Following on from my previous post describing the BEIS Select Committee’s recommendations into improved governance at Ofgem, this post examines the specific market reforms to the retail energy market proposed by the Committee. In particular the Committee is calling for a social energy tariff to be introduced, reforms to the SOLR process and the regulation of third party intermediaries, more action on affordability, and action to reduce heat losses in homes.
The price cap has been poorly implemented and needs reform
The energy price cap was introduced in January 2019 as a temporary measure to “prevent excessive charges by energy suppliers” whilst effective competition was established, and to address the so-called loyalty penalty. This penalty arises when existing customers on the standard variable tariff or default tariff face higher charges than those available to new customers, and is a problem across various industries. The cap is not intended to guarantee affordability but is supposed to be a “fair” price determined by Ofgem after analysing supplier costs.
Witnesses expressed a range of views on the performance of the cap under stable market conditions, with some suggesting that it has contributed to a structurally loss-making market, erodes investor confidence, and does not allow suppliers to earn a reasonable rate of return. These are views I share. According to Ofgem, the average pre-tax margin achieved by large legacy suppliers in 2020 was minus 1.32% for electricity and minus 0.44% for gas. Losses increased during 2021 and 2022 as wholesale prices rose rapidly.
“…the fundamental profitability allowed is 1.9%; in practice, hardly anybody is making any profit at all. In fact, the entire sector has been loss-making for several years, which is why 29 companies have gone bust,”
– Michael Lewis, Chief Executive of E.On
On the other hand, Octopus Energy told the Committee that in normal market conditions it made reasonable margins on price-capped customers and that sufficient margins are “baked” into the price cap to allow for healthy competition between efficient companies, and EDF CEO, Simone Rossi, said that the cap was needed to protect consumers and probably did allow for healthy competition in normal market conditions.
This is debatable. The theory is that challenger suppliers can be more efficient because they lack the legacy infrastructure that legacy suppliers have built up over the years – the implication being that this legacy infrastructure was aging and inefficient, and in some cases, un-necessary. I’m not sure that I entirely buy into this argument – yes, legacy suppliers can have inefficient systems, particularly where businesses have grown through acquisition and operational infrastructure has not always been well integrated. But these are not illegitimate costs and as challenger suppliers also grow through acquisition they will incur similar costs, eventually also losing competitiveness. Perhaps at that point they will be less keen on the price cap.
In other markets, the Government has tackled the loyalty penalty by requiring providers to offer existing customers deals that are not worse than those available to new customers – this would be a much less distorting approach to managing the risk to consumers.
In any case, there was widespread agreement that the cap had been poorly implemented and did not function well in the case of high price volatility. Not only was the six-monthly review insufficiently flexible to respond to rapidly changing wholesale prices, but the cap was designed to be “tough” meaning that when volatility hit, suppliers had insufficient margin to absorb the shock, quickly leading to losses. The result was that suppliers subsidised consumers, insulating them from increases in wholesale costs which they should legitimately have been able to pass on.
“Ofgem’s design of the energy price cap also contributed to market instability and resulted in suppliers subsiding customers; this was not its intended purpose. While the Energy Bill [HL] (2022) included provisions to extend the energy price cap beyond 2023, neither the Government nor Ofgem has evaluated its costs and benefits or considered alternative forms of price protection, including a social tariff. The Government should consider the introduction of a social tariff for the most vulnerable customers and a relative tariff for the rest of the market,”
– BEIS Select Committee
The National Audit Office found that although Ofgem understood that the price cap could make suppliers—especially small suppliers—more vulnerable to price shocks, it did not stress test the price cap’s design in depth. The Oxera review concluded that the interaction of the price cap methodology and the Supplier of Last Resort (“SOLR”) process led to the gap between the maximum price allowed under the cap and the (higher) wholesale price being mutualised through future customer bills, and that the interaction between the two was not understood by Ofgem
Ofgem is considering reforms to the cap methodology and has proposed moving to a process of quarterly updates. However, the Committee has found that Ofgem’s cost benefit analysis of this move did not consider the risk and impact of rising prices this coming winter, and in particular how this would affect vulnerable customers and their potential levels of self-disconnection. This is important – while suppliers should not be expected to subsidise consumers, by failing to carry out this impact assessment, Ofgem has not been able to articulate to the Government the degree of additional support consumers might need this winter.
But the question is whether the price cap should continue in its current form or even at all. Regular readers will know that I opposed it from the outset and more recently have called for it to be replaced with a social tariff aimed at the fuel poor. There have been calls from across the industry for some form of review and proper analysis of alternative approaches. The Energy Bill which was introduced to Parliament on 6 July 2022, included provisions to extend the cap beyond its current expiry date in 2023, but it will not change how the cap functions.
Neither the Government nor Ofgem has undertaken an evaluation of its costs and benefits, nor considered alternative forms of price protection. The Committee is therefore asking Ofgem to undertake an immediate review of the costs and benefits of the price cap to inform decisions about its operation and alternative forms of price protection, and it is calling on the Government to consider the introduction of a social tariff for the most vulnerable customers and a relative tariff for the rest of the market, to be introduced once wholesale energy prices have stabilised. It would like the Government and Ofgem to report their findings on these issues within nine months.
Reforming the SOLR process
The impact of supplier failures on consumers was not just driven by the poor governance which allowed so many suppliers to fail, but by the financial consequences for the market when they did fail. Often these suppliers owed their customers money in the form of credit balances, as well as owing Ofgem money in the form of Renewables Obligations (“RO”) payments which had accrued but not yet fallen due for payment. In addition to this, the Supplier of Last Resort (“SOLR”) appointed to take over the customers of the failed supplier typically had to buy gas and electricity for these customers at higher prices due to market movements over time, meaning the cost to serve was raised but not able to be recovered under the prevailing price cap.
Many witnesses complained that a combination of energy regulation and insolvency laws was disadvantageous for consumers, increasing the costs of the SOLR process. Ofgem has sought to explore solutions to this and recently closed a consultation on ring-fencing credit balances and RO payments. In a letter written to the Committee on 27 June, Ofgem said it had identified a number of potential solutions that would reduce the mutualised costs associated with these issues. These include making the SOLR or a SOLR levy fund a deemed creditor of the supplier for the purposes of the Insolvency Act; amending the Companies Act to make consumer interests equivalent to other stakeholders, and/or making consumer interests equivalent to interests of creditors when facing insolvency in terms of directors’ duties; or a transfer scheme to transfer hedging agreements (of the liquidated value from such hedging agreements) from one supplier to another in circumstances where an energy supplier is facing insolvency, and where the Secretary of State considers that it would be equitable to do so.
However, in his oral evidence to the Committee, Kwarteng strongly opposed making the SOLR levy a creditor saying this would mean creditors would be unlikely to be repaid, and therefore suppliers would struggle to get access to credit and be unable to “raise any capital whatsoever”. This would “essentially kill the industry”.
As a result of this rather over-dramatic testimony, the Committee only felt able to recommend that the Government and Ofgem review the SOLR process. I disagree that the creation of a SOLR levy creditor would make the industry un-bankable – it would certainly make it difficult for thinly capitalised businesses to secure credit, but this is not a bad thing. The markets would create their own resistance to risky business models if unsecured creditors were ranked pari passu with customers.
Of course, this only helps if there is money available in the liquidation process – many of the failed suppliers collapsed with large debts that were never repaid. But it would be a start. Customer credit balances should be ring-fenced, and the law should be changed to require RO payments to be made more frequently (the Government has been resisting this as it is considering wider reforms to the RO and does not want to increase the legislative burden).
In addition, insolvency law should be amended so that hedges are carved out of the insolvency process so that the SOLR could apply for in-the-money hedges to be assigned to it, rather than liquidated for the benefit of creditors, and so that administrators of failed energy suppliers have statutory obligations to provide necessary information to the SOLR within defined timeframes.
The Committee also considered the matter of hedging in relation to Bulb, picking up on the same outrageous comment by the Business Secretary as I did in my previous blog when he described hedging as being “very risky” and comparing it (in level of riskiness) with insurance, indicating a lack of understanding of either product. The Committee was similarly disappointed by this comment, and highlighted the differing view taken by Ofgem and the industry that hedging is an important part of responsible risk management.
Kwarteng has confirmed to the Committee that no hedging has been entered in respect of Bulb since it entered the Special Administration Regime (“SAR”). The explanation given was that the Government hedges across its entire portfolio and follows the Treasury’s Managing Public Money guidance. That guidance in itself does not preclude hedging, but given the Treasury’s wider exposure to a gas long position through North Sea production, it is possible that across the portfolio there is a natural hedge.
The question is whether the Bulb business is ring-fenced or whether it can benefit from this portfolio approach. Given the Government is trying to sell the business, it would make sense if it was managed on a stand-alone basis, which would then include separate hedging. It would not be surprising lack of hedging was a key factor in the failure to attract interest in a sale of the company – a recent auction closed with only one bid, from Octopus – and the business may yet be broken up. In any case, the Committee recommends that rather than seeking to recover the costs of the SAR from consumers, as anticipated in the Energy Act 2004, they should be covered through general taxation.
Government should act to regulate third party intermediaries
In 2018, Ofgem relaxed its rules to allow suppliers to offer discounted deals for new customers through price comparison websites. According to Citizens Advice, in 2019, 49% of domestic consumers that engaged in the market said they did so through a price comparison site, and of these 10% used an auto-scanning or auto-switching service. Those who chose not to engage could rely on auto-switchers to switch on their behalf – by September 2021, the largest auto-switching service, Look After My Bills, reported over half a million users.
Witnesses told the Committee that the combination of using switching rates as the key metric to determine the health of the market, inadequate controls over supplier business practices, and Ofgem having limited regulatory oversight of third-party intermediaries (“TPIs”), led to these services promoting unsustainable offers from shaky suppliers. Comparison websites directed savvy consumers to new suppliers, many of whom were offering unsustainable prices, to the detriment of disengaged and often vulnerable consumers who are now left to pay the costs of supplier failures.
Across the market there was an excess focus on price with other aspects of the supplier offering, such as customer service levels, being largely ignored. Citizens Advice claimed that TPIs disregarded both the financial resilience of suppliers and their customer service standards, and on occasion, switched customers to unsuitable products where they lost out on protections, while Age UK said that customers using auto-switching services were often unable to select customer service as a switching criterion. Auto-switchers do not always compare all available suppliers sometimes only including suppliers paying them commission.
The Committee recommends that the Government brings forward regulation of TPIs to ensure they encourage customers to switch not just based on price, but after also considering customer service standards and other factors. The regulations should also ensure that TPIs are transparent about the services offered and the suppliers that they work with, provide an explanation of remuneration, and access to advice and redress for customers. These regulations should be future-proofed for the significant role TPIs are expected to play in the energy transition.
Wider energy market reform, particularly to address affordability concerns
The previous Energy Retail Market Strategy was primarily driven by the objective to increase switching rates – the only metric considered to indicate the success or otherwise of competition in the market. The collapse of so many suppliers demonstrated the flaws of this approach. The Committee believes the revised strategy should develop a market that differentiates not just on price, but on the wider set of services offered by suppliers, as well as creating incentives for customers to make the investments needed to support net zero ambitions. It would like BEIS and Ofgem to urgently update the Energy Retail Market Strategy so that the supplier retail market aligns with our net zero target, including interim milestones and high-level principles about the role suppliers will play in achieving net zero.
The Committee is also very concerned about the impact of rising energy prices on consumers. It would like the Government to again update the support packages announced this year so they keep pace with these increases, and wants a change to the way in which the relief is delivered to mitigate the risk of prepayment customers not redeeming their vouchers, and to ensure it reduces the costs of energy for customers in debt.
The Committee is also urging the Government to issue the Fairness and Affordability call for evidence, which was originally promised for April 2021, but has yet to materialise. The purpose this was to begin a strategic dialogue between the Government, consumers and industry on affordability and fairness in the energy system with a transparent discussion on costs, including the way policy costs are passed through to consumers, and how costs are apportioned between gas and electricity bills.
The review should include a distributional analysis of the impact of policy costs on vulnerable customers, and a consideration of moving legacy policy costs to general taxation. It says that any reapportioning of policy costs from electricity to gas bills should be accompanied by mitigating negative impacts on fuel poor and vulnerable consumers, and that the review should also include an assessment of the impact standing charges have on vulnerable customers, and whether these charges are appropriate for customers with prepayment meters.
On a related note, the Committee wants to see better compliance with Ofgem’s Ability to Pay licence condition, ensuring that suppliers promote a range of debt repayment options. There have been multiple recent news stories about suppliers taking aggressive actions in respect of delinquent customers, including breaking into people’s homes to install prepayment meters. In several cases the homes in question did not actually belong to the customers of the supplier, leaving consumers both locked out of their homes and with prepayment meters they neither wanted nor needed following administrative errors.
When suppliers cannot recover debt from customers, it is mutualised and accounted for in future price caps – this is referred to as bad debt. Ofgem estimates that approximately £1.3 billion of bad debts will be accrued over 2022–23, across the eight largest suppliers, compared with £522 million between April 2021 to March 2022. This estimate was made prior to the announcement of the Government’s strengthened support package for households so is likely to overestimate the levels now expected. Ofgem does not often update projections of bad debts which makes it difficult for the sector to assess and address the extent of the issue.
The Committee recommends that the Government develops a scheme to help vulnerable customers accelerate the repayment of debt that has arisen as a result of recent price rises, for example, by matching the contribution made by customers through the Fuel Direct scheme. It also recommends that Ofgem publishes data on the levels of debt in the market on a quarterly basis, and asks Ofgem to update and publish its analysis on the levels of bad debt it expects this winter after accounting for further increases to the price cap.
“It is unacceptable that prepayment customers, who are often moved to a prepayment meter because they cannot afford their energy bill, pay more for their energy than direct debit customers. We recommend that Ofgem addresses this differential, for example by reinstating the Safeguard Tariff for prepayment customers, to ensure that they pay no more than direct debit customers for their energy. This would be a temporary measure while the Government consults on the operation of a social tariff.”
It is also concerned about the additional costs faced by prepayment consumers who pay on average £46 per year more than comparable direct debit consumers under the current price cap, which Ofgem, somewhat dubiously claims is because the costs to serve are higher for prepayment customers. There are over four million customers (around 15% of the market) using prepayment meters many of whom are on low incomes and in vulnerable circumstances.
Prepayment customers who cannot afford to top up their meter either self-ration their energy use or self-disconnect. In December 2020, Ofgem introduced new requirements for suppliers to identify customers who self-disconnect, or are at risk of self-disconnection, and offer them short-term support through emergency and friendly hours credit, particularly to those in vulnerable circumstances. Citizens Advice and National Energy Action (“NEA”) found that these rules are not being enforced by Ofgem.
Ofgem only collects partial data on self-disconnection, which largely relates to those with smart prepayment meters – roughly half of all prepayment customers. Ofgem only asked suppliers to resume reporting self-disconnection data last September, following a covid-related derogation. Although Ofgem does not currently publish data on the levels of self-disconnection, it intends to do so from early 2023. Ofgem’s assessment of the levels of self-disconnection do not align with the influx of cases seen by Citizens Advice which has warned that self-disconnections are now at a record high levels, with the first four months of 2022 seeing more cases of self-disconnection than the whole of 2021.
According to Citizens Advice, in April and May 2022 – the two months following the April price cap increase – it saw 2,401 cases where people were unable to top up their prepayment meter, a 646% increase on the same period in the previous year. It believes that if energy bills rise to £3,000 this winter prepayment customers will need to spend at least £10 a day on their energy usage, double the daily cost of the 2021 winter. Despite the significant risk to prepayment customers this winter, Jonathan Brearley, the Ofgem CEO, told the Committee that it has not yet carried out all of the impact assessment to understand how increases in the October price cap could affect households.
Naturally, the Committee wants Ofgem to urgently improve its data collection on self-disconnection and publish these data on a more frequent basis. It wants Ofgem to conduct an impact analysis on how expected price cap increases this winter will affect customers at risk of self-disconnection, as well as a review of the Ability To Pay framework to determine whether further, action is needed to address an increase in self-disconnection come October. It would also like Ofgem to work with suppliers to help identify vulnerable prepayment customers who are at risk of self-disconnection, for example those who have high energy demand due to the use of medical equipment, and offer to convert these users to credit mode to maintain their supply.
Addressing heat losses in homes
Despite the benefits of properly insulated homes being well understood: they reduce energy waste and therefore the cost of heating for households, the Government has taken a stop-start approach to policy in this area, and these benefits are not being realised. The Government’s pathway to net zero sees a million homes treated per year by 2030, but the policies needed to deliver this are not in place. The Government has so far failed to bring forward a replacement for its failed Green Homes Grant scheme which was discontinued on 31 March 2021.
“The Government’s Energy Security Strategy, published on 7 April 2022, and the Energy Bill [HL], introduced to Parliament on 6 July 2022, included little mention of energy efficiency. The strategy stated that energy efficiency was “the first step” to reducing our dependence on gas following Russia’s invasion of Ukraine, yet it included no new policies for energy efficiency measures,”
– BEIS Select Committee
The Committee points out that while the focus to date has been on heating, should hotter summer weather become more common, more households will install cooling and air conditioning measures – this would further increase costs to consumers (as well as straining the electricity grid – currently the thermal generators that underpin the Capacity Market tend to use the summer for maintenance outages – last week’s Capacity Market Notices at a time when 12.5 GW of conventional generation was out for planned maintenance would have been a shock to capacity providers who are exposed to high penalties if they are unable to operate during a system stress event).
The Committee supports an expansion of the Energy Company Obligation (“ECO”). In my view this is a mistake – expecting suppliers to intermediate between homeowners and the building trade is inefficient and does not deliver the best value for consumers. It would be better if a single centralised scheme to address energy waste from homes was developed by Central Government and implemented by local government. Local authorities are more familiar with the housing stock in their areas, already have oversight of the planning and Building Control processes, and can extend the schemes to social as well as privately owned housing.
The Committee reiterates its previous views that the Government should implement urgent, far-reaching, and long-term measures to replace the Green Homes Grant scheme that and ends the stop-start policy approach in this area once and for all. It urges the Government not to divert funds from other energy efficiency schemes to pay for this. However, it does not attempt to offer any solutions other than an expansion of the ECO, which is unfortunate. I previously proposed an outline approach – it’s not perfect but it’s a start. Just about everyone agrees that Something Needs to be Done, but without meaningful proposals and a proper debate about different approaches, we will not move forwards and will continue to complain about lack of action. This is the main weakness in an otherwise excellent report – in the absence of leadership from the Government, the Committee should put forward its own proposals for discussion.
Many of the proposals are sensible but relief for high energy costs should be the priority
Many of the reforms proposed by the Committee are sensible…the price cap should be reformed, and indeed replaced with a social tariff (I’m less persuaded by the relative price cap idea), and the SOLR process requires improvement – ideally through legislative change to both insolvency laws and the RO laws. Regulation of TPIs is desirable and there have been widespread calls for this for years. And of course, we need a proper plan to reduce heat losses in homes.
More pressing than any of these is the need to address issues of energy affordability this winter. The current price cap level is £1,971 for direct debit customers, and even higher for prepayment consumers. The October price cap has not yet been published (it is expected to be announced on 26 August) but analysts estimate that it will increase to as much as £3,420, and, given the likely rule change to quarterly updates, it could rise again to between £3,500 and £3,850 in January.
“Anticipated prices far exceed earlier projections. Current financial support will be inadequate as much of that money will be spent before winter kicks in. We are facing the bleakest of winters. Energy bills are already unaffordable for millions, and millions more are set to suffer. People will be forced into impossible situations. Choosing between heating and eating, forced into spiralling debt and putting their emotional and physical health at significant risk. The energy crisis is the urgent priority for a new prime minister. Higher prices and cold weather are inevitable. Dither and delay are not,”
– Adam Scorer, Chief Executive, National Energy Action
NEA believes as many as one in three households could be in fuel poverty this winter – others have suggested it might be 40%. The support measures announced by the Government earlier this year will not be enough to prevent real hardship this winter, and even former Chancellor Rishi Sunak appears to have had a change of heart in relation to VAT relief, despite previously describing it as an unjustified subsidy.
This winter will be very difficult, both in terms of affordability and energy security. The moneysavingexpert website has produced a useful guide outlining various support measures to help people struggling with high energy bills, but Government action is urgently needed.