Is Ofgem’s regulation of energy markets appropriate?

The failure of GoTo Energy on 18 October brought the total number of supplier failures this year to 16, with 14 since August. Questions are increasingly being asked of Ofgem’s handling of the crisis, with many accusing the regulator of being asleep at the wheel. Now, a group of small suppliers including PFP, Green, UK Energy Incubator Hub (Euston Energy), Utility Point and Neon Reef has written to Ofgem under its complaints procedure, and is threatening legal action if its concerns are not adequately addressed.

Authored by Jo Gilbert, the former chief operating officer of the recently failed PFP Energy, the letter accuses Ofgem of helping to bring the energy market “to its knees” criticising for the way it has regulated the industry throughout the early stages of the coronavirus pandemic and the recent gas price crisis. The letter raises 13 separate issues including the price cap, support offered to retailers during the pandemic and the regulatory requirements placed on them – along with 55 questions they want the regulator to answer. 

The letter outlines four main areas of concern:

• The administration of the price cap;
• The response to the current gas crisis;
• The approach to covid-related regulation;
• The general approach to regulation.

The question is whether these concerns are legitimate or just the sour grumblings of those who failed to succeed in a challenging market.

Failing to maintain the price cap in a way that enables suppliers to make reasonable (or any) profit

One of the authors’ main concerns is the impact regulation has on the ability of suppliers to make a profit. Ofgem was accused of regulating the market in a way that presents suppliers making no profit as a “fair price”, citing comments made by chief executive Jonathan Brearley. The letter also criticised the way the price cap is set, labelling it as a “political tool” to try to show consumers they are being protected, and accusing Ofgem of using the cap for political ends, rather than for its intended use.

“No regulator should be allowed to regulate in a way that allows for no profit to be made by privately owned businesses and this being exemplified by the head of the regulator as ‘we are making sure companies charge a fair price’,”
– Jo Gilbert, former chief operating officer, PFP Energy

The letter also stated that covid-related bad debt was not incorporated into the price cap for more than a year (see below).

In addition, as Dieter Helm has pointed out, Ofgem has not properly analysed the interaction between the price cap and the hedging strategies of suppliers. Although Helm asserts that suppliers should be hedging against price shocks, he assumes this is possible for all suppliers, which in fact it is not – many smaller suppliers struggle to access hedging due to expensive and onerous credit requirements and the small volumes they need to trade to manage shape risk.

“Whilst Ofgem says it has carefully modelled the financial position of these suppliers, it clearly has not done this properly, and it is all the more worrying that it has been urging customers to switch to low-cost providers without checking that these providers can absorb shocks. The Secretary of State points out that at this time of the year around five or six companies tend to leave the market (go bust in other words), but this is hardly a mark of success. Companies regularly going bust is hardly a “good thing” for an essential energy system,”
– Dieter Helm

Ofgem has a real case to answer in relation to the price cap. There is a widely held misconception that the price cap can only be adjusted twice a year, but this is not the case: Ofgem is required by Section 6 of the Domestic Gas and Electricity (Tariff Cap) Act 2018 to review the level of the cap at least every 6 months. In other words, nothing in the Act restricts Ofgem to semi-annual reviews, and indeed Ofgem could review the cap monthly if it so chose.

That Ofgem has chosen not to do this, and is repeating the (false) Government mantra that the cap is there to protect consumers from wholesale price volatility gives credence to the accusations that it is playing politics with the cap. In addition, Ofgem is failing to meet the objectives set out in the Act:

• the need to create incentives for holders of supply licences to improve their efficiency;
• the need to set the cap at a level that enables holders of supply licences to compete effectively for domestic supply contracts;
• the need to maintain incentives for domestic customers to switch to different domestic supply contracts; and
• the need to ensure that holders of supply licences who operate efficiently are able to finance activities authorised by the licence.

Where is price cap is pushing suppliers into supplying at a loss, and the capped default tariffs are the cheapest in the market, the cap does not enable suppliers to compete for customers, or incentivise consumers to switch, or allow suppliers to secure finance. It is also unlikely at this point that further efficiency benefits can be realised.

Failure to anticipate and act on the gas price crisis

According to the letter, Ofgem was made aware early in the gas price crisis that counterparties were withdrawing their hedges leaving suppliers exposed to rising prices. Smaller suppliers had asked Ofgem to step in and provide them with support over the issue, but none was forthcoming.

The concerns over the impact of the gas price crisis are shared by larger suppliers. Keith Anderson, the chief executive of Scottish Power believes the market is “in danger of just sleepwalking into an absolute massacre”. The longer the crisis lasts the worse its impact on suppliers is, since with each passing month more consumers roll off fixed price deals onto the loss-making capped default tariffs. Anderson believes that suppliers could be losing as much as £1,000 per customer, something smaller suppliers will lack the financial resources to accommodate.

Anderson believes, as do many in the market, that the price cap should either be reviewed more frequently or abandoned altogether, something which is unlikely to be acceptable to politicians who have now tied themselves firmly to the notion that it is key to protecting consumers from price volatility this winter. Unfortunately the alternative is to simply allow all but the largest suppliers to fail, re-creating the oligopoly energy regulation has spent years trying to abolish.

Ofgem has been hinting it is working on a new approach with chief executive Jonathan Brearley recently saying Ofgem will “need to regulate the energy market differently” but has so far released no actual proposals nor sought to consult with the market.

“Although the gas price rise is unprecedented today we will need to plan on the basis that shocks like this could happen again. Therefore, Ofgem, with industry and the government, will need to build an energy market that is more resilient to shocks like this in the future. This is likely to mean an approach to regulation which is more focussed on the business models that enter and operate in our energy market, and on the risk they carry. We will also examine the consequences for the wider design and implementation of the price cap,”
– Jonathan Brearley, chief executive, Ofgem

This sounds a lot like an admission of regulatory failure, and although Ofgem points out that it tightened the rules for new entrant suppliers in 2019 in response to the collapse of some new entrants, those changes did not go far enough. Commodity price volatility is neither unusual not unexpected, and although energy markets have been relatively benign in recent years, assuming they would continue in that vein was naive. Indeed, Brearley’s predecessor Dermot Nolan recently admitted that he had not considered “a situation where the price cap was the cheapest tariff in the market”, as it is today.

Lack of support for suppliers during the pandemic

The letter also criticised Ofgem for failing to provide support to suppliers during the pandemic, noting the expectation that suppliers would not chase debts from consumers and provide them with discretionary credit. At the same time, Ofgem applied an “extortionate” interest rate of 8% to the short-term network deferral scheme.

“The issue of no direct support was raised time and again to Ofgem, and it was only when energy suppliers spoke directly to BEIS that the initial network deferral scheme was even considered. Even when suppliers were calling for a second or extended network deferral scheme, Ofgem decided no further support was necessary by what we’ve learnt to be a closed forum that was unknown to most suppliers and with a backdrop of government providing support to others until October 2021.”

Ofgem determined that an interest rate of 8% should apply to the deferral of network costs in order to encourage suppliers to defer the minimum amount of costs and to repay them at the earliest opportunity, which sounds reasonable, except for the asymmetry between this and the expectation that suppliers should extend additional credit to their customers, taking account of their “ability to pay”, and provide them with wider support.

In addition to this, Ofgem only included the recovery of covid-related costs in the price cap from April 2021, a year after they first arose,

An adversarial approach to regulation which places unreasonable burdens on suppliers

Another area of concern for the suppliers is the way Ofgem applies regulation, with the letter claiming that suppliers have faced millions of pounds in costs every year due to “forced regulatory changes”. The extensive programmes of regulatory change were highlighted as contributing to the inability of suppliers to make profits with changes frequently being put in place without quantifiable evidence of their benefits, and without consumer engagement. For example, the letter questioned whether consumers genuinely want initiatives such as opt-in or opt-out automatic switching.

“There is no joined up approach as to how regulations are managed within Ofgem, how much regulation is requested from suppliers at any one time. Suppliers are expected to meet all timescales, irrespective of whether this is even possible to achieve and irrespective of how much it costs.”

The letter claims that suppliers are asked to interpret often “unclear, outdated and complex” regulations, with the move to principles-based regulation adding to regulatory burdens and the risks of fines when there is inadequate guidance from Ofgem around its requirements.

This is another area where Ofgem genuinely has a case to answer. A few years ago a new entrant supplier client of mine asked for some guidance as to its regulatory obligations, a task I naively expected to be relatively straightforward. What I discovered was a mess of confusing and complex obligations with suppliers having different information and payment obligations some of which depend on customer numbers (and where those thresholds are subject to change). In some cases I had to read the primary legislation in order to understand the full nature of these obligations.

At the time I was surprised how little support Ofgem was providing to suppliers to help them to navigate this complex set of regulations. Subsequently Ofgem has improved somewhat providing a wholly inadequate 2-page note listing the main obligations but none of the details which really matter. The note to my client eventually ran to 13 pages.

While Ofgem is not necessarily responsible for the existence of these regulatory burdens (although it is arguably far too passive in the legislative process where it could do far more to ensure that legislation is appropriate and well designed), it could and should do more to support suppliers in meeting those obligations. And in some respects Ofgem actively discourages good governance by suppliers – another client of mine has told me how Ofgem tried to stop it from making regular RO payments insisting instead on the riskier balloon payment at the payment deadline.

Ofgem has a history of poor decisions which have adversely affected consumers

This paper by Despoina Mantzari and Francesca Pia Vantaggiato of the Centre for Law, Economics and Society (“CLES”) describes the troubled history of Ofgem since its inception. Ofgem established as a non-ministerial government department by the Utilities Act 2000 following the merger of the previously separated Office for Electricity (Offer) and Office for Gas (Ofgas). It operates under the direction of the Gas and Electricity Markets Authority (“GEMA”), which determines Ofgem’s strategy, sets policy priorities and makes decisions on a wide range of regulatory matters, including price controls and enforcement relating to the gas and electricity markets of Great Britain.

The aim of the Utilities Act 2000 was to replace the various duties of the regulator by a new single competition-based primary duty: to protect the interests of consumers, where possible by promoting effective competition, with subsidiary duties relating to the protection of vulnerable consumers. The Secretary of State was given new powers to issue guidance on social and environmental objectives to which regulators were required to have regard.

However, two factors considerably increased Ofgem’s uncertainty concerning its mandate. The first was a subsequent broadening of the regulators’ statutory remit include sustainability, security of supply and affordability – essentially the “energy trilemma” – without clear guidance as to how trade-offs should be managed. The second was an overlap in its duties with the relevant government ministry, which at the time was the Department for Energy and Climate Change (“DECC”).

Mantzari & Vantaggiato highlights that time and again Ofgem has failed to fully understand the impact of its decisions, and that it’s un-founded assumptions about the markets and consumer behaviour have led to higher costs and worse consumer outcomes than would otherwise have been the case. The paper cites the non-discrimination policy of 2009 and the simple tariffs regime of 2010 as particular examples which “attracted wide criticism from the academic community at the time of their introduction”.

“Ofgem used little economic analysis or empirical evidence in support of its claim that the number and complexity of tariffs was a major determinant of customer engagement and switching. Nor did it acknowledge the possibility that its prior regulatory interventions might have reduced the number of active customers. Hence, tariff simplification had the opposite effect on consumer engagement: it restricted consumer choice, adversely impacted the competitive process, and reduced consumer welfare. The upshot was that prices increased for all consumers,”
– Mantzari & Vantaggiato, CLES

Ofgem subsequently referred itself and the energy market to the Competition and Markets Authority which in 2016 determined that Ofgem’s interventions in the retail energy market were based less on thorough economic analysis and more on concerns that its powers would be reduced or removed by the Government.

At the time there were calls for Ofgem to be abolished and replaced with another energy regulator although in reality this would be little more than a re-branding exercise since any new regulator would likely be primarily staffed by people from Ofgem, located in Ofgem’s offices, and reporting to the same government department. However, the authors suggest that Ofgem’s reaction to these criticisms was to adopt a “more assertive stance with respect to the implementation of the price cap” than had been the case with previous market interventions.

The study cited empirical evidence derived from regulatory decisions, case law, and staff interviews which indicated that Ofgem is less exposed to the constant threat of legal challenge by market participants but is more exposed to government interference in its decision-making, leading it to downplay its economic expertise in order to comply with the ministerial preferences and thus avoid sanctions. The broad statutory discretion of the regulator and the low threat of legal challenge incentivise ministers to interfere in regulatory decision-making more often compared with other regulated markets in which ministers have more direct control over the regulator such as the water industry.

Essentially this conclusion means that Ofgem deliberately ignores its own economic analysis in favour of what it believes to be the Government’s preferred course of action, in order to minimise the risk of adverse consequences to itself as a result of ministerial displeasure and/or political pressures. To the market it often appears that Ofgem lacks a basic understanding of the mechanics of gas and electricity markets, and that it is biased, reflecting the Government’s long-standing bias, against the supply segment in particular.

Assumptions about competition and customer benefit need to be challenged

Since privatisation, the Government has been of the opinion that more competition is better for consumers since this delivers lower prices. The success of the competitive model is therefore demonstrated by the numbers of consumers switching to lower cost suppliers. But this model assumes that consumers value price and only price, ignoring other aspects of the consumer-supplier relationship such as customer service and even financial stability. In addition, the model fails to take account of the fact that in a world of price caps there is little difference in the tariffs on offer, and the interplay between standing and variable charges can make tariffs difficult to understand and compare.

“The implication of supply competition has always been that customers who do not switch are just stupid, and therefore in the end it is their own fault that they are landed with higher prices. The alternative – that customers are the best judges of their own interests, and do not want to spend their evenings searching the internet amongst the bewildering claims of 70 companies offering them such “good deals”, and what they really want is a secure stable and not volatile supply at a price with a fair rate of return, and to spend as little time and effort on this – has clearly escaped ministers’ and regulators’ minds. As one of those “stupid” customers, I am very glad that I did not switch to the latest bunch of companies going bust. Frankly, like most customers, I have better things to do,”
– Dieter Helm

The Government’s obsession with switching is such that it is now contemplating moving consumers to new suppliers without their input, requiring them to actively opt out of switching. The outcome of this could very easily see consumers being moved from a financially stable if higher priced supplier to a low cost, poorly capitalised new entrant with poor customer service and a higher likelihood of failure in volatile market conditions. If these consumers are genuinely passive and dis-engaged, they will be harmed by such an intervention, and if they are not then they may simply walk with their feet back to the original supplier.

The other problem with this model is that new entrants have been encouraged into the market with very few restrictions or conditions. The assumption was that new entrants would automatically have lower cost bases due to lack of legacy costs and infrastructure, and would have the operational flexibility to deliver innovative new business models serving consumers at lower cost. While market conditions were benign this was possible, but the foundations were shaky. Margins were so low that new entrants were unable to grow their capital in any meaningful way, while the large burden of non-supply activities and external costs reduce the scope for competition. Lack of financial resources limit the ability of new entrants to properly hedge their forward price exposures, leaving them vulnerable to rising wholesale prices.

It is an extra-ordinarily one-dimensional and simplistic view of the market, which actively harms consumers. This narrative has directly led to the introduction of the price cap which compresses supplier margins to a degree that the development of innovative new business models is impossible. Supplier innovations, such as they are, are limited to efforts to find new ways to attract consumers – something they may now be regretting when more consumers mean higher losses.

So is Ofgem fit for purpose?

Ofgem undoubtedly has a difficult remit – its duties are complex and the markets themselves are highly complex, so it is inevitably a challenging regulatory environment. The challenge is certainly more difficult because of the extent of energy regulation, and the wide range of policy objectives that are delivered through energy market regulation rather than by other means – for example, the Government could have chosen to recover the cost of renewables and other generation subsidies through general taxation rather than through energy bills, removing a large component of Ofgem’s duties.

In addition to this legislative complexity, successive Governments have sought to gain political advantage through various approaches to energy markets that have adverse consequences both on the market and by extension on Ofgem. Governments have maintained a hostile attitude to suppliers, accusing them of being first profiteering, requiring intervention by means of the price cap, and more recently asserting that many are badly run. Since Ofgem’s very existence has in the past been threatened by politicians seeking a new approach to energy regulation, it has aligned itself with these hostile attitudes to suppliers, which is evidenced by the punitive way in which it applies regulation.

Ofgem is happy to repeat the anti-supplier narratives, while providing minimal support to energy retailers struggling to navigate an extremely complex regulatory landscape – indeed, not only is little support or guidance forthcoming, but suppliers report being subjected to significant financial penalties for infractions, some of which they claim were difficult if not impossible to avoid. It is certainly the case that Ofgem showed little sympathy to suppliers seeking to defer network costs during the pandemic while at the same time expecting suppliers to fund what were essentially subsidies to their customers.

Ofgem has the discretion to provide more support to suppliers, both in terms of making regulation more transparent and streamlined, and by changing its approach to economic regulation. The price cap could and indeed should be reviewed more frequently, RO payments could (and should) also be collected more frequently, and Ofgem could (and should) assist suppliers in understanding and complying with their obligations, working with suppliers to make the market function more effectively rather than taking an adversarial approach.

Ofgem could be forgiven for its regulatory philosophy if consumer outcomes were positive, but since the inception of the price cap the number of suppliers has fallen by more than a third, prices have risen rapidly even excluding the recent price crisis, there is little price differentiation between suppliers, and customer service is below where it could be if suppliers were able to earn better margins. There is also little innovation in terms of new business models because margins are too low and the risks too high to incentivise radical new approaches.

So while I do not support the abolition of Ofgem (since it would be little more than a re-branding exercise), I do support a significant change in approach:

• In the first instance, the model of market competition and consumer benefit needs to be re-evaluated, and the assumption that price is the sole determinant of consumer benefit needs to be abandoned. The Government and the regulator need to do much more to understand what consumers actually value in practice, and think more broadly about how the kinds of new business models that will be needed to deliver de-carbonisation ambitions can be incentivised;
• The financial regulation of suppliers should be moved to the Financial Conduct Authority (“FCA”). The FCA is not a perfect regulator and has struggled with some of the more complex aspects of financial market regulation, however the supervision of suppliers can have a lot in common with the supervision of retail banks. The FCA Principles would be very relevant in the energy markets and, unlike Ofgem, the FCA has no animus towards suppliers. Since the sale of energy to end consumers is a largely virtual business, the FCA is well placed to regulate it, and Ofgem would continue to regulate the physical energy markets;
• The price cap should be abolished. Since this is now politically unlikely it should be reviewed more frequently and set at a level which allows suppliers to make suitable margins. Even before the recent crisis, suppliers were making close to zero margin on domestic electricity supply, which is not a basis for a properly functioning market and will harm the interests of consumers in the longer term;
• Whoever is regulating the supply market, the regulation needs to be reformed and streamlined, taking a holistic view which balances the Government’s objectives, with the practical realities in the market. The regulator should engage with market participants to re-design poor regulations, proposing legislative reforms to the Government which will improve the functioning of the market and lead to better consumer outcomes. The regulator should also provide suppliers with support, helping them to understand their obligations and comply with them in a way which avoids penalties;
• The regulator should be a-political, and it should take neither credit nor blame for actions initiated at the behest of Parliament. Ofgem is not protecting consumers with the price cap – it merely administers the price cap which was required by legislation. Ofgem’s increasingly political discourse is alienating market participants while doing nothing to improve consumer outcomes or any other of its statutory objectives.

Ofgem has a certain degree of discretion in the way in which it carries out its duties, but over time it has used this discretion to protect itself from perceived threats from political interference and developed an adversarial approach to suppliers in particular. Its relationships both with the Government and with the market need to be re-set, and it should act as a bridge between the two, on the one hand implementing Government policy, but on the other hand using its influence to ensure policy decisions are appropriate to the market context.

For its part the Government needs to set better boundaries between its own duties and those of the regulator, removing the element of policy overlap currently in the Energy Act which blurs the lines between the two. It also needs to adjust its combative approach to suppliers, recognising that consumer trust has deteriorated in part as a result of the Government telling them that suppliers are not to be trusted. This has inevitably hampered the smart meter rollout and has negative implications for the emergence of “energy-as-a-service” business models which would require consumers to hand a degree of control over their consumption to their supplier.

Perhaps the threat of legal action from the failed suppliers might motivate a change in approach, but perhaps not since bankrupt businesses are hardly in a position to pursue expensive litigation. We can always hope…