Public energy company: strategic outline case

Executive summary

This Strategic Outline Case (SOC) presents the case for change for the Scottish Government (SG) to establish a publicly owned energy company (Energy Co.). The intention to set up an Energy Co. by the end of this Parliament (March 2021) was announced by the First Minister on 10 October 2017.

EY has been engaged by SG to prepare this SOC to develop the proposals set out by the First Minister.

In line with HM Treasury business case model and guidelines^[1], this SOC reviews the five cases as follows:

• Strategic Case
• Socio-economic Case
• Commercial Case
• Financial Case
• Management Case.

Each case is summarised below.

Strategic Case

Significant challenges exist in the Scottish energy market, including high electricity prices, a lack of consumer switching and, critically, the existence of significant levels of fuel poverty in Scotland. The Strategic Case demonstrates that the creation of the Energy Co. has the potential to successfully address some of the problems in Scotland's energy market.

The case explores if an Energy Co. is capable of reducing energy costs. The analysis indicates that the pre-tax profit margins made in this market, on average, are limited. This may present challenges to the Energy Co. in a highly complex and competitive market. Nevertheless, price competitiveness has been shown to be the single most common factor energy suppliers promote to try and attract customers. Therefore, if the Energy Co. is able to provide competitive pricing, it would be well positioned to develop a sufficient customer base.

Secondly, it discusses how an Energy Co. can encourage energy efficiency more successfully than existing suppliers. Promoting energy efficiency as a way of reducing energy consumption, as opposed to reducing energy costs, is another means of tackling fuel poverty. By developing a trusted brand and promoting its socially minded objectives, the Energy Co. would be able to focus engagement with customers and encourage energy efficiency measures.

Thirdly, we discuss if an Energy Co. can encourage customers to switch suppliers. An Energy Co., being a public sector initiative, may be able to develop significant and positive brand awareness. It may also seek to communicate with disengaged customers that would otherwise have remained on an uncompetitive tariff.

In addition to tackling fuel poverty, the Strategic Case identifies that an Energy Co. can support economic development and growth. As a market innovation, the Energy Co. has the potential to support a number of Scotland's Economic Strategy pillars, including Investment, Innovation and Inclusive Growth. Specifically, the Energy Co. has the potential to support economic growth by supporting local energy generation and efficiency, delivering lower cost of capital for supplying energy to Scottish customers and encouraging energy efficiency more successfully than existing suppliers.

Socio-economic Case

The Socio-economic Case introduces and provides initial considerations for the appraisal of the proposed long list of delivery options for the Energy Co. Using an agreed appraisal methodology and criteria, EY and SG concluded that the following delivery options should be short-listed for further consideration.

Table 1 - short list of delivery options

	Delivery Option	Description
1	Do nothing	SG does not pursue the creation of the Energy Co. This option forms the counterfactual for the SOC.
2	Existing socially minded supplier	The Energy Co. would utilise an existing socially minded supplier as the future delivery structure. Existing ownership and governance arrangements may need to be reviewed to ensure appropriate SG control.
3	Government owned company	Creation of a new limited company (by shares or guarantee). It would be 100% owned by SG and governed by the Companies Act. An example of a relevant entity would be Skills Development Scotland. SG would appoint the Chairman and Board of Directors to ensure its policy objectives and interests are reflected in the Company Strategy and Business Plans. The Board would oversee an Executive Management Team.
4	Federal model	Creation of a SG incorporated "Topco" company with joint venture subsidiaries operated by individual local authorities (LAs). The subsidiaries will White Label the supply of electricity and gas from the Energy Co. and bring a locally branded supply to the market. The products will be consistent across the LAs. It would be up to individual LAs whether they participate in the vehicle. The top company would be controlled by SG (through Board representation as per a Government Company). Governance arrangements would need to be agreed for the regional subsidiaries, including delegated remit. Funding would be through SG (as shareholder) with the potential for third party funding (including through trading profits).

Source: EY

The appraisal process has been developed on the assumption that the Energy Co. is established to address a specific set of objectives, namely to deliver competitively priced energy which will help to alleviate fuel poverty. As a result, the appraisal criteria and shortlisting process has been carried out with this fundamental principle at its core.

If this underlying principle were to evolve, the appraisal methodology can be updated. For example, SG may seek to refine proposals for the Energy Co. to adopt broader objectives. For example, the Energy Co. focussing on the dual impact of tackling fuel poverty and driving economic development, or being implemented by a wider group of public sector stakeholders, including LAs.

The short list of delivery options should be formally evaluated during the preparation of an Outline Business Case (OBC). This will allow SG to select a preferred delivery structure for the Energy Co.

Commercial Case

The Commercial Case evaluates potential operating models that would allow the Energy Co. to achieve its objectives and operate in the highly commercial and competitive energy retail market. Two operating models have been explored:

Table 2 - Operating models

Operating model	Description
White Label model	Under a White Label model, the Energy Co. would procure an existing licenced supplier to provide the Energy Co. with its own nationally branded and unique products. It would not apply for, or hold, its own supply licence.
Full Capability and a 'Licence Lite' capability	There are two sub-options under this operating model: Full Capability model – The Energy Co., would become a licenced gas and electricity supplier and would be responsible for complying with the associated industry regulatory requirements 'Licence Lite'– is an option that helps new suppliers enter the electricity supply market. It does not apply to gas supply. It allows the new supplier to partner with an existing supplier, with the partner supplier taking responsibility for providing the capability required to comply with some of the more costly and technically challenging requirements of a supply licence.

Source: EY

A third option, a SG wholesale procurement framework model was discounted due to the level of complexity, risk of procurement challenge and the potential impact of prices for existing public sector customers.

The Commercial Case also looks at the use of an existing supplier and Federal structure and discusses additional areas such as the optimal scale and size of the Energy Co., potential future service offerings by the Energy Co. and considerations for digital service offerings.

Financial Case

The Financial Case explores the Energy Co.'s fundamental financial principles and introduces the likely magnitude of the potential set up and operating costs. It does not, however, contain fully costed operating models for the Energy Co. This is appropriate given the project's early stage of development, the complexity of the proposal and the need to develop a preferred underlying operating and commercial model.

Based on our preliminary analysis, the set up costs for the Energy Co. could be in the range of £0.5m - £3.5m. Actual costs will depend on the choice of operating model, the growth ambitions for the Energy Co. and several other key operational considerations that have yet to be determined.

The year one operating costs are likely to be substantial, especially if the Energy Co. is operated as a Full Capability supplier. Based on comparable precedent companies the annual operating cost could be in the region of £2.8m - £9.0m. Under the White Label model the operating costs would be lower given several core functions would be provided by the partner company. The peak funding requirement could, however, be higher than this given the Energy Co. may trade at a deficit for a considerable period.

The total funding requirement would be significantly lower for a White Label model. However, due to the heavy reliance on the White Label partner, the Energy Co. would have less flexibility and control. In addition, given the partnering arrangement, Energy Co. revenues would be lower than under the Full Capability model. As such a detailed cost benefit analysis will need to be performed at the OBC stage.

Scottish Government will need to ensure that its investment in and ongoing support of the Energy Co. are compliant with State Aid rules.

An in-depth review of the Energy Co.'s tax position will be undertaken alongside further work on the delivery structure and operating model at the OBC stage.

Management Case

The Management Case outlines the initial steps to develop and implement the programme for the Energy Co.

Programme and project management plans

The project plan has been established, highlighting timescales for work streams and approvals to allow an operational Energy Co. by March 2021.

Table 3 - Energy Co. project timeline

Source: EY

Governance structure

The governance structure will be developed as part of the OBC. The high level project plan above indicates that the executive team will be appointed in late 2020. In order to develop the project effectively SG will need to bring one or more senior energy sector experts with relevant experience onto the Project Board, ideally experienced from a private sector energy supply company perspective and a SG project governance perspective.

Risk register

A high level risk register has been established for the SOC. The risks have been qualitatively assessed and as the programme progresses risks will be reviewed, updated and quantified where possible. The risk register articulates the high level strategic, commercial and financial risks that currently exist including securing appropriate financial support, establishing a successful commercial vehicle and complying with the appropriate legal and State Aid requirements.

Next steps

The Management Case has considered the initial steps required to progress the programme for the Energy Co. The key next steps which should be undertaken within the OBC are detailed below:

• Confirm the preferred delivery structure and operating model for the Energy Co and obtain legal sign off (including the approach to implement the delivery structure such as procurement strategy and necessary licences)

• Develop a financial base case based on the chosen operating model and delivery structure
• Develop a robust and comprehensive project plan, confirming dialogue and decision points with SG.

Conclusion

The SOC concludes that it is possible to establish an Energy Co. to achieve the stated objective of delivering competitively priced energy to help alleviate fuel poverty in Scotland. We also, however, recognise the challenges of doing this in a highly innovative, competitive and evolving energy retail market. State Aid restrictions prevent the Energy Co. from operating on a subsidised basis, therefore a commercial model is required for this to be successful. As a result, the over-riding strategic question for SG is how to make the Energy Co. cost competitive, in a low margin market.

This challenge requires further detailed scrutiny of the available operating models, including the most cost effective way to utilise market leading technology and capability in a public sector context.