Consultation on commercial framework for Early Competition launched

On 21 October 2024 Ofgem published a consultation (the Consultation) setting out its latest position on NESO’s proposals on elements of the commercial framework for the Early Competition regime: the “Consultation on the onshore electricity transmission Early Competition commercial framework”.

The Early Competition commercial framework, developed by NESO sets out the commercial arrangements applicable to Competitively Appointed Transmission Owners (CATOs) to finance, build, operate and maintain assets on the electricity transmission network. Early Competition is intended to drive innovative solutions, cost efficiencies and new investments into onshore electricity networks.

The proposed framework attempts to balance protection of consumer interests and attracting potential bidders while maintaining competitive pressure post tender award. The framework includes details of various incentives, a re-pricing model, payment mechanism and post award obligations on CATOs.

The Consultation aims to gather views on:

• post-award security obligation on a CATO during the preliminary works and construction stages;
• payments to a CATO during the preliminary works stage;
• post preliminary works cost assessment;
• payment to a CATO and performance incentives during the operational stage;
• additional works obligations on CATOs beyond the scope of work originally tendered; and
• revenue period and the next steps following the end of the revenue period.

Post-award security obligation

NESO proposes that a CATO posts a security equivalent to 10% of the forecast construction costs of the relevant project.

In setting the security requirement at 10%, NESO has noted that the cost of providing the security is likely to be included within bidders’ submissions and setting the cost any higher would not be in the interest of consumers. Ofgem’s view is that setting security at 10% strikes the balance between driving consumer benefits and ensuring the regime appeals to the wider market.

Security is intended to protect consumers by disincentivising the CATO from abandoning the project after the preliminary works period. Similar to the regime for existing grid connections, the security can be in the form of a letter of credit, performance bond, or cash in escrow, and must be posted until Financial Close. The security requirement will taper down to 0% once the CATO has invested a specified amount in the project, equivalent to the initial security level. NESO aims to balance the attractiveness of the commercial framework to bidders while protecting consumer interests with the tapering mechanism. The security posting will also protect consumers interests by disincentivising CATOs from walking away from projects following preliminary works, with the cost of non-delivery not being borne too heavily by consumers.

Preliminary works payments

NESO proposes payments are made to a CATO during the preliminary works phase ahead of commencement of the Tender Revenue Stream (TRS). Said preliminary works refer to the activities carried out ahead of construction.

NESO proposes that preliminary works payments should be available to CATOs during the preliminary works phase to remove barriers to entry and share risks between the CATO and consumers.  These payments are not mandatory but will be capped at a maximum amount determined ahead of each tender. It is proposed that the cap would be based on the indicative cost of the solution in the Centralised Strategic Network Plan and would allow the CATO to assess the financing requirement during the preliminary works stage and plan accordingly. Ofgem’s view is that preliminary payments will play an important part in ensuring incumbent TOs will not have an unfair advantage over other bidders due to their experience and financing capabilities. 

NESO proposes that payments for achieving specific milestones (to be refined and agreed during the tender process and agreed prior to the licence award) form part of a CATO’s preliminary works revenue. Payments are to be made based on achieving specific milestones and will be deducted from the TRS during the recalculation following Financial Close.

Post Preliminary Works Cost Assessment (PPWCA)

NESO’s PPWCA framework allows for cost adjustments between bid submission and the completion of preliminary works, addressing any cost changes due to design modifications or inflation. NESO proposes separating inflation adjustments from other cost changes and applying indexation based on pre-agreed indices. Cost increases will be assessed based on whether they were "reasonably foreseeable" at the time of bid submission.

NESO proposes aligning this test with the technical evaluation of deliverability at the ITT stage. Costs deemed "reasonably unforeseeable" will be subject to an upward adjustment cap of 40% of the forecast construction costs. It is Ofgem’s view that without suitably attractive regulatory arrangements there may be a lack of interested bidders. Therefore it is important that an appropriate allocation of risks is developed to attract new market entrants while driving down costs.

Ofgem notes that the solution to the technical and strategic questions surrounding treatment of cost uncertainty in the preliminary works phase will be a key element in attracting new market entrants while driving down costs. Noting in particular the risk that, without a suitable attractive regulatory and commercial arrangement, the tender process will not generate interest.

The proposed use of the TRS model has similarities to the OFTO model and, in particular, the use of pre-defined indices in regard to the underlying bid costs is expected to drive market interest. In regard to the foreseeability test Ofgem’s view is that this test could become subjective and clear definitions are required. 

Payment mechanism and performance incentives

As noted, NESO has proposed a TRS model similar to the OFTO model. The TRS will be indexed to the Consumer Price Index including housing (CPIH) to ensure matching revenues for project costs.

Also similar to the OFTO regime, NESO proposes to introduce an availability incentive mechanism in an effort to attract bidders. A 98% availability target is proposed with a 2.5% TRS adjustment for each 1% deviation from the target. Further incentives for stakeholder engagement, environmental considerations and timely new connections based on the RIIO-ET2 framework are also proposed. Ofgem notes its view that incentives should be suitably comparable with those introduced in RIIO-ET3.

NESO has set limits on the availability mechanism so that in each year revenue cannot be adjusted down by more than 10% and, if underperformance exceeds this, penalties are deferred and carried into future operating years. Penalties are capped where availability falls by more than 20% at which point no further financial deductions are imposed even if carried forward. This model is similar to the availability mechanism developed for OFTOs.

Additional works obligations

It is noted that as the electricity transmission network expands it is likely that a CATO will need to undertake additional works on its assets over time, either to increase network capacity or to facilitate new network connections. As the scale of these works will not be known to bidders at bid submission, the cost cannot be included in the TRS. NESO proposes a series of thresholds for the cumulative level of investment required for additional works. For works up to 20% of the original capital cost, the CATO must finance the works.  For works exceeding 20%, the CATO can choose to self-finance or receive a pass-through payment.  For works greater than 50%, a bespoke funding arrangement may be negotiated with Ofgem.

Ofgem notes concerns around CATOs self-financing 20% and optionally 50% of the original project costs and notes that the level of financing risk taken by CATOs needs to be acknowledged and mitigated. Ofgem also has concerns about current consumers paying for projects which bring a future benefit and invites further feedback on this point. This issue is not exclusive to CATOs and is an issue which applies to upgrading all transmission network assets such as OFTOs, interconnectors and existing TOs’ assets.

Revenue period         

A standard revenue period of 35 years is proposed by NESO with the asset amortised over 40 years. This is longer than the revenue period adopted by OFTOs which generally adopt a revenue period of 20 to 25 years. However it is predicted that onshore assets may require less maintenance with, for example, an overhead line not requiring major maintenance for 40 years. NESO’s view is that amortising the asset over 40 years will allow for a residual value payment to be made at the end of the period. NESO notes that the 35 year revenue period will raise challenges in raising finance with many banks preferring a 20 year revenue period, however it is hoped by setting the residual value up front that this will ease concerns and assist bidders in raising debt against the assets.

NESO proposes different approaches depending on the length of the enduring network need: If the need ends at or around year 35, the assets will be decommissioned, and the CATO paid the residual value; and if the need extends beyond year 40, the revenue period may be extended, with payment for operation and maintenance plus a margin.

Next steps

The consultation seeks feedback from stakeholders such as potential bidders, TOs and the wider public. It is open for responses until 2 December 2024 and following review of the responses to the consultation Ofgem plans to publish a Decision on the Early Competition commercial framework. No indication has been given on the timescale for Ofgem publishing the decision but it is stated that Ofgem plans to reflect the commercial arrangements in the CATO licence which it intends to consult on in early 2025.