How will principles-based regulation (PBR) change the energy market?

Posted: 20th July 2016

Within a year, Ofgem will announce fundamental changes to the way in which it operates, with knock-on effects inevitable for the energy firms that it oversees.

The regulator’s intention to instil a principle-based approach to regulation (akin to that within financial services) means that firms are now concerned about how their operating model and business plan will be implicated.

The roadmap for Ofgem's proposed move to principles-based regulation (PBR) was set out in a recent communication from the regulator.

The initial go-live date for the changes will be January 2017, with the ‘principles’ of the new regulatory approach identified by the retail market review (RMR) “simpler choices” rules, and the sales and marketing licence conditions, as set out by the Competition and Markets Authority (CMA).

The reasons for such a change are of course not without merit: a customer-centric marketplace is surely one that we would all like to operate within, as it should reduce the current prescriptive approach to regulatory compliance and afford firms the flexibility to offer their customers products and services that are better tailored to their individual needs.

It should also encourage a closer relationship between firms and the regulator, which is something to be mindful of as opportunities arise to contribute to the regulator’s view of issues in the future.

However, what are the challenges that firms are likely to face in moving to this new regulatory approach?

The concerns facing firms

One of the concerns raised by individuals I have spoken to within the energy industry is that principle-based regulation removes some of the clarity around the rules and their implications. The theory behind this objection is that in a more subjective regulatory landscape, it will become difficult for firms to assure themselves that they are operating in compliance with regulatory rules.

Introducing a level of interpretation is seen by many as over-complication. Indeed, many feel that the move to PBR could lead to misinterpretations of regulation while obscuring firms' customer-centric intentions.

Firms have also cited the potential issue of going to market in the belief that they are acting compliantly, only to find out at a later date (potentially years later) that the regulator disagrees and issues an enforcement notice or fine retrospectively. I firmly believe, however, if firms attain the right level of business assurance and retain the right level of evidence to justify their decisions, that principle-based regulation can greatly benefit the energy industry. This, evidently, is also the belief of those responsible for overseeing this supervisory change.

What PBR will do for The energy industry

Energy firms can learn much from the way financial services companies are now regulated, and the journey the industry has been on to get to the supervisory regime we see today. The FCA has operated a principle-based approach for long enough that the pros and cons can be considered, and certainly long enough for the significant benefits of PBR on customer satisfaction and industry trust to become pronounced.

So what are the lessons that financial firms have learned from their journey to principle-based regulation, and what must energy firms do to emulate (or even improve) their own approach to embedding this impending change?

1. Measuring their standard of compliance by looking at customer outcomes

Ofgem following in the footsteps of the FCA will mean customer outcomes will become the unit of measurement for firms’ compliance.

Recognising the difference between customer satisfaction and customer outcomes is imperative here. It will no longer be the voice of customer dissatisfaction that represents the ‘smoking gun’ of regulatory issues, but rather the presence of customer detriment. This infers that a forwards-looking approach to regulation is required by firms. Prescriptive regulation can, and in many instances does, fail those customers that are happy with unsuitable products – generally a result of apathy or blissful ignorance to a better alternative.

Activities like outcomes testing and root cause analysis will become central to firms’ compliance, as these delve deeply into the real outcomes being delivered and allow firms to take an ‘iterative approach’ to their products and processes in a way that simple customer satisfaction surveys cannot.

Taking an iterative approach – although sometimes at an extra cost – is one of the key features of principles-based regulation, and, if done well, can have fundamental effects on the way the energy brands are viewed (and advocated for) by the public.

2. Segmenting the customer base in order to tailor products to individuals

When firms are able to take a more comprehensive look at the customer experience, they will have a superior view of their customer base, and will be far more empowered to make changes for the benefit of customer advocacy and their brand.

Products that are designed to improve customer outcomes should, inherently, be more suitable and less likely to cause detriment. This in turn will mean a reduction in remediation activity and the time and money that would be lost, allowing firms to focus their efforts on further improving their customer outcomes and servicing. The upshot of all of this is greater customer trust, loyalty and advocacy.

This has often been referred to as a ‘virtuous circle’ in a financial services context. The challenge for the energy sector being how quickly they can pick up this baton and run with it. Of course, some organisational development may be necessitated by this new approach.

3. Developing an approach to customer vulnerability

A non-prescriptive approach will undoubtedly require firms to engage more effectively with customers’ individual circumstances. Doing this requires policies designed not just for ‘ideal customers’, but rather for the spectrum of different situations customers could find themselves in at a given time. This, in time, should prompt a wider shift in firms’ culture and lead the industry to focus upon the proactive measures they can take to improve outcomes for their customers.

We have already seen the regulator pushing firms to improve the way in which they treat the minority populations across their customer-base, and this is absolutely true in financial services, too. If Ofgem’s ultimate goal is aligned with the FCA’s, we can expect vulnerable customers – and standards of competency around how to treat them – becoming a major area of focus in the energy sector.

Ofgem need to find a balance that allows firms to provide flexible, innovative and commercially viable products for vulnerable customers, while ensuring, conversely, that customers aren’t baffled by too much choice.

4. Promoting internal challenge and documenting activity

The FCA itself has had to react to increasing challenge and questioning from firms. It, has, however, embraced and encouraged this – for example, by calling for input into its own findings so that firms can contribute their thoughts to the way they are regulated (this will also be the case in the energy sector).

The need for the regulators to be subject to challenge from firms rings true with the FCA’s own assertions that internal challenge within firms contributes a huge amount to a customer-centric culture.

Energy firms should embrace healthy internal challenge over decisions made within their organisations, whether it is a questioning of commercial decisions based on regulatory concerns, or vice versa. This could mean opening more effective channels of communication between regulatory experts and the board.

A ‘risk-based’ approach is something that financial services firms are encouraged to take – the regulator of course recognises the importance of proportionality, and that firms’ commerciality should not be unduly weighed down by regulation. As a result, it’s absolutely vital that when undertaking work that is designed to improve the customer experience, this activity is documented and able to be evidenced in the event of regulatory scrutiny.

The costs and benefits of understanding principles

By setting out principles for business, Ofgem will provide a vehicle for firms to delve deeper into their relationships with the customers they serve.

Outside observers of the ever-evolving dynamic between the FCA and financial services firms would perhaps first note that the amount of resource on both sides has increased significantly.

Much time and resource is now dedicated to correctly interpreting the principles and guidance set out by the regulator, presenting it coherently to internal teams and ensuring that the right measures and internal audits are in place to provide robust assurance and validation.

There is little doubt that the energy market’s move to principle-based regulation will come with an associated cost. However, firms channelling their resources and attention into the right areas will set themselves up for long-term compliance and reap the commercial benefits that come with putting the customer at the heart of their work.

Ofgem will be implementing PBR with the benefit of the FCA’s hindsight. Knowing what works and what doesn’t should mean a simplified process for energy suppliers, and there is no reason why the fruits of the finance industry’s labour cannot also be realised by Ofgem and the energy market.