Ofgem has proposed to raise the allowance for wholesale risks within the methodology for setting the price cap on default tariffs.
The regulator said an increase may be necessary to reflect higher shaping and imbalance costs for suppliers and growth in the number of customers defaulting to standard variable tariffs due to the “unprecedented” increase in wholesale gas prices this year.
Ofgem presented this as its minded-to position in one of a series of five consultations released by the regulator on Friday (19 November) after chief executive Jonathan Brearley promised to review the price cap methodology in an open letter to industry at the end of last month.
The consultation explained that the price cap methodology includes both a core direct fuel allowance and an additional wholesale risk allowance – currently set at 1% of direct fuel costs – to reflect the “uncertain and volatile” nature of wholesale costs.
“The scale and pace of the rising wholesale prices observed in recent months is unparalleled in the GB energy market,” it stated. “The additional costs and uncertainties facing suppliers are likely to be beyond what is accounted for in the cap in the existing methodology.”
In particular, Ofgem said suppliers may face materially higher costs from “shaping” as they refine their hedged trading positions with more granular contracts as they move closer to delivery, along with higher imbalance costs if they are unable to precisely match supply and demand.
“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,” the regulator added. “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.”
It said its preliminary analysis suggests that for the current price cap period these costs have risen by £5 to £20 per customer per year based on typical domestic consumption values.
Ofgem said suppliers may also be experiencing higher costs due to an increase in the number of customers defaulting onto standard variable tariffs.
Although the price cap was never meant to represent the cheapest tariff available on the market, the regulator said the rise in wholesale prices has resulted in the fixed tariffs on offer being priced “well above” standard variable tariffs.
Most suppliers are therefore likely to be seeing more customers than could have been reasonably expected roll over to standard variable tariffs when their fixed price deal comes to an end. Procuring energy to cover these “unhedged and unexpected” tariffs is likely to cost more than is currently allowed under the price cap.
Ofgem said its initial estimate is that the additional cost equates to around £700 per customer per year if they are fully unhedged, or £60 per customer per year when spread across suppliers’ default tariff base.
However, Ofgem said its engagement with industry has found that some efficiently run suppliers have been able to limit their exposure to these additional costs by 70% by adapting their hedging strategy early to reflect the expected increase in the number of standard variable tariff customers.
On this basis, the regulator said an upward adjustment of £20 to £25 could be considered reasonable. It acknowledged that not all suppliers may have been able to limit their exposure to 30% but said an assumption that they have been fully exposed may also be an overestimate.
Ofgem said the aforementioned cost increases will have been partially offset by reduced costs from the Contracts for Difference (CfD) scheme which are determined by the difference between generators’ strike prices and the reference price for wholesale electricity.
The regulator said it currently expects suppliers to recover £16.66 more per customer than the CfD allowances over the 12 months covered by the current price cap period and the previous one that ran to the end of September. It therefore expects to apply a downward adjustment to the price cap of £15 to £20 per customer.
Ofgem said it is also open in principle to applying an adjustment to reflect additional costs resulting from backwardation – the situation in which the price of forward contracts is lower than expected spot prices.
The regulator said the current design of the price cap assumes that over time these costs will be offset by those resulting from contango – the opposition situation in which the price of forward contracts is higher than the market expects spot prices to be when the contracts are delivered.
It said it would welcome evidence from the industry that the costs of backwardation currently seen in the market “represent a clear, material and systemic departure from the assumption that the net costs approximate zero over time.”
Ofgem said the consultation on wholesale volatility will not cover direct fuel and Capacity Market costs as they are already appropriately reflected in the price cap methodology, or costs associated with unidentified gas or the recent introduction of a unique end user category for domestic gas customers, both of which are being considered separately in the another of the five consultations released on Friday.
The regulator likewise said it will not consider the industry levy to pay for cost-recovery claims by suppliers of last resort, which it recently set out plans to expedite, although it will watch out for the possibility of “double counting” these claims through adjustments to the price cap methodology.
Ofgem said any adjustment to the wholesale risk allowance would be implemented for the next price cap period beginning in April 2022 and would take into account any surplus against the current 1% rate that suppliers have accumulated over previous periods.
As it would be informed “atypically volatile market conditions,” the regulator said any adjustment would be considered an interim measure and reviewed within 12 months of a decision.
At the same time, Ofgem noted that “shocks like this could happen again” and said it will therefore conduct a wider review of the design and operation of the price cap, the details of which will be set out in the coming weeks.
“As energy markets are inherently volatile, it is not possible to eliminate risk in the market entirely,” it remarked.
“However, the exceptional market conditions experienced this year prompts a need to think more fundamentally about the role of an energy price cap in protecting customers, and the balance of risk that industry and consumers should bear.
“In carrying out a review of the design of the price cap, we will need to consider key trade-offs related to the price cap design.
“These include whether the current eight-month lag between wholesale prices and their reflection in the price cap is optimal which, along with the price cap’s use of 12-month forward contract prices, exposes suppliers to costs and risks that are hard to manage at times of price volatility, whilst limiting the risk of price spikes for default tariff consumers.”
In another of the five consultations, Ofgem also set out proposals to modify license conditions to allow it to amend the cap outside of its routine six-month cycle in exceptional circumstances.
It said these circumstances would need to be rare, either in terms of their frequency or scale, and have a high impact without urgent action, leading to irreversible effects on the energy market or having systemic consequences.
Ofgem stressed that in-period adjustments should not replace the need for suppliers to proactively manage risks or allow them to pass through costs to customers when they could have been avoided: “For example, if the proposed provision had been available in the current market circumstances, we would not have used it to adjust the cap to reflect the wholesale costs of suppliers who had not effectively hedged their expected demand.”
It said any adjustments would be forward-looking, meaning they would only apply to the remainder of the current cap period.
The other topics covered by the various consultations included the price cap allowance for the Energy Company Obligation and the true-up process for costs related to the coronavirus pandemic.