Ofgem is considering introducing a “dynamic” price cap to encourage consumer flexibility.
It is one of several options being mooted by the regulator in a new discussion paper on the cap’s future, as the market evolves into a smarter and more flexible system.
Other options being considered include a more targeted cap, as well as replacing the cap altogether with a ban on acquisition only tariffs (BAT).
While it argues the cap, along with the temporary BAT, has worked well to protect customers from the loyalty penalty and from the worst of the recent market volatility, it acknowledges that energy retail markets are changing as increasing numbers of consumers adapt their consumption and begin using low-carbon technologies.
Furthermore, it explained, the increasingly renewables-dominated electricity sector will reward consumers for shifting their consumption patterns.
Ofgem added: “The price cap has helped to drive down supplier costs and protect consumers from a volatile market.
“However, as we reflect on lessons from recent significant market volatility, and look to a future where the retail market will need to be considerably more dynamic, it is clear that the cap in its current form has some limitations and reform is needed to ensure it can continue to protect consumers as the retail market evolves.”
Explaining its rationale further, Ofgem said the introduction of Market-wide Half-Hourly Settlement (MHHS) from 2025 will enable flexibility by exposing suppliers to the true costs of their customer’s electricity consumption patterns.
Customers with a higher proportion of consumption during peak periods will become more expensive to serve, while those with lower peak consumption will be less expensive to serve.
However, it warned, the electricity unit rate under the current flat cap does not reflect these changes in cost during the day. Ofgem said consumers need to be encouraged to flex their electricity use where possible, but the sector also needs to consider how to protect those who are unable to engage.
Those consumers able to flex their demand will have an incentive to move to a time of use (ToU) tariff, reducing their bills. Yet those with high-cost patterns of consumption will have an incentive to either stay on or switch to the flat default tariff which protects them from the high costs of their consumption patterns.
Ofgem said that over time this could lead to a “selection effect” where price caped customers are increasingly those with a higher cost to serve.
As such, it is proposing several alternative price protection solutions that could help address some of the challenges.
These include introducing either a static or dynamic ToU price cap.
A static ToU cap, Ofgem said, would have a number of time bands. For example, there could be two weekday periods and two weekend periods with each day divided between peak and off-peak hours. The tariffs for each period could be set quarterly, as per the existing cap
A dynamic ToU price cap on the other hand would likely combine non-dynamic tariff elements, calculated in the same way as the existing price cap, alongside unit rates based on market prices set a day ahead.
Under this scenario half-hourly periods could be grouped as per the example for static ToU. However, dynamic rates for each period would be updated daily to reflect market prices using a published index.
Ofgem said: “By substantially reducing the risk of suppliers being exposed to costly consumption patterns of their customers, a dynamic ToU tariff would likely enable lower headroom and profit allowances. It could also reduce suppliers’ hedging requirements and the associated costs.
“Dynamic ToU tariffs would maximise the incentives to align household electricity demand with market conditions, delivering a more stable and low-cost energy system.”
Yet the risks of this approach include exposing customers to wholesale price variability.
Peak prices would often be determined by weather patterns and therefore would not always be predictable. Ofgem further warned that many consumers may struggle to engage with constantly evolving pricing.
Additionally, to protect customers from very high wholesale peak prices at times of system stress, an absolute cap could be retained.
Another option being considered is replacing the cap with a ban on acquisition only tariffs.
The BAT was introduced alongside the Market Stabilisation Charge (MSC) to ensure fair competition as wholesale energy prices began to soar.
Alongside its price cap announcement last month, the energy regulator revealed that it will extend the ban for another 12 months, but added it intends to open a consultation to consider shortening this extension to just six months.
In the absence of an absolute price cap, the BAT may reduce prices for default customers as suppliers may be less likely to charge default tariff customers a premium to subsidise below cost acquisition tariffs.
Yet Ofgem warned that default tariff customers could still be used to subsidise below cost tariffs offered to all customers on the assumption that they would be unlikely to take up the tariffs offered.
It added: “In this respect, the BAT has a much weaker impact on reducing price discrimination than a relative price cap. However, there are drawbacks to the BAT. Despite promoting sustainable competition, it also has a more general dampening effect on competition as it reduces customers’ incentive to switch.
“This can have a knock-on impact on innovation as the incentive to launch innovative offerings to attract new customers is reduced.”
Other options being considered include the introduction of a targeted cap for vulnerable customers, more flexible, market based price protections such as setting a limit between a supplier’s default tariff and tariffs available in the market and capping the margin suppliers are able to make.
Tim Jarvis, Ofgem’s director general of retail and markets, said: “While the price cap played an important role in protecting consumers from the loyalty penalty that existed before its introduction, the energy market is changing as we move to net zero, and we recognise the systems we have in place may need to change too.
“We’re looking in detail at the elements of the price cap that have worked well and the challenges we’ve identified in recent years, while also considering how a wide range of future consumers will use and pay for energy to make sure we develop the right measures that will protect and benefit consumers across the board.
“We will continue to work with government, industry, consumer groups, charities and the public on the future of pricing regulation. Our aim is ensure the market works for everyone.”
Ofgem’s discussion paper complements the government’s call for evidence on default tariffs published last month.
Elsewhere the regulator has also published its price cap programme of work which focuses on whether to levelise bad debt charges between direct debit and standard credit customers, reviewing suppliers’ operating costs and how these are reflected in the price cap level, and further balancing of the bad debt related costs adjustment.