Energy price cap will fall in April, says Ofgem

Ofgem’s is reducing its controversial energy price cap by 1.4% from April 1st the regulator has announced. Read on for analysis from Selectra.

What is the energy price cap?

The energy price cap is a limit on both the amount suppliers can bill per unit of electricity or gas and the price of the daily standing charge.

It doesn’t mean there is a maximum amount your supplier can charge you, rather it determines the amount an “average UK household” can expect to pay for using a “medium amount” of energy annually, you will still have to pay for all the energy you use.

This latest reduction means the theoretical “average bill” for 11 million households on default tariffs and 4 million on prepayment meters will be reduced by £17.

Ofgem chief executive Jonathan Brearley said the cap was intended to protect customers who fail to switch from poor-value tariffs while at the same time “encouraging competition in the retail market.”

“Suppliers have been required to become more efficient and pass on savings to consumers,” he said.

“In its first year, the cap is estimated to have saved consumers £1bn on average on their energy bills and switching rates have hit record levels.”

However, the cap doesn’t apply if you’re on a fixed-rate tariff or if your tariff includes environmentally-friendly renewable energy obligations, it’s only relevant to you if you're on a standard variable tariff (SVT) and have a standard or smart meter.

The default price cap for SVT customers will be lowered from £1,179 to £1,162. This adjustment will run until September 2020. It’s the third time the energy watchdog has changed the cap since it was first introduced.

The price cap for prepayment meter customers was introduced in April 2017 and is to be reduced from £1,217 to £1,200 per year for a dual fuel customer with typical usage for the six month period from April to September.

Why is Ofgem lowering the energy price cap now?

Unlike us common folks, gas and electricity suppliers are not on quarterly Direct Debit payment schemes and they don’t pay through the nose for their energy via prepayment meters.

Instead, they buy what are called “forward contracts.” This means they work out how much electricity and gas they anticipate they will need, then buy it in advance on the wholesale market.

Ofgem closely monitors this wholesale trading and adjusts its price cap according to how much suppliers have spent on the forward contracts.

The regulator uses the prices paid in the previous six months to determine the level of the energy cap for the following six months.

Thanks to an over-abundant supply of gas, wholesale energy prices fell between August 2019 and January 2020. So, Ofgem calculated that the actual cost of wholesale energy needed to meet the average household’s needs, as per the default tariff cap, dropped by around £38 from £446 to £408.

As other operating costs for suppliers such as network charges, smart meter installation costs and government levies increased to £22, the regulator decided on a net reduction of £17 in the level of the default tariff cap.

How does Ofgem calculate the energy cap?

The price of wholesale gas and electricity is only one factor in the final price suppliers charge to customers and therefore in Ofgem’s considerations when setting the level of the price cap.

The price also includes:

• The cost of building and maintaining the energy infrastructure, the network costs.
• Levies to pay for the government’s energy saving, emissions reduction and renewable energy schemes, known as policy costs.
• The money spent to run the billing and metering systems, including smart meters, these are the operating costs.
• Something called headroom allowance, which is supposed to give suppliers some flexibility in how they set their tariffs and how they manage unforeseen costs.
• A VAT level of 5% added to the tariff.
• A rate of return to allow suppliers to make a profit known as Earnings Before Interest and Taxes (EBIT).

Ofgem then calculate the rates an “efficient” supplier should be charging a “typical” domestic customer with “medium” energy use.

From April to September 2020, the default price cap will be calculated at 18p per kWh for electricity customers paying by Direct Debit or by prepayment meter. For gas, the figure is 4p per kWh for Direct Debit and 3p per kWh for those with a prepayment meter.

How will the price cap help someone who never switches?

The intention of the price cap, which was introduced in January 2019, was to stop firms exploiting customers. However, the cap is set so far above the lowest tariffs on the market that any benefit from it is dwarfed by the savings available to those who shop around.

Despite the multitude of offers on the market, many people stick with energy suppliers long-term either because they aren’t aware of how much they could save or because they believe switching is more difficult than it actually is.

How does the cap affect someone who is always hunting for the cheapest tariff?

The energy price cap itself doesn’t directly benefit you if you take advantage of the market to find yourself a better deal, but it may make you more likely to switch.

Ofgem attributes 2019’s record rates of customers moving to cheaper suppliers to the introduction of the cap.

The cap means the market as a whole is artificially restrained and the cheapest prices on offer are probably lower than they would be in a less-regulated market in which tariffs would likely creep ever-upward.

How does the energy price cap affect prepayment customers?

People on prepayment meters often tend to be more vulnerable, have difficulty making ends meet or budgeting their money and in danger of fuel poverty.

Paying for energy upfront means they can avoid unexpectedly large bills arriving along with threats of disconnection for non-payment.

Unfortunately, these customers are also punished for relying on prepayment meters, paying higher prices per unit of energy compared to the better off who can afford the unpredictability of Direct Debit or other forms of payment.

While the energy price cap prevents firms from squeezing too much out of prepayment customers, the regulator could squeeze the firms themselves a lot more to make things fairer for the people who can least afford to be exploited for the sake of corporate profits.

Is the energy price cap effective?

When the cap was introduced, Ofgem looked at how the six largest suppliers had priced their default tariffs in the previous four years.

Its research found that the average standard variable tariffs of the firms would have been £75 to £100 cheaper if the cap had already been in place. The implication being that, without such a cap, those firms and others would have gone on charging way above the tariffs Ofgem would expect from an “efficient” supplier.

However, poor-value-for-money suppliers haven’t improved that much and the cap’s impact may be more significant in terms of its secondary effects.

According to consumer advocate organisation Which?, there has been an 80% increase in the number of sub-£1,000 energy deals on the market compared to January 2019 when it was introduced.

The five-fold proliferation of cheaper tariffs meant there are 63 better-value tariffs on offer compared to just 12 the year before.

What’s more, the 50 best-value tariffs now on the market are on average £103 cheaper than the 50 lowest-priced deals in January 2019. While last year there were no offers under £900 a year, in 2020 almost 20% of the cheaper deals come in below this amount.

That said, out of 55 tariffs that were offered both in January 2019 and in 2020, 29 have actually increased in price, another example of suppliers treating the price cap as a target rather than a limit.

The price cap is enforced by Ofgem and it monitors suppliers to make sure they’re meeting their obligations.

It has already taken action against those who fall short of its reequirements, with £3m worth of compensation retrieved from four suppliers and, most recently, it has opened a formal investigation into how well Utilita Energy manages the price cap.

What’s a better way to save on your energy bills?

Ed Dodman, the director of regulatory affairs at Ombudsman Services, which runs the Energy Ombudsman scheme, said the reduction in the price cap “shouldn’t discourage people from shopping around for better deals.”

“When switching, we would encourage consumers to look at the customer service they can expect to receive as well as how much money they could save,” he said.

The default price cap was brought in as a temporary measure and its future is not guaranteed. Ofgem is planning to review it over the Summer and give the secretary of state a recommendation as to whether it should be removed or kept in place beyond 2020.