Ofgem to improve transparency of energy supplier pricing and profits

Ofgem has taken two more steps to improve competitiveness and transparency in energy supply markets.

Ofgem announced on 26 February 2014 that new measures are to be taken to improve the transparency of energy company profits and to remove barriers to competition.

Fair trading with independents and wholesale liquidity

From 31 March 2014, the six largest suppliers and the largest independent generators must comply with new guidance on trading with independent suppliers and must improve transparency on wholesale trading prices. Failure to follow the new rules could result in financial penalties.

The new requirements

• It will not be possible for these companies to refuse any reasonable requests by independent suppliers to buy electricity, or to treat these requests as low priority;
• There will be deadlines in place for acknowledging such requests and responding to them;
• Electricity must be sold to independent suppliers at the market rate;
• A full range of products in forward markets must be offered, which will help independent suppliers hedge their costs;
• Credit arrangements for trading should be established that are reasonable and clear; and
• The price at which wholesale power is traded must be published up to two years in advance. The price must be published daily in two one-hour windows, giving independent suppliers and generators the opportunity and products they need to trade and compete effectively.

Changes to annual segmental statements

It has been a requirement since 2009 that the largest energy companies must report annually on the revenues, costs and profits of their activities separately through Consolidated Segmental Statements. In October 2013 Ofgem held a consultation seeking views for improvement in market transparency. In an open-letter of 26 February Ofgem set out new measures to ensure that these statements and any information available regarding energy company profits are more robust, useful and accessible. The changes are set out below.

Increased Auditor Scrutiny

External auditors must scrutinise the companies' statements. For the 2013 statements each company will commission external auditors to undertake detailed checks on the statements. From 2014 onwards, a full audit will be performed. Ofgem intends to embed the requirement for a full external audit in suppliers’ licences.

It will be interesting to observe whether a full financial audit of the segmental statements translates into improved transparency given that some suppliers felt that there was already a transparent relationship between the segmental statement and the audited accounts separately published by suppliers.

Transfer Pricing Review

Ofgem intends to undertake a full review of transfer pricing (“TP”) policies. In particular this review will:

• Update and enhance understanding of the companies' current TP policies;
• Assess compliance with TP rules and best practice;
• Identify and investigate any areas of potential concern, including looking at the specific market prices used, the effect of lower liquidity in the forward markets on transfer prices, and any adjustments companies make to market prices to calculate their transfer prices; and
• Conclude on the implications for the transparency of companies' statements, and their comparability across companies

Greater Insight into Trading Activities

Ofgem has asked the companies to be more transparent in their consolidated statements on the factors that affect the transfer price they use. For the 2013 statements, the companies should do as much as they can to shed further light on the trading function of their business and to address the perception that the trading function can be used to hide profits. Following the TP review Ofgem will make a decision regarding the requirements for the 2014 statements onwards.

The responses, from large suppliers, consumer groups and small suppliers, set out mixed views regarding proposals related to transfer pricing and trading activities. For example, E.on proposed full managerial separation between generation and supply as well as a full market investigation by the Competition Commission. The divergent nature of the responses would appear to support Ofgem’s decision to carry out a further and more in-depth review of companies’ transfer pricing policies, and this review is intended to inform whether it would be useful or practical for Ofgem to require suppliers to disclose more information regarding their trading activities.

Accelerated Publication of Statements

Companies currently have six months following the end of their financial year to publish their statements. Ofgem believes this process should be accelerated. For the 2014 statements onwards, Ofgem intends to introduce a new licence condition requiring publication of statements no later than four months after the end of the financial year. For the 2013 statements, the companies have agreed to use their best endeavours to bring forward publication as far as they can.

Development of ROCE methodology

The return on capital employed (ROCE) is regarded as an appropriate measure of profitability in many markets. Ofgem considers that the publication of ROCE figures for generation will provide a more meaningful picture of the level of profits over time. Ofgem aims that this requirement will come into effect from the 2014 statemenents onwards.

Greater Cost Breakdown

Ofgem will require companies to present bill breakdown information to show network costs separetly from environmental and social obligations costs. Ofgem aims to amend the Consolidated Segmental Statements Guidelines from the 2014 statements onwards for this purpose. There will be some degree of flexibility for the current 2013 statements in terms of cost categories.

Improved Supply Market Indicator

The Supply Market Indicator (SMI) provides a forward-looking view of a representative supplier’s costs and revenues. Ofgem proposes to align the methodology and bill breakdown categories in the SMI with those of the statements. Ofgem is also proposing to publish SMI outputs as far back as the latest set of statements, together with more detail on model inputs, outputs and methodology.

Ofgem and DECC comment

Ofgem CEO Andrew Wright heralded the reforms as “breaking down barriers to competition for new entrant suppliers” and DECC Secretary of State Ed Davey noted that “changing the rules for how energy is sold to suppliers is a big step forward in creating a fairer, more competitive energy market in the UK”.

Given the current political emphasis on energy prices and the profits of large energy companies, Ofgem clearly feels that it needs to be seen to be taking active steps to bolster consumer confidence in energy companies. The result is that the recent changes are consistent with a broader pattern of ever-increasing scrutiny of energy companies, particularly the activities of energy suppliers.

For further details on Ofgem’s decisions, please click here and here.

Co-authors Leanne Bain ([email protected]) and Hamish McKinnon ([email protected]).