Out-Law / Your Daily Need-To-Know

Ofgem consults on new financial measures for energy suppliers

Out-Law Legal Update | 14 Jul 2022 | 2:08 pm | 6 min. read

Ofgem has proposed new financial measures and obligations for energy suppliers aimed at strengthening the sector, providing greater protection to customers and their credit balances, and reducing the likelihood of a repeat of the significant supply company failure seen in 2021.
  • Ringfencing of customer credit balances and renewable obligations payments and strengthening direct debit rules to protect customers.
  • Suggested reforms to energy purchase hedging.
  • Setting requirements for improved capital adequacy amongst suppliers.

Ofgem is consulting on proposals to reduce energy supply company failures. The proposals, set out in three statutory consultations, are aimed at improving the financial health of energy suppliers to a position where they can better withstand market fluctuations. The proposals include:

  • Better protection for customer credit balances and renewable obligations (RO) payments in the event of a supply company failure;
  • Improvement of capital adequacy of suppliers;
  • An obligation for suppliers to have greater control over the key assets needed to run a supply business;
  • Strengthening direct debit rules to prevent excessive credit balance build-up.

There were extensive energy supply company failures through 2021, Ofgem has identified that a recurring cause of the failure was that supply businesses were often not holding sufficient capital to manage fluctuations in the market and had become reliant on customer credit balances, and payments collected towards RO payments, for use as working capital to meet regular payments. This business approach enabled more suppliers to enter the market and grow while wholesale energy costs were low by attracting customers by offering low fixed prices. However, it left those suppliers without a stable business model and unable to raise further capital to meet ongoing payments when wholesale prices began to rise. 

Customer credit balances

Ofgem has proposed that customer credit balances and RO payments be ringfenced by suppliers so that they are held on trust, to be made available to the supplier of last resort (SoLR) in the event of the supplier’s insolvency. Customers generally pay a fixed monthly direct debit which is a higher amount than the cost of their energy use in the spring and summer months and a lower amount that the cost of use in the autumn and winter. Currently, credit balances are not ringfenced and the sector has had to bear significant mutualisation costs from the 2021 failures, with these sums not being recoverable from the failed suppliers. 

Ofgem’s proposal is aimed at removing the risk incentive for suppliers and reducing the mutualisation costs, by ringfencing credit balances so they can be transferred to the SoLR rather than being made available to the general body of creditors of the failed supplier. Ofgem believes that this will have the dual benefit of protecting funds and deterring new market entrants with insufficient capital and poor business models.

Ofgem considers that where the total payments made by each customer to the supplier, less the total cost of energy billed to date by the supplier, less the value of energy used by that customer since their last bill was issued leaves the customer with a credit balance, that credit balance should be ringfenced. Ofgem has suggested a quarterly update to this calculation and ringfencing, and on a forward-facing basis based on forecast energy consumption.

Ofgem is proposing introducing ringfencing protections by the end of 2022 but is interested in understanding what risks may exist with that timeline, and considering what transitional and interim measures may be required to ease those risks. 

To assist with the prevention of excessive build-up of credit balances, Ofgem has also announced a consultation on strengthening the existing direct debit rules. Under the existing rules, the supplier must take all reasonable steps to ensure the direct debit amount is based on the best and most current information available to the supplier. Ofgem is proposing removing the “all reasonable steps” component to make this an absolute obligation and eliminate subjectivity.  

Renewable obligations

Like customer credit balances, RO payments are not currently ringfenced, and are collected from customers during the year for payment once a year into the buy-out fund. On insolvency, up to 19 months’ worth of obligation from the insolvent supplier can be defaulted on, which results in shortfalls in the buy-out fund. The shortfalls are then recovered via mutualisation across other electricity suppliers.  

Ofgem and the Department for Business, Energy and Industrial Strategy (BEIS) consulted on changes to the RO legislation in 2021 to reduce the risk of mutualisation. However, no changes were ultimately made given the instability of the market. Ofgem is now proposing changing the standard conditions of electricity supply licence to require suppliers to protect the RO payments collected from customers. 

Ofgem’s preferred option for achieving this is to require suppliers to evidence that their accruing RO liability is being met by holding renewable obligations certificates, or protecting funds equivalent to their liability in some form of ringfenced trust – similar to the ringfencing required for the customer credit balances – or other insolvency-protected mechanism, such as via an escrow account, third party guarantee, parent company guarantee or standby letter of credit.

Ofgem is recommending a quarterly protection period for RO payments with a backward-facing forecast assessment using actual supply volumes. 

Under Ofgem’s plans, this proposal would be phased in from 31 October 2022, with full implementation by April 2023. Ofgem is inviting stakeholders’ views on the suggested implementation timeline. 

Hedging

Hedges are used by suppliers to buy a certain amount of wholesale energy at a fixed price to shield the supplier from short-term price fluctuations. Currently, if a supplier becomes insolvent, any hedges with a positive value become an asset of the insolvent company and their realisations available to the general body of creditors.

In the SoLR process, all the customers of the failed supplier are transferred to the SoLR but the hedges, while procured to meet those customers’ energy demands, remain with the failed supplier. The SoLR is therefore left to incur the wholesale energy costs at market rates, often at a greater cost, which the SoLR then seeks to recover from the industry levy. Ofgem believes that some of the 2021 supplier failures will have resulted in a financial surplus from the hedges being returned to the shareholders, while the customers bear the expense of the supplier’s failure through increased bills.

Ofgem would prefer that the SoLR be able to access the financial benefit of the hedges held by failed suppliers so as to reduce the value of the levy claim and the impact on customers’ future bills. It acknowledges that legislative change would be required.

Ofgem has suggested two interim ways of allowing a SoLR to access the hedges. Those options are:

  • Introducing a licence requirement that the proceeds of liquidated ‘in-the-money’ hedges must be paid directly into a trust for the benefit of their customers. The proceeds of the hedge would then be preserved for the benefit of the SoLR; or
  • Introducing a requirement that suppliers include in their customer contracts an obligation on the supplier to pay to a SoLR an amount up to the costs incurred by the SoLR as a result of the suppler entering insolvency. This would create a debt owed by the supplier to the customer, enforceable by the SoLR. 

Ofgem acknowledges that the options require further exploration. The regulator wants to better understand how hedges are structured and to what extent the proposals could be possible and effective. On this point in particular, Ofgem is keen for industry participants to contribute their views on the challenges which might be encountered in implementing these proposals.

Capital adequacy

While the current regulatory framework for suppliers requires them to maintain robust financial and risk management arrangements, Ofgem has proposed implementing a framework to more specifically target capital requirements as part of a wider strategy to manage financial resilience risks. 

The proposal recommends the introduction of a minimum regulatory capital buffer, which will require suppliers to maintain a minimum buffer of capital that has been set by Ofgem, taking into consideration the minimum capital needed for a well-hedged supplier to endure unexpected market shocks, and what that capital must consist of – equity versus contingent capital. Ofgem is further recommending that an additional bespoke capital buffer might be required depending on the supplier’s financial resilience in practice. 

Alongside those recommendations, Ofgem also suggests implementing a wider financial resilience monitoring framework – including new capital adequacy assessment reporting, ongoing regulatory stress testing, and ongoing monitoring and reporting related to the full range of financial resilience measures suggested by Ofgem in the consultation proposals. 

Ofgem has not proposed a timeline for implementation for this recommendation and instead has suggested that these changes will be developed under a timeline which accounts for the outcomes and impacts of the other suggested policy reforms on credit balances and RO payments, along with an ongoing assessment of market resilience.

Our view

While the proposals are well-intentioned and likely to improve the overall stability of the sector in the long-term, they may come too late for smaller suppliers currently struggling to survive in the sector. We expect to see more failures during 2022. The consultation closing date is 19 July 2022 with responses and comments likely to be published shortly after that date. Businesses that would be impacted by the proposals are encouraged to engage with the consultation process to raise any issues or concerns.

Co-written by Samantha Poulton of Pinsent Masons.