Energy suppliers face tightened rules under Ofgem's recent proposals

Ofgem has announced proposed reforms aimed at reducing the risk of supplier failure and strengthening the safety net for consumers

15 November 2019

Ofgem has announced proposed reforms aimed at reducing the risk of supplier failure and strengthening the safety net for consumers.

The latest move by Ofgem comes after the introduction of stricter entry requirements for new entrants in July 2019. The proposed rules are under consultation until 3 December 2019, with new measures intended to be implemented by late summer 2020. 

Background

Last year, Ofgem declared its intention to review the licensing arrangements for energy suppliers to ensure adequate protections are in place to counter financial instability and poor customer service in the market. The introduction of new conditions for obtaining a licence came into effect in July 2019.

Ofgem’s current consultation sets out a package of proposals for the next stage of the Supplier Licensing Review. It has identified several proposed measures which it considers will improve ongoing standards around financial resilience and customer service whilst continuing to promote competition and innovation.

Increased market competition

The low bar to entry in the energy supply market, has helped the number of suppliers increase from 27 active domestic suppliers in December 2014 to 64 by June 2019. During the same period, the domestic market share of small and medium-sized suppliers has grown to almost 30 per cent, according to Ofgem's 2019 State of the Market Report.

The increased competition has undoubtedly helped contribute to lower prices for consumers while increasing choice and incentivising existing suppliers to develop their customer service offerings. Yet, as noted by Ofgem in a recent statement, some suppliers have been unable to 'keep up with the pace of more competitive firms'. This has been evidenced by the failure of a significant number of energy suppliers over the past year, including Solarplicity, Brilliant Energy, Our Power, Economy Energy and Toto Energy, which has directly affected around one million domestic customers in the UK. Other suppliers have also failed to meet their financial commitments under government schemes such as the Renewables Obligation, Feed-in Tariff, Warm Home Discount and Capacity Market.

These failures adversely impact the wider market. When a supplier fails, consumer credit balances and unpaid contributions towards government schemes are spread across other suppliers through a process of mutualisation. Those suppliers that manage their costs responsibly are therefore left with an additional costs burden which they will need to try to recover from their customers. On that basis it is understandable why some suppliers have been calling for additional safeguards to protect themselves (and consumers) from this additional costs burden. Research conducted by Citizens Advice estimates that supplier failures have added at least £172 million to bills since the beginning of 2018. 

Ofgem rightly recognises that in the current rapidly-changing energy services market, it is more important than ever that firms with innovative business models, products and services can enter the market. Equally, as an essential service, Ofgem is insistent that there are minimum standards that suppliers must meet and any company entering the market needs to be well-prepared. Ofgem’s recent proposals therefore seek to strengthen the licensing and regulatory regime to raise standards among poorly performing suppliers in the sector and greater reduce competitors’ and consumers’ exposure to the risk of supplier failure.

Promoting better risk management among suppliers

The proposed rules for existing suppliers would allow Ofgem to request independent audits of suppliers’ customer service operations and financial status.

As part of this, Ofgem has recommended milestone checks on fast-growing energy firms before they hit certain thresholds of customers. The proposed figures are 50,000; 150,000; 250,000 and a point to be determined between 500,000-800,000.

If suppliers fall short in the financial health and/or customer service checks, the rules propose that they will be barred from accepting additional customers until they pass such checks. This marks a tightening of regulatory scrutiny by Ofgem, ensuring suppliers have sufficient operational competency to effectively service their customers before allowing them to take on additional ones.

Ofgem has also stated that rules will be introduced to minimise the costs that would otherwise be mutualised across other parties, thereby mitigating the disruption connected with the exit of an energy supplier. Ofgem is proposing to introduce a requirement for suppliers to arrange for the protection of a minimum of 50 per cent of their customer credit balances in the event of their failure. Such protection could be put in place through one or more of a number of measures including parent company guarantees, third party guarantees, insurance schemes, principles-based cost mutualisation protections, or setting aside funds in an escrow account.

Ofgem’s current view is that mandatory protection to cover more than 50 per cent of customer credit balances and any liabilities under government schemes such as the Renewables Obligation would represent an unacceptable barrier to entry to new suppliers. This is on the basis that such suppliers’ business models may be innovative and untested, making it more difficult for them to put in place the necessary arrangements at a reasonable cost.

Mary Starks, executive director of consumers and markets at Ofgem, has commented that the new rules will bolster the ‘safety net’ and enhance the experience of customers when they are transferred, 'so that consumers can be reassured that whatever happens they will be properly protected'. Whilst these requirements would go some way towards limiting the costs left behind when suppliers collapse, it is anticipated that some existing suppliers will argue that the measures should go further.

Improving supplier governance and accountability

Alongside the need for effective risk management, the consultation focuses on ensuring suppliers have appropriate governance structures in place and strong management accountability.

Consequently, the consultation introduces a new openness and cooperation principle which instils the need for suppliers to maintain a constructive relationship with Ofgem as the regulator.

Further, Ofgem proposes to refine its ‘fit and proper’ requirements, with increased scrutiny on the fitness of senior management, for example via checks for any history of insolvency or disqualification from acting as a company director.These would also be scrutinised on a change of control of the supplier.

Ensuring effective market oversight

In the event of supplier failure, the regulator has called for enhanced market oversight in order to protect customers and ensure the ramifications on the wider market are contained. Fundamentally, this means having access to sufficient levels of information to identify risks to consumers in order to intervene proactively. The new rules would allow Ofgem to require suppliers to undertake independent audits in certain circumstances.

In addition, suppliers would have to review their readiness for failure by maintaining ‘living wills’. Suppliers would be obliged to detail in these wills what would happen in the event of their failure, including any impediments to an ‘orderly exit’, with some of the non-commercially confidential elements of the wills being made public. This could include the anticipated costs faced by other consumers, disruption to services for their customers and how they would continue to adhere to any relevant licence conditions.

Ofgem also proposes to adopt a risk-based approach to its monitoring and compliance activities in relation to any new rules introduced under the Supplier Licensing Review. It also sets out a requirement for suppliers to notify Ofgem when there are changes of control of the company.

One of the themes highlighted by Ofgem in the consultation is the difficulty it faces when dealing with administrators who have taken on the book debts left by failed suppliers and are responsible for the final billing of customers, since they fall outside the scope of Ofgem’s regulatory enforcement powers. Whilst some administrators have worked collaboratively, Ofgem is disappointed that others have contributed to poor consumer experiences, involving significant delays in final billing and the aggressive chasing of debts. A measure to address this has been proposed in the consultation in the form of requiring suppliers to include new contractual provisions in their terms and conditions to ensure administrators are subject to some of the same requirements as suppliers. Meanwhile, Ofgem has written an open letter to insolvency practitioners setting out the behaviour it expects of them.

Final thoughts

At a time when the retail energy market and suppliers are grappling with the prolific number of proposed changes to the market and consultations on such changes, Ofgem is mindful of striking the right balance between raising standards and stifling innovation in the retail energy market. It is undoubtedly a tricky tightrope to walk. Few would argue that the status quo should be allowed to continue; the volume of recent supplier failures and the number of customers consequently going through the Supplier of Last Resort process risk damaging the willingness of customers to switch to the new and innovative entrants that Ofgem sees as vital to creating effective and valuable competition in the market.

It is perhaps understandable that Ofgem’s proposals lay the groundwork for greater scrutiny and intervention by the regulator but shy away (at this stage at least) from setting the financial barriers to market entry high by requiring the full cost of customer credit balances and government scheme costs to be protected against. Ofgem is likely to want to assess the impact and effectiveness of the ‘half-way’ cost protection measures first.

The consultation acknowledges that Ofgem is separately discussing with the government whether the current arrangements for collecting and mutualising industry scheme costs should be amended in light of changes to the supply market characteristics since the relevant schemes were launched. It remains to be seen whether future changes to the design of ongoing cost-recovery from suppliers under these schemes will be used to reduce the exposure of consumers and compliant suppliers to the unpaid scheme costs of failed suppliers.

Rules geared at targeting those suppliers with inadequate standards and ensuring that all suppliers are managed by ‘fit and proper’ management should be uncontroversial, although their effectiveness will very much depend upon how these powers are applied in practice. The energy industry will therefore be closely watching the regulator’s moves to see how the tougher rhetoric in the proposals is manifested in practice.

For advice or further information on the consultation, please contact James Phillips.

This article was written by James Phillips and Simon Cox.

Key contact

James Phillips

James Phillips Partner

  • Head of Oil and Gas
  • Energy, Power and Utilities
  • Environment

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