Who will bear the brunt of credit balance crackdown?

As Ofgem presses ahead with plans to protect customer money from unsustainable business practices, a rift has emerged in the energy sector. On the one hand Octopus Energy has concerns about the impact of costs to consumers, while Centrica believes it will be shareholders who will shoulder the burden. Speaking to the experts, Adam John explores the division.

Last week Ofgem announced it was pushing ahead with plans requiring energy suppliers to ringfence customer credit balances and renewables obligation (RO) payments.

A series of consultations outlines the regulator’s aims to crack down on companies using customer money as what it calls “free, and risk-free, working capital” which has encouraged those with insufficient capital and poor business models to “enter the market and grow unsustainably”.

Energy UK deputy director Dhara Vyas tells Utility Week that the package is “really welcome” and adds that industry and consumer groups have been calling for stronger measures for a very long time, particularly for new suppliers entering the retail market.

She says: “The measures should make sure that the people running these companies have the right expertise and that the companies themselves have the financial resilience to withstand volatility, because Ofgem didn’t do that.

“Ofgem focused on a market with dozens of suppliers that gave people choice, because switching was the way that you exercised choice in this market and also how we measured engagement. That’s where their eye was, on choice and the number of companies, and I think that was the wrong place to be looking.”

Within hours of the documents being published, a clear divide between legacy retailers such as British Gas and newer market entrants like Octopus had become apparent, with the latter’s chief executive slamming the plans for ringfencing as “financially illiterate” and “ill-considered”, arguing that it would increase costs for consumers.

On the contrary, Centrica boss Chris O’Shea welcomed the proposals and said: “While some energy companies argue that prices will increase if they have to ringfence customer deposits, they won’t.

“Energy companies must be adequately capitalised by their shareholders so that if they fail, the shareholders feel the pain, not the hard pressed UK consumer – it really is as simple as that.”

Similarly Eon Energy boss Michael Lewis has expressed his approval, saying: “If the chaos in the energy industry over past years has taught us anything, it’s that suppliers should not be allowed to gamble with customers’ money.

“It’s clear this issue needs an industry wide solution to protect all customers while also preserving fair competition in the market, so we support Ofgem’s proposals to ringfence customer credit balances.”

Senior Investec analyst Martin Young says that taken together, the proposals align with Investec’s view that the ongoing changes, whether enacted or proposed, are “supportive of well-capitalised, well-run suppliers, and a positive for Centrica”.

He tells Utility Week that in the past, companies pricing their tariffs at unsustainable levels meant customers would leave suppliers like British Gas in search of cheaper deals, knowing they would be protected by regulatory mechanisms should their new supplier fail.

“So then somebody like Centrica has to think ‘hang on a minute, my customers are walking, what do I do?’ Then they potentially have to respond and if they respond through price then that’s impacting the margins that they can make.

“We need that competitive market but we need a competitive market that is full of sustainable and innovative participants and not people who are running unsustainable business models.”

The advantage of age

The division is perhaps unsurprising when considering legacy retailers, with the advantage of having been long-established in the market, have better credit ratings than their newer competitors –  a fact highlighted by NERA Economic Consulting.

Ofgem commissioned NERA to analyse the potential impacts of its proposed interventions and the subsequent report highlighted the current disparity between large and small suppliers in the costs of capital for insuring credit balances.

NERA calculates that the cost of capital for small suppliers is almost 12%, compared to just over 1% for their larger counterparts.

Despite further calculations that, following the introduction of the proposals, the costs will be 1.12% for both large and small suppliers, there are still concerns about the disparity in credit ratings from the sector.

Amy Marshall, energy expert at PA Consulting, ponders whether if the proposed rules had been in place earlier, they would have had an impact on the market entry of newer players.

She tells Utility Week: “Thinking back to when some of the suppliers that are now successful and well established entered the market you have to wonder how they would have thought differently about their business plans if the amount of funding they would have had to have behind them under the new rules were a requirement.

“It is difficult to prove as a counterfactual but the opportunity cost of innovators not entering the market is something we need to guard against.“

Octopus Energy’s director of economics and regulation, however, is more frank in her assessment of where she believes Ofgem’s plans will leave competition.

“I think it could take us back to having the oligopoly we had in 2015,” says Rachel Fletcher.

She references the report which resulted from a major review into the root causes of supplier failures and Ofgem’s role in them which was undertaken by finance consultancy Oxera.

“We really risk going back to that world. The Oxera report very clearly put a warning out about the risk of Ofgem swinging the pendulum too far in its work on financial resilience and killing off competition and innovation. Just to be really clear, our message to Ofgem is not to do nothing, our message to Ofgem is be effective,” she adds.

In its consultation, Ofgem says while its new ringfencing requirement should deter new entrants with insufficient capital and poor business models from entering the market and growing unsustainably, efficient suppliers will receive an appropriate return on capital.

“As such, we do not consider this proposal will deter efficient new entry or innovation, or competition in the market,” the regulator added.

The alternatives

Octopus proposes that rather than ringfencing credit balances, the regulator should among other things consider ATOL-style insurance. Ofgem has however discounted this from its considered options, stating that while credit insurance could be sufficiently insolvency remote, it may not be available to suppliers or may be prohibitively expensive.

But, how at a time of rampant inflation and record energy bills can Octopus justify its stance against ringfencing to its customers? Fletcher believes in being more outspoken about the financial impact on consumers themselves.

“Centrica talks about ring-fencing without talking about the cost to customers, and Ofgem has been really clear – they will adjust the price cap to accommodate the additional cost of ring-fencing. This is not a zero cost option,” she says.

Despite their differences, there is an acknowledgement that all the industry’s remaining suppliers have the same goal – to create market stability.

Vyas says: “All of our members would agree with the need for financial resilience and the priority of making sure people are fit and proper to run companies in this market. None of our members would dispute the need for that because you want a healthy functioning market that has a good, strong reputation.”

Similarly, in response to the differences between Octopus and Centrica, Marshall’s fellow energy expert at PA Consulting, Liz Parminter, tells Utility Week: “If you subscribe to our hypothesis, that there needs to be a more systemic review of all of the markets, I suspect that there is some commonality between them.

“Because both parties are saying there needs to be some protection for consumers or some form of mutualisation. And it’s just a question of the different types of intervention.”

The future of hedging strategies

Elsewhere, Ofgem has further set out its initial thinking on how failed supplier’s hedges can be passed on to a Supplier of Last Resort (SoLR).

Parminter tells Utility Week that the proposals will have benefits for the SoLR process as they will provide more transparency.

She explains: “I think it’s absolutely the right thing to do because it would encourage people to take on those customers. During the SoLR process people bid for those books and they don’t always bid in the knowledge of what the hedge position is, in my experience.

“If those things were transparent and evident, they may be more attractive. I guess the converse of that is that they may have hedges in place themselves already. And they may not want to double-up on that position. So I guess the key thing is to make those things transparent.”

Marshall adds: “Broadly speaking, I think it’s very sensible. And just from a very basic perspective, it makes eminent sense to have the positively valued assets and the negatively valued assets together if you’re talking essentially about a transfer process which is to protect consumers.

“What do I mean by that? We’ve seen lots of examples and I think it’s mainly by accident, rather than design of customer books that don’t have a huge amount of value going one way down the SoLR route, and then hedge books with a huge amount of value returning value to shareholders and founders etc.

“So from a from a principle perspective, to reduce impact on the consumer and to reduce impact on the supplier of last resort, it makes sense.”

In its consultation, Ofgem points to the fact that the proposals around financial stability are just one component of its wider work to build an energy market that is “fair and works for everyone”, and that related work includes changes to the price cap, new measures around fit and proper persons and more rigorous stress testing.

In order to achieve true market stability, there needs to be a holistic approach to reform. As Parminter observes: “There’s things that Ofgem needs to do which fall into the short, medium and longer term. In the short term, of course they have to address the criticisms around the ringfencing of credit balances and the like, because I think that is part of the problem but not the whole picture.

“In that respect it is welcome but there is still need, in our view, for a proper look at it much more systemically. It is a bit of a sticking plaster when you start to think about the broader issues around security of supply and wholesale markets – you still do need to address those issues as well.”