Ofgem rows back on ring-fencing credit balances

Ofgem has axed plans to require all suppliers to ring-fence their customers’ credit balances and will instead set a “monitoring threshold” to avoid over reliance on the funds to support their businesses.

However, in a statutory consultation on measures to improve financial resilience – one of a raft of documents released by the regulator on Friday (25 November) – the regulator said it is pressing ahead with plans to ring-fence Renewables Obligation (RO) funds and introduce a minimum capital requirement for all suppliers.

Explaining the measures, which have been revised from an earlier consultation in June, Ofgem admitted its previous focus on competition, while benefitting consumers through lower prices, “ultimately led to low financial barriers to entry and light regulation of financial risks”.

“The energy crisis exposed problems with this retail market model, leading to a large number of supplier failures towards the end of last year, ultimately costing all consumers through higher bills,” it added.

The regulator said it now estimates the bill for these failures for taxpayers and billpayers at £9.1 billion, including £6.5 billion of costs incurred by the government for the special administration of Bulb.

The remainder is made up of £1.8 billion of approved Last Resort Supply Payment (LRSP) claims by Suppliers of Last Resort, £423 million of minded-to LRSP claims currently being consulted on, as well as £296 million of RO and Feed-In-Tariff payments since July 2021.

Minimum capital requirement

Among the regulator’s chief proposals to prevent more such failures is the introduction of a a minimum capital requirement for all domestic suppliers.

These would be brought in over a number of years in recognition that the sector is currently under-capitalised and operating in a volatile economic environment.

Ofgem is therefore proposing setting a shorter-term target for domestic suppliers to have net assets of £110-220 per domestic customer by end of March 2025, with suppliers required to submit transition plans showing clear “staging posts” or increments for how they intend to reach that target.

“In addition to balance sheet net assets, suppliers would be able to meet requirements with alternative sources of funding – such as Parent Company Guarantees of long-term liabilities – subject to criteria in the licence and [supply licence condition] guidance,” it added.

Ring-fencing RO receipts

The RO scheme has long been a source of contention in the sector, with Ofgem recently confirming that the mutualisation of missed RO payments has been triggered for the fifth consecutive year.

In the absence of legislation requiring more regular payment of RO receipts, which the regulator believes is “the optimal solution to address misuse of RO receipts”, Ofgem has proposed that all suppliers should be required to ringfence these payments, which it says were never intended to support their business operations.

The requirement would come into effect from 1 April 2023 – the beginning of the 2023/24 scheme year.

Enhanced Financial Responsibility Principle

Ofgem is also proposing to enhance the Financial Responsibility Principle (FRP) to embed minimum capital requirements for domestic suppliers, as well as “introduce a positive obligation” on them to evidence that they have sufficient business-specific capital and liquidity to meet their liabilities on an ongoing basis.

The enhanced FRP will provide Ofgem with additional regulatory tools to facilitate ongoing resilience and minimise mutualisation costs.

Under the proposals, suppliers must notify Ofgem when gross domestic credit balances, net of unbilled consumption, represent the equivalent of 50% or more of their total assets, as well as when they project or anticipate this occurring.

Ofgem will continue to review this figure to ensure it encourages suppliers to avoid over reliance on credit balances.

Customer credit balances

Ofgem’s June consultation included plans for retailers to ring-fence customer credit balances (CCB) so they could be transferred to a new supplier in the case of a market exit.

There was a mixed response from some of the market’s larger suppliers, with the plans being praised by Centrica boss Chris O’Shea but heavily criticised by Octopus Energy chief Greg Jackson.

Explaining its decision to scrap the plans, Ofgem said: “We recognise the views presented by some stakeholders that market-wide CCB ring-fencing would be untargeted and impose costs on all suppliers – including efficient suppliers – in a way that on balance we do not believe to be in the interests of consumers.

“It may also result in ‘inactive’ capital that could be more effectively deployed – particularly in the short term – as capital reserves that would directly increase supplier resilience.”

Ofgem said its revised impact assessment showed that it would expect minimum capital requirements, alongside RO ringfencing, to have net consumer benefits of £74 million to £93 million on average annually over the next six years. This is £34 million to £53 million more than market-wide credit balance and RO ring-fencing.

Furthermore, Ofgem concerns relating to a reliance on credit balances can be addressed by building on existing supplier requirements, with the regulator citing its recently strengthened rules around how suppliers can set direct debits

“Coupled with the requirements we are proposing in this consultation, these changes should help to limit the level of CCBs accrued in the first instance, reducing excessive reliance on CCBs for working capital and the amount of CCBs at risk of mutualisation,” it explained.

However, Ofgem said it does recognise that it may be necessary for some suppliers to ring-fence credit balances in certain circumstances.

To this end, the regulator is proposing new powers for it to order individual suppliers to ring-fence their credit balances, when they are at risk of not meeting or do not meet the requirements set out in the enhanced Financial Responsibility Principle and/or the minimum capital requirement.

Jonathan Brearley, Ofgem’s chief executive, said: “These proposals will provide protections, checks and balances for consumers, suppliers and the entire sector to create a more stable market. We want suppliers to be able to be innovative and dynamic, while also making sure they are financially stable, and that customers’ money is protected.

“This is a delicate balance and while Ofgem want well capitalised businesses that can weather price fluctuations, we also don’t want to block the market for new suppliers or force suppliers to sit on lots of capital they could be investing in innovative ideas. We are seeking views across the industry, recognising the different business models’ suppliers have, on whether we have struck the right balance between resilience and competition.

“Ultimately, we have a responsibility as a sector to ensure we are protecting consumers’ interests by making sure our financial regulations are as robust as they can be. At a time of extremely high energy bills, that responsibility is more important than ever. I accept that there are very different views across the industry, but I encourage all retailers to work with us to move the sector to a more vibrant and resilient position.”

Alongside its proposals for strengthening financial resilience, Ofgem also released multiple consultations on other related measures including an extension to the Market Stabilisation Charge and changes to the price cap methodology concerning the allowances for profit margins and balancing costs.

Extending the Market Stabilisation Charge and the ban on acquisition-only tariffs

Both these measures were introduced in response to the energy crisis in mid-April to ensure that prudently hedged suppliers are not penalised by being undercut by rivals if wholesale prices fall sharply and prevent them from going bust.

The Market Stabilisation Charge (MSC) is triggered if wholesale prices fall to more than 10% lower than the wholesale cost element of the price cap on default tariffs and is paid by suppliers acquiring customers to the ones losing them. It amounts to 85% of the hedging losses of a nominal supplier. Ofgem recently confirmed the MSC had been triggered for the first time.

The measures have already been extended once from September 2022 to March 2023.

In its consultation on the extension, Ofgem noted that the government’s Energy Price Guarantee (EPG) interacts with the MSC by reducing the incentives for consumers to switch if wholesale prices fall, although it does not affect the value of the stranded hedge on each switch that does occur.

The chancellor of the exchequer Jeremy Hunt recently announced that the EPG would be extended by a year from its previous cut-off date of April 2023. However, Ofgem said the decision to raise the level of the price limit to from £2,500 to £3,000 from April onwards will boost the amount of switching that takes place, increasing the need for the MSC to maintain market stability.

The regulator said other possible changes to the design of the EPG from April could also boost switching and require changes to the parameters of the Market Stabilisation Charge.

Ofgem also noted that its latest estimates of the Value at Risk – its measure of potential hedging losses by suppliers – suggest it will be higher throughout 2023 than when the MSC was first introduced.

The regulator said it is therefore consulting on extending both the MSC and the ban on acquisition-only tariffs by 12 months to 31 March 2024. It also intends to give itself powers to further extend either or both measures on an annual basis by merely issuing a statement to that effect, but said these powers will not include the ability to extend the MSC once it has already lapsed.

Reviewing the profit margin under the price cap

Suppliers’ profit margin in terms of earnings before interest and tax (EBIT) is currently set at a flat rate of 1.9% that is applied to the other allowances that make up the price cap – wholesale costs, network costs, policy costs, operating costs, payment method uplift, and an adjustment allowance.

This rate, which was set in 2018, is based a Competition and Markets Authority (CMA) estimate of the cost of capital for a notional energy supplier. The CMA calculated the cost of equity at 10% using the Capital Asset Pricing Model. It assumed that the notional energy supplier would be 100% equity financed and therefore took this to be the cost of capital as well.

The CMA also estimated the level of capital employed by the notional supplier – i.e. the equity investment in the supplier – and multiplied this by the cost of capital figure to establish a rate of return on capital employed. This was then divided by the notional supplier’s revenue to derive the 1.9% EBIT margin.

Ofgem said significant changes in the inherent risks of the energy retail market and the series of measures introduced to mitigate these risks, including the MSC, warrant a “bottom-up” review of the methodology and parameters of the profit allowance. These include the amount of capital an efficient notional supplier needs to employ, the rate of return on capital employed, and how the EBIT allowance should scale with period updates to the cap.

In a previous policy consultation on the profit margin in August, Ofgem said potential changes could include moving away from a fixed percentage, with alternative options including: a fixed cash amount, possibly with periodic reviews; a hybrid approach, combining fixed and variable elements; and a fixed percentage within a cap and collar.

The regulator said its current preference is a hybrid approach as this is most reflective of how capital requirements vary at different overall cap levels, recognising that some components are unlikely to scale with the cap.

Ofgem said the latest policy consultation will be followed by a statutory consultation and that changes could come into effect from 1 July 2023.

Reflecting potential changes to balancing charges in the price cap

Ofgem is currently consulting on its minded-to decision to approve the Connection and Use of System (CUSC) modification CMP361 that would switch Balancing Services Use of System (BSUoS) charges from variable volumetric (per-megawatt-hour) charges, which vary based on the cost incurred by National Grid Electricity System Operator (ESO) during each settlement period, to flat volumetric charges, which would set three months in advance and fixed for periods of a year.

Alongside this consultation, Ofgem issued a call for input on how to incorporate this change, which would take effect from April 2023, in the price cap methodology.

The allowance for balancing charges is currently updated twice per year based on a weighted average of BSUoS charges in each settlement period over the preceding calendar year. In line with the proposed changes to balancing charges themselves, the regulator proposed to switch to a fixed ex-ante allowance that would allow suppliers to recover costs as they incur them.

However, Ofgem said the move would mean there would be a period of charges (January to March 2023) that would not be fully reflected and recover through future price caps. The regulator proposed three potential options for adjusting the price cap accordingly, with its preferred option being the first of the three – an “actual data method”.

This option would have two stages. In the first, the regulator would use actual data for the year to the end of December 2022 to calculate any surplus or shortfall, which would be reflected in the price cap from period 10a, running from April to June 2023.

In the second, actual data for January to March 2023 would be used to calculate any further surplus or shortfall, which would be reflected in the price cap from period 11a, covering October to December 2023.

Ofgem has now issued a consultation on its proposals for incorporating the potential changes to balancing charges into the price cap methodology. It said the “actual data method” remains its preferred option for applying a transitional adjustment, although the second adjustment would apply from period 10b, running from July to September 2023. Each adjustment would apply for a period of 12 months.

The regulator said it expects the transitional adjustment to amount around £27 per electricity customer based on its typical consumption values. It said this amount includes an offset against charges that were over-recovered during the first three price cap periods covering January 2019 to March 2020.

The deadline for responses to the latest consultation is 23 December.