Ofgem updates supply licences to strengthen resilience and protect consumers

United Kingdom

Summary

In recent years, the number of energy supplier failures have increased dramatically. For both consumers and the wider energy supply chain, such failures can be highly disruptive and costly.

Ofgem has therefore been reviewing its approach to supplier licensing, with the aim of improving suppliers’ financial resilience and enhancing consumer protections. Having consulted on the proposed changes earlier this year, Ofgem confirmed on 26 November that it would introduce a package of reforms relating to energy suppliers’ ongoing regulatory requirements and the arrangements for their exit from the supply market. These reforms will take effect through changes to electricity and gas supply licence conditions.

The changes are intended to promote more responsible risk management, improve governance and accountability, increase Ofgem’s ability to oversee energy supply markets effectively and reduce the cost burden and disruption caused when suppliers exit the market.

Notably, Ofgem will introduce a ‘Financial Responsibility Principle’ into supply licences. This demonstrates a non-prescriptive approach to regulation and will be accompanied by guidance, with the objective of minimising the need to mutualise costs if suppliers exit the market. In addition, Ofgem will put in place a new ongoing obligation for suppliers to ensure that senior managers are fit and proper for their role. Suppliers will also be required to prepare Customer Supply Continuity Plans to minimise disruption for customers if they exit the market – in effect, this means suppliers must plan for their own failure. Further changes are introduced to increase Ofgem’s level of oversight over market exits, and to ensure that such exits are orderly.

Context

The energy supply market has become increasingly challenging over recent years. More energy suppliers collapsed in 2019 than in any year on record – a total of 24 businesses, representing a 41% rise from 2018.[1] The coronavirus pandemic is only expected to enhance this trend: in September Effortless Energy became the first small supplier to enter insolvency since the onset of the pandemic;[2] and in October Tonik Energy also collapsed, leaving its 130,000 customers subject to the Supplier of Last Resort (SoLR) process.[3]

There are several reasons behind this trend, including a squeeze on profit margins caused by volatile wholesale energy costs and a lack of hedging, the introduction of an energy price cap and new entrants into the sector resulting in greater competition.[4]

In view of the disruption caused by the failure of energy suppliers, Ofgem has engaged with stakeholders on this topic over the past two years including through a statutory consultation launched in June 2020.[5] On 26 November, Ofgem confirmed its decision to introduce a package of measures to improve energy suppliers’ standards of financial resilience and customer service.[6]

Decision

Ofgem has decided to make a number of licence changes to the ongoing requirements and exit requirements for suppliers.[7]

These changes are intended to promote better risk management, improve governance and accountability and improve Ofgem’s oversight of the energy supply market. Ofgem expects that these changes will not place an undue burden on suppliers whose businesses already act in a responsible way. Combined with the reforms on the requirements for entry into the energy supply market, Ofgem expects that standards will be improved, while also enhancing its capacity to regulate the market effectively.

Firstly, Ofgem will introduce measures to promote more responsible risk management, which include:[8]

  • A new principles-based requirement for suppliers to minimise costs that could be mutualised in the future. This will ensure that suppliers manage their finances effectively and actively manage the risk of leaving costs (including in relation to the Renewables Obligation) to be mutualised in the event of their failure.

  • New checkpoints will be introduced for suppliers, taking into account customer numbers and financial and compliance indicators, so that Ofgem may scrutinise their ability to meet their regulatory obligations and support growth. As an example, Ofgem suggests that it could put in place restrictions for certain suppliers, preventing them from taking on new customers if Ofgem considers that they would not be capable of supporting that growth or complying with their regulatory requirements.

  • A new principles-based requirement will be introduced to ensure suppliers have sufficient operational capability and put in place appropriate risk management structures, an example being in relation to the quality of suppliers’ data management.

Secondly, changes have been made to improve governance and increase accountability, which include:[9]

  • The introduction of an ongoing requirement that senior leaders with significant influence in energy suppliers’ businesses are fit and proper for their role.

  • A new principles-based requirement for suppliers to be transparent and open with the regulator is being introduced.

Ofgem are also making changes to increase their market oversight, with the aim of ensuring that the regulator can identify potential risks to competition and to consumers and take action accordingly.[10]

  • Suppliers will be required to undertake an independent audit of their financial position or customer service systems and processes, if requested by Ofgem.

  • Suppliers will need to produce and maintain “Customer Supply Continuity Plans” so that, if their business fails and they exit the supply market, customers remain protected.

  • Suppliers will be required to promptly report changes in control of their business to Ofgem.

Ofgem has also made changes to arrangements for the exit of suppliers from the market if the business were to fail. The purpose of these is to ensure that consumers experience minimal disruption.[11]

  • New rules will set out that if administrators assume responsibility for the debts of a failed energy supply business, they will be held to the same standards as the supplier.

  • Suppliers will now be required to notify Ofgem if they are engaging in a sale of their customer base. The new rules will also improve Ofgem’s ability to scrutinise such transactions to ensure that they do not put consumers at a disadvantage.

The changes broadly reflect the proposals Ofgem consulted on earlier this year, with some minor changes to improve clarity. Ofgem noted that stakeholders were generally supportive of the proposals.

The new requirements will take effect on 22 January 2021, apart from the Customer Supply Continuity Plans which will take effect on 18 March.[12]They will take effect through modifications to the relevant supply licence conditions.[13]

Comment

The changes outlined by Ofgem are widely anticipated. It is also interesting to note that Ofgem is considering more prescriptive requirements around credit balances and environmental obligations – something that will be consulted on next year.

Cost Mutualisation - Cost mutualisation in the event of a supplier failure is a consistent theme throughout the decision. The ‘Financial Responsibility Principle’ in the licence is intentionally not prescriptive and will be accompanied by guidance that the licensee must have regard to. The incorporation of guidance through such a condition gives Ofgem flexibility to amend the guidance without licence modification in the future. The changes outlined will take effect through licence modification, and Ofgem has the power to make such amendments without legislative change. The further measures that are being considered will not be so simple to achieve, with legislative amendments required.

Ongoing fit and proper requirements – The inclusion of a new licence condition related to persons holding a position of Significant Managerial Responsibility or Influence (SMRI) is clearly aimed at improving governance and reducing the requirement for Ofgem to step in and take enforcement action. It is, in essence, Ofgem introducing rules around how and by whom a supplier should be run.

Customer Supply Continuity Plans (CSCPs) – The introduction of CSCPs should enable more orderly exits from the market for any failing or failed suppliers, allowing any incoming supplier to assume the role of supplier to the book of customers more easily. The level of detail expected and the uniformity of plans remains to be seen, and this will really be what determines the success of this condition. It is, however, an additional burden on suppliers – to plan for their own failure – and it remains to be seen how effective the plan will be if the supplier did not plan well enough to survive.

Exit arrangements – The licence changes will require amendments to suppliers’ terms & conditions related to debt arrangements. There is also a new requirement on suppliers (outgoing and incoming) to inform Ofgem where they are planning to undertake a book sale/purchase. The notification requirement will bite before entering into a binding agreement for a book sale/purchase and there are restrictions on the nature of the commercial terms that can be reached in such deals. In a SoLR process there will be new requirements to honour bids provided as part of the process and on honouring customer credit balances as part of the SoLR process where the incoming supplier committed to that arrangement. 

Next steps

The document released by Ofgem provided an update the regulator’s anticipated timings and process for its next phase of work, which will consider whether further protections are necessary to reduce the risk of cost mutualisation in the event of supplier failure.[14] This consultation will be launched in early 2021.

Ofgem is seeking views on the content for its guidance on the Financial Responsibility Principle. Responses should be provided by 22 January 2021.[15]

How can we help?

CMS has extensive experience advising energy suppliers on regulatory, transaction and contentious matters, including advising on supply licence conditions and matters involving the entrance and exist of supply businesses.

If you would like to discuss any of the issues in this article, please get in touch us.