rebuilding consumer confidence: improving the transparency ... · rebuilding consumer confidence:...

Ofgem/Ofgem E-Serve 9 Millbank, London SW1P 3GE www.ofgem.gov.uk

Rebuilding consumer confidence:

Improving the transparency of energy

company profits

Consultation

Publication date: 31 October 2013 Contact: Diego Villalobos

Response deadline: 6 December 2013 Team: Energy Market Monitoring and Analysis

Tel: 020 7901 1846

Email: [email protected]

Overview:

Promoting transparency of energy company profitability is an important aspect of our efforts

to rebuild consumer confidence in the energy market.

This document sets out the significant steps we have already taken to improve the

information available on energy company profitability. This includes requiring the six large

energy companies to produce annual statements of the revenues, costs and profits of their

generation and supply businesses. We welcome views on what more the energy companies

or Ofgem could be doing to improve the transparency of these statements – or in relation to

prices and profits more widely.

We would like responses to this consultation from interested parties by 6 December. During

this period, we will seek further input by holding a roundtable meeting with a range of

stakeholders and by meeting with the energy companies individually.

mailto:[email protected]


Improving the transparency of energy company profits

Context

As part of our Retail Market Review, we are in the process of implementing a

package of designed to rebuild consumer confidence by delivering a simpler, clearer

and fairer energy market. We intend to be transparent and rigorous in our

monitoring of the impact of these reforms. We are currently developing the detail of

our monitoring approach. In particular, we will produce an annual report that will

provide a clear picture of the state of the market.

We have already taken a number of steps to tackle poor transparency around energy

company profitability. These include requiring the energy companies to produce

annual statements of the profits from their generation and supply businesses.

This consultation looks at whether there are further measures that could improve the

information made available by the energy companies and ourselves.

Associated documents

Energy companies publish 2012 Consolidated Segmental Statements, 3 July 2013

Financial Information Reporting – 2011 Results (52/13), 11 April 2013

Improving Reporting Transparency – Final Decision Document, 29 August 2012

Improving Reporting Transparency of Large Energy Suppliers (95/12), 13 July

2012

Improving Reporting Transparency (09/12), 31 January 2012

Financial Information Reporting – 2010 Results (10/12), 31 January 2012

https://www.ofgem.gov.uk/publications-and-updates/energy-companies-publish-2012-consolidated-segmental-statements

https://www.ofgem.gov.uk/ofgem-publications/39348/css-2011-resultsfinal.pdf

http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/Improving%20Reporting%20Transparency%20-%20Final%20Decision%20Document.pdf

http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/IRT_Condoc_FINAL.pdf

http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/IRT_Condoc_FINAL.pdf

https://www.ofgem.gov.uk/ofgem-publications/39646/irtcondocfinal.pdf

http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/FIR_results_Final.pdf



Contents

Executive Summary 1

1. Introduction 3 What does transparency mean? 4 Structure of this document 5

2. Our current approach to transparency 6

3. Options for improving transparency 9 Improving robustness 10 Improving usefulness 14 Improving accessibility 20

4. Next steps 23

Appendices 24

Appendix 1 - Consultation Response and Questions 25

Appendix 2 - Feedback Questionnaire 27



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Executive Summary

For the third year in a row, consumers are facing large increases in their electricity

and gas bills. Energy suppliers have blamed increases in costs as the cause of these

price rises and have rejected claims of profiteering. Understandably, consumers are

suspicious about these explanations and are looking for independent verification of

whether or not these price increases are fair.

This is where Ofgem has an important role to play. We have been working hard to

help consumers understand what is going on. Since 2009 we have made companies

disclose the profits for their power generation and retail energy supply businesses

separately. This is something that only one of the six large energy companies did

previously.

One important issue is how we can be certain that companies are presenting a true

and fair picture of profits, when they have the ability to trade between their various

businesses, both in Great Britain and internationally. How can we be certain that

costs and revenues are being properly allocated?

We have made a number of improvements in recent years to the reporting of profits

to make them more robust and useful. A review conducted for us by the accountancy

firm BDO in 2011 concluded that the methodologies used by the companies were

broadly fair and appropriate and the statements were consistent with their audited

financial accounts. Based on BDO’s advice and feedback from extensive consultation,

we introduced a further package of improvements last year. A review conducted for

us by accountancy firm PKF of the 2011 statements found that these had led to a

significant improvement in disclosure compared to previous years.

Given continuing consumer concerns about the level of prices, we are keen to

consider whether the companies themselves could do more to improve the

transparency of energy company profits. This is not about publishing ever more

information. It is about providing robust and meaningful information in a way that

can be clearly understood. There can be costs to increasing transparency that would

be borne ultimately by consumers in higher bills. It is important that any steps we

take are proportionate and do not reveal commercially-sensitive information that

could impede competition working well for consumers.

In the light of developments since we last consulted on this issue in 2012, we are

considering a range of measures that would provide greater reassurance about the

robustness of the profit numbers provided by the energy companies and to improve

the timeliness of this information. This includes the recent recommendations of the

Energy and Climate Change Committee.

Subject to responses to our consultation, we would expect to see:

- The companies completing full financial audits of their annual statements. This

should provide a greater level of validation of the information they contain.

- The companies publishing their annual statements earlier. This would provide

visibility of profits sooner after the period in which they were earned.



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We are also keen to explore further a range of other opportunities to improve

transparency of energy company profits. These include:

- The companies publishing more information about their trading activities. This

could provide helpful context to the profits earned in their generation and

supply businesses.

- The companies producing an estimate of their return on capital employed.

This may be a more meaningful measure of profitability for generation

businesses than our current approach of return on revenue.

- Undertaking a review of the transfer pricing methodologies used by the

energy companies. This could provide a better understanding of the way in

which the companies allocate revenues and costs between their generation

and supply businesses.

- Improving the format and content of our annual publication that summarises

the set of company statements. Our report on the 2012 statements is due out

next month.

We are seeking views on these and other options, including evidence on the potential

costs and benefits where possible. To inform the debate, we are also publishing

previously redacted information from the advice BDO gave to us.

We welcome recent initiatives by some of the energy companies to improve the way

in which they report their profits. We encourage individual companies to consider the

improvements they could make to transparency in this area.

We are also seeking to improve the transparency of the energy market more

broadly. Our Liquidity project and our recent call for evidence on Price Reporting

Agencies are examples of the important work we are doing to build confidence of

market participants, for example in the robustness of how prices are formed. We

welcome views on whether there are further measures or activities that could

contribute towards rebuilding consumer confidence in the energy market.

The deadline for consultation responses is 6 December. To inform this consultation

exercise, we intend to meet the six large energy companies individually to explore

what they could do to improve transparency of their profits in the light of best

practice and given their specific structures and circumstances. We also plan to invite

the energy companies, consumer representatives and other stakeholders to a round

table meeting to discuss the broader theme of rebuilding consumer confidence and to

inform our thinking on possible actions.

In the light of responses to this consultation, we intend to publish a decision by the

spring.



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1. Introduction

Chapter Summary

This chapter discusses the relevance of information on energy company profits, what

we mean by transparency of those profits and why it is important for consumer

confidence in the energy market. We also set out the structure of this consultation

document.

1.1. There is an urgent need to rebuild consumer confidence in the energy market.

Trust in the market is currently low, prices are rising and suppliers are not subject to

sufficient competitive pressure. Ofgem is working to make retail market competition

more effective by introducing a range of reforms to deliver a simpler, clearer and

fairer energy market for all energy consumers and make it radically easier for

consumers to make better choices over their electricity and gas supply. We are also

developing reforms to create a level playing field so small suppliers can compete

more effectively in the market.

1.2. Ofgem also has an important role in monitoring the market. We aim to

reassure consumers that the market is operating in their interests or that, if not, we

know to take appropriate action. Profit levels are one of a number of useful indicators

of the state of a market. Given the current situation, it is more important than ever

to provide transparency of energy company profits.

1.3. We have already taken action to shine a light on companies’ profits. In

particular, we require the companies to publish annually separate information on the

profitability of their generation and supply activities. These measures are set out in

the next chapter.

1.4. Nevertheless, there are continuing concerns about the transparency of energy

company profits. The recent Energy and Climate Change Committee (ECCC) report

on Energy Prices, Profits and Poverty highlighted a number of issues and concerns

with the information available on energy company profitability. The Committee heard

evidence from a large number of contributors, including both Ofgem and the

accountancy firm BDO (who completed a review of the Statements for us in 2011).

The Committee called “for more transparency and more robust data to enable an

accurate assessment of profitability to be made”1 and made a number of

recommendations aimed at improving transparency. These included that we should

consider implementing all of BDO’s recommendations from its 2011 review.

1.5. When we consider action in the area of transparency, we have to be mindful

of the public policy framework that governs our energy markets. This establishes

1 9, Energy Prices, Profits and Poverty, Energy and Climate Change Committee, 16 July 2013



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that end-user gas and electricity prices should be set – and kept in check – through

competitive markets. This recognises the additional benefits that competition can

bring, such as providing customer choice and driving innovation.

1.6. We take regulatory intervention very seriously, and intervene where we can

make a positive difference to consumers. In other words, we intervene where we are

confident that the benefits of intervention outweigh the costs to consumers, and the

risk of unintended consequences is minimised. We are required by law to ensure that

our interventions are both necessary and proportionate.

1.7. There are costs to increasing transparency, relating to the production and

publication of additional information. As a common cost across suppliers, these

would be borne ultimately by consumers in the form of higher bills. Similarly,

additional requirements to publish information about company practices or

performance could in some cases harm competition. For example, revealing details of

the cost structure of energy companies or their commercial strategies could reveal

commercially-sensitive information to competitors. Nevertheless, it may be

appropriate in some circumstances for us, as regulator, to see such information.

1.8. Our existing measures aim to strike an appropriate balance between making

public information that helps interested parties to better understand company profits,

while ensuring the costs to consumers are proportionate and changes do not damage

competition.

1.9. Even so, the ECCC’s report and recent actions by some suppliers are relevant

developments since the introduction of our existing measures. Furthermore, the

ECCC has recommended we reconsider a number of policy options on which we have

consulted previously. We use this consultation to examine these recommendations in

the light of recent developments. We explore the costs and benefits of a number of

options to enhance our existing approach to providing effective transparency of

energy company profitability.

What does transparency mean?

1.10. For transparency of energy company profitability to be effective, the

information made available by the companies and Ofgem needs to be:

Robust. The information should represent an accurate picture of the

companies’ revenues, costs and profits and how these are allocated across

their generation and supply businesses.

Useful. The information should be relevant, meaningful and timely for

stakeholders and commentators, without revealing commercially-sensitive

information that could harm competition.



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Accessible. The information should be presented in a way that can be

understood by interested parties, for example by providing for effective

comparison across companies and over time.

1.11. Significantly, therefore, improving transparency is not about publishing ever

more information. It is about providing meaningful and robust information in a way

that can be clearly understood.

1.12. This consultation looks at whether the energy companies or Ofgem could

usefully be doing more to improve the transparency of information on energy

company profitability. We welcome responses by 6 December.

Structure of this document

1.13. This document is structured as follows:

In chapter 2, we set out the measures we have already put in place to

monitor and make available information on energy company profitability. We

also list a number of our other measures that are aimed at enhancing wider

market transparency.

In chapter 3, we explore a range of options for improving transparency. This

includes considering those recommendations from the ECCC and looking at

recent developments in this area. We discuss whether these developments

justify a change in our original conclusions.

Finally, in chapter 4, we detail next steps, including how you can respond to

this consultation and other stakeholder engagement activities planned.



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2. Our current approach to transparency

Chapter Summary

In this chapter we summarise the two most important ways in which we monitor and

make available information on energy company profitability. We describe the steps

we have taken to keep improving these measures over time. We also list a number

of our other activities aimed at enhancing wider market transparency.

Consolidated Segmental Statements

2.1. We require the six largest energy companies to publish Consolidated

Segmental Statements annually, which show the revenues, costs and profits of their

generation and supply arms separately. The Statements are based on companies’

audited accounts and so provide a backward-looking picture of whole company

profitability split across supply and generation activities.

2.2. This is our most important initiative for promoting transparency on energy

company profitability. Through the Statements, and for the first time, data is

available on the companies’ generation and supply profits separately.

2.3. Since the introduction of the Statements in 2009, we have worked to improve

the transparency and comparability of the Statements. As part of this work, we

commissioned a detailed review of the Statements in 2011 by the accountancy firm

BDO. The review concluded that the approaches taken by the companies were

broadly fair and appropriate and the Statements were consistent with official

numbers.2 BDO also found no evidence that profits were being unduly excluded from

the Statements.

2.4. At our request, BDO made a number of recommendations to further improve

the transparency and comparability of the Statements. We consulted on a range of

proposals based on these recommendations and enacted the modifications last year.3

These included changing how the companies reconcile their Statements to audited

accounts and commissioning an independent review of the Statements for at least

the first year after the changes, to verify company compliance.

2.5. The format of the Statements is primarily aimed at market participants,

particularly smaller suppliers, and potential new entrants. However, the information

they contain is important for all of our stakeholders. As a result, every year,

following the publication of the Statements, Ofgem produces an annual Summary

Document.4 This document brings together the information contained in the six

2 See page 56, Ofgem Segmental Statements Review, BDO LLP Final Report, 16 January 2012 3 Improving Reporting Transparency – Final Decision Document, 29 August 2012 4 Financial Information Reporting – 2011 Results (52/13), 11 April 2013

http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/Improving%20Reporting%20Transparency%20-%20Final%20Decision%20Document.pdf



7

Statements, summarising the results and comparing them to previous years. This

year, as with last year, we will also include the results of an independent review we

have commissioned of the Statements.

2.6. We plan to publish the Summary Document for the 2012 Statements this

November. We are keen to receive views from stakeholders on the content and

accessibility of the information in this document. In particular, we would appreciate

any feedback that could improve the document in future years.

Supply Market Indicator

2.7. We introduced the Supply Market Indicator (SMI) in 2009 as a tool for

assessing trends in average energy supply bills, costs and margins of the six large

energy companies’ retail businesses. An important aim is to help stakeholders to

better understand the relationship between wholesale costs and retail prices. The

SMI was originally published on a quarterly basis and, since March 2012 has been

updated weekly in order to make it more useful.

2.8. The SMI shows the relationship between the annual costs for a representative

large energy supplier and the average annual energy bill for a domestic customer on

a standard tariff. The difference between these costs and revenues represents the

average net margin. In this way, the SMI estimates what a large energy supplier

would be expected to make for an average gas, electricity and/or dual fuel customer

for the following 12 months if prices remained constant.

2.9. We aim to keep the SMI accurate and representative of the position for the

average consumer. Where possible, we use publicly available data. We implemented

new, lower consumption figures last month. This brings the SMI consumption data

more in line with the observed declining trend in domestic consumption.5 As a result,

the SMI more accurately reflects the current average bills, costs and margins. We

will continue to review the methodology and input assumptions to the SMI. We

remain open to ideas for improvements and will consider for inclusion in the SMI any

robust evidence that stakeholders provide us.

2.10. The SMI has some limitations as an indicator. Some of the data is necessarily

lagged, and we have to estimate other components. Importantly, the SMI does not

seek to estimate companies’ actual profits, either collectively or individually.6 In this

way, it is not a substitute for the Consolidated Segmental Statements. These remain

the best source of detailed information on individual companies’ revenues, costs and

profits in both their generation and supply businesses on a backward-looking basis.

5 New typical domestic consumption values – Decision letter, 13 September 2013 6 For example, the SMI uses average prices suppliers charge for standard tariffs. To estimate

individual suppliers’ profits, we would need to include their prices for all of their tariffs. We would also need to take account of costs such as debt, corporate tax, depreciation and amortisation.



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Other publications

2.11. We regularly publish a range of documents aimed at providing transparency of

consumer bills. This includes information on our website explaining the composition

of household energy bills7.

Our wider actions to promote transparency

Liquidity

2.12. We have put forward proposals to improve liquidity and transparency in the

electricity wholesale market. We propose to require the six large vertically-integrated

energy companies to post the prices at which they are willing to buy or sell electricity

- in a range of forward market products, ie to be “market makers” for those

products. These measures should allow independent suppliers and generators to

access the range of wholesale market products they need to compete effectively with

the established companies.

2.13. We will take a decision shortly on whether to proceed with these new licence

requirements, taking account of responses to consultation. If we do decide to

proceed, we would expect to see the licence condition implemented in early 2014.

Price benchmarks

2.14. We are also looking at how to improve the robustness of wholesale market

price benchmarks. These are an essential component of the way in which gas and

electricity is traded in the over-the-counter (OTC) market. Following allegations

about the potential manipulation of benchmark prices, we launched a review to

consider some of the specific activity that took place in the market on 28 September

2012. This investigation is ongoing.

2.15. In parallel to this, we considered that the formation of benchmark prices and

the processes of Price Reporting Agencies more generally might be an issue requiring

further investigation. We issued a call for evidence in June 2013. This sought views

from market participants about how they both contributed to and used price

assessments and indices, and sought views more broadly on whether current

arrangements are fit for purpose. We will report on next steps in due course.

2.16. The projects above demonstrate the work Ofgem is doing to improve

transparency and market confidence in a broad range of areas. In the next chapter,

we look at whether more could be done to improve the transparency of information

on energy company profitability.

7 Our factsheet Understanding Energy Prices is available here.

https://www.ofgem.gov.uk/publications-and-updates/understanding-energy-prices



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3. Options for improving transparency

Chapter Summary

In this chapter, we consider a range of options that Ofgem, or the companies

themselves, could take to improve the transparency of energy company profitability.

This includes considering those recommendations from the ECCC and looking at

recent developments in this area. We discuss whether these developments justify a

change in our original conclusions.

Question Box

Question 1: Would a full financial audit provide greater reassurance about

the robustness of the Statements? How much would these audits cost?

Question 2: Do you have further information on the appropriateness of the

companies’ transfer pricing policies beyond BDO’s detailed findings? Is

there more that could be done to provide reassurance in this area?

Question 3: What information could the companies usefully provide on their

trading functions that would improve the transparency of the profits in their

generation and supply businesses? What are the costs and benefits of

including the trading function in companies’ Statements? How possible is it

to distinguish between trading for hedging and speculative purposes?

Question 4: Do you agree with the proposal of reducing the deadline for

companies to compile and publish their Statements from six to four months?

What are the costs and benefits of doing so?

Question 5: Do you consider that there is merit in calculating a ROCE for the

generation businesses of the six large energy companies, but not for their

supply businesses? Are there any specific issues with how ROCE should be

calculated for generation?

Question 6: Do you have any suggestions for improvements to the format

and content of our annual Summary Document on the Statements? What

more could the companies do to improve the presentation of their

Statements?

Question 7: How else could Ofgem or the energy companies themselves

improve confidence in the energy markets?

3.1. In considering options to improve the transparency of energy company profits,

we look, in turn, at the different elements of transparency, notably the robustness,

usefulness and accessibility of the information. For each element, we set out our

existing approach and consider the potential for improvements.



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Improving robustness

3.2. Information on the profitability of supply and generation activities is one of the

measures we use to monitor the evolution of competition in the energy market and

provide consumers with accurate information on companies’ profits. Therefore, it is

important that this information is robust. The aim of the Consolidated Segmental

Statements is to provide this information, both to Ofgem and other interested

parties.

Ofgem’s existing actions

3.3. We commissioned the accountancy firm BDO to conduct a detailed review of

the Statements in 2011. They concluded that the information in them was consistent

with audited financial accounts. In their opinion, they saw “no evidence ... that

profits are being unduly excluded from the [Statements]” and “no evidence that

would suggest that the [Statements] do not represent a true and fair view of the

split of profitability”.8

3.4. The BDO review remains the most detailed analysis of the methodologies

employed by the companies to complete their Statements. It is therefore a valuable

source of evidence on their robustness. At the time of the review, we chose to

publish only the executive summary of the BDO report to us (some 20 pages). The

reason was that the remainder was deemed to be based on a large quantity of

information obtained confidentially by BDO from the six energy companies.

3.5. The review was undertaken for the purpose of highlighting potential

improvements to the transparency of the Statements of the companies. Given the

importance of this review to the subject of this consultation, we will shortly publish

more details of the BDO report, as contained in its Appendix A. This appendix

contains BDO’s high-level findings from a comparative perspective, explaining the

differences between the methodologies used by the companies to compile their

Statements. Many of these are due to differences in company business models.

3.6. The appendix is based on both publicly available information and that provided

by the companies to BDO. The material in the report represents the views of BDO

and in no way represents the views of the companies themselves. We have deemed

that some of this information remains confidential and likely to affect the interests of

the companies it references. We have therefore made minor redactions to the

information contained in the appendix. These redactions do not change the nature of

BDO’s findings and have only been made to help ensure publication of this appendix

does not harm competition in the energy markets. The appendix also contains BDO’s

conclusions to a set of key questions we asked at the outset of the review.

8 Page 56, Ofgem Segmental Statements Review, op cit.



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3.7. It is worth emphasising that the report was prepared in 2011 using data from

2010. Since the report was produced, there have been various changes to the way

companies report, including improvements in the light of BDO’s recommendations.

As such, a number of the descriptions in the report are now out of date.

3.8. Based on the findings of the BDO review and to provide greater assurance of

the information in the Statements, we now require the companies to reconcile the

figures on revenues and profits to those in their audited financial accounts. This

reconciliation sets out the differences between the revenue and profit figures for

generation and supply activities in the Statements, with those contained in audited

financial accounts and provides a justification in each case.

3.9. In addition, we committed to obtaining, at least for the first year, an

independent review of the Statements to check compliance with the licence

condition, including whether the reconciliations have been carried out appropriately.

A review of the 2011 Statements was produced for us by accountancy firm PKF.9

They concluded that the companies had completed the statements appropriately.

They also highlighted a reduced use of accounting adjustments, marking a significant

improvement in disclosure in this area compared with previous years. Nevertheless,

PKF advised on various ways in which the preparation and presentation of the

Statements could be further improved. These findings were communicated to the

companies and we have seen some progress in relation to their 2012 Statements.

3.10. Despite these improvements, we recognise that there remain concerns among

stakeholders about the accuracy of the information contained in the Statements. We

discuss these concerns below.

The ECCC’s recommendations

3.11. The ECCC raised significant concerns in their report on the information

contained in the Statements. Of particular importance is their claim that they have

been unable to “determine with certainty the level of energy company profit

margins“.10 The ECCC concluded that we should make further efforts to assure the

information in the Statements, in particular that we should consider implementing

the following of BDO’s original recommendations:

Obtain a full financial audit of the Statements every year.

Complete further work to assess current transfer pricing policies.

3.12. On the first, this would involve the companies asking their auditors to provide

us with an independent audit opinion on the Statements, notably whether they

9 BDO and PKF merged in April 2013. 10 Page 69, Energy Prices, Profits and Poverty, op cit.



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consider them to be a “true and fair” representation. During their appearance at the

ECCC, BDO reiterated their recommendation for an audit. They stated:

An audit will look at the information in the [Statements] and how that relates

back to the underlying financial information. [It] will give some level of

assurance...that the segmental information has been correctly prepared and

stated.11

3.13. The evidence BDO presented to us in 2011 suggested to us that our current

approach of requiring reconciliation was a sufficient means of verifying the

information in the Statements as being robust. Given this, together with the broader

conclusions of BDO’s review of the Statements, we could not justify the costs of

requiring a separate financial audit.

3.14. Since then, we have commissioned independent reviews of both the 2011 and

2012 Statements. BDO is currently carrying out the latest review. Their initial advice

is that the requirement for companies to reconcile the Statements to audited

financial accounts is not providing the level of assurance intended.12 This is in

particular because some of the companies do not produce audited financial accounts

for their UK group activities. Reconciling the Statements to Group accounts makes

the reconciliation process more difficult and provides less assurance in relation to the

UK segments in the Statements.

3.15. A full financial audit completed before publication of the Statements would

help address these issues around reconciliation. It would provide greater validation

of the information contained in the Statements than the current compliance reviews,

which do not check the validity of individual items in the Statements in a way that an

audit would. We are therefore keen to consider whether a full financial audit would

be a more cost-effective way of providing assurance that the information in the

Statements is robust. We also welcome views on whether the publication of UK group

accounts by all six companies would help improve transparency.



3.16. The ECCC’s second recommendation to improve the assurance of the

information in the Statements was to complete further work to assess the transfer

pricing policies used by the companies. BDO made this recommendation after

concluding that the six companies’ transfer pricing methodologies were broadly “fit

for purpose and transparent13” and the methodologies would likely meet the measure

11 From oral evidence taken before the ECCC on 9 May 2013. See page 168 of Energy Prices, Profits and Poverty, op cit. 12 We will publish the conclusions of BDO’s review of the 2012 Statements together with our Summary Document at the end of November. 13 Page 56, Ofgem Segmental Statements Review, op cit.



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of ‘best practice’ set out in the OECD’s Transfer Pricing Guidelines.14 However, due to

the complexity of transfer pricing methodologies, BDO highlighted two areas they

would have welcomed more time to investigate.

3.17. The first of these related to the effects on the calculation of a transfer price of

low liquidity in the forward markets where generation companies start hedging (eg

three years out). BDO explained that if market liquidity is low then there could be

questions with the reliability of the transfer price when valuing products bought and

sold far into the future. The second issue was that some of the companies make

small adjustments to market prices to calculate their transfer prices to incorporate

risk transfers between different parts of the businesses. While BDO noted these

adjustments were relatively opaque, the amounts involved were limited and unlikely

to cause material distortion to the numbers presented in the Statements.

3.18. BDO reiterated the second of these concerns in their verbal evidence to the

ECCC:

My concern is much more about trying to understand the agreements which

have been entered into with trading, and trying to work out, particularly

where you have brokerage arrangements, whether the price being charged in

the centre by the trader is a fair reflection of the risks being borne by that

trader, as opposed to the risks which go with the generation and retail sides

of the business.15

3.19. At the time that BDO highlighted these concerns to us, they also pointed out

that all transfer pricing methodologies come with their own complexities and that

there is “no clear winner”.16 The decision at the time not to continue this line of

investigation was therefore made not only with BDO’s headline conclusions in mind,

but also that BDO were unable to suggest an alternative or better approach to the

current methodologies employed. Given this, we deemed that further work would

lead to unnecessary additional costs and further delays to the changes we wanted to

make to the Statements to improve their transparency.

3.20. Nevertheless, it is important that we understand the implications of BDO’s

ECCC evidence in full. Appendix A of BDO’s report to us, which we will be publishing

shortly, provides additional information for stakeholders to consider in relation to the

transfer pricing policies used by the companies. We would welcome views on this

issue, including on BDO’s findings and conclusions.




14 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,

Organisation for Economic Co-operation and Development (OECD), 18 August 2010 15 See page 169 of Energy Prices, Profits and Poverty, op cit. 16 Page 32, Ofgem Segmental Statements Review, op cit.



14

Improving usefulness

3.21. The information made available on energy companies should be relevant to

understanding the profitability of their generation and supply businesses. It should

allow for ready analysis, such as comparisons between companies and over time and

be made available in a timely manner. It is also important not to require publication

of information that is commercially sensitive, if publication could harm competition

(though it may be appropriate for us as regulator to see this information).

3.22. In deciding what useful information to publish, we also need to consider the

costs associated with its collection and publication. Requiring disclosure of

information that is not relevant or meaningful could add unnecessary costs, which

would ultimately be passed through to the consumers.

3.23. The companies themselves may choose to publish additional information to

provide context to their Statements. This is to be broadly welcomed, so long as that

information is robust, useful and accessible and does not make it harder for

stakeholders to understand their profitability.


3.24. Information on energy company profits has always been available from the

Annual Report and Accounts made public by the companies on an annual basis.

Regular information is also provided through other communications made by the

companies on their profits, such as interim earnings announcements. However, only

one of the six largest energy companies disclosed the profits of their retail energy

supply and electricity generation businesses separately. This made it difficult to see

where they were making their profits.

3.25. We introduced the Consolidated Segmental Statements to improve the

transparency of the information made public by the companies on their profits. The

Statements require the companies to provide a range of relevant financial

information in a standard format, for ease of analysis and comparison by us and

other interested parties. We also publish an annual Summary Document after the

Statements are produced by the companies.

3.26. The Statements are necessarily backward looking and take time to produce.

We introduced our Supply Market Indicator (SMI) as a complementary tool to

estimate a forward-looking view of the average revenues, costs and net margin that

a large energy supplier would make for an average gas, electricity and/or dual fuel

customer over the following 12 months. Our move from quarterly to weekly updates

was in part driven by a desire to increase the usefulness of the SMI.

3.27. We have consistently sought to improve the information we and the

companies publish on their profitability. We remain open to new evidence or ideas to

improve the usefulness of the information we make available.



15


3.28. As noted earlier, the ECCC concluded that we should consider implementing all

of BDO’s recommendations from its 2011 review. Of these recommendations, there

are two that are aimed at improving the usefulness of the Statements:

Requiring the reporting of trading function results.

Publishing all Statements to the same year-end.

3.29. In addition, the ECCC also recommended that Ofgem calculates the rate of

return on capital employed (ROCE) as a metric to determine whether the supply

market is competitive. We discuss these recommendations below. In each case, we

explain our original approach and explore whether new evidence has emerged that

may give us cause to change our original conclusion.

3.30. The first of the ECCC’s recommendations above would require the companies

to include their trading function results. The trading function of a vertically-

integrated energy company usually sits outside both its generation and supply

businesses and performs a number of market-facing activities. These include both

selling the output of their generation businesses and buying energy for supply to end

customers. To help ensure that they have enough energy to meet their customers’

needs, at the best prices, the companies will buy ahead. This is known as hedging. In

some cases, the companies will also buy and sell energy purely for profit where they

see a market opportunity. This is known as speculative trading.17

3.31. The existence of the trading function affects the transparency of the

Statements. This is because the companies need to make an estimate of the financial

impact of the activities undertaken by the trading function on each of the supply and

generation segments, in order to include the appropriate revenues and costs in the

Statements. To do this, the companies use a transfer price. An appropriate transfer

pricing methodology should be sufficient to attribute the revenues and costs between

generation, supply and the trading function of the companies. BDO reviewed these

transfer pricing methodologies in 2011 and concluded that they were “fit for purpose

and transparent”.18

3.32. Nevertheless, BDO recognised that there may be benefits to the Statements if

the trading function was included. These included cases where the supply and

generation businesses of the companies enter into forward contracts of different

lengths and to try to address concerns about profits being diverted or disguised by

17 Speculative trading is broadly defined as the taking of a market position in pursuit of profit from the trades themselves rather than the management of cost-effective supply for customers. Under existing rules, any results associated with speculative trading should be

excluded from the Statements as they are not part of the licensable activities of generation or energy supply. 18 Page 56, Ofgem Segmental Statements Review, op cit.



16

the companies. With respect to the latter point, BDO noted that significant and

variable speculative trading results may erode this benefit, unless they could be

separated from the hedging trading results.

3.33. Importantly, BDO highlighted that it is not a simple or costless exercise to

include the trading function in the Statements. This is because for each of the six

energy companies the trading function performs two activities: hedging and

speculative trading. As speculative trading is not a core activity for supply or

generation businesses, it would need to be removed from the trading results and not

included in the Statements.

3.34. BDO outlined two main options for the reporting of results for energy

companies’ trading functions, with differing levels of costs and benefits.19 Option A

(‘basic inclusion’) involved including overall figures for trading divisions. Option B

(‘detailed inclusion’) involved separating out the speculative trading activities and

providing detailed analysis of ‘non-speculative’ results.

3.35. BDO presented a number of complications and costs associated with these

options in their advice to us:

GB licensed entities may not have the legal authority to request the trading

information from other Group members, particularly those located offshore.

Licensed entities might have to rely on goodwill and/or shareholder

intervention to obtain the trading information.

Most of the six companies would need to undertake detailed analysis to split

speculative and hedging trading. However, if a company recorded its

speculative portfolios separately, this would be simplified.

Ofgem would have to provide a precise definition of what is/is not regarded as

speculative trading, which could be difficult to substantiate and open to

interpretation by the companies.

3.36. BDO concluded that including the trading function is likely to result in costs to

all six companies in the industry. Furthermore, they noted that including the trading

function would only really improve the transparency and comparability of the

Statements if speculative results could be separated from trading for the purposes of

hedging. As a result, and given BDO’s conclusions on the appropriateness of the

transfer pricing policies, we were not convinced that any benefits of including the

trading function in the Statements would outweigh the costs and complexities.

3.37. Since then, new evidence has emerged on these costs and complexities. In

giving evidence to the ECCC, BDO were asked again about the costs of including the

trading function in the Statements. On this, BDO’s representative expressed his

19 , Ofgem Segmental Statements Review, op cit.



17

opinion that it is likely that the companies would have some form of granular

information on the trades they perform during the year. This, the ECCC concluded,

would reduce the costs of separating the speculative trades from hedging and thus

“eliminate cost as being a genuine reason for not [including the trading function in

the Statements]”20.

3.38. In addition, since the ECCC’s hearing in May 2013, we have received the set

of 2012 Statements. In their Statement, ScottishPower has voluntarily included its

trading function results.21 We welcome ScottishPower’s intention to increase the

amount of information available on its financial performance and we would

encourage similar initiatives from the other suppliers. However, the additional

information presented by ScottishPower in the Energy Management column is not

completely clear and more could be done to explain the contents of this column.

Usefully, ScottishPower’s approach also gives stakeholders an example of the format

an amended Statement could take if speculative trading activities were included.22

3.39. Overall, BDO’s appearance at the ECCC and the actions of ScottishPower and

Centrica has provided new evidence on the scope for companies to provide more

details of their trading functions. We consider these developments are significant

enough to warrant a further examination. We therefore ask stakeholders again to

express their thoughts on the costs and benefits of providing information on their

trading functions and how best to provide for comparability across companies.






3.40. The ECCC’s second recommendation is aimed at improving the comparability

of the information in the Statements. Currently five of the six large energy

companies have a financial reporting period that runs January to December, whereas

SSE is the only company to run April to March. In 2011, BDO recommended that

Ofgem should mandate SSE to change its reporting year, or produce a Statement for

the same calendar-year period as the other five companies. This would mean that all

six companies produced Statements that would cover the same time period and

would be published at the same time.

3.41. We consulted on this recommendation in 2012 and subsequently decided not

to pursue it. The evidence presented to us as part of our consultation suggested that

20 See page 170 of Energy Prices, Profits and Poverty, op cit. 21 ScottishPower do this by adding a column to the pro forma with the title Energy Management. This includes all energy trading on behalf of the supply and generation segments, the pricing for long-term gas contracts and also trades on its own behalf. 22 We also welcome the recent efforts of Centrica to increase transparency of their accounts, including by separating out the profits of their electricity trading activities, and their commitment to provide this – and something broadly comparable in gas – in future reporting.



18

the main benefit to be gained from aligning the reporting period of SSE with the

other five companies would largely be the value of contemporaneous publication of

the six Statements, ie avoiding having to wait until September for SSE’s Statements

to be published. This is because when comparing profitability among companies, it is

often important to look at more than one year’s worth of data to account for

expected variations in year-to-year profitability. Since we now have four years of

data, the difference between the information in SSE’s Statements and from the other

five companies is less important.

3.42. On the other hand, the costs associated with this approach could potentially

be significant. To comply, SSE would either have to change the reporting period for

the entire company, or produce an interim Statement for the 12 months of the

calendar year. Given our requirement that the Statements must be reconciled to

audited figures, SSE would have to produce an accompanying audited interim

statement, the costs of which would fall exclusively on SSE and its customers.

3.43. We would welcome views of stakeholders on how much this approach would

increase the comparability of the information in the Statements and the value in

bringing forward publication of a complete set of reports. Nevertheless, we continue

to consider that it would not be appropriate for us to require SSE to change their

reporting year. Given the potential benefits, we would of course welcome such a

change if SSE chose to make it themselves.

Other ways of improving usefulness

3.44. In addition to the above, we have considered whether there are other

measures that could improve the usefulness of the information collected and/or

made available on energy company profitability.

3.45. One option is to change the deadline that we give the companies to publish

their Statements. Currently, the suppliers have six months following the end of their

financial year to publish their Statements. There are good reasons for doing this. The

time directly following the end of a financial year is a busy period for suppliers’

finance teams and their accountants as they compile their Annual Report and

Accounts. This process can take as long as three months, and it is only after this

work has been completed that the suppliers have access to the relevant information

required to compile the Statements. A deadline of six months was chosen to give

suppliers a cushion of time following the completion of their Annual Report to work

on the Statements. It also recognised that for the initial years, the companies may

need more time to develop their processes and approaches.

3.46. The six month deadline has some downsides: the market does not see the

Statements until halfway through the year after the relevant reporting year ends and

the full set of Statements is not available until the end of September23. This has the

effect of delaying the publication of our Summary Document, which in turn reduces

23 SSE’s reporting period ends in March of every year.



19

the relevance of the information contained within it and can cause confusion for

stakeholders if reading a report based on data almost 12 months old.

3.47. To improve the relevance of the information published in the Statements, we

propose exploring the costs and benefits of reducing the amount of time companies

have to publish their Statements from six to four months. The companies have had

time to become used to these reporting requirements. Several of them have

indicated that they would be able to accelerate the production of their Statements by

a month or more (while noting the risks to quality if the timescale is reduced too

far). This would mean both Ofgem and the market would receive the Statements

sooner after the companies publish their Annual Report and Accounts. It would also

mean that the last Statements would be published at the end of July as opposed to

September. We would then aim to publish the Summary Document before the

autumn.




3.48. The last of the ECCC’s recommendations that could improve the suitability of

the information collected and published on profitability was to calculate the rate of

return on capital employed (ROCE) as a metric to determine whether the supply

market is competitive.

3.49. The ROCE is regarded as the most appropriate measure of profitability in most

markets24. However, this is not the way that retail businesses usually measure

profitability. There are challenges with calculating the ROCE for companies with low

levels of capital investments. An energy supply company is one such example.

Energy supply companies do not have significant physical investments. Instead they

rely on a number of financial assets (eg market contracts) and intangible assets (eg

brand). The calculation of the value of these assets is very difficult. Valuing the

quantity of invested “capital” in a supply company is likely to involve a high level of

subjectivity and could deem the final calculation of little worth.

3.50. We consulted upon the use of the ROCE as a profitability measure in 2012.25

In this consultation, we asked stakeholders for comments on whether it would be

appropriate to request information on the ROCE for the generation and supply

businesses of the six companies. Responses to the consultation were mixed. Some

respondents felt that it would be hard to agree a common methodology or

questioned the value of the measure, while others felt this could be a useful measure

and were happy for Ofgem to explore further.

24 See para 3.82 of Market Investigation References: Competition Commission Guidelines -

In the context of a market reference, the Commission will normally consider profit levels, usually in terms of rates of return on capital in the market or markets concerned. 25 Improving Reporting Transparency (09/12), Ofgem, 31 January 2012.



20

3.51. We maintain that there are significant complications with calculating the ROCE

for a supply business. However, these complications are less apparent for a

generation business. In fact, using a ROCE to present the profits earned in the

generation business may be a better indicator than our current approach of return on

revenue. We therefore propose investigating whether ROCE could add value in

assessing the profitability of the generation businesses of the companies.





Improving accessibility

3.52. To be genuinely transparent, information on energy company profitability

should be presented in a way that can be understood by interested parties, for

example by providing for effective comparison across companies and over time. This

goes for information published by both the energy companies and by Ofgem.


3.53. We publish a large amount of information on the energy markets every year.

With respect to information on energy company profits, we produce our annual

Summary Document on the Statements. For information on trends in companies’

costs and revenues, we produce our Supply Market Indicator (SMI), which is updated

weekly.

3.54. Our annual Summary Document brings together the information contained in

the six Statements, summarise the headline results and compare them to previous

years. This year, as with last year, we will include the results of an independent

review on the Statements. The Summary Document is designed to be readily

accessible by a wide range of stakeholders in a way that the individual company

Statements are not. The document uses charts and descriptive text to present the

information contained in the six Statements and provides some commentary on

differences between companies and previous years.

3.55. In recent years, Ofgem has taken steps to improve the accessibility of the

Summary Document. We have included longer descriptions of the how the companies

are structured to help readers understand the differences between the results

presented by the companies and we have also provided more descriptive text below

the charts to help readers understand the results.

3.56. In addition, we published a factsheet alongside our 2011 Summary Document.

This contained the headlines from the Statements26. The factsheet was welcomed by

26 This factsheet can be found on our website here.

https://www.ofgem.gov.uk/publications-and-updates/understanding-profits-large-energy-suppliers



21

consumers and the media as being an even more accessible report on energy

company profitability. We aim to publish another factsheet alongside our 2012

Summary Document.

3.57. We have made significant efforts since the introduction of the SMI to make the

information presented accessible to our stakeholders. First we designed a set of

simple charts to present the changing information on costs and revenues contained

in each SMI update.27 More recently, we have added additional information to the

charts, made them interactive and have simplified the accompanying webpage text.

We continue to innovate and update the SMI with the aim of making the information

it presents more accessible and useful for our stakeholders.


3.58. The ECCC did not make specific recommendations on how to improve the

accessibility of the information we publish on energy company profitability. However,

we believe this remains an important element of improving the transparency of

information presented to our stakeholders. We discuss below a number of possible

additional actions in this space.

3.59. As discussed above, we already publish a number of documents aimed at

summarising information on energy company profitability to make it more accessible.

An obvious question is therefore whether these documents are useful and meet the

needs of our stakeholders.

3.60. We are always open to receiving feedback on our publications. To date, we

have not actively asked stakeholders for feedback on the content and format of our

Summary Document. Given the role of this document in providing access and

interpretation to the information in the Statements, it is important that we seek

feedback from its readers on the how well it achieves this. We therefore welcome

feedback on the format and accessibility of this document and whether we can make

any changes to improve it.

3.61. In addition, if stakeholders consider that Ofgem could be doing more to

improve stakeholders’ understanding of energy company profitability, we would be

interested in hearing suggestions.




Statements?

27 These charts are available on our website here.

https://www.ofgem.gov.uk/electricity/retail-market/monitoring-data-and-statistics/electricity-and-gas-supply-market-indicators



22

3.62. As stated at the outset of this consultation, Ofgem is working to rebuild trust

and confidence in the energy market. Only then will consumers be comfortable

engaging with the market and competitive pressures on suppliers will increase.

3.63. While improving the transparency of information collected and published on

energy company profitability is one way of achieving this, it is by no means the only

part of our work in this area. For example, improving consumer confidence and

engagement is at the heart of Ofgem’s wide-ranging suite of RMR reforms.

3.64. We recognise that there may be more to do here. Therefore, we welcome

views on whether there are further measures or activities that could contribute

towards improving consumer confidence and trust in the energy market. These could

be from us or the companies, either individually or collectively.





23

4. Next steps

4.1. We ask stakeholders to respond to this consultation by 6 December. Appendix

1 provides details on how to respond.

4.2. During the consultation we will meet individually with the six large energy

companies to explore the actions that they might voluntarily take to improve

transparency of their profits. This is important given the different ways in which they

are structured and the recent developments in best practice in this area.

4.3. We also intend to invite the energy companies, consumer representatives and

other stakeholders to a round table meeting in November to discuss the theme of

rebuilding consumer confidence – to inform our thinking on possible actions.

4.4. We remind stakeholders that at the end of November we will be publishing our

Summary Document on the 2012 Statements. We encourage stakeholders to read

this report, and the accompanying factsheet, to better understand the accessibility

and usefulness of the information we currently produce on energy company

profitability.

4.5. Following the end of the consultation period, we will consider responses and

report on our conclusions by the spring.



24

Appendices

Index

Appendix Name of Appendix Page Number

1 Consultation Response and Questions 25

2 Feedback Questionnaire 27



25

Appendix 1 - Consultation Response and

Questions

1.1. Ofgem would like to hear the views of interested parties in relation to any of the

issues set out in this document. In particular, we would like to hear from energy

companies, consumer representatives and other users of information on energy

company profitability. We would especially welcome responses to the specific

questions which we have set out at the beginning of each chapter heading and which

are replicated overleaf.

1.2. Responses should be received by 6 December and should be sent to:

Diego Villalobos

Energy Market Monitoring and Analysis

Ofgem

9 Millbank

London

SW1P 3GE

020 7901 1846

[email protected]

1.3. Unless marked confidential, all responses will be published by placing them in

Ofgem’s library and on its website www.ofgem.gov.uk. Respondents may request

that their response is kept confidential. Ofgem shall respect this request, subject to

any obligations to disclose information, for example, under the Freedom of

Information Act 2000 or the Environmental Information Regulations 2004.

1.4. Respondents who wish to have their responses remain confidential should clearly

mark the document(s) to that effect and include the reasons for confidentiality.

Respondents are asked to put any confidential material in the appendices to their

responses.

1.5. Any questions on this document should, in the first instance, be directed to the

contact above.







http://www.ofgem.gov.uk/



26
















Statements?





27

Appendix 2 - Feedback Questionnaire

1.1. Ofgem considers that consultation is at the heart of good policy development.

We are keen to consider any comments or complaints about the manner in which this

consultation has been conducted. In any case, we would be keen to get your answers

to the following questions:

1. Do you have any comments about the overall process that was adopted for this

consultation?

2. Do you have any comments about the overall tone and content of the report?

3. Was the report easy to read and understand? Could it have been better written?

4. To what extent did the report’s conclusions provide a balanced view?

5. To what extent did the report make reasoned recommendations for

improvement?

6. Do you have any further comments?

1.2. Please send your comments to:

Andrew MacFaul

Consultation Co-ordinator

Ofgem

9 Millbank

London

SW1P 3GE

[email protected]
