Counting the cost of the energy crisis

The crisis

Until the recently announced 54% rise in the default tariff cap becomes effective this month, energy supply companies continue to face severely squeezed margins as they struggle to recover costs of supply from consumers. Things are no easier for consumers themselves, who are dealing with rising inflation, the looming threat of increased energy costs and the estimated c.£4bn¹  bill to the taxpayer and consumers from supplier failures since January 2021. Adding fuel to the fire are the recent geopolitical events in Ukraine, which have pushed up the price of oil to a seven year high. For UK businesses, particularly those coming to the end of their energy contracts, the situation will put strain on their cash flow, with the average retail store's energy bill expected to increase by 128%. On top of this, businesses will have to contend with upcoming wage and April's National Insurance rises.

Ofgem has the tricky job of steering the ship through these troubled waters so as to ensure that supply of energy to consumers is not disrupted. The legal and regulatory framework equips Ofgem with two tools to deal with failing suppliers - the Supplier of Last Resort regime (SoLR) and Energy Supply Company Special Administration (ESC SAR).

SoLR and SAR – what's the difference?

The SoLR regime allows Ofgem to direct another energy supply company to be appointed as supplier of last resort to the customers of a failing supplier, which the SoLR is obliged to comply with under its licence terms. Although Ofgem can in theory direct any existing energy supply retailer to take up the SoLR role, it must be satisfied that the SoLR could supply the additional customers without significantly prejudicing its ability to continue supplying its existing customers (an increasingly tall order given the consolidation of the market as a result of the sheer number of failures). Ofgem has indicated a preference to select the SoLR on a consensual basis. The failing supplier's licence is revoked (the trigger event usually being the supplier being declared insolvent by the court upon application by Ofgem for such declaration) and simultaneously with the revocation, the SoLR must commence supply to the failed supplier's customers on a deemed contract rate. Continuity of supply is, therefore, ensured by an effective transfer of customers through the concurrent switch off of the old supply and switch on of the new supply.

The ESC SAR, a modified version of the administration process, was introduced as an alternative to the SoLR process for dealing with high impact supplier failures where a SoLR transfer would not be practicable. A failing supplier can be placed into special administration only through an application to court by either the Secretary of State or Ofgem (with the Secretary of State's consent). Once appointed, the special administrator's objective is to continue to contract to supply gas and electricity to customers at the lowest practicable cost until the company is rescued or its business transferred.

SoLR capacity decreasing

In November 2021, special administrators were appointed over the UK's seventh-largest energy supplier, Bulb Energy, in the first use of the ESC SAR, providing a window into the reasons for its use. Apart from competition concerns around Bulb's 1.7m customers being transferred to another large supplier as SoLR, the other reasons cited by Ofgem for using the ESC SAR instead of a SoLR transfer were:

(a) the considerable strain that existing suppliers were already under, having absorbed customers of the 20+ energy suppliers that had failed prior to Bulb in 2021; and

(b) the likely additional levy claim from a SoLR which would add further financial stress to the sector and consumers in the short term².

Around 2.7m domestic customers have already been absorbed by existing suppliers through SoLR transfers in the last year, with the largest such transfer (on the failure of Avro Energy in September 2021) involving the transfer of 580,000 customers. If there are more ESC failures, it remains to be seen what the appetite and ability of the surviving ESCs will be to take on their customers through a SoLR transfer. We know, from Bulb, that 1.7m customers is too many for any one SoLR to cope with under the current circumstances, but it is likely that the maximum number of customers that can presently be absorbed by an existing supplier taking a SoLR transfer is much lower. In such circumstances, Ofgem may be left with no choice but to appoint publicly-funded special administrators to ensure supply continues if any other large (or potentially even mid-size) supplier fails. Although these special administrations come at a heavy cost, evidenced by the c.£2.2bn bill to the taxpayer for the Bulb special administration, we think Bulb is unlikely to be the last.

Going heavy on the levy

The SoLR regime allows for the suppliers acting as SoLRs to make a claim for any reasonable costs they incur as a result of the transfer (which are not otherwise recoverable) – such claims, made against an industry levy, are mutualised and ultimately borne by customers as a constituent part of the "network costs" which form part of the default tariff cap.

Prior to the recent spate of supplier failures, Ofgem's guidance encouraged SoLRs to waive their rights to claim on the industry levy on the basis that efficient suppliers should be able to minimise their exposure to these costs. Recent SoLRs have not had this luxury and as at the start of January 2022, Ofgem was processing c. £1.8bn in claims on the levy - through the 39% increase in network costs (largely on account of these levy claims) which is built into the increased default tariff cap, UK households are projected to pay an extra £80-85 each on their energy bills in 2022-2023 (on top of the general increase in energy bills)³.

Apart from the quantum of these claims, timing has also been a major problem - the earliest SoLRs have begun receiving levy payments is 15 months post transfer, with full repayment only occurring a further 12-15 months later. Recognising the reluctance of suppliers to volunteer as SoLRs and to foot the bill for protracted periods from their already dwindling reserves, Ofgem introduced measures in December 2021 to speed up the determination and recovery of such levy claims in a marked departure from their previous position of discouraging such claims.

In order to encourage smaller suppliers to accept SoLR transfers, and to mitigate the impact on consumers of the (now effective) default tariff cap increase, in December 2021 Ofgem launched a consultation regarding potential third party financing for the costs of a SoLR transfer. Under the mechanism proposed, a third-party financier would "buy" any and all rights the SoLR has to future levy payments (once a valid claim has been submitted), providing the equivalent amount to the SoLR much earlier than it would have been able to recover from Ofgem directly. It is hoped that this will allow more suppliers to be able to fund additional supply costs and therefore, take up SoLR appointments. It may also mean that the costs to the consumer (through mutualisation of the levy claims) would be spread out over a longer period. The consultation has now closed and on 11 March 2022, Ofgem published its decision to modify the supply licences to allow for a third party assignee to take on the benefit of the levy claims, but only with Ofgem consent. It remains to be seen how such financing structures would work in practice. It is possible that the additional finance costs to already indebted suppliers might exacerbate the problem, making suppliers even less resilient to continuing market volatility. Further, the success of any such scheme hinges on the appetite of credit providers.

Shareholder returns: low hanging fruit and the Government's swift response

Recent supplier failures have provided an unprecedented insight into how the SoLR regime operates and enabled a closer examination of the consequences from an insolvency perspective. One such (likely unintended) consequence of the SOLR regime has been the often healthy shareholder returns being enjoyed by parent companies of failed suppliers whilst the downside is borne by the SoLR and, through the levy claims, ultimately the taxpayer. The collapse of energy retailer Pure Planet in October 2021 (whose customers were transferred to Shell as the appointed SoLR) provides a good illustration. BP and other shareholders in the failed supplier's parent company Blue Marble Holdings (in administration) are expected to receive a dividend from the administrators thanks to valuable "in the money" wholesale energy pre-purchase contracts held at the parent company level.

On 28 January 2022, the Government announced that it was introducing the so-called "Public Interest Business Protection Tax" (by way of the Finance Act 2022) to counter this sort of arrangement. In particular focus is the ability for persons that hold derivative contracts and other valuable assets (such as forward purchase agreements) on which energy supply businesses rely to receive profits from those assets, while the supply businesses themselves go into special measures (such as special administration or SoLR transfers) or suffer increased costs⁴. The aim of the new tax is to ensure that energy supply businesses do not transfer valuable assets to shareholders/investors at the expense of the energy business which would then become insolvent, with the costs of maintaining energy supply passing to the state⁵.

The new tax will have effect where steps are taken to obtain value from assets which materially contribute to an energy supply business which enters into special measures on or after 28 January 2022 and before 28 January 2023. The tax will be charged at 75% of the adjusted value of the assets, and a £100m asset value threshold will apply below which the tax will not apply. "Public interest businesses" would be defined as "energy supply businesses", i.e. businesses requiring a gas supply licence or an electricity supply licence, although there is an option to extend the definition by regulation to also cover other types of business subject to a special administration regime.

No quick fix

Ofgem have stated that they will be implementing reforms to help deal with the energy crisis, with improvement in financial resilience being one of the main drivers for change. There is talk of a more adaptable price cap, a proposed market stabilisation charge, stress testing and transition plans for energy supply companies to help stabilise the market, as well as ringfencing customer credits along the lines of the reforms introduced by the Bank of England in 2019 as part of the Government’s package designed to prevent the costs of failing banks falling on taxpayers. It remains to be seen whether these energy reforms will go far enough, quickly enough. 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 are being brought to court in a directions hearing that is due to be heard later this year, could, in turn, impact levy claims.

The above uncertainties are symptomatic of the fact that both the SoLR and ESC SAR regimes are relatively new and the energy crisis is putting them to the test. One thing, at least, is certain - this energy crisis is far from over and we expect to see more SoLR transfers and special administrations before it ends.

Authors: Maria Staiano-Kolaitis and Adi Jain

1. _{This figure includes the c.£2.2bn cost of the Bulb special administration and the c.£1.8bn (and increasing) claims by SoLRs under the industry levy.}
2. _{Ofgem has said that as at the start of January 2022, it was processing c. £1.8bn in total claims on the levy. Included in this number is a bill in the region of £200m (and counting) for lost consumer credit balances through ESC failures (as admitted by the CEO of Ofgem to MPs on 8 February 2022 at the business, energy and industrial strategy (BEIS) select committee).}
3. _{Network costs have gone up from £268 in Period 7 (October 2021 – March 2022) to £371 in Period 8 (April 2022 – September 2022) - Link to Ofgem letter.}
4. _{The companies hedge against fluctuations in the energy market price by using forward purchase agreements to buy energy in the future at a price fixed at the time the contract is entered into. With the wholesale cost of gas and electricity increasing steeply in recent months, the opportunity to buy energy at the lower fixed price is worth a great deal. This creates a risk that companies might decide to distribute the value of the assets to their investors rather than using the assets for the benefit of energy supply. In such a scenario, the energy supply business would likely become insolvent, leaving the government to pick up the cost of ensuring continuity of energy supply.}
5. _{Link to H&M Customs - Public Interest Business Protection Tax .}