Ofgem delays review of wholesale cost allowances in price cap

Potential changes to the way wholesale cost allowances are set within the price cap will not come into force in January as previously slated.

Instead, any changes to wholesale cost allowances will now be implemented in April 2024 at the earliest if deemed necessary by Ofgem.

When it launched a review of wholesale cost allowances earlier this year, the regulator stated that any changes would take effect from the January 2024 price cap announcement.

However, Ofgem has now delayed its consultation on the cost allowances.

The regulator said: “Following our collection and initial analysis of […] data, we have decided to reschedule the intended follow-up consultation from late September to late November/early December.

“This will ensure that the analysis and calculations used to consider whether an adjustment is appropriate, are robust.

“Rescheduling the consultation will also move the implementation date of an adjustment, should we decide that one is appropriate, from January 2024 to April 2024, at the earliest.”

It adds: “Coupled with our consultation, we consider that the putback approach provides the required level of transparency and meaningful consultation to enable stakeholders to comment effectively on our analysis and calculations.”

Ofgem’s review will assess whether the allowances led to either a benefit or costs for suppliers as prices fell in 2023. If appropriate, the allowances will be adjusted to ensure that any previous gains are recovered and passed back to customers.

In an open letter sent to all domestic energy suppliers in July, the regulator’s deputy director of price protection Dan Norton outlined the case and scope of a review.

Norton said: “Conditions in the retail market have now stabilised as wholesale prices have fallen. However, wholesale prices remain historically high, placing significant pressure on customers. […] We are keeping the price cap formula under review to ensure that customers continue to pay a fair price that reflects the underlying efficient cost to supply the energy and it does not over-reward suppliers where a fall in prices may lead to benefits.

“This includes the subject of this review – examining areas where suppliers were allowed to recover costs from last year to understand whether a similar ‘benefit’ has been created in current market conditions which should be recovered for customers.”

The review will largely cover a combination of unexpected Standard Variable Tariff (SVT) demand, as well as shaping and imbalance costs. Ofgem additionally intends to review its approach to the backwardation recovery period.

Norton explained how prior to the government’s announcement in March 2023 that it will extend the £2,500 Energy Price Guarantee by a further three months, rather than increasing it to £3,000, suppliers may have expected that it would be possible to offer fixed tariffs below the EPG level during the April to June 2023 cap period.

Suppliers, he said, may therefore not have hedged for customers who they expected to move to fixed tariffs. In practice, customers largely remained on default tariffs during this time.

Elsewhere, Ofgem said it intends to review the recovery period for the backwardation costs in the cap.

To smooth out seasonal fluctuations in energy prices, allowances for wholesale costs are set based on forward prices over a 12-month reference period starting at the beginning of the relevant price cap. This results in the under-recovery of costs during the winter – referred to as backwardation costs – and the over-recovery of costs during the summer – referred to as contango benefits.

The price cap methodology previously assumed that these backwardation costs and contango benefits roughly offset each other over prolonged periods. Last year however Ofgem said this assumption does not necessarily hold during periods of high price volatility.

It therefore introduced an ex-ante allowance for exceptional backwardation costs that would not be recovered through contango benefits. From October 2022, backwardation costs above a £9 deadband – £4 for electricity and £5 for gas – will be recovered over six months following the start of the relevant price cap.

This was a change from the regulator’s minded-to position of a 12-month recovery period.