What caused the supplier failures?

Following the wave of failures in the GB domestic supply market, Ofgem commissioned a report to assess its regulation of the domestic supply market - which is revealing both for what it says, and what it misses.

So, what does the review of Ofgem's regulation of the supply market tell us?

Having ploughed through the report, and been on the inside of suppliers for many years my thoughts are below. Starting with the highlights of what the report concludes, and then adding some areas that I am surprised to find missing.

The confused relationship between politics and regulation

The review finds unclear delineation between Ofgem and BEIS, with the political direction being set by BEIS and ofgem following this – which included focussing on competition through the prism of switching and number of suppliers.?No assessment was made of alternative models, the trade offs made, or the risk of correlated failure.

This risk of correlated failure is particularly odd to me, as suppliers have been saying for years that they control a decreasing amount of the total cost – so by definition the risks of one are the risks of the others.

The output from the CMA investigation in 2015 was clearly also a driver of the view of how competition should be enacted – including the notional ￡1.4 Billion of customer overpayment, a number which was always somewhat flaky to say the least in that it assumed all customers could access the cheapest price available which could simply not happen.

Privatise profit, socialise losses

The structure of the market is such that any failing supplier has certain costs mutualised across the whole industry.?Of the ￡1.8 Billion far realised in SoLR levy claims, the vast majority (￡1.7 B) is associated with wholesale price movement – which is claimed to not be down to the regulatory environment.?However, as the claims relate to costs that cannot be recovered due to the SVT cap, its hard to see how this isn’t part of the regulatory set-up.

Concerns have been raised about the ability of suppliers to place in-the-money hedges in a stand alone business before pushing the supplier into default – allowing the supplier’s owners to realise the profit.?This is possible, but would require whoever was the other side of the hedge to provide its approval to such novation – so a business in trouble would surely struggle to make this happen.

The need for financial liquidity

To manage bumps in the road, funds are required.?The report analysis shows that of the unredacted domestic suppliers considered (including Octopus and OVO) only the original big 6 had a positive equity balance at any time following 2015 – irrespective of size.

Added to this profitability margins have been low for suppliers, with big 6 pre-tax margins of between -6% and 8% over the last 10 years, and generally declining in the last 3; while non big-6 domestic suppliers have margins of between -60% and zero, making the precariousness of the domestic supply market is clear.

Although the report does not find any link between payment of dividends and failure, the need to be able to access funds and withstand risks is clear from those that remain.

Cultural weaknesses

The regulatory approach has been very reactive, with a focus on responding to events rather than taking pre-emptive action.?The report notes that this is aligned with the view of competition, in which supplier exits are ‘not a particular cause for concern’-?which would be fine if the costs of failure weren’t socialised across all other suppliers / customers through the market set up and delayed payment of items such as RO and SSFiT.

What’s missing?

From a personal perspective, having spent many years in the market there are a number of other regulatory related areas that I am surprised not to see included in the report.?The energy supply market is, and has become subject to growing regulatory intervention over recent years – both to protect customers and to underwrite the funding for the energy transition.?The latter is one area where the hand of BEIS has been at play, and the regulator has appeared to unquestioningly follow the political direction.

Relevant experience

There is a lack of experience of how the energy markets actually work, and the commercial pressures and incentives that exist. ?I have dealt with Ofgem many times and have been surprised at the reliance on external consultants that also do not have experience of the real market, and rely on pure economic modelling in isolation.?In one discussion where I suggested using less econometrics and more commercial modelling that recognises the real world imperfections I was effectively laughed out of the room.

Weakness in SVT design creating a free option

The current SVT cap provides a free option for all domestic customers, meaning that in extreme circumstances such as exist at the moment, all customers can benefit from the cap simply by doing nothing.

For customers this creates a world where the worst-case scenario is the cap, no matter what happens.

For suppliers, the flip side of this is an open-ended exposure to all customers coming off fixed price contracts or moving house, which cannot be effectively hedged before delivery commences.?In any portfolio, the number of customers expected to be on fixed / SVT prices will be pre-determined for hedging purposes, and inaccuracies create either gains or losses for the supplier.?In normal circumstances this is part of managing a portfolio, in extreme cases it creates an unquantifiable and potentially terminal risk to the supplier – just because of the way the cap is designed.

In reality this may be down to the political repositioning of the cap from a protection of the disengaged customers against profiteering suppliers, to a protection of all customers against market forces that happened during in 2021; but it is a foreseeable design error.

Non-Commodity costs and their socialisation

Part of the reason why socialising costs has been so important and large is the way that the non-commodity costs that pay for everything from wires to renewable generation, to metering are structured – a regulatory/ political market design choice

In general, the design of these costs is that suppliers must pay the actual costs based on outturn circumstances in order to keep the provider financially whole – a way of providing security to investors and providing the off-balance-sheet financing wanted by Government.

For suppliers in the market these mechanisms create some unknowable costs, which have to be factored into customer prices as a fixed cost.?Although things like small scale FiT for example may average around ￡7/MWh over a year, suppliers are on the hook for paying whatever the cost to be paid to generators is, whether higher or lower.?During covid this doubled compared to any reasonable expectations due to demand reductions – weakening suppliers balance sheets as a result of regulatory decisions, and potentially limiting their ability to withstand other shocks that have since followed.

Likewise, as demand dropped in covid the volume of electricity and gas through the networks dropped – and through the way the systems are set up… the network operator can reclaim payments below expectations in future periods – passing the shortfall back to suppliers.

The overall regulatory picture on non-commodity costs is one of loading unknowable costs onto suppliers and expecting them to be able to balance the market – something that is ongoing and in reality poses a risk to the whole energy transition.

Change overload

Suppliers have been the chosen delivery route of many of the complex changes required to drive the market forward.?Again this has been a regulatory choice; with for example the installation of smart meters, faster switching and half hourly settlement all being pushed at the same time, creating lack of resource for suppliers to focus on improving day-to-day operations.

The scale of change has left suppliers unable to focus on doing the very things that they are chastised for not doing - innovating, driving better service...

The pantomime villain

For years suppliers have been political/regulatory short-hand for all that is wrong with the energy industry.?Media, Government and the regulator have all been guilty of attacking suppliers no matter what they do - and clearly they are not all angels so robust regulation is required rather than a catch all view.

Rather than using its position as regulator to have a sensible discussion about what suppliers are doing well, whilst still calling out failings, the regulator has regularly joined in the attacks; which does not foster a positive relationship.

Delivering what is needed to take the energy market to its next stage of development requires co-operation and performance from across the sector.?Having one of the pillars weakened by politicians and regulators helps nobody.

Conclusions

The failures in the market has many causes, not all of which can be directly linked back to Ofgem, and Government must bear some responsibility for the politicisation of energy supply, although to quote the summary of the Oxera report (page 4 paragraph 2)...

“[The] regulatory approach does not seem to have been justified by an evidence-based assessment of trade-offs or a detailed understanding of the supplier business models and supplier incentives that arose as a consequence of this approach.?In the pursuit of higher levels of competition Ofgem did not seek evidence of trade-offs on an on-going basis”