New for 2022: Ofgem look to build energy market resilience

Introduction

The significant rise in wholesale gas prices over the last year and the significant strain this has put on market participants and consumers alike has been high up the political agenda. In particular, the energy price crisis has shone a light on the financial resilience of energy suppliers and their ability to withstand market pressure of this (albeit unprecedented) kind.

Almost 30 energy suppliers failed in 2021 and the costs of such failures will ultimately be borne by end-consumers. On 29 October 2021, Ofgem published an open letter which set out how it intended to protect the short and long term interests of consumers in light of energy price volatility. Further to this, on 15 December 2021 Ofgem published six policy documents setting out its plan of action to: i) strengthen the financial resilience of suppliers to cope with energy price volatility; and ii) potentially adjust the price cap methodology to strike a balance between protecting consumers without creating unsustainable risks for suppliers.

The policy documents comprise:

1. An action plan on retail financial resilience;
2. A supporting statutory consultation on strengthening milestone assessments and additional reporting requirements;
3. A call for views on potential adaptations to the price cap methodology for resilience in volatile markets;
4. A supporting statutory consultation on potential short-term interventions to address risks to consumers from market volatility; and
5. Two decision letters regarding the time period for assessment of supply licence applications and tacit authorisation and revocation of dormant supply licences.

In this article, we consider the measures put forward by Ofgem.

Action plan on retail financial resilience (the “Action Plan”)

The Action Plan sets out steps that Ofgem proposes to take in the near and medium term to ensure financial resilience of suppliers and that risks are not passed on inappropriately to consumers. These measures are in addition to work Ofgem has already implemented in this area, such as introducing higher standards for new entrants to the market in 2019 (see our commentary here) and new licence obligations on operational capability, financial responsibility and ongoing fit and proper requirements in 2021 (see our commentary here).

The Action Plan identifies five outcomes it seeks to achieve:

1. Implementing robust minimum standards to ensure commercial risk is well managed;
2. Protection of customer money (and not passing inappropriate risk to consumers);
3. Accountability, including minimum requirements for staff in significant leadership or executive roles and board members;
4. Proportionality, regulating as necessary, and no more than needed; and
5. Ensuring any regime is sustainable, innovative and competitive to promote the transition to net zero.

In the Action Plan, Ofgem notes that recent events indicate that it requires a greater understanding of the financial position of individual suppliers and the wider retail market to protect consumers effectively. As such, the Action Plan consists of the following:

1. Enhanced monitoring and data: Ofgem already receives data from suppliers relating to market resilience and where necessary it will expand the scope of this reporting. It is noted that Ofgem will expect suppliers to be responsive in this process and failure to respond fully or accurately will be met with robust enforcement action. Areas of enhanced reporting are likely to include information to demonstrate financial resilience, operational preparedness to secure supply for new and existing customers and strategies for risk management, including approaches to hedging, customer credit balances, pricing, volume management and policy costs such as social and environmental schemes.
2. Stress testing: From January 2022, Ofgem will be launching a programme of stress testing assessments to gauge whether suppliers are robust enough to withstand a range of scenarios through capital cover or risk management. Ofgem advises that initial stress tests would likely be a range of ‘what if’ scenarios, noting that these will be as targeted and simple as possible. Possible scenarios include: price volatility, differing levels of customer bad debt and significant acquisitions or loss of customers.
3. Management Control Framework: Ofgem expects suppliers to have a robust management control framework in place to support delivery of their commercial strategy and management of their risks. It will launch a self-assessment exercise in early 2022 to be undertaken by suppliers and will request board assurance to Ofgem that risks are appropriately managed. This exercise will cover governance, policies, processes, controls, and management information used to manage and monitor commercial risks.
4. Financial Responsibility and Operational Capability obligations: Alongside stress tests and self-assessments, Ofgem will evaluate whether suppliers are meeting the minimum requirements introduced by the Operational Capability condition (SLC 4A) and the FRP (SLC 4B).
5. Credit balances: Ofgem acknowledge the urgent need to ensure that customer credit balances are used properly. It notes that given the number of recent supplier failures, it will review options for protecting customer credit balances and will be engaging with suppliers on this early in the new year.
6. Managing new customer acquisitions and growth: This is dealt with in the statutory consultation published alongside the Action Plan (see below).
7. Governance and accountability: It is noted that Ofgem are exploring whether to enhance the regulatory framework in this area, particularly in respect of senior leadership.
8. Extension of the new supply application assessment period: This is dealt with in the decision published alongside the Action Plan (see below).
9. Mutualisation – credit balances and RO payments: This is the subject of a previous consultation (see our commentary here) though it is noted this remains under review and if a licence solution is taken forward, this will be implemented holistically with the work on credit balances referred to above.

Statutory consultation on strengthening milestone assessments and additional reporting requirements (the “Consultation”)

Alongside the Action Plan, Ofgem published the Consultation, which also aims to strengthen the financial resilience of suppliers and contains targeted proposals to strengthen Ofgem’s milestone assessment regime, and more closely monitor suppliers’ significant commercial developments and personnel changes.

The Consultation proposes the introduction of a new supply licence condition which would require suppliers to pause domestic customer onboarding once they reach the 50,000 and 200,000 domestic customer milestones for each of the relevant gas and electricity supply licences, until such time as Ofgem has completed any necessary milestone assessment and the supplier has had sufficient time to take any necessary action.

Whilst this measure would temporarily restrain a supplier’s ability to expand, Ofgem argues that the measure is proportionate considering the context of recent supplier failures. It contends that the measure will ensure suppliers with weaker business models and poor practices do not grow without scrutiny.

In addition to the above, the Consultation seeks views on the proposal to require that Ofgem is notified about significant planned commercial developments and personnel changes in advance of them occurring. Ofgem believes this would give it the necessary time to carry out an assessment of the impacts these changes may have on consumers, and for any necessary action to be taken.

The Consultation closed on 17 January 2022, with Ofgem expecting to publish its decision around February in time for any changes to take effect in April 2022.

Adapting the price cap methodology for resilience in volatile markets (the “Call for Input”)

Ofgem is seeking views on technical adaptations to the price cap methodology to ensure it is better able to handle energy market volatility, whilst balancing the need to protect consumers. If it becomes apparent that change is necessary, Ofgem will issue a formal policy consultation on changes to the price cap methodology in early 2022, with a view to implementations being made in October 2022, ahead of the winter.

The Call for Input puts forward three potential adaptations to the price cap methodology (whilst recognising that a fourth option is to do nothing):

1. Enhanced status quo: This involves retaining the existing methodology, but with an enhanced ability for Ofgem to adjust the price cap in extreme circumstances. This could also involve an automatic ‘circuit breaker’ triggered by certain circumstances. Additionally, Ofgem suggest reducing the current two-month gap between the observation window closing and the price cap period starting, thereby lessening the eight-month lag.
2. Quarterly updates: This option uses the existing cost-based price cap methodology but updates the wholesale cost component every three months (instead of six months under the current cap). This achieves a quicker pass through of wholesale costs rises and falls, thereby reducing the lag between wholesale price movements and their recovery from eight to five months. Ofgem note that the price level could be set using forward prices for three months, six months, or twelve, with different balances of price smoothing for consumers against risk remaining with suppliers.
3. Fixed term default tariff: Ofgem compare this option to a fixed mortgage, having a price fixed for six months, that is set by Ofgem each month (for consumers starting their tariff that month), and an exit fee that would potentially decline over the six months. Apart from the change to the way the wholesale cost element is calculated, all other costs (such as network costs) would follow the existing calculations for the price cap. This option would protect both consumers and suppliers from price volatility. The price of the tariff could be based on either six or twelve-month forward prices hedges. Alternatively, Ofgem suggest an annual fixed contract, with matching twelve-month forward pricing.

The Call for Input closed on 13 January 2022 and Ofgem will be publishing a policy consultation document early this year proposing the options it believes address the issue and best protects consumer interests.

Statutory consultation on potential short-term interventions to address risks to consumers from market volatility (the “Consultation”)

This Consultation seeks views on potential short term, temporary interventions to help stabilise the market in light of current wholesale market volatility. Whilst adjustments to the price cap will not be in place until October 2022 at the earliest, Ofgem recognise that the market remains volatile, and is looking to implement short-term measures to ensure customer protection.

The Consultation sets out three temporary actions that Ofgem could take to ensure consumer protection, whilst again recognising the “do nothing” option:

1. Requiring suppliers to make all new tariffs available to existing customers: This would require domestic suppliers offering tariffs for the acquisition of new customers to make them available to all existing customers as well, aiming to mitigate risk by reducing, to some degree, the incentives for suppliers to price significantly lower to acquire new customers and, in this way, reducing the potential losses caused by high levels of churn in scenarios with significant falls in wholesale prices.
2. Allowing suppliers to charge exit fees on certain Standard Variable Tariffs: Here, Ofgem would allow suppliers to introduce temporary exit fees for domestic customers on Standard Variable Tariffs (“SVTs”). Exit fees are commonplace for fixed-term contracts but are currently not permitted for contracts of indefinite length, such as SVTs, by SLC 24.3. Ofgem argue that exit fees would enable suppliers to recover the legitimate hedging costs they have incurred on behalf of their SVT customers.
3. Requiring suppliers to pay a Market Stabilisation Charge when acquiring new customers: Under this option, Ofgem would require all suppliers acquiring a domestic customer to pay a ‘Market Stabilisation Charge’ to the losing supplier. This would be a proportion of the economic loss to the losing supplier and would be applied when the switch occurs. It would be based on a customer’s estimated annual consumption. The Market Stabilisation Charge could, Ofgem believes, mitigate risks by enabling suppliers to recover a portion of the efficient costs incurred on behalf of SVT customers when those customers choose to switch away as market prices fall.

Ofgem notes that these options could help suppliers to better manage the risks posed by severe energy price volatility, and therefore may mitigate the potential costs to customers if wholesale prices rise or fall significantly. It does, however, recognise that at least in the short term, the suggested options could dampen competition and reduce the savings available to customers. The intention would be for the chosen measure to be time limited until the end of September 2022.

The Consultation closes on 17 January 2022, and Ofgem will use responses to inform a decision on how to proceed, which will be taken by the start of February 2022.

Decision relating to time period for assessment of supply licence applications and tacit authorisation

In Ofgem’s open letter of 29 October 2021, it confirmed that it would be temporarily pausing assessment of applications for new supply licences for a period of six months. It has further published a decision confirming it will continue to pause its assessment of new applications for a further three months in an effort to protect the retail market and consumers. In addition, the decision confirms that tacit authorisation for supply licence applications does not apply to supply licences as an interim measure, and until further notice.

Decision on revoking unused and dormant licences

Ofgem also published another decision confirming that it will be taking active steps to identify and revoke any unused and/or dormant licences. All relevant licences will receive 30 days’ notice of revocation as required under the Gas Act 1986 and Electricity Act 1989.

Next steps

Ofgem intends for these measures to be delivered in the near future and are working to the following implementation timetable:

• A programme of stress testing will be launched in January 2022;
• A decision in relation to the consultation on strengthening milestone assessments and additional reporting requirements is expected in early February 2022;
• A decision in relation to the consultation on potential short-term interventions to address risks to consumers from market volatility is expected in early February 2022; and
• A formal consultation on changes to the price cap methodology will be issued in “early 2022 with a view to implement measures in October 2022 ahead of the winter”.