Innovation incentive under regulation – The case of the electricity networks
Electricity networks exhibit natural monopoly characteristics and are thus subject to economic regulation. In the absence of competition there is little incentive for innovation especially if the regulatory model is not innovation friendly. At the same time, electricity networks play a pivotal role in realising the objective of low carbon economy. In fact, integrating distributed energy resources, electric vehicles and implementing smart grid solutions requires ample amounts of investment and innovation by grid companies. Thus the question is how to incentivise innovation in regulated infrastructures. In recent years, electricity sector regulators have recognised this need and incorporated specific innovation stimulus in their regulatory framework of network companies. The UK electricity market regulator Ofgem, for example, initiated Innovation Funding Incentive in 2004 where the distribution network companies were allowed to spend half a percent of their revenue on innovation projects. In 2010 price control review, this was replaced by Low Carbon Network Fund (LCNF) under which distribution companies were competing for innovation projects. In the most recent regulatory framework (RIIO) Ofgem has allocated three specific funds for innovation. These all highlight the importance of innovation on the agenda of electricity sector regulators. This paper analyses the problem of incentivizing innovation under regulation with a specific reference to the case of electricity network and the RIIO regulatory model in the UK. The result of this paper provides some insights for the possible approaches that the innovation incentives can be designed and implemented under regulation.