A frantic autumn for suppliers

This item initially appeared in December’s New Power report.

Moving into the autumn there has been a distinct increase in regulatory activity. Ofgem kicked off the month with a modest reset of domestic retail price caps – down £75 to £1,179, based on its representative consumption for the notional domestic customer. This predated the successful challenge to its methodology by Centrica supported by other large suppliers (which I will pick up in a later article). But other stand-out developments at Canary Wharf have potentially big, and probably adverse, impacts for suppliers.

FURTHER SUPPLIER FAILURES AND THE ‘HOLE’ IN THE RO

There continue to be frequent exits from the GB energy retail market. Given the chaotic levels of new entry enabled by the dramatic fall in market entry costs in recent years, especially from pre-licensed ‘supplier in a box’ solutions, this was inevitable. The trend will continue, and so will consolidation. As last year, the compliance process for the 2018/19 Renewables Obligation (RO) saw a shakeout.

Failed or struggling suppliers have again left significant unpaid RO bills. Four recent entrant suppliers were named and shamed by Ofgem in October, one of which – Toto Energy – has since gone into administration and its customers moved through the supplier of last resort (SoLR) scheme to EDF Energy. As October drew to a close, provisional enforcement orders were also issued to Nabuh and Breeze. GnERGY, which is also widely rumoured to be struggling to meet its commitments, has got a final demand.

Few were expecting the level of RO shortfall notified by Ofgem in early November. It said 42 suppliers did not meet their obligations, and the overall deficit was eye-watering – more than £200 million. The regulator is trying to recover some of this, but failed supplier debts have already pushed it above the threshold for triggering mutualisation. This means more pain for other suppliers already struggling to get by, and whose tariffs do not reflect these unforeseen new commitments.

It is looking unavoidable now that some form of major surgery will be needed by BEIS on addressing credit risk under the RO. The obvious options to consider are reducing the compliance timetable, introducing shorter compliance periods or suppliers collateralising the scheme. But all of these hold major implications for both sides of the market and achieving agreement across stakeholders will be difficult for incoming ministers.

TIGHTENING LICENCE RULES AROUND SUPPLIERS

Ofgem was already resetting requirements to ensure new entrants – and existing businesses – better understand market risks and are resourced to deal with them. Business failure is, of course, an organic threat in any well-functioning competitive market. But recent experience has brought home the reality that existing standards around financial resilience and customer service in energy supply have been found wanting in far too many cases.

New rules and entry processes for suppliers entering the market were announced back in April, along with new draft applications regulations. Implementation of both occurred in July. But Ofgem has also now proposed new regulations for suppliers’ current operations. They fall under three broad themes: promoting more responsible risk management; encouraging more responsible governance and increased accountability; and improving market oversight.

Key among the proposals is a ‘fit and proper’ requirement on suppliers and a principle for them to be open and cooperative with the regulator. There is a very necessary requirement for suppliers to maintain ‘living wills’ that identify and plan for risks to customers and the wider market if they fail. There are also new arrangements and a menu of options to protect at least 50% of the value of customers’ credit balances in the event of market exit. This has been subject to widespread abuse by suppliers to fund their operations. Another sensible proposal is capability assessments or ‘milestone checks’ when suppliers cross thresholds that trigger new social and environmental obligations. Ofgem is also minded to bring forward new rules that would allow it to request independent audits of supplier customer service operations and financial status of poor performing suppliers.

Other areas discussed, but without firm proposals, include exit arrangements. For example, Ofgem warned that it will treat trade sales shortly before market exit “very seriously, as they reduce the competitiveness of SoLR events and may not lead to best outcomes for customers”. It may disallow such trade sales on a case-by-case basis. It also wishes to explore possible splitting of customer portfolios of a failing supplier. This is a very important consultation and it closes on 3 December.

These options are very sensible. They align with good practices seen in some other developed competitive energy retail markets. But they will not be popular with newer suppliers because of the additional cost and complexity they will bring, a point borne out in an accompanying draft impact assessment. It is, of course, also closing the stable door after the horse has bolted.

UNMAKING THE ELECTRICITY MARKET MAKER

The energy industry has been debating trading liquidity issues for more than a decade now and I have argued vociferously for more supportive arrangements for smaller suppliers to access energy on reasonable terms. So a third major recent intervention of note by Ofgem concerns the market maker obligation (MMO). This was introduced in 2014 alongside a package of other measures to ‘secure and promote’ access to wholesale electricity markets for smaller suppliers and newer entrants. The MMO has now been suspended.

Suppliers depend on liquid markets to manage risks of exposure to wholesale prices and volatile energy imbalance charges. But trading multiples in the GB market are relatively low and spreads wide. Smaller and new suppliers do not have the financial standing to buy energy in advance like their larger competitors and, especially in a flat market, many go unhedged. This exposure contributed to a wave of failures in 2006 and 2008, when wholesale electricity prices spiked, and will have been a factor in some recent failures for small suppliers locked into aggressive fixed price tariffs.

The question Ofgem is facing is what to do with the secure and promote arrangements in a rapidly changing market structure. It suspended the licence condition on 18 November. In the circumstances it had no alternative. The suspension is by no means the end of the story. Ofgem flagged further work in

its Forward Plan for this year and announced in May that it would undertake an options assessment to support a decision on future liquidity policy, building on thoughts summarised from previous responses and its own market monitoring work. It is considering whether interventions are still required and, if so, what form they should take. It emphasised exploring alternatives to the MMO even before its suspension.

The issues around market making are complex and highly controversial among different types of industry stakeholder. Since the MMO was introduced, churn has increased by about 20%, spreads for the mandated products have decreased from about 1% to 0.3%, and many new suppliers and generators have entered the market. These are all good indicators. But against this, there are concerns that in additions to burdens on the obligated parties the MMO distorted the market concentrating trading in specific, limited windows.

Six independent generators and three growing, intermediate suppliers argued in response to the RWE disapplication request that without a replacement the MMO should not be suspended. “We are concerned that liquidity will fall back to even lower levels without it”, the response stated. They noted that out of 41 respondents to Ofgem’s previous open letter on MMO changes, the large majority – 30 respondents who are predominately independent suppliers, generator and energy traders — were against its suspension for this reason.

They went on to “urge Ofgem to commit to a clear timetable to develop and implement an alternative liquidity support measure as soon as possible, and by spring 2020 at the latest”, given there is a clear majority of GB market participants who consider that a measure to support GB wholesale market liquidity is both necessary and desirable. I agree, and suspension of the MMO should be without prejudice to the outcome of the analytical work still underway, but this needs expediting.

A key strand of this work is being undertaken by consultancy NERA. The emerging thinking was previewed at a workshop on 1 October. Frustratingly the workshop materials are not up on the Ofgem website at the point of writing. I hear that, if trading support is to be retained, it may be on a voluntary, probably tendered, basis. Arrangements already implemented in Singapore but also being scoped in Australia might provide a reference point, illustrating that this is not an issue limited to GB.

Reading between the lines, it looks like Ofgem needs convincing of the case for retaining market making arrangements, and if it does they are likely to look rather different to those they will supersede. Nevertheless, the basic argument for intervention is no less now than it was earlier in the decade, arguably more so. And having taken more than five years to establish a safety net, we would not want to see it taken away in less than five months simply because of changes to wider market structure that of themselves do not seem to have materially improved the trading environment.