Funds Insider Energy crisis

Market stabilisation mechanisms

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).

The energy crisis has provided an unprecedented test of how these regimes work in practice – gaps in legislation and the regulatory environment have been revealed and some distressed opportunities discovered.

The SoLR regime allows Ofgem to direct another ESC to be appointed as supplier of last resort to the customers of a failing supplier.

Although Ofgem can direct any existing retailer to take up the 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).

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 by 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. There has only been one example of this so far: Bulb.

New investment opportunities

Ofgem has clearly stated that its preferred option for dealing with failing suppliers is a SoLR transfer to another supplier. Ofgem would only use the ESC SAR if a SoLR cannot be appointed. As capacity in the market for suppliers to absorb consumers of failed suppliers is waning, we expect to see increased use of this procedure particularly for large supplier failures. ESC SARs come at a heavy cost, evidenced by the c.£2.2bn bill to the taxpayer for the Bulb special administration given the considerable strain that existing suppliers were already under, having absorbed customers of the 20+ energy suppliers that had failed prior to Bulb.

Around 2.7m domestic customers have already been absorbed by existing suppliers through SoLR transfers in the last year, with the largest such transfer¹ 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 additional customers through a SoLR transfer. Octopus Energy and Shell Energy in particular have picked up a lot of customers, with several smaller challenger suppliers taking advantage of the SOLR process to consolidate their business. Recently, Octopus received an investment of $600m to increase their sustainable energy platform, and we foresee more investment of this nature as investors increasingly focus on the ‘E’ in ESG.

Industry levy financing

The SoLR regime allows for suppliers acting as SoLRs to make a claim for any reasonable costs they incur as a result of the transfer – 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 failures, Ofgem’s guidance encouraged SoLRs to waive their rights to claim on the 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 January 2022, Ofgem processed over £1.8bn in claims on the levy.

Apart from the quantum, timing has also been a major problem – the earliest SoLRs have received 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. Although this door has now been opened, it remains to be seen what the appetite is amongst credit providers to provide such third party funding and how these structures will work in practice.

Further areas of Ofgem reform to watch out for are:

• ring-fencing customer credit balances and renewables levies, preventing them being used as working capital, and significantly reducing the risk of this money being lost if a supplier fails;
• improving governance and risk management; and
• adapting the price cap to allow it more flexibility for volatile market pressures.

Investment considerations – taxes on shareholder profits and NSIA regulatory concerns

The market that had emerged by 2021 did not prove resilient in the face of an unprecedented rise in wholesale energy prices, exacerbated by the ability of owners of ESCs to extract in-the-money financial derivatives (or other assets), and then declare the supplier insolvent, with the downside borne by the SoLR and, through the levy claims, ultimately the taxpayer. The collapse of energy retailer Pure Planet in October 2021² provides a good illustration. BP and other shareholders in the failed supplier’s parent³ company are expected to receive a dividend from the administrators as a result of 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 costs. 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 state. 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.

On 26 May 2022, with the cost of living crisis continuing without relent and a further 40% hike in the default tariff cap expected in October 2022, the Chancellor announced a further “windfall” tax targeting the “excess” profits made by electricity generators, which means UK energy generators will pay an additional 25% tax for the next 12 months. Investment decisions will need to consider the impact of this and shareholder distributions may look less certain than they did before.

Another regulatory consideration for investors is whether a notification is required under the National Security and Investment Act 2021, which came into force on 4 January 2022. Given the national importance of the energy sector, investors may be required to give notice of, and obtain UK government clearance for, transactions involving the acquisition of more than 25% shares or voting rights in an energy company. There are a wide range of powers that the Act equips the authorities with and given the energy crisis and both market and geopolitical volatility, it is likely that investment activity in the energy sector will be examined more closely than it has been in the past. On the plus side, the government recognises there is a need for building resilience into the sector in order to ensure continuity of supply, and investment is likely to be welcomed. Whether bridge funding SOLRs for the deferred levy payments or the working capital deficits caused by ringfencing credit balances, there is a potential new home for the dry powder in the current market.

Authors: Maria Staiano-Kolaitis, Senior Associate; and Adi Jain, Solicitor

<sub>1. Avro Energy in September 2021
2. Customers transferred to Shell as the appointed SoLR
3. Blue Marble Holdings (in administration)</sub>