technology, infrastructure and capabilities will be essential to building a smart, sustainable grid to enable the energy transition.

3. Whole system coordination – Our future energy system must optimise interactions between energy vectors (electricity, gas, hydrogen, etc.) and energy actors. Will the reforms ensure interoperability at a large scale (e.g., of data, technology, and stakeholders)?

4. Flexibility – Will the reforms allow the market to adapt to changes to market conditions, consumer behaviour and policy shifts?

Risks & Costs:

5. Cost of delivery – How much will implementation and ongoing operations cost?

6. Acceptability – Is the future model acceptable to actors? Will they support or resist the transition?

Governance:

7. Regulation – The next regulatory framework must allow increased agility, drive competition, and incentivise modernisation. Will regulators be able to achieve these aims via these reforms?

8. Independence – Will the reforms balance independence to allow for effective operation while mitigating potential conflicts of interest?

9. Clarity of accountability – Will the reforms provide clear accountability for actors? This sits at the heart of our list as it underpins the success of reforms overall.

How did we assess Framework 4 – Interacting Organisations against our 9 Criteria?

On paper, Framework 4 gives you positive attributes from other frameworks (see our assessment below), so we understand why Ofgem would want to use it as a foundation for further development, however concerns in flexibility and clarity of accountability persist.

Looking firstly at energy system outcomes:

• Keeping real-time operations with the DNOs (as in Framework 1) secures a high level of operational feasibility. There should be low risk to keeping the lights on in our local communities if organisations can interact as planned.
• Implementation of the Regional System Planner role (as laid out in Framework 3) will be highly beneficial for increasing regional investment, with greater levels of independence at the local level and greater ability to plan for the needs of the local community.
• The RSP will also drive whole system coordination/planning, working closely with local government, DNOs and Gas Distribution Networks (GDNs) to promote cross-vector energy plans.
• We were hopeful that centralising the regional system planner and the market facilitation elements could unlock large volumes of small-scale flexibility through providing clear market signals and removing barriers to entry, as Ofgem intend.
• However, in terms of flexibility, delivering market changes in individual segments should be relatively easy, but wholesale changes could be impeded by the need for consensus between the RSP, Market Facilitator, Local Government, GDNs and DNOs.

These concerns on the practical complexity of the reforms continued for the criteria related to governance:

• While the increased segmentation of roles is a positive for independence, will organisations be empowered to deliver their roles, or will all progress rely on sector-wide collaboration, and will that be effective? There is a balance to be struck between segmentation and dilution of accountability. The ability to incentivise behaviours that benefit consumers (e.g., through license obligations) amidst competing needs and priorities will be critical.
• The potential for inefficiencies also raised concerns on regulation. Given the proliferation of regulated actors – RSP, Market Facilitator, DNO – and unregulated actors – market enabling infrastructure, providers – if poor performance occurs, how will Ofgem address it? Will the system’s complexity inhibit them? Could these faults impact DNOs’ ability to operate the system safely, if organisations can’t interact as planned? With many handoffs needed to decide what to dispatch to manage an inaccurately forecasted darkness peak on a cold day – happening up and down the country at the same time – could the level of segmentation actually risk operational feasibility?

We had similar questions related to the risks and costs criteria:

• Long-term, costs should be lower. If the FSO adopts the new RSP and Market Facilitation roles, this would centralise skills with significant synergies to their transmission network roles. But this will take time with the FSO needing to build capabilities from scratch, requiring investment. This will lead to significant disruption to the FSO, with staff moving, operating models changing, processes adapting to incorporate new roles. DNOs will be significantly disrupted as well, as they also adapt processes and operating models and most likely lose staff to take on these new roles at the FSO, making the reforms less appealing for DNOs to accept.
• The threat of over-complexity, disruption and the long implementation time pose severe risks. But if handled well, these reforms could unlock significant benefit for our energy transition and decarbonisation of the economy, so they could be risks worth taking – but the devil will be in the detail.

What could these proposed reforms mean for the wider energy sector, the energy transition, and our pursuit of a net zero economy?

This is a fundamental shift in the structure of the energy system – in an industry that has been historically slow to change. There are still many uncertainties, which require all actors to become more nimble, and adaptive to emerging industry needs.

The building blocks for industry change remain relevant:

• With the establishment of new entities, having an intentional design for the industry structure and operating model will be key, combined with appropriate capabilities at the individual level – how the industry attracts and develops talent, how entities increasingly become ‘learning organisations’ and build their change management muscle will remain critical success factors
• Pace of digitalisation will need to accelerate to enable the collaborations needed for this framework. This will only be possible with clear industry standards, prioritisation and maturing of digital delivery capabilities to benefit from new technologies and innovations
• This new structure will evolve over time requiring iterative delivery. This will require a significant change not only in people’s mindset but also in the regulatory framework, as long-term detailed plans are no longer fit for purpose.

We will explore these topics further through subsequent blogs and Utilities Horizons debates in this series.