UK regulator Ofgem launches consultation into gas, power price cap

The UK's national energy regulator, Ofgem, has opened a consultation into the default tariff cap for domestic retail gas and power supply, it said in a Nov. 19 statement.

Amid record-high prices and unprecedented volatility within the wholesale market for energy, Ofgem said it needed to consider changes to the cap's design "in order to consider and possible unintended consequences," adding that it needed to focus on "targeted changes" to reflect the current circumstances.

"We are consulting on whether the recent rise in wholesale prices has caused the level of the price cap to materially depart from the efficient cost level allowed for in the price cap," Ofgem said.

"It is in the interests of both consumers and industry to ensure that the price cap appropriately reflects the costs, risks and uncertainties facing suppliers."

Ofgem invited industry stakeholders to provide evidence of the extent their costs are reflected within the methodology, as well as encouraging responses from suppliers, consumer groups, other stakeholders and the public. The consultation will run until Dec. 17, 2021, and changes to the methodology could be implemented as soon as April 1, 2022, the regulator said.

Since September, a number of small UK energy suppliers have ceased to trade in the market environment, and it is feared more will become insolvent if prices remain high.

Some industry observers have noted how the wholesale price of natural gas, consideration of which makes up around 40% of the gas tariff cap, may have risen to such an extent that it would be unprofitable to sell supply on the retail market if their revenues are limited by the cap.

Focus

With the current market conditions bringing the cap's effectiveness and suitability into sharp focus, facets of its design are now to be examined, such as the eight-month lag between wholesale price movements being reflected in the cap itself.

"This limits the risk of price spikes for default tariff consumers, but in periods of price volatility exposes suppliers to additional costs and risks that are challenging to manage," the statement said.

The consultation will consider what kind of reform would "best deliver fair prices for consumers... while enabling us to have a regard to supplier's financeability of efficient costs," it said.

Ofgem also mentioned that they would need to consider how the price cap would evolve as mandatory half-hourly electricity settlement moves closer. A separate entity within Elexon was approved by the regulator, also on Nov. 19, for this purpose.

The statement went on to say that Ofgem wished to consult on how the cap allows for uncertainty in establishing consumption hedges, and how to account for unparalleled changes in the energy market.

"Suppliers incur costs related to forecasting demand before refining their positions by converting from less to more granular forward contracts closer to delivery," it said.

"The current cap methodology includes a range of additional direct fuel allowances to allow suppliers to recover these costs," it continued. "These allowances are indexed, based on an assessment of historic costs conducted when the cap methodology was designed."

"Given these additional allowances are indexed to direct fuel costs, the monetary value of these allowances will increase irrespective of any adjustment from 1 April due to the higher wholesale prices."

Ofgem also said that it expected suppliers would be facing higher costs due to imbalance costs, as well as unexpected demand for Standard Variable Tariffs (SVTs), the kind protected under the default tariff cap.

"Suppliers may have seen a material and sudden increase in the number of customers defaulting from fixed-term contracts to SVTs," it said.

"As many suppliers hedge far in advance, the higher numbers of customers defaulting onto SVTs is likely to be beyond what suppliers would have reasonably expected and hedged for."

"As such, suppliers may need to procure much of this unanticipated SVT demand at short notice, and at prices above the current cap level," it continued. "However, some suppliers may have at least partly anticipated this risk and adjusted their hedging strategies to reduce these losses."

The regulator also acknowledged that Contract for Difference (CFD) costs faced by suppliers are currently materially lower than the cap accounts for.

In launching the consultation, the regulator also published its own 'minded-to' position on the matter, giving an indication of what reforms it is likely to decide upon should stakeholder responses support its position.

"Our minded to position is to introduce an upward revision to the wholesale additional risk allowance as an interim solution," Ofgem said. "This recognizes the fact that we do not yet know the duration for which the current period of higher costs and volatility will continue. We would then propose to review the adjustment as part of a wider ranging review of the price cap."

"We consider that an adjustment to the wholesale additional risk allowance is the most appropriate near-term change to update the cap on the basis that this allowance is specifically targeted at allowing efficient suppliers to recover uncertain wholesale costs. This option also allows us to introduce a change to the cap from April 2022, if we determine it is appropriate to do so."