Ofwat has published a paper setting out its key decisions on how credit and collateral arrangements will operate between wholesalers and retailers in the new business retail market.

Introducing the paper, Ofwat said credit arrangements are an important aspect of any market arrangement , commenting:

“Any disproportionate, discriminatory or unclear credit arrangements could act as a barrier to entry for new entrants, resulting in a chilling effect on the levels of rivalry and choice in the new market, to the detriment of customers.”

“ Similarly, if credit arrangements do not adequately address the risks that wholesalers are exposed to under the new arrangements then they could potentially, in extreme circumstances, impact on the financeability of the wholesaler.”

“Finally, most significantly, if the risks of default are not allocated efficiently then the new arrangements may tie up capital in the new arrangements, unnecessarily creating costs and inefficiency or encouraging excessively risky entry and bad debts which may be passed on to customers.”

The decisions are grouped into four key themes  - analysis, level of collateral, suite of credit options and wholesale risk sharing mechanism - reflecting the issues where Ofwat sought stakeholders’ views in its consultation.

On the basis of the responses and evidence provided the regulator has decided to retain the approach and assumptions used as part of its original analysis. However, Ofwat has updated the impacts on retailers to show more clearly the impact of requiring 50 days of collateral.

Many wholesalers and retailers have raised concerns with the suggested 50 days of collateral that should be required from retail entrants. Ofwat considers that this largely reflects the challenge of efficiently allocating risk so as to promote competition and reduce barriers to entry in retail services and avoid imposing undue or inefficient costs on wholesalers.

Ofwat’s key decisiona are as follows:

Key decision 1 – Within the regulated credit arrangements for the retail market set out in the wholesale-retail code we expect retailers to provide 50 days of collateral to wholesalers to cover the risk of retailer default for all post-payment options.

We do not consider that, on its own, the evidence emerging from this consultation on credit and working capital arrangements suggests a need to increase the WACC or wholesale cost allowances to compensate for this risk (where 50 days of collateral are provided).

Key decision 2 – We will consider whether there is a more efficient way to manage this risk beyond 2020 through other regulatory tools, after considering the development in the business retail market.

The suite of credit options – given the market power of wholesalers, and the likelihood of different retail business models, we proposed that regulated credit arrangements should be set out in the codes and that a suite of six standard regulated options should be available. We also proposed that a seventh option be added that allowed parties to deviate from the six regulated arrangements where they agreed to do so.

Given the broad support for and the greater flexibility from providing a range of credit options we continue to consider that the codes should specify a menu of different credit options including the unsecured credit option. To provide even greater flexibility we consider that there is merit in including a seventh ‘negotiated’ credit option.

Key decision 3 – Within the regulated credit arrangements for the retail market set out in the wholesale-retail code we expect a range of options to be provided that are available to retail entrants. This should include pre-payment, cash deposit, letter of credit, third party guarantee, insurance and unsecured credit .

Retailers should be free to choose from any of these options and wholesalers must accept them, provided that retailers meet the criteria set out in the codes.

Key decision 4 – Within the regulated credit arrangements for the retail market set out in the wholesale-retail code we expect there to be a negotiated credit option. This should allow retailers and wholesalers to agree alternative, bespoke negotiated credit terms where both parties agree to these.

Key decision 5 – Within the regulated credit arrangements for the retail market set out in the market arrangements code and wholesale-retail code we expect that a retailer in default with one wholesaler should be treated as being in default with all wholesalers.

Key decision 6 – Within the regulated credit arrangements for the retail market set out in the wholesale-retail code we expect there to be a scale for unsecured credit.

Key decision 7 – We will not introduce a wholesale risk sharing mechanism, but will review credit arrangements after the market is open.

Ofwat has considered the case for a wholesale risk sharing mechanism that would allow wholesale price limits to be re-opened in the event of a major retailer default under certain circumstances, effectively transferring some of the risk onto customers.

Based on the evidence provided the regulator is not planning to introduce a risk sharing mechanism at this time. Ofwat said it analysis suggests that, even in a worst case scenario, the impact on wholesalers would not be of such significance as to threaten their financeability.

Implementation - next steps

Implementing the credit arrangements will principally require the updating of the ‘codes’, including the Wholesale and Retail Code and the Market Arrangements Code that are available in draft form on the Open Water website.

Ofwat now plans to develop a change proposal for the codes and discuss this with the Interim Code Panel in September and, if necessary, October.

Before that, and following discussion with the Interim Code Panel, the regulator said it has established a working group with balanced representation to develop further detail on how the credit arrangements will operate in practice.

Click here to download Credit terms between wholesalers and retailers in the new retail market