Consultation launched on supplier payment default under the Renewables Obligation scheme

Introduction

On 10 August 2021, Ofgem and BEIS published a joint consultation (the “Consultation”) focusing on supplier payment default under the Renewables Obligation (“RO”) support scheme. The Consultation seeks to address a trend in recent years which has seen an increasing number of electricity suppliers defaulting on their obligations under the RO by failing to settle their obligation by the required 1st September or late payment period (31st October) deadline, and subsequently exiting the retail market.

Supplier payment default is of particular concern to both electricity suppliers and generators due to RO mutualisation. The mutualisation mechanism seeks to recover RO payment shortfalls left by suppliers unable to meet their obligation from other suppliers where these shortfalls meet certain thresholds. Mutualisation payments are then recycled back to suppliers who met their RO with RO Certificates (“ROCs”). Supplier payment defaults ultimately result in the remaining suppliers in the market having to meet the unpaid obligations of competitors. While the government has already legislated to increase the level of the mutualisation threshold in England and Wales to reduce the likelihood of mutualisation being triggered, this ultimately did not address the underlying causes of payment default.

The Consultation proposes several options to address supplier payment default under the RO, which may involve introducing new legislation or amending the supply licence. We consider these in further detail in this article.

Proposed measures to address supplier payment default under the RO:

Option 1: Introducing legislation requiring suppliers to settle their RO annual obligation more frequently

The Consultation proposes increasing the frequency of RO settlement via amendments to the Renewables Obligation Order 2015. Under the proposals, the current single annual settlement payment by suppliers would be replaced with four quarterly settlement payments. The level of the obligation would continue to be set on an annual basis and would still apply to electricity supplied to customers during each 12-month obligation period.

The rationale for this proposal is that more frequent settlement would lower the maximum sum that suppliers could default on, and this would also act as an early warning indicator, allowing Ofgem to take earlier regulatory intervention where suppliers are non-compliant with their obligations under the RO.

Three sub-options for legislative change are proposed in the Consultation as follows:

1. A new legislative requirement for quarterly RO settlement either with ROCs and/or buy-out payments;
2. As with option 1, legislating for quarterly RO settlement with ROCs or buy-out payments as well as compression of settlement timelines and the abolishment of the late payment period; or
3. Implementation of option 2 and RO settlement through letters of credit. Under this third sub-option, suppliers would be required to substitute any letters of credit presented in fulfilment of a quarterly obligation with ROCs and/or buy-out payments on or before the final settlement deadline.

Option 2: Introducing a new licence requirement to periodically protect sums at risk of mutualisation under the RO

Under this option, electricity suppliers would be subject to a new licence requirement to periodically protect sums at risk of mutualisation. This would allow Ofgem to claim against the protection put in place to settle a supplier’s obligation (or a portion of it) in the event the supplier was either unable to settle it when it was due or unable to meet new licence requirements. The rationale is that this reform would lower the potential quantum of default which in turn benefits suppliers and generators.

As part of this option, suppliers would choose which measures to implement to protect sums at risk of mutualisation under the RO. The protective measures would relate to the amount of obligation the supplier has accrued or likely to accrue within a “protection period”. If a supplier exits the market or fails to put additional protections in place when required to, any protection measures in place would contribute towards settling that supplier’s obligation.

The Consultation proposes that the requirement for suppliers to protect sums at risk of mutualisation under the RO could be either forward-looking or backward-looking as follows:

Forward-looking basis

Forward-looking requirements would mean suppliers put in place protections before their obligation had accrued. This would allow a supplier’s accrued obligation to be settled in full (or close to full) if it exits the market or fails to put protections in place at the start of the next protection period. Under a forward-looking approach, suppliers would need to estimate their electricity supply volume for the upcoming protection period, to protect their obligation before it accrues. This approach allows suppliers to forecast their likely RO liability and ensure an adequate level of protection is in place.

Backward-looking basis

Alternatively, on a backward-looking basis, suppliers would be required to put protections in place once their obligation has already been accrued. If a supplier exits the market or fails to put protections in place at the start of the next protection period, any existing protections put in place by that supplier would be used to settle its accrued obligation. Due to the retrospective nature of backward-looking protection, a certain amount of a supplier’s obligation would remain at risk of being unrecovered in the event of default. However, the extent of this risk would depend on the length of the protection period and level of protection required.

Protection measures

In addition, to further lower the potential level of payment default, the Consultation sets out various protection measures which suppliers could put in place, depending on the sums being protected and individual supplier circumstances as follows:

• Parent company guarantees: the Consultation notes that while cost effective, this option would only be available to a small subset (and typically the largest) of suppliers.
• Third party guarantees: it is recognised that this could result in high costs for suppliers in terms of obtaining guarantees, and costs will vary greatly across supplier size and business models.
• Funds in escrow: similarly, it is recognised that there are high administrative costs associated with escrow accounts and suppliers would likely have to raise alternative sources of working capital.
• Other measures: the Consultation also opens the door for suppliers to propose alternative means for protecting sums at risk. An example of an alternative protection mechanism could be allowing ROCs to be posted as collateral or allowing early settlement with ROCs or buy-out payments, to lower the amount that needs to be protected.

Option 3: Continue with existing policy

The Consultation sets out the merits of allowing recently introduced legislative and licence changes to take effect. Namely, these include legislative updates to mutualisation arrangements and licence changes to increase supplier standards of financial resilience (see our commentary here).

BEIS and Ofgem point out that the risks that some of the options presented pose to the ROC market means there remains a case for maintaining the status quo and continuing with existing policy.

Comment and next steps

Publication of the Consultation will be welcome news across the industry, as supplier payment default has long been a concern of RO scheme participants. As the Consultation recognises, while recent legislative measures have sought to manage the risk of mutualisation and reinforce financial resilience of suppliers via changes to the supply licence, this has not gone far enough.

While the proposals put forward by BEIS and Ofgem have the potential to address the immediate issue at hand, there remains the risk of unintended consequences and the proposals are certainly not without their challenges. Generally, any approach that will impact upon suppliers’ working capital (e.g. via more frequent settlement or protecting their obligation), will increase their operating costs. This in turn will put added pressure on supplier’s cash flow.

Currently, there are no supply licence conditions that relate to this topic. The options put forward in the Consultation will require detailed consideration when it comes to implementation to ensure consistency. The electricity supply licence regime is different as between Great Britain and Northern Ireland, adding a complication to a licence-based approach. The RO is governed by three separate orders in England and Wales, Northern Ireland and Scotland, so any legislative approach would need to be carefully considered.

In addition, the ROC market is now well established, and any changes will have an impact on that. In terms of implementation of option 1, the availability of ROCs may also present additional challenges as suppliers will need to take ownership of ROCs much earlier than they do currently, potentially reducing the period available to take ownership from 17 months after the beginning of an obligation year down to 6 months. This may require the renegotiation of PPAs to accelerate the delivery in ROCs. Further, the requirement to have more ROCs in the market quicker (for option 1) will mean that scrutiny on generators’ data submission and ROC account management by suppliers may increase. In terms of option 2, suppliers would need to carefully weigh up the pros and cons of implementing either the forward-looking or backward-looking approach. For example, while a forward-looking approach would be more costly to implement (as access to capital will be delayed), the risk of payment default would be reduced. Regardless, both approaches would add costs to the suppliers’ operations in an already thinly capitalised market. As the Consultation notes, there remains challenges around implementing option 2, such as how this approach may interact with insolvency law.

It will be interesting to see how stakeholders respond to option 3, and whether the industry considers that the issue of supplier payment default necessitates action beyond the only recently implemented measures by Ofgem. It may well be that, given the costs and implementation challenges associated with options 1 and 2, stakeholders are minded to allow recent changes to take effect.

Alongside the Consultation, BEIS has also published a call for evidence to increase its understanding of how third-party intermediaries operate in the energy retail market (which we consider in a separate article) – further indicating its appetite to reform areas of the retail market.

Ofgem is seeking views on the main options available for addressing supplier payment default under the RO. Responses should be provided by 9 November 2021.