Ofgem reviews price cap profit margin

Ofgem is reviewing the profit margin allowed under the price cap following concerns the current approach could provide unduly high returns to energy suppliers.

An initial consultation was published by the regulator on Friday morning (26 August) alongside its announcement that the cap will jump by 80% to £3,549 from the beginning of October.

Under the current methodology, there is a flat 1.9% allowance for earnings before interest and tax (EBIT) which is applied to all other allowances in the cap, including for wholesale, network, policy and operating costs. This means the allowed profit margin scales directly with customer bills.

The 1.9% margin was set when the price cap was first introduced in 2018. At the time, the market was more stable and typical energy bills varied between around £1,000 and £1,300. However, following soaring wholesale gas increases, the new cap level is three times higher than this historic range and the EBIT allowance has seen an equivalent increase.

Market volatility has also meant that some components of the cap, such as wholesale costs, have become highly variable, meaning the EBIT allowance has changed “significantly” in recent cap updates.

Ofgem said it has concerns that the current approach “compounds the impacts of the price increases for customers and could unduly provide high returns to suppliers”. Alternatively, it added, a return that is too low could pose risks to consumers through potential negative impacts on long-term investments, including those needed to help deliver the net zero transition.

As such, Ofgem is now considering whether applying the flat percentage margin to variable components continues to be the most appropriate method of setting the EBIT allowance, or whether alternative methodologies would be more suitable and reflective of the current volatile market conditions.

The options put forward by the regulator include a fixed absolute allowance, such as pounds per customer, and a hybrid approach that combines an absolute allowance (pounds per customer) with a variable allowance or allowances that relate to costs such as the underlying cost of energy.

It also suggested another hybrid approach whereby the allowance would be bounded between an upper limit (a cap) and a lower limit (a collar) and would change when required to best reflect market conditions.

Ofgem said it does not want to state a preference between these options at this stage.

As part of this work, Ofgem is also seeking views on whether the Capital Asset Pricing Model (CAPM) methodology remains an appropriate way of calculating the cost of capital for suppliers and how the components of the model – the risk-free rate, total market returns and the asset beta – should be determined.

Alongside the consultation, the regulator published a report commissioned from Cambridge Economic Policy Associates giving its calculation of the cost of capital for energy suppliers.

Ofgem is additionally consulting on capital requirements for suppliers given the increase wholesale costs and market volatility they now face.

The frictions inherent in balancing net zero, security of supply and affordability are at the core of the agenda for the Utility Week Forum, on 8-9 November in London. Find out more here.