“Customers to pay less for energy bills from summer,” trumpets UK energy regulator Ofgem this morning.
From 1 July, the energy price cap will be set at an annual level of £2,074 for a dual fuel household paying by direct debit based on typical consumption, which reflects recent falls in wholesale energy prices.
The new price cap represents both a reduction in last quarter’s cap, and also a reduction in how much customers will pay on their bills. Since October 2022, consumers have been supported by the Government’s Energy Price Guarantee, which caps the typical bill at £2,500.
Hooray! Wait, what’s this bit?
These changes mean that energy suppliers will need to be able to raise more capital and, to be able to do that while still being able to make a reasonable profit within the price cap, Ofgem is proposing that the element of the price cap that covers profit margin – known as Earnings Before Interest and Tax (EBIT) – will see a small increase.
Under these plans, the EBIT allowance will allow an efficient energy supplier to make a reasonable profit that reflects its business model and ensure it can be investable in the long term, while keeping a lid on excess profits.
For the October price cap, the EBIT allowance is indicatively expected to be £37 for the typical bill. Under the proposed changes, the EBIT allowance in the typical annual bill would be around £10 higher, with the new EBIT allowance being set at around 2.4% of the full price cap level in that period. By contrast, supplier failures during the gas crisis cost each household an average of £83 and Ofgem is determined not to see a repeat of this situation.
The energy EBIT allowance is controversial, so might have merited more attention than it’ll get tagged onto the price cap announcement.
At the moment, UK energy retailers have a pre-tax profit margin limited to 1.9 per cent. Suppliers have been moaning that a fixed rate made hedging for volatile markets uneconomic so contributed to last year’s wave of supplier failures. British Gas owner Centrica said in January, in a spiky letter to the regulator, that the shakeout of its smaller rivals had . . .
… exposed fundamental flaws in domestic energy retail market design and regulation, at huge cost to consumers. On the regulation side, suppliers have been permitted – even encouraged – to offer below cost unhedged tariffs and use customers’ money to run their businesses. With consumers being encouraged to focus on price above all else, and healthy competition being judged solely on switching, the result was a race to the bottom.
Ofgem’s proposed solution amounts to a regressive energy tax. Adding a variable rate element means that while the typical profit per customer will be about £10 higher, frugal energy use may mean paying relatively more per therm.*
You’d probably not spot that from the reams of documentation published this morning, however. The below chart is in an appendix on page 88 of the consultation document:
There’s also a table showing the working. In essence, the higher profit allowance inflates consumer bills by £227mn in a “low price scenario” (the current base case) but also results in fewer failures, probably, so saves them £132mn. There’s no detail given to show how the latter figure was estimated:
A maze of tariffs options and loyalty penalties complicate the impact assessment. Here are the some vulnerable customer estimates:
This is all quite good news for Centrica, which has a 20 per cent UK electricity retail market share. Simplistically, an extra £10 per household boosts its annual EBIT by about £56mn. Here’s Citigroup:
The move to a cap and floor mechanism with absolute minimum £/customer (£20) linked to an extent to commodity prices to the upside should be well-received as this will essentially protect earnings in a falling commodity price environment and allow upward escalation should prices increase [ . . . ]. Ofgem is now consulting on its position and if confirmed, we expect potentially 40+% uplift to consensus energy retail EBIT at Centrica
At pixel Centrica shares are up nearly 5 per cent to 118.95p, its highest since 2019, on approximately five times the average daily volume.
* Update 2:45pm BST: An Ofgem spokesman disputes that its cap proposals would be regressive based on usage, saying: “You have mistakenly interpreted that the fixed component of the proposed EBIT allowance (£19 out of £47 expected for 11a [the period between October and December 2023]) directly flows to the standing charge. This is incorrect. In reality, we propose to set the EBIT allowance in a way that keeps the current cap ratio of standing vs unit charge the same.”
The relevant parts of the consultation are section 6.7 and 6.8, which concern the ratio of standing charges to unit charges. It says:
We are minded to implement the EBIT allowance in the nil consumption cap charge on an equivalent percentage basis, so that the existing ratio between standing charges and unit charges is preserved. The formula for EBIT in the nil consumption cap will be set as: 1. Nil consumption EBIT = typical consumption EBIT for period / typical consumption allowances for period * nil consumption allowances for period
Indicatively for 11a this would be £1.32 higher than the status quo, increasing the standing charge as a whole by 0.45% compared to under the existing 1.94% allowance. For simplicity, we are minded to set the fixed components for electricity and gas as 50% of the total fixed component, with the scalable component the same percentage for each. We are minded to set the multi-rate electricity cap with the same fixed and scalable components as the single rate electricity cap.