Unpacking the latest price cap announcements

As has become the norm, the latest price cap announcement was once again accompanied by a dump of documents on the latest tweaks to way the mechanism works.

As well as revealing that the price cap will drop by more than £1,200 for a typical dual fuel customer from 1 July, Ofgem confirmed changes to price cap allowance for profits, launched a review of the allowances for operating costs and issued guidance on the resumption of dividends.

Utility Week presents a summary of the key updates:

Profit margins

Under the current arrangements, the price cap includes an EBIT (earnings before interest and tax) allowance of 1.9%, which is applied to the sum of the allowances for wholesale, network, policy and operating costs as well as the payment method uplift and an adjustment allowance. This means the EBIT allowance broadly scales in line with overall cap levels.

In a new statutory consultation, Ofgem has confirmed it is moving ahead with proposals to shift to a hybrid approach to scaling, with fixed and variable components, starting in period 11a (October to December 2023).

The current 1.9% rate is derived from estimates of the pre-tax cost of capital and level of capital employed by suppliers. In the case of the latter, Ofgem has hitherto used the 10% figures calculated by the Competition and Markets Authority in 2016. The regulator has recalculated the figure using more recent market data and now estimates it at 12.2%.

Ofgem has proposed to set the level of capital employed per customer based on three components – fixed assets, working capital and collateral – with working capital being set at level to enable the notional supplier to withstand 1-in-20 years market conditions. Its current estimates for these components are £90, £127 and £165 respectively.

On the basis of £380 of capital employed and a cost of capital of 12.2%, Ofgem said the profit per customer would be £46.60. It said the portion of this profit relating to capital employed on fixed assets and collateral required for Renewables Obligation will be fixed. It calculated this amount at £19.20.

The regulator divided the remaining £27.40 by the forecast allowances to which the variable component of the profit margin will apply (£1,940) to derive a scalar for this portion of 1.41%.

Ofgem said these figures are all indicative and subject to change. The indicative £47 profit margin for period 11a amounts to 2.4% of the overall forecast price cap level. The regulator estimated that the proposed changes to the EBIT allowance would increase consumer bills by £227 million over the first 12 months following their introduction.

Operating costs

Ofgem has issued a new review of price cap allowances for operating costs to reflect the many market and regulatory changes over the last several years, as well as update its data, much of which was collected in 2017 or earlier. The regulator said the review will cover:

• Core operating costs – considering whether calculating a new baseline is appropriate based on re-benchmarking core operating costs. Key cost items include customer contact, billing and payment collection, metering, sales and marketing, central overheads, depreciation and amortisation, and industry charges.
• Payment method differentials – exploring options for reflecting differences in operating costs between payments methods.
• Smart meter costs – exploring options for reflecting differences in operating costs between smart and traditional meters.
• Industry charges – exploring costs associated with recent and future industry changes and the options for setting an allowance for them.
• Implementation approach – exploring the options for updating the allowances over time and allocating costs across the standing charge and unit rate.

Among other things, Ofgem said the review will consider whether it should retain its current top-down method for calculating operating costs or adopt a more complicated bottom-up approach; whether there are differences in suppliers’ costs unrelated to efficiency; whether recent cost changes are temporary or enduring; and how costs have been affected by mergers and acquisitions.

Dividends

Ofgem also published an open letter to energy retailers setting out its expectations for financial distributions to shareholders following a long period of losses during which “the bulk of suppliers have not paid dividends”.

“This has been a financially responsible response to the gas price crisis,” the regulator explained. “But a resilient market must be investable which in turn requires prospects for reasonable profitability… Suppliers are collectively projecting a return to profitability this year.”

Ofgem said some suppliers may wish to recommence dividends this year but said these distributions “must not, of course, place the supplier in breach of their regulatory or other obligations”.

It said suppliers must evidence that they have “sufficient business-specific financial resources so that their liabilities can be met on an ongoing basis. This may include meeting a prospective common minimum capital requirement, subject to the authority approving the modification of supply licence conditions over the summer of 2023 following our consideration of responses to the April statutory consultation.”

“We will expect to be satisfied that any distributions would not create excess vulnerabilities to stress for a given supplier, impair its ability to treat customers fairly, or impede its ability to manage responsibly costs that could be mutualised,” the regulator added. It said any supplier wishing to make distributions outside of this framework should expect a “high bar for justifying any exceptions”.

Last Resort Supply Payment claims

In another set of open letters, Ofgem said it is bringing an end to the temporary process for claiming Last Resort Supply Payments, which was introduced in the second half of 2021 for a rapid succession of supplier failures.

The process was introduced to enable Suppliers of Last Resort, which had to pay extremely high prices to purchase energy for their new customers that exceeded the price cap at the time, to make an expedited initial claim. Companies could then make further claims as they incurred additional costs, finishing with a final true-up claim once they had full certainty over the amount they sought to recover.

Ofgem said it intends to return to the previous single claim process from the start of September. Along with the stabilisation of the energy market, it said the move a quarterly price cap period with shorter lead times as well as the introduction of measures such as the Market Stabilisation Charge and the ban on acquisition-only tariffs have removed the need for a multiple claim process.

As part of this reversal, Ofgem said it expects to return to a situation whereby companies seeking to become a Supplier of Last Resort make “competitive bids” in which they “waive some or all of their right” to make claims through the levy. However, the regulator said it plans to retain the requirement for claims to be subject to an independent audit.

Ofgem set a deadline of 7 September for outstanding final true-up claims. It said any claims submitted prior to this date will be assessed and decided upon this year, enabling suppliers to begin receiving the corresponding payments from network operators in the next charging year beginning in April 2024.

Price cap end date

Ofgem has confirmed its decision to remove the price cap end date in suppliers’ licence conditions, which was originally set at December 2023 when the mechanism was introduced. It will be replaced with new wording stating that the secretary of state will specify when the price cap ceases.

The regulator said it will also extend its price cap models to 2030 but emphasised that this is not intended to pre-empt the secretary of state’s decision.

Typical domestic consumption values

Finally, Ofgem has decided to update the typical domestic consumption values used by the government, regulator, suppliers and price comparison websites to quote typical household bills under different tariffs, including the price cap rates.

The new values, which have been reduced in most categories, are based on consumption data from 2019 and 2021. Ofgem decided to use data from 2019 rather than 2020 to exclude the impact of the Coronavirus lockdowns.

The regulator said it will begin using the new values immediately although suppliers and price comparison website should do so from the beginning of October.