More stringent cap on operating costs could push suppliers to cut back services

Energy UK has urged Ofgem to use a weighted sector average as the benchmark when updating the price cap allowance for energy suppliers’ core operating costs.  

The trade association said using the lower quartile supplier as the benchmark again risks pushing companies to achieve savings by cutting back their services.  

Energy UK was responding to a consultation published by Ofgem in May as part of a review of the price cap allowance for operating costs.  

The current allowance is based on cost data collected from suppliers in 2017 ahead of the introduction of the price cap. Ofgem set the baseline as the operating cost per direct debit customer of the lower quartile supplier – the median supplier in the lower half of the sample – minus £5 to incentivise improvements in efficiency. This baseline was indexed to inflation to keep it at the same value in real terms.  

In the consultation document, Ofgem said it intends to update the allowance using freshly collected data to reflect numerous developments that may have raised or lowered suppliers’ operating costs since 2017. These include market consolidation following multiple supplier exits, regulatory changes and external events such as the Covid pandemic and the energy crisis.  

Ofgem said it is considering two possible options for benchmarking suppliers’ operating costs: taking the operating costs of the lower quartile supplier as the benchmark; or calculating an average for all suppliers in the new sample, weighted according to the number of customers in each of their portfolios.  

In the case of the former, the regulator said it would seek to identify a supplier that is “broadly representative” of the wider market.  

Ofgem said the use of the lower quartile supplier as the benchmark would provide additional price protection for customers and a stronger incentive for suppliers to make improvements in efficiency.  

Responding to the consultation, Energy UK said: “Ofgem’s theory is that benchmarking should encourage suppliers to invest in steps that reduce their operational costs so that over time they will be able to operate with a lower allowance.”  

However, the organisation said it has not seen “clear evidence” that this is the case, adding: “A reduction in operation costs does not necessarily mean increased efficiency.” 

Energy UK claimed there is “significant risk” from “deciding ex-ante that a certain amount of efficiency improvements will be found”. 

“This predicts a level of unattributed efficiency which exposes energy suppliers to losses or a requirement to make service reductions,” it warned.  

Energy UK said the level of the operating cost allowance will be critical to suppliers’ ability to build and maintain their business, and that: “In setting this allowance, Ofgem must have regard to, among other factors, the ability of energy suppliers to invest in the systems, services and tariff propositions that customers need now and into the future”.  

The trade body said developments such as electrification and market-wide half-hourly settlement will bring greater diversification of tariffs and services, increasing the importance of “non-price competition that depends on energy supplier investment in operational performance”.  

It said Ofgem’s inclination to set an “overly stringent price cap” has previously led to issues such as cashflow volatility that “arguably contributed to significant market consolidation and routine loss-making across the sector which has held back investment. Ofgem needs to avoid replicating this through the setting of the operating cost allowance.” 

As well as the need for investment to improve services for future customers, Energy UK said the allowance must also reflect “the additional unfunded requirements from Ofgem that have shaped energy suppliers’ operations since the current allowance was set, which are cumulative and likely significant.”