In this alert, we consider prevailing volatility in the UK energy supply market, Ofgem’s supplier of last resort regime, and the regulator’s recent move to tighten rules for energy suppliers.
Following the introduction of stricter entry requirements for new energy suppliers in July 2019 (as considered in a previous client alert), Ofgem recently announced proposals aimed at reducing the risk of insolvency among suppliers and, in turn, strengthening the protections afforded to consumers.
Ofgem plans to issue the statutory consultation for its proposals in early 2020. Implementation of the new measures will likely follow in late summer 2020.
The proposals mark the second stage of Ofgem’s Supplier Licensing Review. Supplementing the new conditions for obtaining a supplier licence introduced in July 2019, the new proposals are designed to improve the financial stability of market participants and, at the same time, continue to promote innovation and competition within the industry.
A low bar to entry into the energy supply market has caused the number of energy suppliers to proliferate in recent years. While the influx of new suppliers has increased competition and exerted downward pressure on energy prices, there has been an attendant rise in energy supplier insolvency.
The effects of an energy supplier’s insolvency are often felt across the energy supply market. In accordance with a process of mutualisation, a failed supplier’s consumer credit balances and unpaid contributions toward government schemes are spread across the remaining active energy suppliers. Those remaining suppliers are left with an additional costs burden which they will inevitably endeavour to recoup from consumers. It is estimated that supplier failure added £172 million to energy bills between January 2018 and October 2019.1
The most recent example of supplier failure came in December 2019 with Breeze Energy ceasing trading and Ofgem appointing British Gas as the supplier of last resort (‘SoLR’) for Breeze Energy’s 18,000 domestic customers.2
Providing a safety net in the event of a supplier’s insolvency, the SoLR process was introduced in 2003 to ensure continuity of energy supply to consumers.
In the event that an energy supplier becomes insolvent, Ofgem will revoke that supplier’s supply licence and exercise its discretion in appointing a SoLR. Upon appointment, the SoLR assumes responsibility for the failed supplier’s customers.
How will a SoLR be appointed?
Ofgem’s preferred method of appointment is a “trade sale” of the assets belonging to the licensee whose licence is to be revoked, without the need for regulatory intervention.3 If a trade sale is not feasible, Ofgem will proceed to appoint a SoLR by giving a direction under the SoLR’s relevant supply licence, known as a ‘Last Resort Supply Direction’.
Should the SoLR process not be viable, Ofgem will seek the Secretary of State’s permission to apply to the court for an energy supply company administration order, pursuant to sections 155 and 156 of the Energy Act 2004.4
What are the criteria for selecting a SoLR?
As set out in Condition 8.1 of both the Standard Conditions of Electricity Supply Licence and the Standard Conditions of Gas Supply Licence5 (the ‘Standard Conditions’), Ofgem may only appoint a SoLR if that supplier can comply with its obligations as a SoLR without significantly prejudicing its ability to: (i) continue to supply its existing customers; and (ii) fulfil its contractual obligations for the supply of energy.
Given Ofgem’s discretion in appointing a SoLR, the criteria detailed in the Standard Conditions represent the minimum requirements. In its guidance on the SoLR process,6 Ofgem outlines additional criteria which will be taken into account, including:
- whether the supplier has volunteered to be a SoLR – Ofgem will show preference to volunteers;
- whether the supplier would seek a ‘Last Resort Supply Payment’ (essentially, a levy that socialises some of the costs associated with fulfilling its role, over and above the charges the SoLR would be entitled to under its deemed contracts);
- whether the supplier can procure any additional gas or electricity as may be necessary to fulfil the role of SoLR;
- the level of charges the supplier proposes for the deemed contract under which it would be supplying the failed supplier’s customers; and
- whether the supplier will be able to accommodate an efficient transition so as to minimise disruption to customers.
In relation to this last point, given the high potential for service disruption following the insolvency of an energy provider, a SoLR will need to be able to move quickly at the acquisition stage if it is to be considered as a credible purchaser. This means it will need to be able to complete its due diligence on the target, and, among other things, obtain any necessary licences and consents, organise financing and make any relevant regulatory notifications in a proactive and timely manner.
Although not formally one of the criteria Ofgem uses to select SoLRs, a SoLR also will require a firm grasp of the implications of acquiring a business out of an insolvency process. A SoLR will need to be able to negotiate with insolvency practitioners, for which it will require an appreciation of the relevant insolvency practitioner’s duties to the target’s creditors, particularly in relation to valuation. Insolvency practitioners also are unlikely to have a detailed understanding of the target’s business, and will therefore be unable to give the same extensive warranties and contractual protections that a seller would ordinarily provide in a solvent sale. This, in turn, will place greater importance on the quality of the due diligence undertaken by the SoLR.
When will a SoLR be appointed?
The power to appoint a SoLR only arises once Ofgem becomes entitled to revoke the failing supplier’s licence to supply.
A SoLR appointment lasts no longer than six months, after which the customers of the failed supplier become ordinary customers of the SoLR, and are charged at the SoLR’s rates.
What are the SoLR’s obligations following appointment?
Within a reasonable period of time following its appointment, the SoLR must send a notice to each of the premises listed in the Last Resort Supply Direction, informing each customer:
- that the SoLR took over responsibility for supply of energy from the failed supplier on the date upon which the Last Resort Direction was given;
- that supply will take place under a deemed contract;
- that the customer is entitled to enter into an alternative contract with the SoLR or with a different supplier (though customers are urged not to switch until the SoLR process has completed in order to avoid additional complexity); and
- how charges will be determined under the deemed contract.
Overview of new Ofgem proposals
Notwithstanding its undoubted utility, the SoLR regime was devised as a safety net and, as the name suggests, a last resort. However, the low bar to entry referenced above has contributed to a marked increase in the number of insolvent suppliers and, as a result, necessitated use of the safety net more and more frequently.
With a view to reducing instances of supplier insolvency and, therefore, cause to resort to the SoLR regime, Ofgem’s new proposals seek to strengthen the licensing regime, as well as raise standards across suppliers, and reduce suppliers’ and consumers’ exposure to risks related to supplier failure.
Proposed new rules for existing suppliers would enable Ofgem to request independent audits of suppliers’ financial status and customer service operations.
As part of the auditing measures, checks would be introduced for growing suppliers before they hit certain consumer number thresholds in order to ensure that those suppliers have sufficient operational capacity to effectively serve their customers. Currently, Ofgem proposes that suppliers demonstrate they have appropriate resources for growth and can satisfy relevant regulatory obligations when customer numbers reach 50,000, 150,000, 250,000, or 500,000 - 800,000.
Governance and accountability
Ofgem proposes bolstering current ‘fit and proper’ requirements for suppliers, with increased scrutiny of the fitness of those in senior management positions – for example, new checks would look for any previous instances of insolvency and / or any disqualification from acting as a company director.
In addition, there would be greater scrutiny upon a change of control of supplier, with suppliers obliged to notify Ofgem should a change in control take place.
The proposals also introduce a new openness and cooperation principle, requiring suppliers to maintain a constructive relationship with the regulator.
Under the new proposals, suppliers would be required to assess their readiness for failure by maintaining ‘Living Wills’. Subject to review by Ofgem, a supplier’s Living Will would need to detail the practical steps to be followed in the event of its failure, including any barriers to an “orderly exit”.
Details included within a living will might include, for example, the likely costs faced by other consumers, any disruption to the services offered to existing customers and how the supplier plans on continuing to adhere to its licence conditions.
Reducing costs of mutualisation
Finally, Ofgem intends to introduce rules to minimise the costs of mutualisation for other suppliers in the event of a supplier’s failure by requiring suppliers to arrange for the protection of a minimum of 50 per cent of customer credit balances in the event of insolvency.
Methods of protection considered by Ofgem include parent company guarantees, third party guarantees, insurance schemes, principles-based cost mutualisation protections, and a requirement to set aside funds in an escrow account.
It remains to be seen whether Ofgem’s proposals effectively stem the growing tide of failed energy suppliers and, in doing so, reduce the use of the SoLR regime. What is clear, however, is that the changes proposed by Ofgem represent a significant tightening with respect to the regulation and oversight of energy suppliers. As such, it is imperative that suppliers take time to properly digest the plans.
Those energy suppliers considering the SoLR regime as a means through which to acquire a failed supplier’s customer base must ensure that they understand the process, as well as the various obligations to be undertaken and their potential impact on the business.