Distressed Energy Update

Introduction

Soaring energy costs and the effect of this on consumers' finances is widely acknowledged to be a national crisis in the making. Potential Government intervention to help consumers is, and will continue to be, front-page news as we head into winter.

In this article we discuss three key developments in this area:

The Ofgem proposals 

Ofgem's proposals, made earlier in the year, include three key suggestions concerning financial resilience of energy supply companies, which will be of importance to anyone with an interest in the sector: ringfencing of customer credit balances; hedging; and capital adequacy proposals.

Ringfencing of customer credit balances

When an energy supplier fails, its customers are quickly moved to a new energy supplier (with responsibility for supplying its customers)¹ and their existing customer credit balances remain intact. This new 'supplier of last resort' (SoLR) honours those credit balances, takes on liability for paying the renewables obligation and charges the customers of the failed supplier a price no higher than the default tariff cap. This process protected over 2 million customers last year. However, under current rules these balances are available for use as working capital by energy supply companies and the new supplier does not receive the benefit of the credit balances, such that the costs of replacing those balances are currently shared across all consumer bills (a similar arrangement is in place for money paid through customer bills to the renewables obligation; the government’s green levy scheme).

Since September 2021, the cost of moving customers to new suppliers from 28 failed suppliers, replacing lost customer credit balances and the green levy/renewables payments was £94 per household.²

In response, Ofgem has proposed protecting customer credit balances and renewables obligation payments so that they remain available to customers and cannot be used as working capital. To do so, Ofgem has proposed that customer credit balances and renewables obligation payments be ringfenced, even in an energy supply company insolvency. The options suggested for doing so include trust accounts, third party escrow accounts, standby letters of credit and third party or parent guarantees.

The aim of the proposals is therefore to:

1. reduce the mutualisation costs directly associated with customer credit balances and renewables obligation payments, and to ensure suppliers do not have access to risk-free working capital that incentivises them to take excessive risk and pursue risky business models;
2. ensure that owners of failed energy supply companies cannot extract value from such assets at the expense of future bill payers when the company becomes insolvent or is wound up; and
3. enable suppliers to survive market shocks and incentivise robust risk management.

Hedging

It is widely accepted that Bulb failed as a result of its hedging strategy and its inability to obtain sufficient credit lines to hedge into 2022. The SoLR process sees the customers of the insolvent supplier transferred to a SoLR with the responsibility for incurring costs to supply energy to those customers firmly remaining with the SoLR. Any valuable in-the-money hedges of the insolvent supplier are not transferred to the SoLR, and remain in the insolvent estate for the benefit of its creditors.

Ofgem have calculated that the wholesale energy costs for autumn/winter 2022 are significantly higher than can be recovered through the price cap (despite its rise by an average 80% on 1 October 2022)³. We wrote about measures introduced in January 2022 to attempt to reduce the impact of any windfall being returned to shareholders on insolvency⁴  whilst consumers foot the bill. One report⁵  in particular found that systemic risks were exacerbated by the ability of energy supply companies' owners to extract in-the-money financial derivatives and then declare the supplier insolvent. Ensuring this cannot happen will be an important factor in reducing mutualised costs following energy supply company failure. As a result, the latest proposals aim to benefit consumers by ensuring that valuable hedges can transfer alongside customers as part of the SoLR process. We await final proposals from Ofgem on how this will be implemented in legislation.

Capital adequacy proposals

A key pillar of Ofgem's goal of improving the financial resilience of energy suppliers is to strengthen the existing "capital adequacy" regime. Very broadly, capital adequacy refers to requirements, to be set by Ofgem, to maintain minimum levels of capital, with the aim of staving off future energy supplier failures.

Capital adequacy requirements had already existed in the energy supplier sector and also exist in a range of highly regulated sectors. Various forms of "capital adequacy" exist in a number of regulated sectors and are most often associated with banks and financial institutions. It is notable, particularly given the recent energy supplier company failures, that the Ofgem consultation refers to the Basel standards introduced to banking after the global financial crisis in 2008 as inspiration.

What can we expect from a capital adequacy regime for energy supply companies?

The latest Ofgem consultation proposals give an indication of what can be expected of more detailed proposals, projected to follow soon. Ofgem is proposing two 'pillars' or key aspects within the requirements:

This 'two pillar' approach would be familiar to investors who have experience of the regulatory regime concerning banks. The Ofgem consultation very broadly focusses on two forms of capital that energy suppliers would need to raise in order to meet Ofgem's requirements:

Bulb and customer credit balances

On 29 October, the Government approved a deal between the special administrators of Bulb and Octopus Energy to acquire Bulb's 1.5 million customers⁶. The sale will be completed following a statutory process called an Energy Transfer Scheme (used for the first time in the UK), which will transfer the relevant assets of Bulb into a new separate entity that will protect consumers during the transfer process and will practically mean no disruption to consumer supply. The process is subject to approval by the Secretary of State for BEIS and will take effect at a time ordered by the High Court, expected mid-November. Importantly, customer credit balances are protected and direct debits will be automatically transferred. This novel exit from special administration will pave the way as a useful precedent for other energy supply company special administrations that may occur in the future.

Court hearings considering the statutory regime governing energy supply in an insolvency context

A number of energy supply companies had their licences revoked and entered administration in 2021. The administrators of some of these failed energy supply companies have subsequently applied to the High Court in order to receive judgment on a number of issues regarding the obligations of suppliers under the statutory regime that governs the supply of energy, to whom they are owed and how they should be dealt with in insolvency processes.

The applications were prompted largely by proofs submitted by Ofgem in the administrations of the suppliers for a number of payments, but they also concern a number of unanswered questions that have arisen regarding supplier obligations (and entitlements of transferee suppliers i.e. SoLRs). Much of the legislative regime is as of yet relatively untested in the context of the scale of insolvencies we have seen and as such, the case raises numerous matters of interest, which the market will no doubt be watching carefully.

Considering twelve issues, the case concerns the ability of Ofgem to prove in the administrations of failed suppliers in respect of payments including those under the renewables obligation, the ability of SoLRs to claim against failed suppliers for honouring customer credit balances and the status of customer payments made in periods between the loss of suppliers’ licences but before the commencement of insolvency proceedings. Specifically, the SoLRs are seeking to refute a number of proofs of debt submitted by Ofgem and the SoLRs. The SoLRs claim (amongst other arguments) that the failed energy supply companies are being unjustly enriched by the fact the new suppliers are honouring customer credit balances, which means they can claim some of the energy supply company's assets. The case could help determine some of the authority's rules and powers, which have not yet been tested in insolvency proceedings. Indeed, the case is one of the first to test how the regulator's rules interact with insolvency law and procedure.

Comment

The Ofgem proposals are at an early stage and we await the outcome of the consultation process. However, if they are implemented, they can be expected to lead to many energy suppliers seeking to increase their available capital, either through the issue of new equity or new debt instruments. In turn, this creates an opportunity for investors interested in the sector.⁷

The energy retail market is clearly in flux. The net zero agenda requires momentous change across the energy sector, and any further policy decisions will require primary and secondary legislation. Ofgem plans to publish responses from the industry in late autumn, and we expect a decision on implementation of these proposals over the coming months, particularly given BEIS' recent recommendations for strengthening the energy market.⁸

The SoLR administrations have also brought into focus a number of questions as to the extent and priority of their liability for, among others, various debts relating to customer credit balances. These questions, which have been heard in the High Court, could also impact levy claims. The issues raised in the case are both highly relevant and potentially controversial where supplier failures may continue and shareholders in insolvent suppliers may subsequently otherwise receive financial benefit denied to struggling consumers. Whether or not key stakeholders such as Ofgem and SoLRs have claims into the administrations of failed suppliers is likely to have implications for further policy reform and the willingness and capacity of SoLRs to absorb further supplier failures.

There is much change afoot. Watch this space.

Footnotes

_{1. The only exception to this so far being in respect of Bulb, which is a Special Administration. We explain more about Bulb, SOLR and SAR processes and the costs of mutualisation in our previous article: https://www.ashurst.com/en/news-and-insights/legal-updates/counting-the-cost-of-the-energy-crisis/}

_{2. https://www.ofgem.gov.uk/publications/ofgem-announces-tough-new-financial-measures-ensure-energy-suppliers-can-withstand-future-shocks-including-protection-customers-credit-balances}

_{3. Estimated wholesale market costs were around £1.7bn.}

_{4. https://www.ashurst.com/en/news-and-insights/legal-updates/funds-insider-energy-crisis/}

_{5. Oxera were commissioned by Ofgem to conduct an independent review of Ofgem’s role in the supplier failures, and to draw out lessons learned and recommendations—report found here: https://www.ofgem.gov.uk/publications/review-ofgems-regulation-energy-supply-market}

 _{6. https://www.gov.uk/government/news/uk-government-approves-agreement-between-bulb-and-octopus-energy-providing-certainty-to-15-million-customers}

_{7. See also our previous article on this topic: https://www.ashurst.com/en/news-and-insights/legal-updates/funds-insider-energy-crisis/}

_{8. On 19 July 2022, BEIS published its report on "Energy pricing and the future of the Energy Market". The select committee’s report lays out eight core recommendations for strengthening the energy market. These include encouraging Ofgem to publish proposals on a capital adequacy regime and a more robust impact analysis of its proposals for suppliers to ringfence customer credit balances and be explicit about the implications of this on energy bills and competition, having consideration for the cumulative impact of its reforms.}