Key Points
- Since 2019 the domestic retail energy market has, on average, been loss-making, as suppliers have been required to sell energy at a price below the amount it costs them to supply customers.
- Suppliers have made losses of around £4bn (Ofgem) due to instability in the market.
- Following Covid-19 and exacerbated by the Russian invasion of Ukraine, the wholesale price of gas rose sharply, at its peak to 20 times more than the levels seen at the start of 2020.
- 31 energy companies have since ceased trading due to these unprecedented price rises, adding additional cost to energy bills (£2.7bn at November 2022) and disruption to many customers.
- The Price Cap is set by Ofgem, and should ensure that customers pay a fair price that also reflects the underlying costs to supply energy. During high energy prices, the costs to supply energy increased materially from allowances expected in the Price Cap.
- The energy sector, like all businesses, needs to be financially stable. The scale and pace of these negative returns are not sustainable in medium-term; if more companies cease to trade, it will increase energy bills further.
- To address this issue, the energy regulator Ofgem has recently introduced several one-off and temporary steps to allow businesses to recoup unavoidable costs from wider market instability.
- This cost recovery will last until around March 2024, meaning profits may temporarily be higher than they have been, to partially offset previous multi-year losses.
- The level of returns seen this year are likely to be a one-off; more must be done to ensure the market is sustainable and able to invest in customer service and new technologies in the long term.
What is the Price Cap and how does it work?
The Domestic Gas and Electricity (Tariff Cap) Act was introduced in 2018 and requires Ofgem, the energy regulator, to design and implement a standard tariff cap. The Price Cap (“cap”) sets a maximum amount that suppliers can charge per unit of energy for customers on default tariffs. This cap is set at the amount Ofgem calculates it would cost for an “efficient supplier” to serve their customers. Running a resilient energy supply business requires considerable capital that needs to be raised by investors, so the cap calculation has included a theoretical modest profit margin of 1.9% to reflect that investment.
Average domestic EBIT margin (% weighted average)
Source: Ofgem. Figures above based on unaudited estimates.
The cap has forced suppliers to sell energy at a loss
In reality, far from achieving 1.9% profit margins, on average domestic retail energy suppliers have been loss-making since the introduction of the cap at the start of 2019 -, contributing to over 30 suppliers exiting the market when wholesale prices spiked. Ofgem has stated that these losses total £4bn over the last four years underlining how the cap has forced suppliers to sell energy at a loss.
The cap is based on complicated calculations and estimates of the many different costs involved in supplying energy. The dual economic shocks of Covid-19 and the energy crisis have made estimating these costs ahead of time extremely challenging. Ofgem acknowledges that this has resulted in price caps that have been too low and has therefore included some additional allowances in the current cap to help offset those losses.
What has been done to the cap to allow suppliers to recoup their costs?
Ofgem has introduced two allowances so suppliers are able to recoup some of the observed costs they incurred from selling energy at a loss during the pandemic and through rapidly rising wholesale prices, as these costs are not recoverable through other means. These allowances are known as “Backwardation” and “Covid-19 True-up”. To reduce the immediate impact on customer bills, recovery of these costs has been allowed over 12 months, which means that costs incurred in 2022 will be predominantly recovered in 2023.
On top of these allowances, Ofgem has also implemented a Market Stabilisation Charge (MSC) designed to ensure that when a customer switches to a new supplier, their old supplier is able to recoup some of the costs resulting from having purchased expensive energy in advance for customers that will no longer use it. This is important as it ensures suppliers continue to have an incentive to hedge responsibly on behalf of customers.
- Covid-19
Ofgem recognises that suppliers incurred significant costs during the pandemic as a result of higher customer debt and associated capital requirements, and they were unable to recover these through the existing cap during the main Covid period from April 2020 to September 2021. As a result, Ofgem has amended the cap temporarily until March 2024 to reflect these additional costs incurred during Covid. - Backwardation
Energy suppliers buy energy for their customers on wholesale markets. To limit the impacts of price volatility, suppliers purchase energy months in advance (known as “hedging”). In setting the price cap, Ofgem observes the average price of these hedges and uses this to set the level of price cap suppliers are able to charge their customers. However, suppliers are unable to hedge 100% of their customers’ energy use (for example, due to uncertainty over weather and demand). This means some energy is inevitably purchased nearer to the time of use.
During this period of extreme price volatility, which at times resulted in a wholesale gas price 20 higher than it had been at the start of 2020, suppliers needed to buy energy at considerably higher prices than they were allowed to charge customers. Ofgem’s backwardation allowance is designed to compensate for this significant shortfall. - Market Stabilisation Charge (MSC)
Another reason suppliers are at risk when purchasing energy is that a customer may switch to another supplier before using the energy already bought for them. In a market with falling prices (as seen so far in 2023), this would mean the supplier would be holding expensive energy, responsibly purchased ahead of time on behalf of the customer, which it could no longer sell for a fair price. The MSC has been introduced temporarily to account for this issue. It is a charge that only applies when the price of energy has fallen significantly below the price used to set the Price Cap. It is similar to an exit fee, designed to cover some of the costs incurred in purchasing the energy the customer no longer requires, but paid for by the new supplier to previous supplier, rather than by the customer.
Longer term, the energy retail market needs to be financially sustainable
These allowances will result in a short-term stabilisation of the sector – enabling suppliers to improve their financial resilience and invest in customer services. However, they are not a long-term fix to the systemic issues facing the market.
Energy suppliers have a connection with almost every home and business in the UK. The retail market however needs reform and attention from all parties. Policymakers and the energy sector need to work together to create a market that is financially stable, that can innovate and ensure the most vulnerable are not left behind. Every failure of a company in the market increases costs on customers through more expensive bills.
