Public energy company: strategic outline case

5. Financial Case

5.1 Introduction

The purpose of the Financial Case is to explore the Energy Co.'s fundamental financial principles and introduce 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 early stage of development of the project, the complexity of the proposal and the need to develop a preferred underlying operating and commercial model. This is also consistent with the HM Treasury Green Book guidance for the level of analysis required at the SOC stage.

Nevertheless, the Financial Case does consider the high level impact of establishing an Energy Co. based on its core operating principles. It also discusses what impact the implementation would have on SG's budget and accounts and includes an examination of the relevant tax considerations. In addition, it describes how the Financial Case will be developed to a greater level of detail at the OBC stage.

5.2 Assumptions

The analysis is based on the following set of assumptions:

• The preferred delivery and operating models have not been selected and will impact the financial position for the Energy Co.
• The Energy Co. will provide a return on the funding from SG once it generates a surplus, with subsequent surpluses being re-invested back into the Energy Co. in order to comply with the not-for-profit principle
• The Energy Co.'s activities and financial arrangements will comply with State Aid restrictions
• The indicative set up and operating costs do not represent the final costs required. For example, the set-up costs will be affected by factors such as the Energy Co.'s growth ambition, staffing level, service offering and degree of outsourcing.

5.3 Funding requirements

The establishment and running costs of the Energy Co. will be funded from the Scottish Budget. The costs involved in setting up the Energy Co. will be scored as Capital and Resource DEL. The split will broadly be determined by the nature of the costs.

Regardless of the chosen model, it is expected that the funding requirement to incorporate the Energy Co., commence trading and successfully acquire and deliver services to customers will be substantial.

Determining a possible funding requirement for the Energy Co. requires detailed analysis. This includes refining the financial assumptions in this SOC, market testing the operating models and developing a set of benchmarks based on a more articulated business plan for the Energy Co. This analysis will be carried out at the OBC stage.

5.4 Costings and affordability

5.4.1 Overview

This section explores the cost implications of establishing an Energy Co. based on its core principles set out in this SOC. SG investment will need to be sufficient to cover project costs, set up costs for the Energy Co. as well as working capital to cover operating costs up until the Energy Co. starts generating sufficient cash from revenue to cover its costs.

The costs are dependent on a number of key operational considerations. This includes, but is not limited to, the capabilities and functions of the Energy Co., the number of employees, the location and volume of office space required, business infrastructure including IT systems and equipment.

At the SOC stage, our review of set up and operating costs has been based on a top down review of existing relevant market participants.

We have also provided a qualitative review of how these costs may differ based on the proposed operating models, including:

• White Label model
• Full Capability model and a 'Licence Lite' capability model.

The analysis does not review the SG procurement model identified in the Commercial Case.

5.4.2 Scale of customer base

A key assumption underpinning the cost base and future affordability analysis will be the scale of customers an Energy Co. is able to attract and retain.

The Strategic Case identifies that in 2016, 8% (183,000) of customers in Scotland were defined as extremely fuel poor. For the purposes of this SOC, we have assumed that the Energy Co. would therefore seek to, at a minimum, target a customer base of this magnitude.

The review of set up and operating costs are based on a series of data points from existing relevant market participates. We have narrowed our population to review dual fuel energy suppliers, who are not vertically integrated and cater for between 100,000 and 250,000 customers. This "top down" approach provides a basis to explore the cost base that the Energy Co. is likely to have.

This assumption may not, however, accurately reflect Energy Co.'s future trading ambitions. Given Energy Co.'s intended purpose in the Scottish market, its expected customer base may be larger.

5.4.3 Energy Co. set up costs

There are a number of one off set up costs that the Energy Co. will likely need to incur. These will vary depending on the ultimate delivery vehicle and operating model, but would include:

• Project costs
• Corporate governance
• Employee recruitment
• Premises and infrastructure
• Initial marketing, branding and communication strategy
• Contingency.

The review of the relevant precedent companies in the market and publicly available information has identified the following indicative ranges of set up costs.

Table 10 - indicative set up costs

Model	Range of costs (£m)
White label	0.5 – 1.0
Full capability	1.5 – 3.5

Source: EY

The analysis indicates that the Full Capability model will require significantly more set up costs than the White Label model, with costs of £0.5m – £1.0m and £1.5m - £3. 5m respectively. Detailed affordability analysis will be developed at the OBC stage.

These costs do not represent the peak funding requirement of the Energy Co., which would represent the cumulative net costs to the Energy Co. over the start-up phase.

5.4.4 Energy Co. operating costs

The Energy Co.'s operating costs, as with the set up costs, are likely to vary significantly depending on the final selection of delivery vehicle and operating model. However, the key costs are likely to include:

• Ongoing employee and management costs
• Premises and infrastructure costs
• Support services including HR, IT and legal
• Customer acquisition and management (if applicable)
• Energy wholesale and procurement (if applicable).

The indicative cost analysis is based on entities which operate under the Full Capability model. This model would have a significantly higher cost base (and funding requirements for SG) than a White Label model. Given the bespoke nature of the White Label arrangements and variety of these in the market, standard costs do not exist. The precedent companies used in the analysis are shown below.

Table 11 - precedent companies operating costs

Precedent Company	Number of Customers	Operating Costs (£m)
Company A	180,000	4.3
Company B	100,000	2.8
Company C	110,000	9.0

Source: EY

The analysis indicates that the Full Capability model will have total operating costs of £2.8m - £9.0m. This analysis is based on publicly available information. The underlying operating conditions and business models for each company will vary and therefore the range represents an appropriate estimation of expected future costs.

5.4.5 Affordability analysis

The affordability analysis of the Energy Co. will be undertaken at the OBC stage when a comprehensive financial review of the preferred commercial position can be undertaken. It is important to note, however, that this will be based on the net cashflow position. This will incorporate all the relevant trading and financing assumptions, as well as the costs outlined above. It is also possible that the Energy Co. may operate with a net annual trading deficit over several years before sufficient scale is obtained to allow it to generate an ongoing surplus.

5.5 Operating models considerations

We have also undertaken a qualitative review of the likely financial implications of the White Label and Full Capability model and how they differ.

5.5.1 White Label model

The financial implications of establishing a White Label model will likely include:

Set up costs

• Costs relating to the procurement, negotiation and agreement of terms with the licenced supply partner. The negotiations will include the cost of senior internal SG resource and the cost of hiring professional advisors to support the process. The scale of these costs will be dependent on the length of time it takes to finalise the terms
• A White Label supply partner may require upfront investment in a marketing function to attract customers. As a result, the Energy Co. would need to recruit sales and marketing staff and meet some upfront advertising cost
• The Energy Co. may consider offering additional services to customer acquisition such as customer support or smart meter installation. If this were the case, the Energy Co. would incur additional costs such as hiring extra staff and purchasing a customer relationship management (CRM) system

Operating costs and working capital

• The Energy Co. will incur ongoing operating costs, salaries and customer acquisition costs. Costs will depend on the services that the Energy Co. will offer, but as a minimum, it will require a management team and sales and marketing personnel. Customer acquisition costs will depend on the growth ambitions of the Energy Co

Operating income

• Under the White Label model, the Energy Co.'s primary revenue streams will be based on either customer acquisition or retention payments. An acquisition payment will involve Energy Co. receiving a single payment from its supply partner for each customer it signs up. A retention payment involves the Energy Co. receiving an annual payment for each customer that remains with the Energy Co. after the initial sign up period has passed.

5.5.2 Full Capability model and 'Licence Lite'

The Full Capability or 'Licence Lite' models are likely to require a larger cost base than the While Label model. The financial implications of these models may include:

Set up costs

• The Energy Co. will need IT systems to manage customer data, central market administrators as well as its regulatory reporting requirements. This could be developed internally, however, it is common for new entrants to procure an off the shelf system known as a 'supplier in a box' where a specialist vendor will develop the relevant systems that comply with the core industry codes. The cost of a 'supplier in a box' can be substantial, and will include an initial purchase and configuration fee as well as an ongoing service charge. Notwithstanding the cost, buying the service is likely to be cost efficient (rather than building the capability) and relatively low risk
• The Energy Co. will also require considerable commercial and energy sector capability, likely through a combination of internal and external support. Permanent staff will be required to fulfil regulatory and licencing obligations, as well as hedging, trading and customer service functions. Some of these resources may be outsourced but the Energy Co. would need to weigh up the cost benefit against delivery and reputational risks. The staff cost would be reduced under a 'Licence Lite' model, as the Energy Co. would have fewer compliance obligations
• The Energy Co. would require additional funding for balancing and settlement, network charges with wholesale trading partners and under renewable schemes. As a new entrant the Energy Co. could face considerable credit requirements. The industry regulations allow for some provision of credit through a parent company guarantee, but it is unlikely that an SG Guarantee would be feasible, given State Aid restrictions.
• Operating costs
• A Full Capability model will incur significant staff and customer acquisition costs. These could, however, be reduced through the use of a 'Licence Lite' model.
• The Energy Co. will purchase energy from the wholesale market, directly from energy generators using PPA's or a combination of the two which, depending on its hedging strategy will require a significant level of working capital.
• Operating income
• In contrast to a White Label company, under the Full Capability model the Energy Co. will have direct contracts with its customers. As such it will earn income from charging customers a set tariff for the supply of energy.

5.6 Working capital considerations

Energy market participants, who fall into the Full Capability model category, have traditionally required substantial working capital commitments. This is required to support the build-up of customers and the associated operating costs that are typical of this model. The working capital requirements would be higher if customer uptake is slow and initial customer acquisition targets are not met.

To illustrate this point, we have calculated Energy Co.'s indicative working capital requirement over a five year period. This assumes that the operating costs represent the net annual trading deficit. Taking the midpoint of our costs range, £5.9m (£2.8m - £9m), the five year cumulative requirement could equate to £29.5m. This demonstrates the potential magnitude of the working capital requirements.

The working capital requirements for a White Label provider are expected to be lower than the Full Capability model given the reduced capability requirements.

We therefore recommend that, subject to the preferred operating model being finalised, detailed cash flow analysis is undertaken to review the short to medium term cash flow requirements for the Energy Co. This should include sensitivity analysis to account for varying levels of customer acquisition.

5.7 Government accounting and budget considerations

In the Socio-economic Case, we identified that ONS is most likely to classify the Energy Co. as a public corporation. This is because the delivery options that were short listed require SG ownership and hence control, and the expectation that Energy Co. will be financially self-sufficient means that it will meet the Market Test (revenues from sale of services meet more than 50% of Energy Co.'s total operating and finance costs including depreciation).

Appendix D summarises the principles and factors that we expect ONS to consider in reaching that sector classification.

This classification, however, is for ONS to determine and its view may differ. If ONS does classify the Energy Co. as a public corporation, the Energy Co. would be able to retain year end surpluses. It also means that SG would score against the Revenue Departmental Expenditure Limit (R-DEL) any financial assistance it pays to the Energy Co., less any dividend income it receives.

Finally, under HM Treasury's Consolidated Budgeting Guidance (CBG) Section 3.14 states that Government bodies budget for financial investments in the same way as spending to acquire fixed assets; this suggests that an investment in equity will generate a Capital Departmental Expenditure Limit (C-DEL) impact equal to the investment's cost. In addition, CBG Section 1.117 states that lending to public corporations also scores against C-DEL.

These principles therefore suggest that there is no difference between C-DEL and R-DEL impacts of a SG investment in, or a loan to, the Energy Co.; this is because in both cases the SG funding results in it acquiring an asset.

5.8 State Aid considerations

The Energy Co. will need to ensure that it is compliant with State Aid rules. State Aid restrictions would be breached if it were determined that SG were providing assistance to the Energy Co. that unfairly distorted competition. Such assistance may take many forms and could include grants, loans, tax breaks or financial guarantees.

The State Aid rules were established to determine where aid can be given and under which circumstances. In order to determine if State Aid rules apply, there are a number of tests that must be considered. These include:

• Determining whether an intervention by SG or through SG resources takes place
• The intervention gives the Energy Co. an advantage on a selective basis
• Competition has or may be distorted
• The intervention is likely to affect trade between Member States.

Exemptions exist, including an exemption if aid falls within the de minimus limits of €200,000 over three years.

In order to demonstrate State aid compliance, SG will need to ensure that any public funding to the Energy Co. complies with the Market Economy Investor Principles (MEIP).This ensures that SG's actions as a funder would be compared with those of a normal market operator.

This review assumes that, post Brexit, State Aid (or equivalent rules) will continue to be applied to any aid provided by SG.

During the development of the OBC, the State Aid considerations will be considered as the commercial and financial implications of the Energy Co. are developed.

5.9 Tax considerations

We have undertaken a high level review of the possible tax implications of operating the Energy Co. under the delivery structures and operating models identified in earlier sections. The key findings are presented below, with more detailed analysis in Appendix G.

5.9.1 Direct Tax

• Under any of the shortlisted options, direct tax charges will arise once the entity becomes profitable, unless the entity/group is established with a charitable purpose
• Start-up losses in the initial years of operation will be available for carry forward to set off against profits arising in future years. However, loss utilisation will be restricted to 50% in years where profits exceed £5m per annum, resulting in tax becoming payable sooner
• Capital expenditure and debt funding may provide tax relief to offset against profits arising in the Energy Co.
• If the Energy Co. were to involve multiple group companies (including Joint Venture (JV) entities), complex shareholding structures may reduce the tax efficiency of the group where losses and profits arise in different JV entities.

5.9.2 VAT

• The choice of legal entity should not significantly impact the VAT position as the supply of power and electricity is a business activity for VAT purposes
• Energy Co. will be required to register for VAT and it will need to account for VAT at the appropriate rate on the supplies of gas and electricity to its customers
• The VAT liabilities to be applied to the Energy Co.'s supplies will be dependent on the type of customer and the quantity of gas and electricity supplied
• The wholesale purchases of gas and electricity are likely to be subject to the UK domestic reverse charge. This means that no VAT will be incurred on the purchases of gas and electricity, however the Energy Co. will be required to self-account for VAT through its VAT return using the reverse charge procedure
• Consideration should also be given to the VAT implications associated with the Energy Co.'s non mainstream transactions, including the provision of any management charges and support services provided by SG.

5.10 Financial Case at OBC stage

The Financial Case will need to be developed to a considerable level of detail at the OBC stage. The following summarises the ways in which this work will take place:

• Funding requirements: This will be developed further through a) analysis and recommendation of desired operating model, b) detailed cost and funding bench-marking of relevant case studies, c) market engagement where relevant (e.g. potential White Label partners)
• Accounting and budgetary impact: Will be developed through interactively working through the delivery vehicles and operating models to a greater level of detail, based on pros and cons to evolve and refine the models
• Tax: This will be developed further (and interactively) based on a) choice of delivery structure and b) more detailed development of the potential operating models.

5.11 Conclusion

Based on our preliminary analysis the following key points have been identified in the Financial Case:

• The set up costs for the Energy Co. could be in the range of £0.5m - £3.5m. The actual figure will depend on the chosen operating model and the growth ambitions for the Energy Co. and several other variables
• The year one operating costs are likely to be substantial, especially if the Energy Co. is operated as a Full Capability supplier. Based on similar precedent companies the annual operating cost could be in the region of £2.8m - £9.0m. The peak funding requirement could however, be higher than this given the Energy Co. may trade at a deficit for a considerable period. Under the White Label model the operating costs would be lower given that several core functions would be provided by the partner company

• 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, the 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
• The initial classification consideration suggests that (regardless of operating model) SG would budget for its investment in the Energy Co. as if it is acquiring a long-term asset. This would apply whether the investment is equity or debt
• 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.