Energy providers able to pursue ‘high-risk/high-reward’ business model

The review, written by economics and finance consultancy Oxera, also found that the regulator’s approach to regulating the market created the opportunity for suppliers to enter the market and grow to a considerable scale while committing minimal levels of capital. By pursuing a “high risk/high-reward business”, such suppliers would benefit from the upside, while being able to exit costlessly if the downside materialised. 

It was commissioned by Ofgem’s board to look at the root causes of the recent supplier failures and, more specifically, how regulation of the industry played its part. 

Since the surge in wholesale gas prices last year, nearly 30 energy companies have gone bust, with the regulator stating in writing in a select committee hearing in March, that the estimate for total claims against these firms is “approximately £2.2bn to £2.4bn”. 

In the evidence session held by the Business, Energy Strategy (BEIS) Committee on 22 March, this money would be recovered from bills charged to UK consumers, as the suppliers taking on customers must buy more energy on wholesale markets. 

It also said about 85% of overall costs incurred by providers under supplier of last resort were from buying wholesale energy for new customers. The cost for which has become increasingly expensive since the final few months of last year. 

The issue has been exacerbated by Russia’s invasion of Ukraine, with supply disruption with Russia putting wholesale gas prices in the UK at 650p per therm at the start of March. Wholesale gas prices have fallen sharply since these record highs but - according to the BBC - many energy companies have already bought the gas they will supply this winter at these higher prices. 

These record wholesale gas prices have led to some predicting the winter price cap will hit more than £2,900 in October - close to £1,000 than the current cap of £1,971, which is itself a record. 

Off the back of this, bosses of some of the biggest energy companies in the UK have called for the government to scrap the price cap. At a BEIS Committee hearing, ScottishPower’s chief executive Keith Anderson said the cap should be replaced by a social tariff - which is designed to give those struggling a discounted price. 

In assessing Ofgem’s effectiveness in regulating the market during this time, according to Oxera there were several regulatory options that could have mitigated either the risks of failure, the costs of failure, or both. 

This includes requiring a substantial commitment of shareholder equity prior to market entry, setting and monitoring minimum levels of capital adequacy, and requiring and verifying third-party or parent company guarantees that protected prepaid customer balances.

As part of Oxera’s recommendations to the regulator, it says the determination of the consumer interest - for both existing and future consumers - is key. Where policy trade-offs are being made, they should be guided by an explicit weighing up of the expected costs and benefits to consumers. 

It also believes a definition of the criteria and the expected characteristics of effective competition would be valuable. This would be designed to provide a framework against which to assess whether intended outcomes are being achieved on an ongoing basis. 

Such analysis should consider whether the market can sustain the number of market players in the longer term by examining ongoing profitability. Oxera does emphasise the intention is not to switch the focus to a zero supplier failure regime, but to understand the risks of failure. 

Ofgem should also consider the extent to which competition delivered innovative business models are in the consumer interest. 

In addition to this, the report’s recommendations call on the regulator to draw on its cross-disciplinary skills within its organisation. It explains a combination of skills from the energy retail industry, economic and financial analysts, and regulatory expertise is needed to understand the demand side as well as the supply side. 

This may necessitate overcoming horizontal frictions in information flows that have taken the form of divisional silos between different teams at Ofgem.