There has been much comment of late on the number of energy supply businesses going bust. Nine failures in about the same number of months is unprecedented in this market.
Depending on who you talk to, or what you read, you may blame Ofgem for allowing the companies to enter the market in the first place; you may blame incompetent management for being naively ambitious or lacking skills; or you may point your finger at the underlying market design. The truth is that it is probably a combination of all three.
So, in reverse, why is market design to blame? In simple terms, suppliers in their role as industry “hubs” are the backstop for absorbing industry cost risks. Suppliers have the obligation to pay for wider industry costs, which they do by forecasting the costs and recovering them through their tariffs. However, suppliers do not necessarily have the capability at an individual level to manage the risk of greater or lesser industry-wide activity than they forecast.
For example, suppliers are obliged to recover the costs of funding incentive schemes to stimulate investment in renewable generation. Many of these costs are fixed retrospectively, once it is known how much investment and new generation has been delivered. The supplier has to forecast what they think the costs are going to be across the whole market and determine their own liability based on their forecast market-share. They then must ensure that those forecast costs are recovered via their tariffs ahead of the liability crystallising.
If the forecasts are wrong, or the tariffs are set too low, it can be catastrophic for the supplier when the final bill comes in and there is not enough cash accrued in the coffers. Over the years, the number and variety of these “retrospective” costs have increased, all of which have different but nuanced calculation methods. The implementation of the price cap makes it harder all round as effectively Ofgem have now taken on the mantel of cost forecasting in setting the cap.
If Ofgem are wrong in their forecasts as many suppliers are claiming, even for a couple of months, it is the supplier who bears the excess, not the customer or Ofgem. In a market with low single-digit margins and high cash requirements, there is little room for error.
The situation is made worse if and when supply businesses fail. Under regulation, as businesses go bust, the new supplier picking up the failed supplier’s customers is able to recover some of their resultant costs from the whole supplier community. That community has no control over the timing, frequency or magnitude of these costs, and has to take whatever the resultant hit is to their already stressed bottom lines.
Every aspect of the market is complex. Whether it be in relation to the plethora of market regulations, industry processes, management of commodity risk, or controlling vast quantities of data. Detailed knowledge and experience are required on the minutiae of the business, and this cannot be learned overnight. With the rapid growth of the number of suppliers in the market, appropriate skills and experience have been increasingly thinly spread and businesses have suffered from lack of capability.
Sometimes this is due to management arrogance, but often just down to lack of specialist skills availability. Senior teams who do not have the knowledge and experience to hand, and don’t take the time to get into the weeds of the industry processes often inadvertently lead their business into difficulties and don’t have the knowledge or capability to navigate their way out of trouble.
So what about Ofgem and their failure, through letting all these companies enter the market? Fundamentally, I would always argue for a free market, stimulating competition and innovation. If entry hurdles are too high for new entrants I believe it would be a backwards step for the market.
However, I do support the strengthening of entry criteria, particularly focusing as is proposed, on financial strength and management capability, the two essential criteria for navigating through difficult situations. There is a halfway house, which is the direction that we appear to be going in, to ensure that we limit future market failures.
So far, so miserable. Believe it or not, whilst times are tough for energy retailers at the moment, I am more optimistic about the future market than I have been for some time.
Ofgem are actively looking at market design and market entry criteria, and technology is developing rapidly with falling costs, enabling new and exciting propositions to come to market. Many of the poorly run companies have now failed, and those businesses that are surviving in tough conditions are generally doing so because they have strong teams and are well run. If they can weather the current climate and keep innovating, we can all have reason to be positive about the future.