The energy retail price cap: cleaning the (observation) windows

There was much speculation during 2018 about whether any of the energy suppliers would dare to challenge Ofgem’s implementation of the energy price cap mandated by Parliament through the Domestic Gas and Electricity (Tariff Cap) Act 2018. Indeed, the Energy Minister at the time warned suppliers against doing so and delaying the cap’s entry into force. British Gas however did bring a challenge to the cap, but in such a way that avoided the cap being delayed and on an aspect of the cap’s design that related only to the initial transitional period of the cap and therefore would have a limited effect on the overall operation of the cap. The High Court upheld the challenge brought by British Gas in respect of the methodology for calculating the allowance for wholesale energy prices in its judgment of 13 November 2019 (the “Judgment”), requiring Ofgem to revisit this aspect of its methodology and make any necessary corrections by way of adjustments to future cap levels.

Ofgem ran an initial consultation from January to March 2020 regarding how this adjustment should be factored into the cap for the period from October 2020 to March 2021. Ofgem has subsequently conducted a statutory consultation on the licence amendments required to effect the adjustment on 18 May 2020 (the “May 2020 Consultation”), and published its decision on this consultation on 5 August 2020 (the “August 2020 Decision”). In this article, we consider the key points arising from the Judgment and the August 2020 Decision.

Default Tariff Price Cap

In 2018, the Domestic Gas and Electricity Tariff Cap Act 2018 (the “Act”) was enacted. The Act required Ofgem to amend the standard conditions of electricity and gas supply licences to include maximum levels for standard variable and default tariffs (together “Default Tariffs”). This cap is known as the “Retail Price Cap”.

The Act sets out a number of matters to which Ofgem must have regard when determining the level of the Retail Price Cap, including the need to ensure that energy suppliers are able to finance their activities.

The Act also required Ofgem to consult on the methodology initially proposed to calculate the Retail Price Cap.

The value of the Retail Price Cap is set regularly in respect of fixed periods (“Cap Periods”). Cap Periods are generally six months in duration, running from April to September and October to March, though the first Cap Period was three months long, running from January to March 2019.

What aspect of the Retail Price Cap methodology was challenged?

A substantial component of the value of the Retail Price Cap is the allowance in respect of the purchase of energy on the wholesale market. Suppliers will typically hedge their exposure to the volatility of the wholesale market by purchasing energy in advance of the relevant settlement period, spreading these purchases out over time and “shaping” their costs as the settlement period approaches. Since the Act requires a single cap value to apply to all suppliers, the cap cannot be based on the costs actually incurred by any one or more suppliers. The challenge for Ofgem was therefore to find a way of working out the wholesale market costs that an efficient supplier would be likely to incur.

The approach Ofgem took in response to this challenge was to assume that suppliers purchase the energy they will need for a Cap Period within a six month “observation window”, the end of which is generally two months prior to that Cap Period. The wholesale costs incurred by suppliers are deemed to track the value of an index of future supply contracts within the observation window with a delivery date within the relevant Cap Period. In order to reduce the risk of incurring wholesale market costs in excess of the allowance built into the Retail Price Cap, suppliers are likely to align their purchasing for each Cap Period to the relevant observation window.

The issue leading to the challenge arose in respect of the first Cap Period. The Act came into force in July 2018, Ofgem’s final decision on the cap’s design did not occur until November 2018 and the first Cap Period was to be in Q1 2019. A crucial consequence of this short timescale was that by the time Ofgem’s decision was made on how to set the observation window it would be too late for suppliers to align their purchasing strategy with the chosen observation window (the “retrospectivity issue”).

Wholesale energy prices rose substantially over the course of 2018. Consequently, the earlier Ofgem fixed the observation window for the Q1 2019 Cap Period, the lower the wholesale cost allowance built into the Retail Price Cap for that period.

In its initial consultation on the Retail Price Cap methodology in May 2018, Ofgem proposed “standard” observation windows of February – July for winter Cap Periods and August – January for summer Cap Periods. However, to mitigate the retrospectivity issue with respect to the first Cap Period in Q1 2019, Ofgem proposed a “transitional” observation window of April – September 2018.

Ofgem’s view changed in its subsequent consultation paper of September 2018. On the basis of certain assumptions about suppliers’ likely purchasing patterns, Ofgem considered that the April – September window would lead to significant overcompensation of suppliers (at the expense of consumers). Ofgem therefore revised its proposed observation window to February – July 2018, stating that its aim was to “ensure the wholesale allowance better reflects the underlying costs that suppliers are likely to have incurred”. This was the observation window that was ultimately confirmed in Ofgem’s decision of 6 November 2018 (the “November 2018 Decision”) on the Q1 2019 Retail Price Cap.

A key assumption underlying the decision to move the observation window related to the point in time at which suppliers would adjust their existing long-term hedging strategies to align with the shorter-term purchasing pattern assumed for the purposes of the wholesale allowance. Ofgem assumed that suppliers would have maintained their existing hedging strategies until the time of the May 2018 consultation. This was labelled the “Continuity Assumption” by the High Court. Ofgem justified the Continuity Assumption in the November 2018 Decision by reference to the responses to its April 2017 Request for Information, stating that these responses had provided sufficient evidence of how suppliers typically purchase energy for their Default Tariff customers.

Source: May 2020 Consultation, Figure 2.9

The Judgment

British Gas challenged the November 2018 Decision on the following bases:

1. Ofgem did not communicate the Continuity Assumption sufficiently clearly in its consultation documents to give stakeholders a fair opportunity to comment on it;
2. Ofgem failed in its duty of enquiry to take reasonable steps to gather the information needed to make an informed decision; and
3. the Continuity Assumption was a mistake of fact, and therefore not a fair basis for the assessment that Ofgem made.

The High Court upheld the challenge on the basis of ground (i). After rejecting Ofgem’s surprising claim that it did not make the Continuity Assumption, the Court found that the Continuity Assumption was not communicated to stakeholders in the consultations in May or September 2018, despite the fact that it was a “critical factor in the assessment made by GEMA of the sufficiency of the allowance”.

The Court also briefly considered grounds (ii) and (iii) “for completeness”.

The Court was not persuaded on ground (ii). Ofgem had gathered evidence by way of its April 2017 Request for Information. The fact that this evidence was flawed by virtue of relating to a period of time before the Retail Price Cap was contemplated was not sufficient to establish that Ofgem had not taken reasonable steps to gather information. Rather, the issue was that Ofgem failed to appreciate the implications of the information it had, which was more attributable to a lack of transparency in the consultation process.

However, the Court was persuaded that ground (iii) was made out. It found that, contrary to the Continuity Assumption, at least five of the Big Six energy suppliers had in fact shifted to a shorter hedging strategy much earlier than May 2018. Energy suppliers had already begun to anticipate that the observation window would be shorter-term than their existing purchasing practices in light of the development of the Act that had taken place through 2017. The Continuity Assumption was factually incorrect and was not a fair basis for the assessment that Ofgem made. The Court also found, on the evidence, that the fragility of the Continuity Assumption was apparent at the time to at least one person working for Ofgem.

Having found in favour of British Gas, the Court did not quash the November 2018 Decision. Instead, it required Ofgem to reconsider the wholesale allowance that should have been granted in the Retail Price Cap for the Q1 2019 Cap Period, and to implement any necessary correction by means of its statutory power to adjust future caps to address inadequacies in previous allowances.

The August 2020 Decision

Ofgem published an initial consultation regarding the implementation of the Judgment in January 2020. Building on the responses to this, the May 2020 Consultation set out a proposed three-stage approach to the adjustment of the Retail Price Cap. This approach was confirmed in the August 2020 Decision, and can be summarised as follows:

1. Reassessment of the wholesale costs deemed to be borne by each of the Big Six suppliers in the Q1 2019 Cap Period, substituting in their actual energy purchase profile in place of the observation window previously used;
2. Determination of the difference between the allowance that was actually granted for the Q1 2019 Cap Period and the allowance that should have been granted, based on a weighted average of the Big Six suppliers’ deemed wholesale costs; and
3. Determination of the appropriate adjustment to the Retail Price Cap for the October 2020 – March 2021 Cap Period to account for this difference. In annualised terms, the value determined for this adjustment is £10.71 per Default Tariff gas customer and £4.56 per Default Tariff electricity customer.

The key issues considered by Ofgem in formulating this approach included the following:

• The focus of the approach was to correct the shortfall in the wholesale allowance granted in the Q1 2019 Cap Period only. While the wholesale allowance in multiple Cap Periods may have been impacted by the Continuity Assumption, there was broad stakeholder support for restricting the exercise to the Q1 2019 Cap Period, and any impact on subsequent Cap Periods is not anticipated to be material.
• Ofgem limited the adjustment to address the impact felt by the Big Six energy suppliers only. This is because the Big Six serve the vast majority of Default Tariff customers and seek to align their hedging strategy with Ofgem’s observation windows.

The main aspect of Ofgem’s approach that developed between the May 2020 Consultation and the August 2020 Decision was Ofgem’s approach to the challenge of changing customer numbers. The Big Six energy suppliers are expected to have 15% fewer Default Tariff customers in the October 2020 – March 2021 Cap Period than they had in the Q1 2019 Cap Period. Ofgem considered whether (a) suppliers should be able to divide the total impact of the wholesale allowance shortfall (c. £85m) in Q1 2019 between their reduced Default Tariff customer base in 2020-21 (such that individual customers are required to pay more than they “saved” in the Q1 2019 Cap Period); or (b) the wholesale allowance shortfall per customer in Q1 2019 should be applied to the reduced Default Tariff customer base in 2020-21 on a per-customer basis (such that suppliers are unable to recoup 15% of their total loss in the Q1 2019 Cap Period). In the May 2020 consultation, Ofgem proposed to follow approach (b) on the basis of the overriding importance of its consumer protection objective. However, in light of further stakeholder feedback, Ofgem’s August 2020 Decision prefers approach (a), citing the need to ensure efficient suppliers’ ability to finance their licensed activities.

Amendments to standard licence condition 28AD of the gas and electricity supply licences to implement this adjustment by means of a separate “adjustment allowance” were issued alongside the August 2020 Decision.

Comment

This case is a great example of the public law toolkit being strategically deployed, through the challenge of one specific element of a decision without challenging other aspects. It demonstrates the versatility of public law remedies and encourages businesses to think carefully and creatively how best to challenge any regulator decision, where there are both positive and negative elements of the decision for the business. There is always a risk (as could have been the case here if the challenge was framed differently) that a court success leads to the quashing of a decision, but when the decision is retaken the outcome is no better (or is in fact worse) for the business that brought the challenge. By challenging more limited parts of a decision (where possible) and seeking more limited remedies, there is potential for maximum benefit with the downside risk being significantly mitigated.

In looking for aspects of a decision that may be susceptible to challenge, the fairness of the consultation process may well be a fruitful route. Businesses looking to challenge decisions are therefore well-advised to carefully analyse the relevant decision to identify any key assumptions that:

• are factually wrong; and
• were not properly communicated in the consultation proposals such that stakeholders were unable to provide intelligent responses.

Given the regulatory context in which businesses continue to operate, and the clear trajectory of increased regulation across most sectors, we are likely to see many more businesses making creative use of the tools that the public law toolkit has to offer.

Case cited: R (on behalf of British Gas Trading Limited) v The Gas and Electricity Markets Authority [2019] EWHC 3048 (Admin).