RECENT GAS SUPPLIER FAILURES IN THE UK

Legal, Regulatory and Insolvency Issues

Over the past decade there has been an influx of small and medium-sized entrants to the U.K. gas supplier market, which is supervised by Great Britain’s^[1] independent energy regulator, the Office of Gas and Electricity Markets (Ofgem).^[2] According to Ofgem, this market development has increased price competition and put pressure on incumbent suppliers to improve customer service for consumers.^[3]

However, following recent sharp increases in gas prices globally, a number of gas suppliers have come under strain; in particular, several smaller gas suppliers have failed during September, requiring intervention from Ofgem.

This note highlights certain of the gas regulatory and financial markets issues arising out of the current crisis that participants may need to navigate. We expect this note to be of interest to trading companies in the gas supply chain, participants in the gas financial markets and their clearing firms, insolvency officials and practitioners, and even consumers.

This is very much a live issue that is expected to remain relevant for some time yet. The table below shows some of the gas suppliers recently exiting the market.

Source: Ofgem

Downstream Gas – Key Entities

Gas Suppliers

Gas suppliers sell gas to an end consumer. They require a gas supplier licence under the Gas Act 1986, unless they benefit from an exemption. Gas suppliers only have a retail relationship with the end consumer and do not own or operate the local pipelines used to deliver the gas. They do not own the gas while it is transported in the pipeline systems, nor do they arrange for the transportation of gas through those networks. That role is performed by a gas shipper, which may be (but is not necessarily) a separately licensed company within the same group.

The price gas suppliers can charge consumers on a standard (variable) tariff is capped by Ofgem. Further, many consumers purchase gas at a fixed rate from their suppliers.

Gas Shippers

Gas shippers buy and sell gas and arrange for the transportation of gas through the pipeline networks owned by gas transporters. Gas shippers must be licensed under the Gas Act 1986 unless an exemption applies.

Gas shippers may buy gas from producers—the entities who extract gas from the ground—in one of four ways:

• Under a long-term, bespoke bilateral agreement with a producer;
• Through bilateral “over the counter” (OTC) physically delivered futures contracts;
• Through exchange traded physically delivered futures contracts; or
• By buying gas in the “on the day” spot market. Spot transactions may be exchange traded or OTC.

Financial participants in the gas markets—i.e., traders that do not form part of the gas supply chain that have no intention of ever taking physical delivery of gas—may also invest in, hedge or seek financial exposures to gas contracts either by trading in cash settled derivatives or closing out their trades in physically delivered derivatives before the final settlement date.

Entities that only trade in gas, but do not ship it,^[4] do not need to obtain a gas shipper licence from Ofgem for trading on U.K. markets such as ICE Futures Europe (IFEU). Traders and shippers trading gas on an exchange will be subject to regulation by the Financial Conduct Authority, including for compliance with market abuse regulations and derivatives trading requirements, and activities must be carried out in accordance with the rules of the relevant market. The role of exchanges and clearing houses in the gas industry is discussed further below.

Several commentators have observed that part of the reason new entrant suppliers were able to undercut established names such as British Gas and EDF is that they have been able to deal with shippers who buy gas primarily unhedged on the spot market. Shippers who do not adequately hedge do not need to price in the cost of hedging arrangements, so—provided the spot price stays well below the consumer price cap and fixed rates—lower prices can ultimately be offered to the consumer. However, if the spot price rises significantly, unhedged suppliers cannot pass the price rise to consumers, eroding or eliminating the suppliers’ margin. This dynamic is suggested to be behind the recent failures at small suppliers. It should also be said that start-up companies tend to have lower overheads in terms of e.g., office space or pensions costs than do incumbents, which may also have contributed to the lower cost base at new entrant suppliers; on the other hand, incumbents will often benefit from economies of scale.

Gas Transporters

Gas transporters own pipelines in the gas distribution network. Transporters must be licensed under the Gas Act 1986 unless exempted. In Great Britain, National Grid Gas plc (National Grid) operates the high pressure national transmission system (NTS); for the most part, consumer and some industrial gas is taken off the NTS by transporters operating the “gas distribution networks” (GDN), which are local lower-pressure pipeline networks. While historically gas trading was primarily deemed to be traded at the “beach” —the physical shoreline locations at which producers input gas into the pipeline network—trading and delivery is now primarily deemed to take place at the National Balancing Point, a notional (i.e., virtual) point of delivery.

National Grid also plays a role in gas balancing, discussed below.

Ofgem

Ofgem regulates the electricity and downstream gas sector in Great Britain, acting on behalf of the Gas and Electricity Markets Authority.^[5] Its roles include granting, modifying and enforcing licenses; approving significant changes to the “industry documents,” the collection of codes and agreements that govern the conduct of licensed gas industry entities (and, in limited circumstances, unlicensed entities); issuing price control regulation for companies in the gas network; and capping prices to consumers.

Among Ofgem’s principal objectives is the protection of consumers’ interests. This covers a wide range of interests, including the reduction of greenhouse gases, fair treatment of consumers and security of receiving gas. With several of the smaller gas suppliers exiting the market within a short timeframe, Ofgem’s focus has been ensuring continuity of gas supply by requiring the transfer of customers from the exiting companies to other suppliers. Ofgem has also used its power to further increase the cap on consumer gas prices, which it is hoped will mitigate some of the financial issues pressuring gas suppliers and limit further exits.^[6]

Exchanges & Clearing Houses

As noted above, gas shippers may buy gas on exchange, either with physically delivered futures or OTC contracts. Intercontinental Exchange hosts the physical futures contract^[7] (through IFEU) and operates the market for spot contracts^[8] (through ICE Endex Gas Spot UK) that deliver at the National Balancing Point. Both contracts are cleared by ICE Clear Europe.

The roles of exchanges and clearing houses are discussed further below.

Gas Industry Codes

The gas industry codes govern the rights and obligations of companies operating in the downstream gas industry. Under Section 5 of the Gas Act 1986, licensed gas companies must comply with all relevant codes for its licensable activities.

Uniform Network Code (UNC): The UNC sets out all terms that must be contained within transportation arrangements between licensed gas transporters (companies that own/operate gas pipelines and other networks to transport gas to customers) and gas shippers (companies that buy/sell gas and arrange the transportation of gas). Licensed gas transporters will have their own network codes. These codes will be aligned with the terms set out by the UNC and will specify all terms that govern arrangements between gas transporters and gas shippers.

Independent Gas Transporters Uniform Network Code (iGT UNC): The iGT UNC sets out all terms for the transportation of gas between independent gas transporters. Independent gas transporters constitute a specific category within the gas distribution networks and are connected to larger gas transporter networks.

Smart Energy Code (SEC): The SEC sets out the rights and obligations of gas network operators (responsible for the running of local gas pipelines and cables that serve customers) involved in the management of smart metering.

Retail Energy Code (REC): The REC sets out all provisions for the process of changing gas suppliers.

Supplier of Last Resort

When a gas supplier exits the market, Ofgem’s preferred option is for that supplier to arrange for its customers to be transferred to another supplier through a trade sale. However, this takes time and is unlikely to be a realistic option during a fast-moving crisis. If this private market solution is unavailable, Ofgem will consider two options for regulatory intervention: the Supplier of Last Resort (SoLR) framework and the energy supply company special administration regime (esc SAR). From the consumer’s perspective, the objective and outcome are largely the same: the continued supply of gas. However, for the supplier, the interventions are different in several important ways, not least that the SoLR means the exiting supplier will go through the normal insolvency process once its customers are transferred and its licence revoked, whereas a supplier under esc SAR administration will be subject to a special insolvency regime.

In the event a private sale is unlikely or not feasible,^[9] Ofgem will look to use its powers to direct another gas supplier to take on customers of the exiting supplier under the SoLR process.^[10] The SoLR framework is best suited to market exits of small or medium-sized suppliers, as their customer base is more likely be capable of being absorbed by a larger supplier. Recent regulatory interventions have been by way of SoLR, but as discussed below, if the current crisis continues, it is conceivable that Ofgem will use the esc SAR regime in respect of both larger and smaller suppliers.

When a gas supplier is experiencing financial difficulties, it is required to notify Ofgem of the circumstances.^[11] Ofgem will then begin to obtain relevant information from that supplier and will send requests to other licence holders for information as to whether they are able to take on the customers under the terms set. Crucially, Ofgem must ensure that the chosen supplier is able to supply gas to the additional customers without impinging on its ability to service its existing customers. The SoLR regulatory regime, set out in the Gas Supply Licence Standard Conditions, aims to protect the customers by ensuring continued gas supply within a short time frame.

The SoLR process involves revocation of the licence^[12] of the exiting supplier and granting of the licence to the SoLR simultaneously. The grounds upon which Ofgem may revoke a licence are set out in the Gas Supply Licence Standard Conditions. If a licencee is unable to pay its debts (within the meaning of the Insolvency Act 1986), has a receiver appointed, has an administration order is made in relation to it or is subject to winding-up, Ofgem may revoke its licence on 24 hours’ notice.^[13]

Once Ofgem has revoked the licence of the exiting supplier, it will no longer be licensed under the Gas Act 1986 and the statutory restrictions on the normal administration or insolvency process applying to regulated gas industry entities fall away. As such, the exiting supplier will go through the ordinary insolvency process.

This SoLR regime generally results in customers being transferred from smaller suppliers to larger suppliers, which have the capacity to take on additional customers at short notice when compared to their smaller counterparts. Its use will likely lead to consolidation in the industry in the near future.

Ofgem’s preference is to appoint a SoLR that has consented to the role.^[14] However, Ofgem has powers to appoint a supplier as SoLR without the supplier’s consent, which it will consider exercising if no suitable supplier agrees to act as SoLR. This can be contrasted to transfer schemes under an esc SAR, which do require the transferee’s consent (discussed below).

With gas prices remaining high, some commentators have suggested that many more suppliers will exit the market in the coming months. This has raised concerns about how even the larger suppliers will be able to provide gas to customers on fixed tariffs or on variable tariffs (which are subject to the gas price cap) on a commercially viable basis given the current high spot prices, especially if current hedging strategies are insufficient to cover customers transferred under SoLR.

If large suppliers cannot take on any more customers under SoLR arrangements, or indeed if large suppliers themselves come under pressure, the esc SAR regime, discussed below, may come into more widespread use.

There is no equivalent to the SoLR regime for gas shippers. SoLR applies only to gas suppliers.

Gas Trading – Exchanges and Clearing Houses

Exchanges

As discussed above, gas shippers may buy and sell gas on an exchange, either on a same-day or close-to-same-day basis under spot contracts or using physically delivered futures. At the moment, the pain point in the gas supply chain is at supplier level. It is not generally being suggested that companies engaging exclusively in gas shipping are at imminent risk of failure. However, companies and groups that engage in both gas supply and gas shipping may be at risk in the current crisis—indeed, a recent casualty, Enstroga Limited, was licensed for both gas supply and gas shipping.

Therefore, the consequences of the failure of a gas shipper that is a member of an exchange under the exchange’s rules should be considered. There are a number of companies licensed to both supply and ship gas that are members of major exchanges.

Insolvency of an exchange member will be an event of default under the rules of an exchange. If an exchange member defaults, e.g., due to an insolvency or similar event, the exchange would usually suspend its access to stop further trading and work with other participants to ensure a smooth process for any outstanding or upcoming deliveries.

In addition, even if the current crisis does not result in insolvencies at exchange members, participants in the gas markets—both physical and cash settled—should recognise that increased price volatility will usually result in a higher cost of trading as a result of e.g., increased collateral contribution obligations in respect of trades assessed as more risky. Higher volatility, of course, means scope for larger trading losses, as well as gains.

Clearing Houses

Exchange traded contracts are required to be cleared by a clearing house. Clearing house members are usually financial institutions who do not trade physical gas themselves. However, many of these members will clear contracts on behalf of customers who are active in the gas supply chain. Insolvency or administration at the customer of a clearing member is not generally dealt with under the rules of the relevant clearing house, but rather this will be governed by the documentation between the clearing member and its customer. Common clearing member-customer documentation are those forms published by the Futures Industry Association with the International Swaps and Derivatives Association (FIA-ISDA).

If a customer defaults under its agreement with the clearing member, the clearing member usually has extensive rights to liquidate the customer’s open contracts. For example, the FIA-ISDA Cleared Derivatives Addendum^[15] (Addendum)^[16] allows the clearing member to enter close-out transactions in respect of the customer’s account. The clearing member will close out the transactions either by entering into offsetting contracts on the customer’s account (i.e., by entering into opposite positions to the customer’s existing positions) or by assigning or novating the customer’s positions to a third party (or most likely both).^[17] In connection with closing out the customer’s transactions, the clearing member will be entitled to apply margin and other collateral provided by the customer (“Credit Support” as defined in the Addendum) to meet amounts resulting from the close out of the underlying positions between the clearing member and clearing house (“Termination Amounts” under the Addendum).

On a customer insolvency or administration, a clearing member will request the assistance of the clearing house to carry out the necessary steps at clearing level (e.g., entering into the necessary offsetting contracts and recording assignments and novations). For contracts that go to physical delivery, the clearing member will work with the clearing house and the exchange to ensure that deliveries are effected to the substitute parties.

Generally, in the U.K. and EU, netting transactions entered into to close out a customer’s positions are protected from the effect of national insolvency law that may otherwise prevent or inhibit such transactions, for instance, the general moratorium on new contracts imposed by an administration. These protections are provided for by, primarily, the Financial Collateral Directive, the European Market Infrastructure Regulation, and (if the clearing house is a “system” for these purposes) the Settlement Finality Directive and local law and regulations implementing this legislation (including as these regimes apply in the U.K. under the Financial Collateral Arrangements (No. 2) Regulations 2003, the Financial Markets and Insolvency (Settlement Finality) Regulations 1999 and the onshored U.K. EMIR).

Gas Balancing

Any gas that enters the NTS must be balanced to ensure its safe operation The NTS is the high-pressure system for transporting gas and refers to the process whereby the levels of gas in the NTS are maintained within safe limits. Gas shippers are encouraged to put in as much gas as they take out of the system each day. The terms of the Uniform Network Code establish incentives for gas shippers to flow gas on and off the NTS in a reliable and predictable manner. The National Grid, which operates the NTS and is also a regulated entity, acts as the residual balancer. It will only act if it considers that the system will not stay within the safe range. The National Grid will only intervene in balancing as a last resort because of the effect its balancing actions are likely to have on gas prices.

Energy Supply Company Special Administration Regime

The energy supply company special administration regime (esc SAR) is provided for in the Energy Act 2011, which sets out when and how an energy supply company administration is put into place. The esc SAR process will be used where SoLR is not possible or practicable (and it should be noted that the Energy Act 2011 incorporates the broad statutory transfer scheme provisions that exist for energy companies under the Energy Act 2004, which means that a transfer of the business could be achieved through the protection of an esc SAR). It is therefore primarily intended for failure of larger gas suppliers where Ofgem does not believe that another supplier could take on additional customers without prejudicing its ability to serve its existing customers or where the SoLR is not feasible to deal with the transfer of the business outside of an esc SAR and the protection of an esc SAR is required together with the use of a statutory scheme to effect the transfer. In the context of the present crisis, it is conceivable that esc SARs may be used even for small and medium suppliers, if large suppliers are unable to take on any more customers after already having been designated SoLR for a number of failed suppliers.

Ofgem must obtain the consent of the Secretary of State to make an application to court for the appointment of an energy administrator. The Secretary of State may also make such an application itself.^[18] A court will grant an esc administration order when it is satisfied either that: (i) the gas supplier is, or is likely to be, unable to pay its debts; or (ii) grounds exist for the Secretary of State to apply under the Insolvency Act 1986 to wind up the company on public interest grounds.^[19]

The energy administrator must manage the supplier to achieve the objectives set out in the Energy Act 2011,^[20] which are to (i) continue to supply gas at the lowest cost which it is reasonably practicable to incur; and (ii) secure the rescue of the supplier as a going concern, and where that is not possible, to transfer the supplier as a going concern to another company or companies.^[21]

This changes the statutory objectives that would otherwise apply to an ordinary administration (where the objectives are principally focused on requiring the administrator to perform his functions for the benefit of the creditors as a whole or if that cannot be achieved, to perform his functions in a manner that does not unnecessarily harm the interests of the creditors as a whole). The esc SAR objectives clearly prioritise the interests of the consumer creditors and, potentially, achieving a transfer of the supplier as a going concern. If a business has been transferred, either through a SoLR process or transfer scheme under the esc SAR, the objective for an esc SAR will have been fulfilled and the remaining supplier would no longer be an energy supply company, such that technically, any administration over what remains of the company should proceed on the basis of a normal administration, pursuant to which the administrator will be focused on collecting in the assets for the benefit of the remaining unsecured creditors (and, it applicable, secured creditors) having regard to his duties to those creditors.

When an esc SAR order is in place for a gas supplier, the Secretary of State may also provide financial support, guarantees or indemnities.^[22] The Secretary of State has wide power to define the terms and conditions of any such support. The Secretary of State also has the power to modify the conditions of a gas (or electricity) licence or their standard conditions^[23] and to modify licence conditions to secure funding of the esc SAR.^[24]

The esc SAR is relevant only to gas suppliers and not also to e.g., gas shippers (although a broadly equivalent regime exists for gas transporters as “protected energy companies” under the Energy Act 2004). Gas shippers would be subject to the ordinary insolvency regime.

A significant point of difference between the SoLR regime and the esc SAR process is that while Ofgem can direct a supplier to take on an exiting supplier’s customers under SoLR, transfer of customers to a new supplier under an esc SAR requires the transferee’s consent. While in the ordinary course suppliers would tend to welcome taking on new customers in an esc SAR process, in an unsettled market with difficult economics, it may prove difficult to find willing transferees.