Energy consumers 'better off' under UK quarterly tariff cap regime: Ofgem

The UK's national energy regulator, Ofgem, has said its proposal to adjust the Default Tariff Cap for household gas and electricity supplies on variable rates to a quarterly regime will leave consumers "better off".

Following the launch of a consultation into the shift from seasonal to quarterly focus, Ofgem commissioned the NERA consultancy to compile a "distributional impact analysis" of the proposals, which are scheduled for effective launch from October if approved.

"Our analysis, based on stochastic modelling of current energy prices forecasted forward shows that customers are expected to be better off under the quarterly updates, reduced notice period and backwardation costs approach compared to the status quo," it said in a late June 8 statement.

The proposed changed would result in an average GBP43/year saving for households assuming dual-fuel usage, it said, with top income decile households saving GBP55/year, and bottom decile saving GBP40/year.

Ofgem also tested the new quarterly model against what it called an "alternative forward curve," simulating a more stable market, and found that the methodology change would have "virtually no impact."

"This is consistent with the fact that our proposals have greatest effect in times of volatility and high prices, such as those we are currently experiencing," Ofgem said.

Proposal

The tariff cap currently operates under a complicated formula, utilizing data from a six-month observation window for front-season valuation, a two-month lead time from the cap's announcement to its implementation, and an assumed hedge of 12 months.

Under the new proposals, a three-month observation window will be used for front-quarter valuation, with a maximum of one month lead time examining a "12 month price reference period."

With respect to backwardation costs, Ofgem's model incorporated the addition of supplier expenses in hedging a forward contract to remedy any disparity between this and the revenue it is possible to recover, distributing these costs over a 12-month period for the purpose of the cap.

"Backwardation costs occur when the forward period for the price suppliers can charge is different to the forward period a nominal supplier would use for its hedging," Ofgem said.

"When the market is in backwardation, the forward prices in the later six months are lower than in the first six (the actual cap period)," it continued. "It brings the cap level below the cost to suppliers of purchasing that energy for customers (for that cap period)."

It defined a "stable market" as one which exhibits a traditional contango, where risk premium is applied to later dated contracts due to uncertainty in delivery, while also acknowledging that amid the current market volatility this "may no longer hold true."

"Given backwardation is a cost that suppliers incur to serve their customers, we propose to include it in the wholesale methodology," it said.

Backwardation was cited by many critics of the tariff cap as a contributor to 29 independent UK energy suppliers becoming insolvent since wholesale prices entered a new era of extreme highs and volatility since October 2021. Many of these businesses were built upon a strategy of sourcing gas on prompt markets as risk premium erodes closer to delivery, and may not have had the capital to hedge seasonal or quarterly contracts.

The regulator hinted for the first time that the new proposals could come into force effective from Oct. 1, 2022 in its analysis. Market sources have told S&P Global Commodity Insights that an introduction after Oct. 1 would be too late to avoid the worst retail prices for consumers.

'Alternative' forward curve

In examining the model against its "alternative forward curve", Ofgem assumed stable market conditions comparable to the first six tariff cap periods since its introduction in 2019, but disregarded the latest forward curve in 2022.

"This has been estimated by taking the five-year average of the historical seasonal forward curves between 2017 and 2021 grouped by winters, summers, peak and baseload for electricity and by deriving gas forward prices based on regression analysis," it said.

While the move to quarterly updates would have no impact of consumer bills, the incorporation of backwardation costs "would result in a small increase in consumer energy bills relative to the status quo," Ofgem said in its analysis.

It concluded by saying that using the alternative forward curve resulted in a 1% increase in a typical energy bill once backwardation costs had been incorporated.

According to Platts Market on Close assessments by S&P Global, which have historically proven to be close to Ofgem's assessments of wholesale price in the observation window, the average forward Summer 2022 NBP gas price was 123.569 pence/therm.

For this coming winter, the NBP front season has averaged 244.448 p/th since the current observation window opened in February. The NBP Q4 2022 contract has averaged 231.936 p/th in June-to-date, the start of the proposed quarterly window, and since April 1 has recorded a 241.91 p/th mean.