Ofgem publishes new round of Statutory Consultations

United Kingdom

Following its decision on its Supplier Licence review in November 2020, Ofgem has continued to develop proposals aimed at decreasing the likelihood of energy supplier insolvencies and mitigate the associated risks. To this end, on 20 June 2022 Ofgem published three consultations:

Key Takeaways

Suppliers, by way of a supply licence change, will be required to ringfence a proportion of their domestic customer credit balances by the end of the year. Ofgem is proposing the following ways in which ringfencing could be achieved: by trust account; escrow account; third party guarantee (from a financial institution); parent company guarantee; or standby letter of credit.

From the Renewable Obligation (“RO”) period starting April 2023, suppliers will be required to ringfence Renewable Obligation payments, or hold a sufficient number of Renewable Obligation Certificates to cover their obligation (or a combination of ringfenced funds and ROCs). This will be introduced by way of supply licence change.

In the medium term, Ofgem is exploring ways of ensuring ‘in the money’ hedges or the value of hedges can transfer alongside the customers as part of the Supplier of Last Resort (“SoLR”) process.

Further, Ofgem is considering the implementation of a capital adequacy regime that would require a minimum amount of capital to be held by energy suppliers that would work flexibly alongside the ringfencing provisions. This would mean ringfencing requirements could be stepped back if a supplier has access to a higher amount of working capital.

Ofgem is displaying a more prudential approach to the supply market and its capital requirements, and is clearly looking at other regulatory regimes such as the finance sector’s Basel framework as a template.

In order to reduce excessive consumer credit balances, the supply licence condition with respect to determining appropriate amounts for consumer direct debits is set to be tightened to an absolute, mandatory obligation.

Ofgem has proposed amendments to the supply licences that would require suppliers to have “Sufficient Control” over the “Material Economic and Operational Assets used or needed to run its supply business”.

In this article we consider the proposals in more depth:

1. Strengthening Financial Resilience

The first in the series of consultations was published by Ofgem on 20 June 2022. The wide-ranging policy consultation (the “Consultation”) considers and proposes a wide range of regulatory approaches to address the financial resilience of the retail energy market. The Consultation contains a number of immediate proposals and medium-term considerations. Ofgem invites responses by 7 July 2022.

What is Ofgem seeking to address?

The retail energy supply market has seen a large number of supplier failure over the last couple of years. Ofgem found many suppliers were under-capitalised with poor liquidity and under-hedged in the face of increasing wholesale energy costs. This has put increasing pressure on the regulator’s Supplier of Last Resort regime under which existing suppliers absorb the customer book of the failed supplier and claim SoLR levy costs to address the costs of (1) mutualisation costs to honour domestic customer credit balances (“CCBs”); (2) supply customer with wholesale power and build the new customers into its future hedging strategy; and (3) contribute to the mutualisation of the Renewables Obligation fund.

Ofgem has identified that many of the failed suppliers were overly reliant on domestic customer credit balances and money collected to meet RO payments as working capital. Ofgem alleges that hand-to-mouth business practices by some suppliers “do not incentivise good operational performance or good customer service, as suppliers are able to attract new customers based not on their service offering, but rather with non-cost reflective (and ultimately unsustainable) pricing, driving some suppliers to accumulate more and more customers simply to stay afloat.” 

The chart from the Consultation below shows a correlation between failed energy suppliers and higher reliance on CCBs for their working capital:

Ofgem published image 01 LN

Ofgem states that the Consultation is building upon its previous work in response to the market of high energy costs and supplier exits. It points to a range of consultations and steps taken thus far:

  • 2019, to introduce higher standards for market entrants (see the final proposals here);

  • 2020, its introduction of the Financial Responsibility Principle (“FRP”) (which we covered fully here); and

  • 2021, its consultation on RO supplier payment default (which we covered here), with many of its considerations raised again in this Consultation.

However, some have accused Ofgem of being “asleep at the wheel”[1] by allowing many under-capitalised market entrants, permitting unsustainable business practices and rising supplier failures even before the current energy cost crisis. Any new measure is also accused of being “too little, too late” in what some have seen as a slow response from the regulator.[2] 

The Consultation is primarily focussed on domestic suppliers, as Ofgem believes these suppliers carry the highest risks in relation to cost mutualisation and its focus in on reducing the costs and impacts borne by domestic consumers of supplier failure. Ofgem will further consider the scope of the proposals and perhaps extend them to non-domestic suppliers, in particular, it believes that the capital adequacy proposals may also be of benefit to non-domestic suppliers.

CCBs Ringfencing

Ofgem’s objectives in relation to CCBs are to “remove incentives for suppliers to take excessive risk and to reduce the mutualisation costs directly related to CCBs”. It is assessing its proposals against the following criteria:

  • likely effectiveness;

  • deliverability

  • impact on existing business models; and

  • wider consumer impacts.

It examined two proposed approaches for protecting CCBs: (1) ringfencing; and (2) client accounts. It has subsequently discounted client accounts as it believes ringfencing will be quicker to implement by not requiring changes to billing systems and customer contracts and would be easier to monitor compliance.

Ringfencing mechanism - This proposal would require a supplier to protect an amount of money with an ‘Approved Protection Mechanism’. Such mechanisms include the following with minimum requirements:

  • trust account;

  • escrow account;

  • third party guarantee (from a financial institution);

  • parent company guarantee; and

  • standby letter of credit.

Ofgem is minded to remove insurance from its consideration as an Approved Protection Mechanism as it believes it would not be available to all suppliers and may be prohibitively expensive, but it is seeking views on this.

In the event of a SoLR transfer, the ringfenced amount would be transferred to the SoLR. The SoLR licence condition would be amended to ensure that the SoLR levy claim could not include the amount of ringfenced CCBs transferred.

The amount to be ringfenced - Ofgem considers several ways of setting the amount of CCBs that should be ringfenced, based on the following:

  • Gross Credit Balance – the total payments made by each customer minus the total cost of energy billed to date, includes only customers who have a credit balance after this calculation;

  • Gross Credit Balance net of Unbilled Consumption - the total payments made by each customer minus the total cost of energy billed to date and minus the value of energy used by that customer since their last bill was issued, includes only customers who have a credit balance after this calculation;

  • Net Credit Balance – the total payments made by each customer minus the total cost of energy billed to date and minus the value of energy used by that customer since their last bill was issued, includes all customers who after this calculation (i.e. both in debt and in credit); and

  • Unbilled Consumption – the value of energy used by a customer since their last bill was issued.

Ofgem is of the view that the Gross Credit Balance net of Unbilled Consumption measure is the most appropriate of ringfencing a meaningful amount of CCBs.

Calculating the amount to be ringfenced

Ofgem proposes that suppliers should be required to calculate the ringfenced CCBs amount every quarter using forward-looking data. This would require suppliers to forecast the peak CCBs for that quarter and provide the highest level of cover. Ofgem takes the view that it would rather suppliers over-ringfence than provide under provision.

Implementation

Ofgem is minded-to introduce ringfencing as soon as possible (by the end of the year) through changes to the supply licence, to ensure it reflects the rising CCBs throughout the summer and the Government’s Energy Bills Rebate. However, Ofgem will not require 100% of Gross Credit Balance net of Unbilled Consumption to be ringfenced from the outset. It currently estimates that most domestic suppliers have provision to ringfence 30% of their Gross Credit Balance net of Unbilled Consumption by winter 2022.

RO Payments Ringfencing

RO payments are collected by suppliers from energy consumers. Suppliers then accrue the RO over a 12 month period, and then have 5 months to settle their obligation by paying into a buy-out fund or presenting RO Certificates (“ROCs”). If a supplier faces financial difficulty and defaults on its payment into the buy-out fund, then other suppliers must meet the amount through a mutualisation process. The mutualisation payments will ultimately be collected by suppliers through higher electricity bills. RO payment defaults can cover a maximum 19 months’ worth of payment obligations (taking into account the 2 month late payment period), and therefore the mutualisation costs may be high.

Ofgem and BEIS consulted in 2021 to amend legislation to make RO payments more frequently and therefore shortening the potential default period and amount. However, BEIS has concluded that it will not be pursuing a legislative requirement. This leaves Ofgem to take action through a licensed-based option.

Ofgem considers a number of approaches to protect RO payments through the licence:

  • a report or protection obligation – that would require suppliers to report on a quarterly basis of how they intend to meet their RO obligations, and failing that protect the RO payments;

  • a protect obligation – suppliers would be required to protect the amount of their RO liabilities, regardless of whether they have purchased ROCs; and

  • a protect or discharge through ROCs obligation – would require suppliers to hold ROCs or protecting funds equivalent to their RO liabilities, or a mixture of the two.

Ofgem has concluded that the protect or discharge through ROCs would provide the best balance of protection but ensuring incentives of the ROC market remains. It states that any ringfenced funds should be protected under an Approved Protection Mechanism regime as with CCBs (as outlined above). ROCs purchased by a supplier will also have to be insolvency remote to ensure they remain available in the case of a supplier insolvency. Ofgem is considering that supplier may be required to create a trust in favour of Ofgem for ROCs proceeds of sale, which Ofgem could claim on in the event of supplier insolvency or RO payment default.

Calculating the amount to be ringfenced

Similar to CCBs, Ofgem considers that a quarterly calculation by suppliers strikes the correct balance of up-to-date protection and administrative burden. Ofgem is minded to make this calculation backward-facing, so that actual supply volumes are used and closer to the actual RO obligation payment date. Ofgem also favours this approach as it aligns with the Feed-in tariff levelisation procedure.

Implementation

Ofgem is minded-to require suppliers to protects their full RO on a quarterly basis from the obligation period starting April 2023. Immediately, within its current information gathering powers, Ofgem will be requiring suppliers to demonstrate how they will comply with their RO and take enforcement action as required.

Hedging

Hedging is when an energy supplier enters into trades to enable it to stabilise its wholesale energy costs against short-term price volatility. Under the Consultation, in the event of a supplier failure, the SoLR will have to purchase energy for the customers and include them in its hedging strategy, and will include these costs in its SoLR levy claim. Meanwhile, an insolvent supplier which holds hedges that are ‘in-the-money’ holds an asset which could be used to pay company creditors and possible shareholders.

Therefore, Ofgem has the aim of ensuring consumers have the benefit of hedges held by suppliers pre-insolvency, and that the hedges or value of hedges can transfer alongside the customers as part of the SoLR process. To do so however, raises a number of insolvency law considerations which would only be overcome with legislative change. While Ofgem believes legislative change provides the best option, it considers some licence and contractual changes as a suitable workaround:

  • Supply licence change that would require proceeds from liquidated in-the-money hedges to be held in trust for the benefit of customers (and transferred to the SoLR in case of a customer transfer); and

  • Contractual change (that would be implemented by way of licence change), that would require the supplier to include in all of its customer contracts a provision to pay a SoLR an amount up to the costs incurred by the SoLR as a result of the insolvency, and thus making the customers creditors to the insolvent supplier.

Ofgem sets out its early thinking on the pros and cons on each of these options, but does not set out any solid proposals in the Consultation. 

Capital Adequacy

Ofgem sets out the Consultation that there are already regulatory requirements that a supplier must comply with relating to its financial standing, including:

  • new entry requirements which require demonstration of funds (for the first year only);

  • notification requirements at certain milestones; and

  • ongoing compliance with the FRP and the OCP.

However, Ofgem is of the view that a framework of capital adequacy is required to ensure following the “clear role” that lack of working capital and general financial resilience played in recent supplier failures. It believes specific requirements and more robust regulatory overview will be required to ensure suppliers have sufficient capital and robust risk management.

Ofgem’s desired outcome is to “develop a more resilient energy supply market in which customers, energy suppliers and investors can have confidence going forward.”

Design of a regime

Ringfencing of CCBs and RO payments ensure funds are further protected from insolvency, and provide a clear route to deliverability, however it may reduce a supplier’s working capital. Ofgem envisages a future framework that flexes to each supplier’s financial resilience. The more capital a supplier holds, the more resilient they are, and ringfencing requirements may be stepped back. It would look to apply a two pillar approach:

  • Pillar 1 , Minimum regulatory capital buffer – Ofgem will determine a minimum amount of capital and what such capital should consist of (i.e. its liquidity). The capital buffer would be fed into appropriate return calculations in setting the price cap.

  • Pillar 2, Additional bespoke capital buffer – Ofgem will look at “the holistic picture of a supplier’s financial resilience”, which would inform the requirements placed on the supplier consisting of ringfencing or additional capital. For example, a poorly hedged supplier would need higher capital requirements.

Ofgem looked at international Basel standards for bank adequacy (Pillar 1), and The Prudential Regulation Authority’s Supervisory Review and Evaluation Process (Pillar 2), to develop its thinking of a dynamic two pillar approach. Pillar 2 would require further granular and prescriptive reporting requirements, and would require the development of a dynamic resilience framework.

Capital requirements interacting with the price cap

Ofgem acknowledges that the impact of capital requirements on GB supply licensees would be wide reaching. Once area requiring further analysis would be how it would interact with the price cap. Ofgem is reviewing its approach to calculating the returns permitted under the EBIT margin as part of the price cap, and in particular:

  • whether the assumptions on supplier capital and returns underlying the EBIT margin are still accurate;

  • the impact of a capital adequacy regime and other potential licence changes on capital employed; and

  • whether an EBIT margin that scales fully with the bill level remains appropriate.

What risks should Ofgem be trying to protect with capital adequacy?

Ofgem seeks to cover the following risks in a capital adequacy framework:

  • price risk;

  • churn / volume / demand risk;

  • counterparty credit risk;

  • liquidity risk;

  • market risk (e.g. FX and interest rates); 

  • credit risk (primarily consumers);

  • operational risk; and

  • systemic risk (knock-on effects of a central market participant).

What is “capital” for the purposes of any regulation?

Ofgem identifies that it is aiming to focus on going-concern capital that is of sufficient liquidity to absorb unexpected losses, and it that it can take two forms: (1) going concern capital; and (2) contingent capital.

Going concern capital includes:

  • equity;

  • retained earnings

  • reserves

  • any other perpetual capital instruments that are sufficiently subordinated.

Contingent capital includes:

  • credit facilities;

  • letters of credit;

  • overdraft facilities; and

  • parent company guarantees.

Any element of contingent capital, if included within the capital adequacy regime, would have to be subject to criteria to ensure it could be reliably drawn upon in the event of unexpected loss. Ofgem lists the following considerations:

  • maturity of the instrument;

  • conditions placed on access to the funding;

  • to what extent is it subordinated (its ranking of when it must be paid in the case of default); and

  • whether there are requirements in the instrument that would affect its ability to absorb the loss.

There are further considerations as to whether the capital requirements are applied at a subsidiary or group level and whether it is looked at a consolidated basis or not.

Implementation

Ofgem has no express proposals on a capital adequacy regime under the Consultation, but it is proceeding “at pace” on its analysis. Therefore, more details including implementation can be expected in the future, and is likely to develop with the ringfencing proposals set out above.

2. Strengthening fixed direct debit rules

In March 2021, Ofgem consulted on a range of measures intended to protect consumer credit balances in the event of supplier insolvency. One of these measures was to tighten energy suppliers’ obligations with respect to fixing the amount of the direct debits by which domestic consumers pay their bills. The proposal aims to prevent suppliers building up excessive credit balances from consumers paying unnecessary amounts up front for their energy, with a view to ensuring that suppliers have a more realistic picture of their revenues and that consumers are paying accurate direct debit amounts. Ofgem is proceeding with the next step towards effecting it: a statutory consultation, published on 20 June 2022, setting out the intended licence amendments.

The proposed amendment is to Standard Condition 27.15 of the electricity and gas supply licences. The current drafting requires domestic energy suppliers to “take all reasonable steps” to base the fixed amounts of their customers’ direct debits on “the best and most current information available”. However suppliers can “contract out” of this obligation by way of clear wording within their terms and conditions. Ofgem is proposing to tighten the obligation by:

  1. deleting the reference to “all reasonable steps”, making the obligation absolute; and

  2. removing the possibility of contracting out, such that energy suppliers will have no choice but to comply with the obligation.

3. Supplier Control over Material Assets

Ofgem published guidance in January 2022 setting out its experience, through both its routine monitoring and its recent experience with supplier failures in the market, that some suppliers’ businesses were structured in a way that meant that they did not own, control, or have key economic or legal rights to their “material assets” (see our previous commentary here).

Ofgem’s view is that this places an unfair and disproportionate risk onto energy consumers, by allowing connected companies to retain valuable assets that could otherwise have helped offset the contributions from consumers and taxpayers following the failure of a supplier. Ofgem gives the example of the termination of key supplier assets (like its hedging contracts), leading to the supplier’s insolvency, but unregulated parts of the supplier’s group retaining the value of those assets. Accordingly, Ofgem consulted on making changes to supply licences in order to rectify this. The consultation closed on 20 July 2022, with decision pending.

The proposed amendments to conditions 4A and 4B of both the gas and electricity SLCs follow directly from Ofgem’s updated guidance of the “Financial Responsibility Principle” or “FRP”, and the Operational Capability Principle or “OCP”, in order to rectify the issues identified above.

The FRP and OCP set out broad principles-based rules around the financial and operational arrangements suppliers must have in place. Introduced in early 2021, the FRP (SLC 4B) is an enforceable rule that requires suppliers to responsibly manage costs that could be mutualised, and to take appropriate action to minimise such costs. The OCP (SLC 4A) obligates a supplier to ensure it has and maintains robust internal capability, systems, and processes to enable it to efficiently and effectively serve each of its customers.

The amendments to the FRP and OCP require suppliers to have “Sufficient Control” over the “Material Economic and Operational Assets used or needed to run its supply business”. The definition of both of these terms, which is set out in full in the proposed amendments to the SLCs, raises interesting questions about what suppliers’ compliance with these updated principles will look like in practice. “Sufficient Control” is defined as:

“having either direct ownership or legally enforceable rights over Material Economic and Operational Assets so that the licensee can legally rely on them and enjoy the benefit of them”.

“Material Economic and Operational Assets is non-exhaustively defined as:

“those assets, mechanisms or arrangements used or needed by a supplier: to run its supply business and meet its obligations with regards to customers; to manage responsibly its costs at risk of being Mutualised; as adequate financial arrangements to meet its costs at risk of being Mutualised, with such assets, mechanisms or arrangements including, but not limited to, premises, facilities, staff, equipment, IT system, brand name and hedging contracts”.

Suppliers will need to pay close attention to the approach Ofgem takes in practice to defining the boundaries of both “Sufficient Control” and “Material Economic and Operational Assets”. The Ofgem guidance currently available is limited, but gives an example of a supplier not relying “on informal intra-group arrangements or the goodwill of third parties as such arrangements may be able to be terminated at will”.

Comment

The Consultation is wide ranging and has the potential to redefine the energy supply market. There are a lot of ideas, issues and potential implications for the market to digest . Those areas which appear immediate and certain are that suppliers will be required to ringfence a proportion of their CCBs by the end of the year with RO payments to follow. Suppliers will need to build this regulatory risk into their working capital calculations, and establish their Approved Protection Mechanism.

In the longer term, Ofgem is displaying a more prudential approach to the market and its capital requirements, and is clearly looking at other regulatory regimes as a template. Any regulatory changes are likely to cement positions of larger players which have easier access to capital, and these reforms may prompt market consolidation as smaller players look to bolster their capital position.

What is not clear is how these changes will interact with other measures in the supply market, such as the price cap. Careful consideration of how increased costs are dealt with will be important to ensure the measures achieve the intended aims to protect consumers while still encouraging innovation and competition.