On Wednesday, Ofgem’s default tariff cap hit the headlines as the Office of National Statistics announced that the lowering of the cap had contributed to UK inflation reaching a three-year low. However, it was a decision issued later in the day that will have greater significance to the industry. The High Court ruled in British Gas’s favour that Ofgem had not followed the correct procedure when setting the initial level of the default tariff cap.
British Gas’s Judicial Review (JR) challenge centred around Ofgem’s decision on the wholesale energy cost allowance for the initial three month cap period of 1 January 2019 – 31 March 2019. The allowance was based on an “observation window” of wholesale energy costs, which Ofgem initially consulted on in May 2018. At this time, Ofgem proposed a six month observation window of April – September 2018.
Wholesale prices rose by around 30% from April 2018, meaning that suppliers which had bought energy for delivery in Q1 2019 prior to April 2018 would have likely done so at lower prices than the allowances based on April – September 2018 would provide for. As a result, Ofgem reached the view that basing the allowance on the proposed window would result in an allowance that over-compensated suppliers and insufficiently protected consumers.
In a September 2018 consultation Ofgem revised its position, announcing that it would be setting the initial cap period based on the observation window of February – July 2018. There were concerns that Ofgem had not provided sufficient justification that the allowances under the new approach would be sufficient for suppliers who had adjusted their hedging strategies in response to the May 2018 proposals. In Ofgem’s decision it said that using the new observation window would provide adequate allowances for those suppliers which had continued to use a typical hedging strategy, and those who had used a typical strategy until the May consultation before adjusting their strategy in light of the May and September proposals.
The key argument that won the case was that Ofgem had incorrectly assumed that the six largest suppliers would have continued to use their long term purchasing strategies until May 2018. These strategies were communicated through a Request for Information in the first half of 2017. When assessing whether the February – July 2018 observation window would allow an efficient supplier to recover its costs, Ofgem assumed that a typical supplier would have purchased 76% of the Q1 2019 energy it needed between April 2017 and May 2018, based on the assumption that the supplier would have continued to use its typical hedging strategy until the initial consultation was issued. The Court said that this “continuity assumption” had incorrectly ignored the announcement on the introduction of a default tariff cap, which would have had a significant impact on the general nature of suppliers hedging strategies after October 2017 when the draft price cap legislation was published.
The Court found that the Ofgem’s use of the continuity assumption had not been adequately communicated to consultees, as it was only revealed in the cap decision itself. The Court said that this meant that it was too late for suppliers to raise concerns about the incorrect assumption through a consultation process, and that when they asked Ofgem to reconsider the decision it refused to do so. It was therefore found that Ofgem had not provided enough transparency around its thinking so that consultees could adequately respond, and a lawful decision could be made.
British Gas did not seek to quash Ofgem’s decision, but rather sought declaratory relief, which means that the cap will not see any sort of suspension. However, it was noted by the Court that Ofgem is able to adjust the level of the price cap to deal with inadequate allowances in previous periods, and the declaratory relief means that there will now be an expectation on Ofgem to adjust future cap periods to account for its shortcomings. A lot of media attention has focused on the moving of the wholesale observation window, which British Gas had previously claimed had led to a £70mn cost increase and a £19 cap shortfall per dual fuel customer. However, the Court’s decision is on to the lack of transparency around assumptions on hedging between 2017 and the May 2018 consultation being issued, and it will be for Ofgem to come up with a solution that resolves the issues. The Court noted that Ofgem would be able to seek further information on suppliers before reconsidering allowances, and so it may look to collect evidence on how hedging strategies were influenced after October 2017 before considering how future cap periods may need to be adjusted. Ofgem has said that it is considering its next steps, and we await its response with bated breath.