Regulatory Alignment To Eliminate Perverse Incentives

1. Concept and Importance

Regulatory alignment means designing electricity laws, licences, price controls, market rules and institutional duties so that regulated entities receive incentives consistent with wider objectives such as reliability, affordability, competition, decarbonisation and efficient investment. A perverse incentive arises where a rule technically encourages compliance but economically rewards undesirable behaviour—for example, unnecessary capital expenditure, delaying flexible connections, favouring network reinforcement over demand response, or protecting incumbent technologies from competition.

In Great Britain, this issue is particularly important because electricity governance is divided among Ofgem/GEMA, NESO, network companies, suppliers and industry-code bodies. The Electricity Act 1989 provides the core statutory framework, while the Energy Act 2023 strengthened the legal emphasis on achieving net zero within energy regulation.

2. Sources of Perverse Incentives

Traditional utility regulation can produce a capital-expenditure bias. If network companies obtain more predictable returns from building physical infrastructure than from procuring flexibility, efficiency or demand-side solutions, they may rationally prefer network expansion even where a cheaper whole-system alternative exists.

Misalignment can also occur between connection rules and decarbonisation. A DNO may face incentives to manage its own costs and risks conservatively, while society benefits from rapid connection of renewable generation, storage and electrified demand.

Similarly, poorly designed wholesale or capacity mechanisms may favour conventional generation over demand-side response, storage or aggregation, even where those resources provide comparable system services.

3. RIIO and Outcome-Based Regulation

Ofgem's RIIO framework attempts to reduce these distortions. Under RIIO-ED2 (2023–2028), DNO revenues are linked to incentives, innovation and specified outputs rather than simply allowing unrestricted recovery of expenditure. The framework seeks to encourage efficient investment while supporting the transition to net zero.

Regulatory alignment therefore requires remuneration to depend increasingly upon system outcomes rather than the volume of infrastructure constructed.

Totex regulation is important here because combining capital and operating expenditure within a broader expenditure framework can reduce incentives to choose capital-intensive solutions merely because they receive more favourable regulatory treatment.

4. Flexibility and Whole-System Incentives

Modern alignment should make network reinforcement, storage, demand response and flexibility procurement economically comparable regulatory options.

Ofgem's flexibility-market reforms are relevant because the Market Facilitator is intended to increase standardisation and coordination between local and national flexibility arrangements. Elexon has been selected as the delivery body.

A well-aligned framework should reward DNOs for resolving congestion efficiently rather than automatically expanding networks. It should also prevent operators from favouring affiliated technologies or imposing unnecessary participation barriers on independent flexibility providers.

5. Consumer and Environmental Alignment

Perverse incentives may also shift excessive costs or risks onto consumers. Regulators must therefore align corporate incentives with consumer interests through performance targets, reliability standards, price controls and penalties.

Environmental alignment is equally important. The Energy Act 2023 introduced a statutory net-zero-related objective into the regulatory framework, strengthening the connection between economic regulation and the UK's climate obligations.

Thus, short-term cost minimisation should not automatically dominate investment necessary for efficient long-term decarbonisation.

6. Case Law

Case Name/Citation

R (SSE Generation Ltd) v Competition and Markets Authority [2022] EWCA Civ 1472

Facts: The dispute concerned GEMA's approach to electricity transmission charging and the interpretation of EU-derived rules limiting certain transmission charges associated with congestion management.

Legal Issue: Whether GEMA's regulatory approach and interpretation of the relevant charging requirements were lawful.

Judgment: The Court of Appeal examined both the meaning of congestion management and the legality of the interim regulatory arrangements adopted by GEMA.

Legal Principle/Ratio: Regulatory discretion in technically complex electricity markets remains constrained by the governing statutory and regulatory rules. A desirable regulatory outcome cannot override legal requirements.

Significance: The decision demonstrates why incentive alignment must be achieved through lawfully structured charging methodologies, rather than administrative convenience alone.

Case Name/Citation

Commission v Tempus Energy Ltd, Case C-57/19 P

Facts: Tempus Energy challenged approval of the UK Capacity Market, raising concerns about the treatment of demand-side response compared with conventional generation.

Legal Issue: Whether serious difficulties concerning the compatibility of the capacity mechanism required the European Commission to commence a formal State-aid investigation.

Judgment: The Court of Justice overturned the General Court's judgment and upheld the Commission's initial approval procedure. Nevertheless, the litigation extensively exposed questions concerning differential treatment of demand-side resources within capacity-market design.

Legal Principle/Ratio: Complex energy-support mechanisms must be assessed under the applicable competition and State-aid framework, including the evidence available when regulatory approval is granted.

Significance: The litigation illustrates how market rules can create potentially different incentives for generation and demand-side flexibility, making technology-neutral design an important regulatory objective.

7. Future Regulatory Alignment

Future electricity regulation should integrate price controls, network charging, connection incentives, flexibility procurement, reliability standards, carbon objectives and consumer protection rather than regulating each independently.

Regulators should test whether companies can increase regulated returns by producing outcomes contrary to system objectives. Performance-based remuneration, transparent benchmarks, competitive flexibility procurement, independent monitoring and periodic incentive reviews can reduce such distortions.

8. Conclusion

Regulatory alignment is ultimately the principle that commercially rational behaviour by regulated firms should also produce socially desirable electricity-system outcomes. Eliminating perverse incentives therefore requires more than individual prohibitions. It requires coordinated market design in which profitability, reliability, flexibility, consumer welfare and decarbonisation increasingly point in the same direction.