Ofgem has revealed the new price cap level from April of £1,971 per year includes a £61 uplift for wholesale costs incurred during the current six-month period.
The adjustment will also apply to the following price cap period beginning in October.
Ofgem said the corrective measure is intended to reflect exceptionally high wholesale costs and market volatility that were “beyond what was accounted for” in the seventh price cap period from October 2021 to March 2022.
It said the adjustment will be applied as uplift to the existing wholesale additional risk allowance, which is normally set at 1% of direct fuel costs but will be raised to 8.7% for electricity and 6.1% for gas for the eighth price cap period covering April to September 2022.
The allowance will equate to £71 for a dual fuel customer, comprising £10 for the original value of 1% of direct fuel costs plus adjustments of £34 and £27 for electricity and gas respectively.
Ofgem said the absolute value of the adjustment will be the same for all meter types and payment methods, meaning the percentage uplift will differ slightly between them.
By far the largest component of the £61 uplift is a £41 adjustment for unexpected demand from customers shifting onto standard variable tariffs (SVTs) as they became cheaper than fixed price deals due to the price cap – £18 for electricity and £23 for gas.
Ofgem said the volume of customers choosing to roll-over onto SVTs when their fixed price tariff expires has “increased considerably compared to historic norms.” It said evidence from suppliers showed the number of customers on standard variable tariffs increased by around 16% between 1 October 2021 and 1 January 2022, with seven retailers reporting combined additional costs of £650 million.
The regulator said it expected suppliers to take mitigating actions through procurement and hedging decisions but they have seen a higher volume of customers move onto SVTs than could have “reasonably been predicted and hedged for, especially since August 2021.”
“For this higher-than-expected volume of SVT customers, suppliers will have had to procure this additional demand for delivery in cap period seven at a higher cost (likely above the current cap level) given recent wholesale price increases,” it added.
Ofgem noted that suppliers with a higher starting proportion of customers on fixed-term contracts will have been more exposed to this trend.
The uplift also includes £8 of exceptional backwardation costs – £4 each for electricity and gas.
To reduce seasonal fluctuations, the price cap is determined based on forward prices over a whole year.
Ofgem said this typically results the under-recovery of costs during over winter when wholesale prices are higher than over the following six months – a phenomenon referred to as backwardation. It said when the price cap was first introduced, this deficit was assumed to be balanced out in the long run by over-recovery during summer periods when there is the opposite phenomenon known as contango.
The regulator forecast the under-recovery for the current winter at £24 per customer but said £16 of this would fall within the normal range of backwardation costs that suppliers can expect to recover through contango over the summer.
The uplift additionally includes a £12 adjustment specific to electricity for additional shaping and imbalance costs as supplier refine their hedged positions with more granular contracts as they get closer to delivery.
“Shaping costs will depend on wholesale prices near to consumption and how these compare to the price at which a supplier bought the bulk of its wholesale energy,” Ofgem explained. “As wholesale spot prices have increased sharply, we expect the costs of shaping and imbalance may therefore have also increased during the current cap period.”
The overall £61 uplift is significantly higher than the £25 to £45 range proposed by the regulator in a consultation in November, partly because of even higher prices and volatility over the intervening period but also because its decision not to include an offset for reduced Contracts for Difference costs.
Under the Contracts for Difference scheme, generators benefit from a guaranteed price for electricity they produce, receiving top-up payments via a supplier levy when wholesale prices are below this level. However, they must also return the excess when wholesale prices exceed the strike price.
The Low Carbon Contracts Company (LCCC) recently announced that it expects to hand back £39 million to suppliers after the final quarter of 2021 became the first in which generators returned more than they received. The Interim Levy Rate has been set at £0/MWh – the lowest allowed by regulations – since the LCCC made an in-period adjustment in September.
Nevertheless, Ofgem has decided not to include a corresponding offset within its price cap adjustment after the majority of suppliers told the regulator they had fully hedged their exposure to CfD costs.
Whilst acknowledging that suppliers which had not done this would see a benefit, Ofgem said it does not want to “penalise suppliers with prudent risk management strategies in place” and it cannot set the price cap at different levels for different suppliers.
As the price cap allowance for CfD costs is determined by the Interim Levy Rate, which cannot be lowered further, Ofgem said it does expect suppliers to see a £7 benefit per customer over the next period from the refunding of levies by the LCCC.
However, the regulator said it does not intend to claw back this money, which it said may offset other “additional and uncertain” costs that suppliers incur. It said it plans to amend how the CfD allowance is calculated in future to ensure it remains reflective of costs.
Ofgem also dismissed calls from suppliers for adjustments to reflect increased costs for Renewables Obligation mutualisation, unidentified gas, balancing charges and bad debt.
Its final decision on the uplift to the wholesale additional risk allowance was one of a raft of documents published by the regulator on Friday (4 January) following the announcement of the new level of the price cap from April.
They also included its decision to press ahead with the introduction of in-period adjustments to the price cap, a consultation on changes to way the price cap operates and updates on its plans to improve the financial resilience of suppliers.