‘Reactive’ Ofgem was ‘slow’ to address retail risks

Ofgem has been accused of being reactive in its approach to assessing financial resilience in the energy retail sector, as well as slow to design new policies which address risk, in a new report.

Soaring energy prices have seen dozens of suppliers fail in the last year, with millions of consumers being displaced.

As a result a major review into the root causes of the failures and Ofgem’s role in them was commissioned by the regulator last December, with finance consultancy Oxera being appointed to take on the work in January.

The 111-page document, published on Friday (6 May), made a series of recommendations to strengthen Ofgem’s regulatory regime.

It found the approach to regulation allowed prospective retailers to enter into the market “on the basis of a ‘free bet’” as they could grow to a considerable scale without committing a large amount of money.

“By pursuing a high-risk/high-reward business model, such suppliers would benefit from the upside, while being able to exit costlessly if the downside materialised,” it added.

In its pursuit of a more competitive market, Oxera said the regulator did not seek evidence on trade-offs such as between competition and financial resilience on an ongoing basis.

Furthermore, Ofgem did not sufficiently test whether the economic incentives at the point of supplier entry and exit were aligned with the protection of customers’ interests.

It added: “In the absence of detailed proactive regulation and/or monitoring, this left Ofgem reliant on industry codes and companies’ governance arrangements— in particular, directors’ financial statements and auditors’ statements—to foster financial resilience.

“A sample of publicly available audit statements from suppliers shows that these did not provide sufficient independent assurance to obviate any need for Ofgem to undertake its own monitoring and scrutiny of energy suppliers.”

Overall, Ofgem’s approach to assessing financial resilience in the sector was found to have been “reactive rather than proactive”.

“Ofgem did identify risks to the sector that could have been addressed with earlier intervention, but in some cases was slow to design new policies,” the report explained.

“For example, according to board papers, Ofgem’s Supplier Licensing Review – which would encompass considerations of financial resilience – was delayed over the period 2016–17, and consultation began in late 2018.”

Part of Ofgem’s regulatory philosophy, reinforced by the policy environment, was that low barriers to entry would protect both existing and future consumers’ interests.

Oxera said it was intended that high levels of switching would deliver consumers’ interests by increasing choice and incentivising the delivery of efficiency and innovation. However, there were several weaknesses to this approach.

These include the fact there was no “ex-ante framework” for defining and measuring consumer outcomes, as well as no evidence of quantitative impact analysis being undertaken to inform policy choices at the time of significant regime changes such as the Supplier Licensing Review.

Additionally, there was no subsequent ongoing market monitoring to account for the dynamic costs and benefits of a regulatory regime in different circumstances.

As an example of this, Oxera said that the benefits of competition may accrue more than proportionately with early entrants in a highly concentrated market and then taper off as competition increases to unsustainable levels, with the market hosting a high number of loss-making companies.

“Taking a dynamic view in monitoring market outcomes is therefore important in understanding how the benefits of competition, and the risks as well as costs of supplier failure, evolve over time,” the report said.

In its conclusion, Oxera recommended that analysis of effective competition should consider whether the market can sustain the current number of suppliers in the longer term, for example, by examining ongoing profitability.

It additionally called for better communication between the various departments within Ofgem and its senior leadership team.

Furthermore, while Ofgem’s agility and responsiveness in dealing with the recent failures was  described as “exemplary at all levels of the organisation”, Oxera noted concerns around timely information exchange in a business-as-usual environment.

As such, the report suggested Ofgem could consider undertaking an internal review of business-as-usual stakeholder relationship and communication processes.

Responding to the publication, Ofgem said its board accepts the recommendations, many of which it was already implementing.

It added: “The board will ensure all recommendations are carried out to further strengthen the regulatory regime, building on work by colleagues across the organisation to ensure that through robust regulation, Ofgem does the best it possibly can for consumers up and down the country.”