Financial resilience in energy supply: closing the stable door

Ofgem has recently launched a consultation into new measures to improve financial resilience within the energy sector, specifically aimed at gas and electricity suppliers. This came after half of the suppliers in the market failed last year, and highly critical reports by consultancy Oxera and the National Audit Office highlighted Ofgem’s failures to appropriately regulate the sector. In other words, the horse has well and truly bolted, and only now is Ofgem consulting on whether or not to close the stable door.

“Ofgem could not have prevented the increase in wholesale prices in 2021 from significantly affecting consumers, but it did not do enough in the years that preceded it to ensure the energy supplier sector was resilient to external shocks. By allowing many suppliers to enter the market and operate with weak financial resilience, and by failing to imagine a scenario in which there could be sustained volatility in energy prices, it allowed a market to develop that was vulnerable to large-scale shocks and where the risk largely rested with consumers, who would pick up the costs in the event of failure,”
– National Audit Office

These proposals are:

• Protecting consumer credit balances and Renewables Obligation (“RO”) payments: Ofgem believes there is a “good case” for insuring or otherwise protecting customer credit balances and RO payments so they are available to a new supplier should the original supplier fail. This would reduce RO and Supplier of Last Resort (“SOLR”) mutualisation costs and mean that suppliers do not have access to free, risk-free working capital that may incentivise them to take excessive risk;
• Protecting the value of hedges for consumers: a significant proportion of the costs that all consumers were exposed to as a result of recent supplier failures was a result of the new supplier having to buy gas and electricity in the wholesale markets at higher prices that might otherwise have been the case (for example if they had known that they would have these customers), and these prices were much higher than the price allowed under price cap due to the rate at which prices increased last year. Although some of the failed suppliers had hedged, insolvency rules meant that those hedges were liquidated for the benefit of the suppliers’ creditors, rather than being transferred to the SOLR;
• Capital adequacy: Ofgem believes that suppliers should be required to maintain enough capital to survive market shocks. While current rules allow Ofgem to set capital adequacy expectations, it believes that more specific requirements are needed to increase supplier resilience and incentivise more robust risk management.

Ofgem believes these proposals will have a total net benefit across the three different customer groups (customers of failed suppliers, engaged customers with other suppliers and disengaged customers) yields a net benefit of the policy for consumers of between £87 million and £467 million per year.

The need for prudential regulation in the retail energy sector has been apparent for a long time, but Ofgem and the Government were so narrowly focused on switching as the sole measure of competition that for years there were almost no barriers to entry – until relatively recently, the only requirements for securing a supply licence were to not ever have been declared bankrupt and payment of the £400 admin fee. Although some additional checks were introduced in 2019 they were woefully inadequate (this was the first time suppliers were expected to adopt “effective risk management”), and the directors of new supply businesses continued to be able to enter the market with little capital, and withdraw cash from their businesses with little oversight.

However, not everyone is pleased by the proposals. While Centrica is ahead of the pack having already committed to ring-fencing customer credit balances, Octopus CEO, Greg Jackson has described the proposals as “financially illiterate”, saying they will increase costs to consumers, and that an ATOL-style insurance approach as in the travel industry would be more appropriate.

The consultation is set to run until 19 July.

Ring-fencing credit balances and RO payments

Under normal circumstances, the majority of customers pay for their gas and electricity with equal monthly direct debits, however, since they generally use less energy in summer (when there is a reduced need for heating and lighting) than in winter, they build up credit balances in the summer by paying for more energy than they consumer which are then eroded in the winter when they pay for less energy than they consume. This is a perfectly reasonable way for the market to operate: most consumers are paid wages in equal monthly amounts and do not earn more money in winter, so it is helpful for them to spread the cost of their energy avoiding seasonal jumps in cost.

The excess money paid by consumers in the summer is a free form of working capital that many new entrants have used to fund growth in the business. In theory they could also use this money to pay dividends to shareholders. This has been perfectly legal, but filled with moral hazard, since the penalties for the business owners have been minimal: under the SOLR process, customer balances are honoured by the new supplier and the costs are mutualised across the entire market. Ofgem has long believed that consumers should not be penalised if their supplier fails, but this removes the incentive for consumers to make sure their suppliers are credit worthy – if consumers faced losing their credit balances when a supplier failed, they would likely be more cautious about their selection of a supplier. The main reason the market does not work this way is that energy is an essential service, and many consumers may be unable to make assessments about the robustness of their suppliers meaning they would potentially remain with incumbents reducing the scope for competition in the market.

“If the chaos in the energy industry over past years has taught us anything, it’s that suppliers should not be allowed to gamble with customers’ money…It’s clear this issue needs an industry wide solution to protect all customers while also preserving fair competition in the market, so we support Ofgem’s proposals to ringfence customer credit balances,”
– Michael Lewis, CEO, E.On UK

There is wide consensus that suppliers should no longer be able to treat credit balances as free money, but the question is what approach to protection is best, the main alternatives being ring-fencing, use of client accounts or insurance. Under ring-fencing, suppliers would hold the aggregate customer credit balances in some protected way (as outlined below), whereas client accounts would require entirely separate bank accounts for each customer, as is the case for solicitors. Insurance schemes would mirror those used in the travel sector when a customer pays in advance for a holiday. Ofgem has rejected both client accounts and insurance as suitable options: it believes the use of client accounts is likely to be administratively burdensome and create difficulties with monitoring, and is not confident that suitable insurance would be available to all suppliers at a reasonable cost.

Ofgem is consulting on the different implementation options for example whether gross or net credit balances should be protected, whether the calculations should be forward or backward looking, and the frequency with which determinations should be made.

On the Renewables Obligation, Ofgem favours a ring-fencing approach where suppliers protect RO balances or demonstrate that they have purchased ROCs – a requirement to only protect the balances would potentially dis-incentivise suppliers from buying ROCs as they would potentially have to tie up capital both in ROC purchases and in setting aside the amount of cash required for the buy-out fund. Therefore, a hybrid approach is preferred, where suppliers would select an approved protection measure for cash balances, and/or demonstrate that ROCs had been purchased to meet their Obligations. Ofgem is considering a further requirement for any ROCs to be placed into trust for the benefit of Ofgem so that in the event of a supplier failure they are not sold in order to pay creditors as is normally the case in when a bankrupt company’s assets are liquidated.

Ofgem reports that stakeholders have asked it to engage with BEIS on increasing the frequency of RO payments from once a year to four times a year, which would reduce the amounts outstanding at any time, and be an efficient way of managing the risk, since it would lower the costs associated with protecting outstanding balances, however, BEIS has determined that this would not be the right approach because it is considering wider reforms to the scheme and wants to avoid excessive legislative change. A call for evidence on these wider reforms is expected later this year.

Types of protection measures under consideration

Ofgem is minded to approve the following protection measures for both credit balances and the RO:

• Trust Account: funds would be held in a separate bank account, acknowledged by the bank to be a trust account, only to be drawn down for purposes specified in the declaration of the trust and set out in the licence condition. Suppliers would be required to recalculate the protected amount quarterly and adjust the amount held in trust accordingly.

While this may be less expensive than other mechanisms, the trust may still require collateral from the supplier and may still create a barrier to market entry. It is also possible that should a supplier be close to insolvency, amounts transferred to the trust may be at risk, or the directors may decide it is not consistent with their statutory duties under the Companies Act to transfer funds into the trust when they should be preserved for the benefit of creditors;

• Escrow Account: funds would be placed in a ring-fenced escrow account, maintained by a third-party escrow agent, with payments only being made to Ofgem or Ofgem’s nominee (eg a SOLR) to reduce credit balance and RO mutualisation costs in the event of the supplier’s insolvency – the escrow agent would have no discretion not to pay funds on demand. This approach might be expensive for suppliers and suffer from similar issues to the Trust Account if a supplier were approaching bankruptcy;
• Third Party Guarantee (“TPG”): a creditworthy financial institution would issue a guarantee to pay an amount up to a maximum guaranteed amount to Ofgem or an Ofgem nominee on demand by that person or Ofgem. TPGs offer time-limited protection, with a cap on liability, so may not readily accommodate fluctuating amounts. Rolling arrangements might be expensive, and suppliers may have to provide collateral to the guarantor which would likely be more difficult for smaller suppliers;
• Parent Company Guarantee (“PCG”): suppliers with a parent company which meets specified creditworthiness requirements could have the option of their parent company providing a guarantee, which would work on a similar basis as the TPG although it would not generally include any collateral obligations. However, these funds would not be insolvency remote from the parent supplier, but should be insolvency remote from the supplier acquiring the guarantee;
• Standby Letter of Credit (“SBLC”): a financial institution with a minimum credit rating would provide an SBLC. SBLCs are usually time-limited and would therefore require regular replacement – rolling arrangements, where available, would likely be expensive. SBLCs are irrevocable during the period for which they are valid, meaning there could be replacement risk if the issuing bank decided not to extend or replace it if the financial health of the supplier were to deteriorate, and the supplier may be required to post collateral. This would likely be more expensive for smaller suppliers with the costs possibly acting as a barrier to entry.

Treatment of hedges

At the moment, when a supplier fails, its hedges are treated as business assets that are liquidated for the benefit of creditors in line with insolvency law. This proved controversial, particularly when CNG failed last year, since it had bought hedges on behalf of other suppliers, creating a cascading effect that led to the failure of other suppliers. Many people in the market blamed the CNG management for not allowing the hedges to be assigned to the suppliers who believed they “owned” them, but this is not permitted under insolvency laws and the management had no discretion once the business entered administration. Even if the hedges and other assets of the business exceed the value of the liabilities the surplus funds are paid to the shareholders of the failed supplier and not to anyone else such as the customers transferred to the SOLR or the SOLR itself.

In a rising market, this means SOLRs must enter into entirely new hedges for the customers of the failed supplier at much higher prices than they would have done had they acquired these customers under the normal course of business. These additional hedging costs are also mutualised (if they were not, no supplier would ever agree to act as a SOLR). Ofgem would like to find a mechanism by which hedges can be assigned to the SOLR without the need for changing insolvency law. 

One approach would be to require suppliers to allocate “in-the-money-hedges” – that is ones that can be liquidated at a profit – to a trust for the benefit of the supplier’s customers in the event of bankruptcy. This could be achieved through a change to the supply licence. However, there are difficulties with this: where suppliers are part of a larger corporate group hedging may be undertaken by a different entity, monitoring could be difficult since suppliers should legitimately be able to access the liquidated value of hedges in the normal course of business for example for hedge restructuring, and Ofgem only wants the positive value of hedges to be captured – it does not want to create liabilities for consumers should the hedges be loss-making at the time of liquidation.

Another approach would be to change all contracts between suppliers and customers that would create a debt owed by the supplier to the customer in the event of insolvency that equals the customer’s share of the SOLR costs. This would turn customers into unsecured creditors of the failed supplier meaning they would benefit from funds arising from the liquidation of the business. For administrative ease, the SOLR would have third party enforcement rights under the customer contract giving it the ability to pursue these amounts in the insolvency process. The risks with this approach are such a clause for customers signing up with the supplier when it is close to bankruptcy may be legitimately rejected by the administrators and that not all amounts owed to creditors might be recovered through the liquidation process creating a shortfall which still needs to be mutualised.

Ofgem is in the early stages of its thinking in this area and is seeking views on these ideas as well as any new ideas which may deliver the desired outcomes. These are both options that are within Ofgem’s powers to implement since it cannot change insolvency law, however, it may be that a change of law would be a better approach.

Capital adequacy – borrowing from banking

The current regulatory framework requires suppliers to maintain robust financial and risk management arrangements, while new entrants must demonstrate they can adequately fund their businesses for at least their first year of operation. Suppliers must also comply with milestone assessments to ensure they are appropriately resourced as they grow.

Two new obligations were introduced last year: the Financial Responsibility Principle which requires suppliers to have adequate financial arrangements in place (including capital where necessary) to meet costs at risk of being mutualised, ie that they have suitable plans and processes to meet government obligations, set direct debit levels and return customer credit balances. The Operational Capability Principle requires suppliers to demonstrate they have the capability, systems and processes to effectively serve customers and comply with regulatory obligations.

Ofgem is considering whether it should go further and set out specific capital adequacy requirements for suppliers, and how such rules might affect vertically integrated businesses whose business models are inherently less risky. The focus would be on domestic consumers since the credit balances of business are not protected in the SOLR process.

Regulatory capital can either consider “going concern capital” which is designed to absorb unexpected losses and allow a company to keep operating; or “gone concern capital” which is set off against obligations to reduce costs after a company fails. Since Ofgem wants to increase supplier resilience and reduce the instances of supplier failures, it is leaning towards regulating going concern capital which means the use of highly liquid instruments that can be accesses quickly in case of need.

On-balance sheet capital includes equity, retained earnings, reserves, and subordinated capital instruments, while businesses can also have off-balance sheet resources including credit and overdraft facilities, letters of credit, and parent company guarantees.

Ofgem is considering a tiering approach similar to that used in financial services, with Pillar 1 Capital being the minimum regulatory buffer suppliers would be expected to maintain and Pillar 2 Capital being additional capital Ofgem may require a supplier to hold based on assessment of its risk management. Suppliers may be able to reduce their obligations under ring-fencing rules if they hold more capital.

Ofgem is betting that higher costs now will provent higher losses later

All of these approaches to building financial resilience in the sector are likely to be more expensive for smaller, less creditworthy suppliers, creating barriers to entry and benefitting larger, more established businesses. Octopus Energy’s director of economics and regulation, unsurprisingly agrees with her boss, saying that Ofgem’s plans will hurt competition and potentially take the market back to the oligopoly of 2015.

However, the specific purpose of these measures is to deter thinly capitalised businesses from entering the market. In the first instance, this is likely to reduce competition, but they do not act to deter large, high quality business from adjacent sectors from entering the market. What deters those businesses is the adverse regulatory environment where suppliers are burdened with a wide range of non-supply activities (collecting green taxes, distributing welfare, installing network equipment and helping customers with home improvements) while being prevented by the price cap and by political pressure from earning an attractive level of returns.

If Ofgem and the Government want to see a more competitive, vibrant supply segment, and one with higher levels of innovation they need to make the sector more attractive by reducing these superfluous regulatory burdens and allowing energy companies to earn good profits. Greater prudential regulation is desirable, but abusing the supplier-customer relationship to force suppliers to act as the customer interface for every market initiative while severely restricting their ability to earn profits is not a recipe for attracting new entrants.