Ofgem proposes quarterly price cap to reduce time lag

Ofgem has proposed to introduce a quarterly price cap period to reduce the time lag between market prices and their reflection in the price cap.

The regulator identified this as its preference out of three potential options to make the cap more resilient to extreme price volatility, which were first outlined in a call for input in December and are now subject to a formal consultation.

Ofgem said the current time lag between market prices and their reflection in the cap can lead to volume risk for suppliers: “When energy prices rise sharply, active consumers will move to the price cap tariff, leaving suppliers with higher demand than they expected or hedged for, which they have to meet at high market prices.

“When prices fall, those consumers then move off the price cap tariff, this time leaving suppliers with unexpectedly low demand. In both cases, this can cause large, hard to avoid losses for suppliers, which can ultimately lead to higher prices for consumers.”

It also highlighted risks around backwardation, whereby short-term market prices are higher than over the long run. As the price cap is currently set for six-month periods but is based on forward-prices over a whole year, this can lead to under-recovery during winter periods.

The price cap methodology assumes these deficits are offset by over-recovery during the summer periods when there is the reverse situation of contango in which prices are lower over the short term. However, Ofgem said the current arrangements may not allow suppliers to recover backwardisation costs within a reasonable timeframe.

Ofgem said there is “no perfect solution” to these issues, with each of the three options involving trade-offs between the risks and costs borne by consumers and suppliers.

“The challenge is to find a solution that reduces the costs and risks facing suppliers so that energy bills can be kept low, whilst preserving the wider benefits of the price cap for consumers – the choices are finely balanced,” the regulator explained.

“Market risks currently sit with suppliers, causing large losses and exits at times of market instability, which in turn leads to higher costs for consumers; but shifting all the risk to consumers would leave them with more volatile energy bills.”

The first option is a “strengthened status quo” consisting of a six-month cap but with the possibility of earlier reviews in exceptional circumstances.

This, Ofgem said, somewhat reduces the volume risk, but not as effectively as the second option – a quarterly update with a one-month notice period.

It said a quarterly price cap would “significantly reduce volume risk”, potentially by as much as 60-80%, because the observed prices are closer on average to delivery and observations are updated more frequently.

“The combination of more frequent price changes and the reduced length of the price cap period reduces the likelihood of a supplier experiencing volume risk and limits the impact of such an event,” it added.

For consumers, quarterly updates would mean smaller but more frequent changes, including price hikes in winter when demand is higher. Ofgem said this option does increase potential backwardation costs for suppliers.

The regulator said it also considering an alternative version of this option in which the cap would be updated every four months, again with a one-month notice period.

Ofgem’s third solution is a ‘price cap contract’. This would be either a six- or twelve-month contract, without exit fees.

Depending on the length of the contract, there would be six or twelve concurrent price cap levels which are updated either every six months or annually on a rolling cycle. Under this option, price cap contracts would close to new customers at the end of a month, and a new price cap contract with a different price level would begin for new customers in the following month.

Ofgem admitted that this should be the most effective at mitigating volume risks and would carry little to no backwardation costs, thus resulting in the lowest costs to consumers overall.

However, it added, the challenges of transitioning and operationalising this options are “significant” – there are potential negative impacts on the wholesale market, as well as challenges around perceptions of fairness for consumers.

Ofgem is additionally consulting on reducing the advance notice it gives to suppliers of the updated price cap levels, a move which it believes will also help to reduce the volume risk faced by suppliers and reduce consumer costs.

This would see the notice period reduced from almost two months to 28 days.

“The current 2-month period was introduced on the basis that it provides suppliers with sufficient time to make the necessary preparations for the price change. We consider that reducing this to a minimum of 28 days has benefit to both suppliers and consumers,” the regulator said.

It also outlined options for addressing backwardation costs specifically, including ex-post adjustments; calculating the price cap based on forward prices for the period it covers; developing an ex-ante allowance; and doing nothing. Ofgem said its preferred options is ex-post adjustments, saying the second of these options would increase volatility for customers, whilst the third could hand windfall gains to suppliers.

In-period adjustments

The consultation was one of a number of documents published the regulator on Friday (4 February).

They also included its decisions to apply a £61 uplift to the price cap level from April to reflect unforeseen costs during the current period, partly due to backwardation, and to press ahead with supply licence changes to enable it to adjust the price cap outside of its routine cycle.

Ofgem said in-period adjustments will allow it to either raise or decrease the cap in responses to exceptional circumstances such as the recent wholesale cost increases.

The regulator noted concerns raised by industry stakeholders in its November consultation on the issue, namely that adjustments will create additional uncertainty as there is reduced forward visibility on when the cap will be updated.

As such, Ofgem has designed a test framework of five criteria that a situation must meet before an adjustment will be triggered. These are:

• Rare: a rare event in either nature or scale, the consequence of which was not wholly included in the calculation of the current cap.
• Externally caused: the cause of the event is external to suppliers within the energy market.
• Not reasonably avoidable: when even suppliers who have taken reasonable steps to mitigate the impact of the event have limited or no success and face unavoidable changes to their costs.
• Appropriate: the event impacts the efficient costs of supply.
• Requires urgent action: urgent action by Ofgem is deemed necessary within the remaining cap period, to mitigate otherwise potential long-term and/or enduring impacts on the market and customers.

Ofgem added that the nature of the exceptional circumstances and suppliers’ ability to implement any changes will be considered when consulting on and applying the updated cap level. Where appropriate, the regulator will shorten the consultation or implementation period compared to the timings set out in legislation.

Furthermore, any in-period adjustments would be forward looking only, applying for the remainder of the cap period, and would not be applied retrospectively.

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