Clarity on the scope for Ofgem to provide for self-modification of electricity and gas licences

United Kingdom

The Competition and Markets Authority (the CMA) published the non-sensitive version of its final determination on the Energy Licence Modifications Appeals on 1 November 2021.  Although it is easy to be distracted by the headline-grabbing outcomes of the CMA’s decision on the reduction to the Cost of Equity and the reduction in the allowed return on equity on account for anticipated outperformance by licensees with respect to regulatory targets (the outperformance wedge), an important outcome was achieved on the licence modifications appeal ground.  The CMA’s decision, being largely in favour of many aspects of this appeal ground, is of key importance in the context of the electricity and gas licensing regime.

Background

Following Ofgem’s final determinations on RIIO-T2 and RIIO-GD2 price controls and the associated statutory consultation on the licences, appeals were referred in March 2021 by all electricity transmission licensees (other than the Electricity System Operator) and gas distribution licensees to the CMA.  All licensees appealed Ofgem’s decision in so far as it related to the Cost of Equity and the outperformance wedge, but thereafter the 9 appellants’ approaches differed in respect of bases and number of grounds of appeal pursued.   

After a 7-month period of submissions, responses and hearings, the CMA issued its final determination to the parties and interveners on 28 October 2021, with the non-sensitive version being published in 4 volumes on the CMA’s website on 1 November 2021[1].  Volume 2B[2] includes the CMA’s final determination on the licence modifications appeal ground.

The RIIO-2 Licences for T2 and GD2

As part of the RIIO-2 price control, Ofgem developed Licence Drafting Principles[3].  The Licence Drafting Principles were developed by Ofgem to “ensure a consistent approach to all the licence conditions in RIIO-2[4].  These principles included detail as to the intended structure of conditions, how obligations should be set out and how changes to the licence conditions, obligations and associated documents should be made during the price control period. 

In respect of changes to the licence conditions, obligations and associated documents, Ofgem noted that in addition to the “full licence modifications using the statutory process” (being the process set out in Sections 11A – H of the Electricity Act 1989 (EA89) and Section 23 of the Gas Act 1986 (GA86)) it would also make changes by “self-modification” and direction.  In respect of self-modification Ofgem noted this would “not include the option for licensees to require the Authority to use the statutory process. However, we will make sure self-modification procedures have a remit appropriate for challenge by way of judicial review rather than an appeal to the CMA and where potentially the self-modification procedure has a very wide remit include some curtailment such as the "significant" test in the PCFI condition.[5]

The rationale for the self-modification procedure being introduced to the RIIO-2 price control was claimed by Ofgem to cater for the “known unknowns” of Net Zero and to introduce flexibility and responsiveness to the price control, mid-price control period, whilst also reducing resource burden of additional administration and compliance. 

The Licence Drafting Principles were implemented in the RIIO-2 statutory licence consultation for RIIO-T2 and RIIO-GD2, published on 17 December 2020[6].  Following the consultation closing, Ofgem issued its decision on 3 February 2021[7].  Within the RIIO-T2 and RIIO-GD2 licences, extensive provision was made for self-modification through certain key licence conditions comprising price control reopeners, evaluative price control deliverables, the network asset risk metric and the price control financial instruments.  There was also provision made for modification by direction of a significant number of associated documents (documents intended to supplement licence conditions, be subordinate to them, providing information, requirements and guidance). 

The licence modifications appeal ground

Appeals were raised against a number of Ofgem’s special licence conditions which reserved powers of self-modification.  This was on the basis that Ofgem had erred in law and had acted ultra vires Section 7(5) of the EA89.  Section 7(5) of the EA89 provides that:

Conditions included in a licence may contain provision for the conditions–

(a) to have effect or cease to have effect at such times and in such circumstances as may be determined by or under the conditions; or

(b) to be modified in such manner as may be specified in the conditions at such times and in such circumstances as may be so determined.[8]

In particular, it was argued that in respect of specific licence conditions, Ofgem had not complied with the requirements in Section 7(5) of the EA89 by having failed to set out detail of the manner, the times and the circumstances in which such conditions might be modified during the price control.

There was also a separate argument that Ofgem’s decision to include licence conditions in subsidiary documents which could be changed by issuing directions was wrong because Ofgem had failed to have regard to its statutory duties under Sections 4AA(2)(b) and 4AA(5A) of the GA86[9].  Section 4AA(2)(b) of the GA86 is Ofgem’s duty to have regard to the need to secure that licence holders are able to finance the obligations imposed on them by statute.  Section 4AA(5A) of the GA86 is the duty of Ofgem, when carrying out its statutory functions, to have regard to:

“(a) the principles under which regulatory activities should be transparent, accountable, proportionate, consistent and targeted only at cases in which action is needed; and

(b) any other principles appearing to him or, as the case may be, it to represent the best regulatory practice”.

It was argued that because Ofgem had failed to have regard to its statutory duties, it had created regulatory uncertainty, regulatory risk and revenue uncertainty.

Given the difference in arguments being run, the CMA considered the appeal grounds separately.

The CMA’s findings

Ultra vires Section 7(5) of the EA89

The CMA determined that Ofgem was wrong in law and had acted ultra vires Section 7(5) of the EA89 in respect of the majority of the licence conditions appealed to it.

In assessing Section 7(5) of the EA89, the CMA concluded the following:

The purpose of section 7(5)(b) is to ensure that licence conditions can be suitably modified to adapt to changes of circumstance which may or may not be predictable at the outset of a price control of potentially long duration.[10]

 

Section 7(5)(b) does not require Ofgem to specify the full detail of the changes that may be made. However equally Section 7(5) cannot be construed as merely requiring Ofgem to set out the instrument or process by which the licence may be modified, and otherwise allowing Ofgem to make at some future time any substantive change it wishes to direct.

 

A licence condition will properly specify the manner of its possible future modification where Ofgem clearly sets out the nature and parameters of such modification in the condition itself with sufficient specificity to enable the licensee(s) to understand its potential scope. The condition must accordingly contain two types of criteria:
  1. criteria defining the scope of the potential modification and Ofgem’s approach to the making of the modification (“manner”); and
  2. criteria defining the time and circumstances in which the modification may be made, i.e. the ‘trigger’ for the modification (“circumstances”).

If such criteria are properly set out in the condition, the licensee in question should be able to understand the potential impact on it of a future modification and be in a position meaningfully to appeal the condition to the CMA at the outset of the price control, rather than be limited to a challenge based on an alleged breach of Ofgem’s statutory duties.[11]

 

The condition must set out the criteria by which Ofgem will assess any future modification with sufficient specificity that a licensee is able to understand the framework within which Ofgem will operate and can mount an effective challenge to the condition if it considers that the criteria to be deployed by Ofgem vitiate Ofgem’s decision in respect of the condition itself.[12]

 

In order for the criteria to be sufficient to meet the requirements of Section 7(5)(b), they must be contained in the licence condition itself, or in a document which has the status of a licence condition. It is insufficient for the criteria to be contained in a subsidiary document, which (i) may or may not be published at the time of the adoption of the licence conditions themselves, and (ii) is subject to change by direction at any point during the price control period. In that case, licensees may have no effective ability to challenge the criteria in an appeal under Section 11C of EA89.[13]

 

Then, using this framework for what a “self-modification” licence condition must comprise in order to meet the requirements of Section 7(5) of the EA89, the CMA considered each of the conditions appealed to it.  The CMA determined that of the conditions appealed, 14 were ultra vires and 2 were intra vires. 

Failure to have regard to its statutory duties.

This licence modification appeal ground was dismissed by the CMA. The CMA’s assessment was largely focused on wording in Sections 4AA(2)(b) and 4AA(5A) of the GA86 that these were duties that Ofgem were to “have regard to”.

In respect of the requirement to “have regard to” a duty, the CMA referred to the case of R (Pharmaceutical Services Negotiating Committee) v Secretary of State for Health [2018] EWCA Civ 1925 which the CMA considered to be “squarely on point” in providing a clear exposition of the nature of a “have regard to” duty.  The CMA stated that, based on case law, provided there is evidence that the decision-maker did not wholly disregard its “have regard to” duties, a public law challenge based on an alleged failure to have regard will only succeed if it can be shown that the decision was irrational[14].  The CMA concluded that the appellant had failed to demonstrate that Ofgem had failed to properly have regard to the statutory duties referred to. 

Next Steps

In respect of the licence conditions that have been successfully appealed, the CMA has quashed Ofgem’s decision to the extent they provide for self-modification, and for amendment of Associated Documents by direction, and remitted them to Ofgem for reconsideration and determination. 

The CMA has directed Ofgem to reconsider and redraft the affected licence conditions so that:

  1. they are capable of being brought within the powers conferred by Section 7(5)(b) of the EA89; and
  2. any self-modification provisions that are not capable of being brought within the powers conferred by Section 7(5)(b) of the EA89 are replaced with the statutory licence modification procedure. 

Ofgem must complete this task within 9 months of the CMA’s order (i.e. 28 July 2022).  Until these licence conditions are amended, any modifications made by Ofgem to the affected licence conditions must be done using the statutory licence modification procedure.

Comment

The CMA’s analysis of Section 7(5) of the EA89 is the first of its kind.  The CMA’s detailed assessment and conclusions provide a useful insight into how Ofgem should approach licence modifications, and the new powers of self-modification in a licence, going forward.  The analysis of the “have regard to” duties, considered in light of the GA86, is also helpful context.  Further, whilst the respective parts of the appeal focused on the EA89 and the GA86 separately, the common language used across both statutes means the CMA’s decision is relevant (although not binding on any future CMA appellate body) to both electricity licensees (including those not subject to price control arrangements) and gas licensees.



[12] Volume 2B (publishing.service.gov.uk), para 8.125, pp. 315 and 316

[14] Volume 2B (publishing.service.gov.uk), para 8.277, pp 359 and 360.