Ofgem to review wholesale energy allowances in price cap

Ofgem is reviewing whether allowances in the price cap are fairly reflective of actual costs incurred by suppliers, as market conditions continue to stabilise.

The energy regulator has previously made a number of adjustments to the cap in recent years in response to events such as the pandemic and wholesale price volatility linked to the Russian invasion of Ukraine.

These include adjustments for increased wholesale costs which were made in February and August 2022.

In an open letter to all domestic energy suppliers the regulator’s deputy director of price protection, Dan Norton, outlined the case and scope of a review on additional wholesale costs during the period October 2022 to September 2023.

Ofgem 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 for the January 2024 price cap to ensure that any previous gains are recovered and passed back to customers this winter.

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.

“As set out in our CEO’s letter of 4 July, 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.

He added: “To the extent that this may have created unexpected SVT demand for suppliers, the impact will be dependent on the prevailing market prices. For example, if the prevailing wholesale prices were lower than those captured in the cap wholesale index, then there would be a saving from unexpected SVT demand.

“This is the opposite of buying additional volumes when wholesale prices are higher than those captured in the cap wholesale index, for which we previously provided adjustments.”

Norton said that the regulator considers this a “clear reason” to explore whether the EPG changes led to unexpected SVT demand, and any consequent differences between allowances and costs.

Ofgem said it also intends to review whether unexpected SVT demand has materialised during cap period 10b (July to September) 2023.

“Forecasting customer numbers is a normal task for suppliers. However, in certain circumstances such as unexpected changes in government policy, the impacts could be systematic,” added Norton.

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.

Norton said: “Our change in position was to support market resilience and stability given the high level of backwardation we observed last winter, which could have created acute risks. However, this did focus the bill impacts for customers over a shorter period and introduce some wholesale price seasonality into the cap.

“In this decision it was noted that we intended to review this approach in future to determine whether a six-month recovery period is the best approach for customers on an enduring basis. Now that we have seen prices begin to stabilise and fall, we consider that this is a good opportunity to review whether a six-month recovery period is still appropriate or whether we should increase the recovery period (eg to 12 months) to reduce the seasonal bill impacts for customers going forward.”

Industry stakeholders have until 14 August to respond to the letter.

If an adjustment is necessary the regulator will publish a statutory consultation in September ahead of a decision by late November to allow for implementation in January next year.