The last five years have been turbulent for UK Energy Supply Companies (‘ESCs’). In that time over 30 suppliers have exited the market¹, with many seeing their customers transferred away using the Supplier of Last Resort (‘SoLR’) process after encountering financial difficulty.
Green Network Energy was one of the most recent casualties - and the largest ESC to go through the SoLR process to date² - when its 360,000 customers³ (myself included) made the journey across to EDF in
In view of the high number of supplier exits (and the swelling size of affected consumers), Ofgem has a keen focus on improving the financial resilience of other ESCs, and reducing the cost to the wider market when the next ESC does fail⁴.
ESC funding models are in Ofgem’s cross-hairs
In our experience, a heady mix of wholesale price volatility, aggressive tariff pricing (often designed to attract switching customers) and an undercapitalised balance sheet are the recurring drivers of ESC financial distress.
When a supplier exits the market through a SoLR process, two large bills can fall to the rest of the industry’s participants – and therefore consumers - to pay:
1. underwriting the credit balances owing to the defunct ESC’s domestic customers (although the appointed SoLR takes a good share of the pain upfront)
2. making good any unfunded Renewables Obligations (RO).
It is unsurprising, then, that areas of particular concern for Ofgem are ESCs that run a high value of unfunded customer credit balances, and suppliers that do not pay their RO on time, or at all.
However, amassing customer credit balances and the long delay between collecting RO cash through energy bills, and accounting for it to Ofgem, are sources of significant, cheap working capital for ESCs. Indeed, to provide context for one of its proposals, Ofgem analysis indicates that ESCs operate with a combined customer cash surplus of as much as £1.4bn.
The regulator’s proposals: internalising the externalities
Ofgem is currently exploring policy changes that will seek to push energy supply companies to bear the true cost of their funding models and reduce the systemic risk to the rest of the market. Possible options on the table include:
Periodic repayment of credit balances
Ofgem may require ESCs to automatically repay credit balances on the anniversary of a domestic customer’s contract, with limits on the overall value of unprotected customer deposits the ESC is allowed to carry; and
Changes to Renewables Obligations (‘RO’) scheme
Changes could see ESCs being required to ring-fence levies collected from customers under the RO scheme, or ESCs being forced to account for levies more regularly than once a year.
Acceptable parent company guarantees have been mooted as an alternative to ring-fencing cash. Instead, the guarantee would be called to fund whatever credit balances (and/or unpaid RO liabilities) the ESC business cannot meet following its failure.
Being unable to access a parent guarantee will undoubtedly put some ESCs at a distinct cash flow disadvantage. Albeit, being able to provide the guarantee brings with it potential contagion risks where the ESC is part of a diversified group.
How can you prepare for Automatic refunds?
The good news is that any policy shifts that affect customer credit balances are not expected to come into force until 2022. A timeframe for altering the RO framework is not currently set, but changes before 2022 seem unlikely.
With this in mind, you should be taking steps now to understand what the impact could be for your ESC business, including:
- Financial scenario planning to identify what the cash flow consequences of the different policy changes might be, and what your options are to meet any funding requirements
- Ensuring that your management tools for cash forecasting are sufficiently robust and flexible to support the scenario planning process
- Considering the structure of any group, to ensure ESC and non-ESC businesses are adequately funded and insulated if one part fails
- Considering stakeholder engagement
Boosting cash flow for ESCs
If you are concerned about working capital in your business, we are able to support you with a number of measures that will help improve the position, including:
- Reviewing the billing platform and processes to ensure customer energy usage is being billed regularly and accurately (both to avoid excessive credit balance build up, and to ensure customers are not being undercharged in light of restrictions on back-billing)
- Checking that direct debit levels match customer usage
- Focusing on collecting outstanding debts (whilst being mindful of customers’ circumstances and over-riding licence obligations to be fair in customer dealings)
- Reviewing hedging arrangements to mitigate exposure to wholesale price volatility
- Exploring whether the business would be suitable for a working capital facility.
If you would like to know more about the Ofgem proposals, or you are worried about the potential impact on your business, please get in touch with John Strowger and Tony Nygate who can provide you with expert advice and support.