Written evidence submitted by Elexon (EPM0016)
31 January 2022
Online submission
Dear Business, Energy and Industrial Strategy Committee Members,
Elexon is a not-for-profit company that acts as Code Manager for the Balancing & Settlement Code (BSC), which facilitates the effective operation of the electricity market through managing and delivering the end-to-end services set out in the BSC and accompanying systems that support the BSC. This includes responsibility for the delivery of balancing and imbalance settlement and the provision of assurance services to the BSC Panel and BSC Parties (energy suppliers, generators and network companies). We manage not just the assessment, but also the development, implementation and operation of changes to central systems and processes. In addition, our expertise is available to support the industry, government and Ofgem in considering future changes and innovation against the existing industry rules, for the benefit of the consumer.
Through our subsidiary, EMR Settlement Ltd, we calculate, collect and distribute payments to Contract for Difference (CfD) generators and Capacity Market (CM) providers, on behalf of the Low Carbon Contracts Company (LCCC). Those services are provided to LCCC through a contract and on a not-for-profit basis.
Given our role in the market, we are subject to the electricity market regulatory regime overseen by Ofgem. We have been instrumental in ensuring the BSC and accompanying systems evolve to deliver Net Zero solutions and facilitate innovation in the energy market. We recognise the importance of the BEIS Committee inquiry into energy pricing and the future of the Energy Market and welcome the opportunity to share our comments, observations and suggestions. We do this from the perspective of having more than 20-years’ experience of working alongside Ofgem, BEIS (and predecessors) and the energy industry and encompass a vast wealth of knowledge and experience through our team.
In our response to the Committee’s questions we focus on those questions where we believe we can add value and outline practical considerations and suggestions based on our role at the centre of the electricity market.
We are willing to give oral evidence to the Committee to add further details if required.
The regulatory requirements companies must meet in order to trade as a regulated entity in the retail energy market
1.1. It is now fairly generally acknowledged that the controls over market entry into energy retail were over-relaxed by Ofgem with the aim of getting more companies into the market (see, for example, the Citizens’ Advice paper: Market Meltdown, which notes that from 2010 onwards, dozens of companies entered the market with limited checks). As well as limited controls on entry, so also were there limited in-life controls and little action taken against the new entrant suppliers.
1.2. Against that background, and the history of unprecedented numbers of supplier failures, Ofgem, as an economic regulator, has been reviewing its approach to regulatory requirements and supplier licensing since late 2018 in order to ensure that appropriate protections are in place against poor customer service and financial instability. The most recent package of measures was announced on 15 December 2021. While new measures and controls have been introduced since the start of the review, and been proposed very recently, the BSC Panel twice drew Ofgem’s attention to a particular aspect that is causing concern in 2021 - risk management.
1.3. Very early in 2021, following several supplier defaults (the situation of a Supplier not being able to meet their financial obligations), the BSC Panel was increasingly concerned that Suppliers were unable to provide satisfactory explanations or reasons why they were entering into default under the BSC. The BSC Panel wrote to Ofgem about their concerns and findings at that time. It appeared that, for a number of companies, their cash flow and risk management strategies were not robust or effective enough to safeguard the companies from going into default. The BSC Panel suggested that Ofgem needed to consider encouraging or require Suppliers, wherever possible, to develop effective daily cash-flow management systems, prudent hedging arrangements and better risk management approaches, especially to ensure adequate planning for their working capital requirements. The Panel took the view that Ofgem needed to consider whether it should ensure that Suppliers and traders had in place robust strategies to mitigate their exposure to price volatility. In that context we welcome Ofgem’s publication on 15 December 2021 of its Action plan on Retail Financial Resilience, which includes as a draft outcome, robust minimum standards around hedging and sufficient financial capital to manage different market scenarios.
1.4. We are also pleased that Ofgem has taken action to crack down on the formerly available and much used model for entry of “supplier in a box”. Ofgem has over time been reviewing and revoking “supplier in a box” licences and, again as part of the 15 December package, issued a decision letter on revoking unused and dormant licences, indicating that this will be its policy going forward.
1.5. Elexon has played a role in seeking to educate new entrants into the market. It has continuously adapted its operational services to support an increased number of new market entrants with little or no prior experience in energy markets. We have assisted a wide range of new energy industry participants and technology providers through our education and advice on market entry requirements, seeing this service as an important component of our neutral and independent role of a critical friend, facilitating equal access to energy markets. We maintain our focus on helping BSC Parties to operate efficiently and effectively through their lifetime as BSC Parties. We do this through our programme of training, support and performance monitoring, which is constantly evolving to reflect the changing market conditions, potential knowledge gaps and any emerging performance issues. This service is highly appreciated by the industry and rated highly in Elexon’s own customer satisfaction survey as well as Ofgem’s energy codes satisfaction survey.
The mandate, role and performance of Ofgem in setting regulation and supervising regulated entities
1.6. Ofgem has extensive powers to regulate and to enforce licence conditions and other requirements over regulated entities. It has the powers – the question lies around its use of those powers and whether it has been sufficiently robust in exercising them in the case of some newer entrants into the market. The incentives of those running companies will vary, depending on whether they have a short or long-term interest in the market (e.g. grow quickly, attract customers, sell out; as opposed to participating in it for the long term).
1.7. We believe that, for any of its existing and any potential new roles, clearly defined KPIs (key performance indicators) and service standards need to be developed by Ofgem and successfully applied and monitored. We are not clear that is happening.
1.8. Ofgem’s role has always been that of an independent regulator. Its role as an independent economic regulator pre-dated that requirement being introduced as part of the EU Energy Liberalisation Package (Chapter IX of Directive 2009/72/EC). In Elexon’s view, having that independence is important to the running of the market and therefore, should Ofgem’s views differ from those of the Government of the time, it is important that those differences should be made publicly known, such that they can be understood.
The performance of previous policies introduced to stimulate effective competition within the retail energy market, and an assessment of the impact on competition of proposed future regulatory frameworks
1.9. A referred to in para.1.1. above, there was a clear policy intent to stimulate greater new entry and competition in the market. On a pure numbers basis, those policies appear to have achieved their aim - according to the market statistics collated by Ofgem, the number of active domestic suppliers increased from 14 at the end of 2011 to 70 in June 2018[1].
Source: Ofgem’s retail market indicators (retrieved on 29 January 2022)
1.10. Coupled with that policy, there has been an intense focus on switching as a metric for the health of the market. This has been evidenced by detailed reporting on levels of switching, destination of switchers, rewards for switching and Government campaigns focused around switching. As part of that, industry and Ofgem have invested considerable cost and effort into the Faster and More Reliable Switching Programme, which was designed to reduce the time taken to switch significantly and to give consumers more confidence in switching. At the same time, Ofgem has run switching trials, including collective switch trials and, in the Energy White Paper in late 2020, Government proposed plans for “opt in” and “opt out” switching.
1.11. While we do not disagree that switching (like any other industry process) must be seen to be reliable, we believe there needs to be more room for debate whether the focus on faster switching and the corresponding cost is justified. This is especially so as the retail energy sector moves its interactions with customers to a different paradigm, built around new propositions such as energy as a service, bundled services, and time-of-use tariffs – all of which are likely to be more customised to specific household needs and potentially underpinned by longer-term relationships.
1.12. The future regulatory frameworks for the retail energy market need to recognise the changing nature of the supplier-customer engagement, the transition to Net Zero, the inevitable emergence of diverse types of customers and consumers (some of whom are turning into prosumers) and the need to protect the interests of all those different types of consumers.
1.13. Ofgem, in its Energy Retail Market Strategy for the 2020s (published in July 2021), provided a short summary of its key goals and actions for the short-, medium- and long-term. However, we note that there needs to be more detail and industry debate on the proposed policies and changes to the retail market frameworks that focus beyond the current programme of work[2]. We all need to contribute to a retail energy market that is sustainable and innovative; that is fit for Net Zero and the relationships between supplier and customers that that requires, where customers are able to engage with the market and where vulnerable customers are protected.
The functioning and performance of the ‘energy price cap’ and an assessment of its use in the future, and an assessment of the role of auto-switching
1.14. Standalone episodes of energy Suppliers failing may be a normal facet of a competitive market. However, the sheer number of recent Supplier failures suggests that something is going badly wrong and that the current market framework is not sustainable. It is notable that the Impact Assessment, published at the time that the price cap was set by Ofgem in 2018 estimated that, for its then chosen cap level (option 2), the overall market EBIT margin would reduce to approximately minus 1%.[3]
1.15. Whilst a number of failures may be attributed to a lack of sound business models or robust risk management policies, we have also experienced examples of suppliers who appeared to have demonstrated that they had run their businesses well in the past but were unable to operate successfully in the exceptional market circumstances since around September 2021 - they blamed the current price cap regulation for their failure.
1.16. Such suppliers have asserted that they were unable to hedge their energy commitments at prices which brought their operating costs under the current price cap. Moreover, given that they generally could not envisage the position improving over winter or even spring 2022, several suppliers told us their investors could not justify continuing to fund their losses, in particular when they were so high.
1.17. Whilst neither Elexon nor BSC Panel has a formal role in relation to the default tariff cap, the obligation for which sits wholly with Ofgem under the Domestic Gas and Electricity (Tariff Cap) Act 2018, the BSC Panel does have a role in relation to the promotion of ‘effective competition in the generation and supply of electricity, and in promoting such competition in the sale and purchase (as defined in the Transmission Licence) of electricity’ (see the Panel’s objectives, set out in Section B1.2 of the BSC).
1.18. With this objective in mind, we note that the BSC Panel expressed concerns in its December 2021 letter to Ofgem about the impact on the effective competition and confidence in the market caused by the unprecedented numbers of failing suppliers, and the consequential impact of debts being mutualised on the remaining Suppliers. Therefore, we welcome Ofgem considering the operation of the default tariff cap within the package of consultation documents issued on 19 November 2021, and also welcome urgent steps being taken to make the price cap adaptive to market conditions in order to prevent more well-run companies falling into distress.
The future of Bulb and the recovery of public funds and the cost to consumers of other energy supplier failures
1.19. There appears to be little information on how and when the loan to the administrators of Bulb, following its failure, is to be re-paid. Whilst, as was set out in the letter from the CEO of Ofgem to the Secretary of State on 19 November 2021, it appears that, in an ESC Administration, the funding will be repayable by the industry, this is only to the extent that there is a shortfall in the funds of the Company, and the recovery of that shortfall is subject to discretion on timing so that, for example, it could be spread across multiple years. We believe there needs to be more transparency and clarity on any options discussed for the loan re-payment.
1.20. In addition, whilst we have no reason to believe that the administrators are doing anything other than a robust and prudent job, we are unclear how the costs and activities of the ESC Administration are being scrutinised to ensure that the costs are efficiently incurred and the activities effectively carried out.
1.21. The cost of mutualising market failures has escalated significantly in 2021. Surviving suppliers in the market are hit by a large variety of mutualised charges left behind by those who have failed, increasing the burden upon them and possibly resulting in contagion risk – or even systemic failure risk. This raises the question whether it is right that the full, increasing costs of supplier failures should be borne wholly by the remaining suppliers and their customers, especially considering that the customers of those suppliers will largely not have had the benefit of lower cost tariffs. Moreover, in the case of Bulb customers, as the Bulb entity and licence continue in existence under the ESC Administration, a Bulb customer can stay on its potentially below market cost tariff for the duration of that tariff, until it is changed, unlike the situation of a SOLR customer who is transferred to a new tariff offered by their new supplier.
1.22. It is worth noting that vulnerable customers and those less able to engage in the competitive market (i.e. less able to shop around for lower tariffs) have historically been less likely to be in that category of those on beneficial lower cost tariffs. Therefore, they may be worse off financially than other categories of customers who may have benefited from more competitive, lower prices for some time through switching to low tariffs. Of course, in today’s market, the default tariff, or Standard variable tariff, protected under the price cap, is the best value tariff in the market.
The role of retail market reform in the context of the UK’s net zero transition and domestic energy security requirements
1.23. With the commitment to achieve Net Zero by 2050, there needs to be an unwavering focus on the critical path for the energy industry and retail sector to reach it. If consumers are to be engaged on the path to Net Zero – as they must be, if we are to achieve it – suppliers will play an important role (amongst other actors) in that engagement. This will be around matters such as the source and nature of customers’ power and heating needs, the insulation of their homes, their choice of new technologies such as solar PV, charging points and heat pumps, as well, all importantly, as customers’ behaviours. That reinforces the need for a sustainable, trusted supply sector. This goes both to the relationship between regulator and the supply sector and also to how effectively the regulator maintains oversight of the sector.
1.24. Retail market reform has a significant role to play in the UK’s Net Zero transition. With the smart meter roll out scheduled to be completed by the end of 2025 and new settlement processes introduced through market-wide half-hourly settlement (MHHS), domestic and small business consumers will have near real time information on their energy use. This will allow them to make informed decisions about their energy use and modify it according to price signals if they choose to do so. However, they will only be able to do this if suppliers start to offer time of use tariffs to give them the signals of when best to use their energy. It is worth noting that it is difficult to reconcile dynamic time of use tariffs with a single price under a price cap.
1.25. In April 2021, Ofgem made the decision to implement the move to MHHS. MHHS is one of the biggest changes to energy markets since retail competition was introduced. MHHS will allow Elexon to settle suppliers of domestic customers on a half-hourly basis, rather than relying on estimates of when they use electricity. At the moment, most domestic customers are settled based on a profile of the average consumer usage and their own meter reads when they are provided. The MHHS roll-out will facilitate new time-of-use tariffs and new products that allow customers to move consumption away from peak demand periods, thus helping the customer control their spend on energy. Ofgem estimated that MHHS would deliver net benefits to GB energy consumers in the range of £1.5bn-£4.5bn over the period 2021-2045. Without the industry-wide implementation of MHHS, the benefits of the smart meter roll out will not be realised, it is therefore a key programme in achieving the Net Zero objective.
1.26. Ofgem has directed Elexon to act as the Implementation Manager for MHHS. This role involves managing the activity of around 180 organisations across the energy sector to implement MHHS. The programme is due to complete by October 2025. Working together with the industry and Ofgem, Elexon is fully committed to delivering the MHHS reform and the re-development of the industry central systems on budget and according to the timeline. It will be important to ensure that all parties to the programme develop the changes that are needed to make the programme a success and deliver the benefits for consumers. It is crucially important for all parties involved in MHHS to deliver the programme on time as, based on the benefit assessment figures above, net potential benefits foregone could be of the order of £2 million a week in case of any delay.
1.27. We believe it is essential that existing markets and the supporting industry arrangements are effectively changed to accommodate new technology, business models and markets. Elexon actively works with industry participants, interested parties, government and Ofgem to progress changes to the BSC and wider industry arrangements to enable the much needed transition to Net Zero. Working alongside the industry, Elexon is also progressing several important changes[4] to the BSC rules that will create more opportunities for smaller asset owners and encourage the greater uptake of flexibility products and services.
1.28. Those changes, when implemented, could have a transformative effect on the energy system, by offering Demand Side Response (DSR) providers and other small asset owners more opportunities to provide balancing services, thereby encouraging more use of flexibility in the system. DSR can also act as an additional resource for security of supply (like a Virtual Power Station), and will be important in allowing networks to cope with demand, especially, with the ongoing uptake of EVs and the upcoming electrification of heat.
January 2022