By Kathryn Porter, Watt-Logic

This week, the House of Commons Business, Energy and Industrial Strategy Committee Select Committee published its report on its inquiry Energy pricing and the future of the Energy Market. This wide-ranging and damning report sets out not only the failures of the regulator, but also those of the Government both in the areas of oversight, and policy.

“Ofgem has proved incompetent as the regulatory authority of the energy retail market over the last decade. It allowed suppliers to enter the market without ensuring they had access to sufficient capital, acceptable business plans, and were run by individuals with relevant expertise. The regulator enabled poorly capitalised suppliers to be overly reliant on customer credit balances and operate with inadequate hedging, leaving the market ill-equipped to absorb wholesale price increases. The rules that were in place were not enforced and Ofgem did not understand the business models of the suppliers it is mandated to supervise. The Government prioritised competition over effective market regulation and overlooked Ofgem’s lack of supervision of this essential market,”
– BEIS Select Committee

The Committee recognises that Ofgem is attempting to remedy its previous errors, but has concerns that if reforms are not well designed and executed, they will risk further destabilising the market and distorting competition. It recommends that:

• Ofgem improves its regulatory oversight, its decision-making processes, the use of its enforcement powers, and the quality of its governance;
• Ofgem proactively reports to the Committee on how it is ensuring effective accountability and transparency and to explain key decisions and policy concerns on an ongoing basis;
• Ofgem regularly reports to BEIS on how it is meeting its duties and to inform Ministers of any risks associated with the delivery of Government strategy;
• the Government publishes its long-delayed Strategy and Policy Statement for Ofgem to clearly delineate responsibilities between the regulator and BEIS to ensure transparency and effective scrutiny;
• Ofgem publishes proposals on a capital adequacy regime and monitors suppliers’ risk management strategies as standard;
• Ofgem upskills its workforce to implement its regulatory reforms effectively and proportionately;
• Ofgem publishes a more robust impact analysis of its proposals for suppliers to ringfence customer credit balances and be explicit about the implications on energy bills and competition, and considers the cumulative impact of its reforms; and
• the Government brings forward legislation to increase the frequency of Renewables Obligation payments and ensures its Energy Retail Market Strategy aligns with its net zero target, rather than a focus on switching.

In other words, the Committee requires Ofgem to “do better”, both internally and in its engagements with the Government and Parliament.

I previously discussed some of the evidence given to the inquiry, particularly the oral evidence of former Ofgem CEO Dermot Nolan, current CEO Jonathan Brearley and UK Business Secretary, Kwasi Kwarteng (who memorably told the Committee that hedging is “you know, very risky”). I criticised the behaviour of the Ofgem Board, and the lack of oversight of the Ofgem by both the Business Secretary and Parliament.

The Select Committee has now committed to exercising much greater oversight of the regulator. Not only does it now require Ofgem to provide it with detailed updates of its plans and performance, but it also expects to have oversight of key decisions before they are made. In particular, it wants the opportunity to scrutinise a revised impact assessment of Ofgem’s proposals for the ring-fencing of customer balances before a final decision is taken, presumably so it can ensure it agrees with both the process and proposed solution. This represents a significant increase in the exercise of Parliamentary oversight over the regulator.

Addressing Ofgem’s poor performance

As the number of small suppliers entering the market accelerated in the early 2010s, market participants began to express concerns about unsustainable business models and poor practices. Ofgem was warned “time and time again” that it had made it far too easy for poorly resourced suppliers to enter the market as there was no requirement for them to submit information on their business models, working capital arrangements, or financial viability. As early as 2013, Citizens Advice formally wrote to Ofgem to express concerns over the lack of entry requirements  – in his evidence Dermot Nolan “seemed unable to recollect calls from Citizens Advice to reform supplier licensing during his tenure, these were in fact plentiful and well-documented”.

In November 2016, GB Energy became the first supplier to fail in almost ten years. A further seven companies collapsed before Ofgem consulted on its approach to supplier licensing in November 2018, at which time there were 70 suppliers in the market. An additional five suppliers failed by the time the reforms to entry requirements were introduced in June 2019. Despite the pace of new entry having already slowed, when the Supplier Licensing Review eventually started, it prioritised a review of entry requirements and delayed action to tackle the practices of existing suppliers which were operating in a financially unsustainable way. Ofgem introduced new entry criteria from June 2019 which required entrants to have appropriate resources, appropriate plans to meet their regulatory obligations, and be run by individuals that are fit and proper. From this point the rate of new entry slowed.

Once a supply licence had been granted, suppliers were able to operate with minimal oversight from Ofgem – in particular there were no ongoing requirements for companies to maintain adequate levels of working capital or have appropriate risk management strategies in place. There was nothing to prevent companies relying on customer credit balances and the collection of Renewables Obligation payments to fund their operations and drive business growth. Dermot Nolan described the regulatory regime as “permissive”, something he said this was a conscious decision by Ofgem’s Board which was encouraged by the Government, to create a market that attracted new entrants.

“The key reasons identified by witnesses for Ofgem’s failure was its low bar approach to licensing energy suppliers, which allowed companies with glaringly inadequate financial arrangements and high-risk business models to enter the market at minimal cost, grow rapidly once in the market with limited requirements or monitoring, and then face no barrier to exit. This was compounded by Ofgem’s failure to enforce the rules that were in place…Witnesses from across the energy sector agreed that Ofgem had failed to deliver on its duties and is responsible for a significant and structural failure of supervising an essential market,”
– BEIS Select Committee

Although the Supplier Licensing Review focused on new entry, there was some attempt to consider the conduct of existing suppliers, leading to new rules which included:

• requirements for suppliers to be financially responsible and to take action to minimise costs that could be mutualised;
• assessments to check suppliers are adequately resourced as they grow;
• powers to require independent audits of a supplier’s service or financial health,
• requirements to ensure senior staff are fit and proper on an ongoing basis; and
• for suppliers to be open and cooperative with Ofgem.
• However, these reforms were not implemented until early 2021 by which time a further 13 suppliers failed. As the National Audit Office noted in its report, these reforms came far too late to have any meaningful impact, and suppliers still had nothing to lose from exiting the market. Citizens Advice found no evidence to demonstrate that the suppliers who failed following July 2021 changed their behaviour in response to the new rules, in part due to ongoing failures by Ofgem to enforce existing rules as described in this highly critical report published by Citizens Advice in January this year.

“We’re not aware of Ofgem making use of some of its new powers, like requiring independent audits of companies,”
– Citizens Advice

Both Nolan and his successor, Jonathan Brearley claimed that Ofgem’s record on enforcement was good, however the Committee disagreed, citing evidence from witnesses that Ofgem “consistently and frequently failed to enforce its rules against suppliers in breach of their licence conditions, even when evidence was directly reported to the regulator”. Ofgem failed to take action against suppliers who “openly and repeatedly flouted” rules, including on accurate billing, debt collection, self-disconnection, smart metering, and customers having access to phone lines. A number of companies had been referred by Citizens Advice for potential breaches of their licence conditions, but Ofgem failed to take meaningful action.

The most egregious example appears to be that of Avro, which was founded in 2014 by Jake Brown, a former non-league football player who had just finished an undergraduate degree in law. The company failed in September 2021 at an estimated cost to consumers of £700 million. The Committee found that “the directors consistently enriched themselves, despite the company accruing heavy losses and ultimately failing”, and has made a recommendation that the administrators of Avro submit a request to the Insolvency Service for it to consider bringing action against the company’s directors, and to update the Committee on what, if anything, can be done to recover customers’ money.

Citizens Advice complained to Ofgem about Avro’s conduct no fewer than 10 times between 2018 and 2021 without success. Unsurprisingly, the Committee recommends that Ofgem improves its approach to enforcement and uses its powers to ensure suppliers are in compliance with their licence conditions. However, it goes further and has introduced a requirement for Ofgem to provide it with a detailed strategy on how it will improve its enforcement and compliance activity, and the timelines within which this will be achieved. It is also insisting that from this financial year onwards, Ofgem must provide an annual report to the Committee, which includes a breakdown of the allocation of its resources and a summary of the enforcement and compliance action it has taken in response to rule breaking by energy suppliers.

“Ofgem has proved incompetent as the regulatory authority of this complex market, thereby costing taxpayers billions of pounds. The scale of failure and the cost exposure to taxpayers is only comparable to the financial crash of 2008,”
– BEIS Select Committee

The Committee recommends that Ofgem implements the recommendations of the Oxera report in full “to ensure that it has the proper frameworks for defining consumer interests and competition”. It calls on Ofgem to “carry out rigorous quantitative impact analysis to underpin regulatory reforms and to make these publicly available for scrutiny”, and says that Ofgem must “take urgent steps to improve the quality of its governance and the effectiveness of its Board by proactively challenging decisions made within the organisation, ensuring it has the necessary information and sufficient time to vigorously deliberate issues and make evidence-based decisions”.

The Committee goes on to say that while it has been somewhat reassured that changes are being made to the governance, leadership, and performance of Ofgem it remains “deeply concerned that such negligent behaviour was able to take place for so long”. Indeed, the Committee says that had Dermot Nolan still been in post, it would be calling for his dismissal.

As a result, the Committee requires the current and any future CEO and Chair of Ofgem to report annually to both the Committee and to BEIS on the measures in place to ensure effective accountability and transparency.

Strong stuff.

Better oversight of Ofgem

In my previous blog I criticised the level of accountability and oversight of Ofgem. Firstly, it was clear that Ofgem’s Board was asleep at the wheel, even to the extent of allowing its decisions to be over-ridden by operational teams. This is unacceptable in any organisation – directors have certain statutory duties, and it is vital that they maintain their authority in order to ensure they comply with those duties.

Secondly, while Ofgem is independent of Government, the Business Secretary does have the ability to appoint the Ofgem Board and can replace Board members that are failing in their duties. There is no evidence that Kwasi Kwarteng is even aware of these powers, let alone of his having sought to use them.

Thirdly, Ofgem is accountable to Parliament. The question is how does Parliament exercise its oversight? There are two relevant Committees: the House of Lords Industry & Regulators Committee and the BEIS Commons Select Committee (which was responsible for the report discussed in this blog). Neither group has exercised particular oversight of Ofgem, and both have been reactive rather than pro-active in response to the changing market environment both from a policy perspective and a market price perspective.

The BEIS Committee has now recognised its own failings and has committed to exercising greater oversight of Ofgem. It makes some important recommendations:

• Ofgem should clearly outline to Ministers and Parliament the risks and consequences associated with the delivery of Government objectives. The Committee does not believe that Ofgem properly raised the risks to Government, or Parliament, that a deregulatory approach to promoting competition could severely undermine the financial resilience of the retail energy market;
• There should be more robust lines of communication and a clear delineation of responsibilities between Ofgem and BEIS to ensure transparency and effective scrutiny;
• Ofgem must regularly and proactively report to BEIS on how it is meeting its duties and to inform Ministers of any risks associated with the delivery of Government strategy. The Committee asks BEIS and Ofgem to review, update and publish a new Framework Document within six months;
• Ofgem is required to share key decisions, performance issues, and relevant policy concerns with the Committee in addition to providing its Annual Report and Accounts and making both the Chairman and the Chief Executive Officer available for public scrutiny via the Committee.

In addition, the Committee is concerned by the Government’s apparent lack of understanding of Ofgem’s “extensive failings” and the consequences this can have on the market in the event of any demand or supply-side shocks. While it is not in favour of further interventionism from Government towards Ofgem, it expects BEIS to adhere to the principles set out by the Framework Document. It also recommends that the Government urgently publishes its long-delayed Strategy and Policy Statement for Ofgem to “guide the regulator on how to manage the political and distributional trade-offs intrinsic to its responsibilities and clarify the split of responsibilities between Ofgem and BEIS”.

The Committee wants a say in Ofgem’s decisions on financial resilience

Following the collapse of a large number of suppliers in 2020-21 and the associated uproar, Ofgem has published a raft of proposals to increase financial resilience in the market, which could have long-lasting and structural impacts on competition. These have been met with a mixed response from the sector, and despite the Oxera report highlighting Ofgem’s failure to carry out robust quantitative impact analysis to support key decisions, the Committee heard worrying reports that Ofgem “is making the same mistake all over again”.

Unsurprisingly, there was a distinct difference in response from legacy suppliers who on the whole welcomed Ofgem’s proposals, and newer entrants who felt they would drive up costs for consumers and reduce competition. They are not wrong to believe this, but the question is whether increasing the base cost of the industry through higher capital costs would reduce the overall costs by reducing the number of supplier failures. Similarly, competition would be lowered as poorly capitalised businesses with inadequate risk management would no longer be able to enter and remain in the market.

Again, unsurprisingly, some suppliers expressed concerns about Ofgem’s ability to design a capital adequacy framework, while others were frustrated by its slow progress in this area. Considering Ofgem’s previous failure to identify risks in the energy market, even after collecting comprehensive data from suppliers in relation to their financial health, the Committee lacks confidence in the regulator’s ability to undertake market monitoring and stress testing, and has concerns about the adequacy of expertise and skills within Ofgem. This concern is validated by Ofgem’s high staff turnover, which reached 22% in 2021.

The Committee supports Ofgem’s efforts to ensure suppliers are well-capitalised and prudently run, and recommends that Ofgem upskills its workforce to ensure it has the appropriate expertise to implement its capital adequacy and risk management monitoring in an effective and proportionate manner. It wants Ofgem to publish a plan on how it intends to do this.

I would go further – there is no need for Ofgem to acquire these skills when there is already a competent authority operating in the UK carrying out a nearly equivalent activity in the financial sector. It would make far more sense if the Financial Conduct Authority were to take over the responsibility for regulating the retail energy sector altogether: this is a largely virtual business which has little day-to-day connection with physical regulated activities such as generation and networks. Aspects of energy regulation such as the trading of gas and electricity futures already falls within the purview of the financial regulator, so extending this oversight to bilateral forward trading would be a small step. It would also be an opportunity to remove many of the licence conditions that have little to do with energy supply such as the Energy Company Obligation, the smart meter installation programme and the distribution of the Warm Homes Discount, all of which can be better executed by other bodies.

The Committee discusses in detail the differing perspectives of legacy and challenger suppliers to Ofgem’s financial resilience and ring-fencing proposals. There are some legitimate criticisms of Ofgem’s process, with some suppliers complaining that Ofgem issued a 100+ page consultation with a 100+ page accompanying report, during the summer, with only a 4-week period for organisations to respond. Some described this as a “box ticking exercise”. In addition, the impact assessment relied on various assumptions which may turn out to be unsupported by actual evidence.

The Committee recommends that Ofgem publishes a more robust impact analysis of its proposals for the ring-fencing of customer credit balances, based on evidence received from suppliers following an information request, “so that it is underpinned by facts, rather than assumptions”. This analysis should include comparisons of Ofgem’s preferred option with alterative options, and it should be transparent about the implications for energy bills and competition, as well as the cumulative impact of this proposal and the other measures Ofgem is taking to boost resilience in the market.

Crucially, the Committee wants to see this analysis – and have time to scrutinise it – before Ofgem makes a final decision.

On the related question of ring-fencing Renewables Obligation (“RO”) payments, the Committee agrees with Ofgem and the industry that a better approach would be for RO payments to be made with greater frequency. This would require legislation which the Government has been reluctant to bring forward for reasons which are, in the Committee’s view, insufficiently clear. Therefore, the Committee asks that ask the Government sets out the reasons for failing to act in this area in its response to this report, and recommends that the Government brings forward legislation to increase the frequency of RO payments.

This report is by far the most meaningful challenge that has been made to the status quo, and while the Committee has no powers to compel the Government to act – it can only make recommendations although the Government is expected to formally respond to the Committee’s findings – it can impose requirements on Ofgem, and has clearly signalled its intent to be significantly more proactive in its oversight in future. It will be essential that the Committee continues to engage with stakeholders across the industry to properly inform its actions, but this is a very positive step.

Original article   l   KeyFacts Energy Industry Directory: Watt-Logic