The Ofgem price cap is expected to deepen the cost of living crisis from October 2022 after the previous hike in April added two percentage points to inflation
One of the biggest drivers of the crisis has been soaring energy bills, which have soared for households and businesses in the wake of the Russia-Ukraine war and Covid lockdowns.
So how does the Ofgem price cap work – and how will it change?
What is Ofgem’s energy price cap?
Ofgem – or the Office of Gas and Electricity Markets – is the UK’s energy regulator.
Independent of government, it works to keep energy prices as low as possible, protect consumers and bring the UK closer to its net-zero goal.
Part of its role is to set a cap on which utilities can charge defaulting – i.e. variable by default – rates for a unit of energy to prevent them from being ripped off.
This includes consumers who have prepaid meters.
These variable tariffs tend to be more expensive than fixed tariffs and tend to be followed by the UK’s poorest and most vulnerable households – at least until 2022.
You’re likely to be placed on one if you’ve never switched providers, your fixed-rate term has expired, your provider has gone bust, or you’ve moved.
When you look at your energy bill, the price cap governs the maximum base fee and price per kWh of gas and electricity that your provider can charge you.
So what you’re being charged is almost certainly above the price cap, as it doesn’t set the maximum amount you’ll have to pay for your energy consumption.
How is the energy price cap calculated?
Ofgem determines its energy price cap by calculating how much it would cost a typical utility to power an average household.
To do this, it analyzes multiple factors affecting our energy bills, usage and market data over a period of time.
- Wholesale cost of gas and electricity (i.e. what it costs suppliers to buy energy)
- Network costs (e.g. what it costs suppliers to maintain energy infrastructure such as pipes and wires)
- Social and environmental obligations (e.g. the cost of complying with government climate regulations, including environmental taxes)
- Supplier operating costs and margin (about 2% of the average invoice below the price cap)
- Headroom allowance (an amount that helps suppliers meet unexpected costs, which in theory allows them to make competitive bids)
- taxes, such as VAT
The factor that led to the large increase in the price cap was wholesale costs.
These have more than doubled from an average of £528 for the 2021/22 winter cap to £1,077 for the 2022 summer cap.
Ofgem also said network maintenance costs have risen – a likely consequence of the UK supply chain’s woes – while political costs, such as the rise in the warm house rebate, have risen.
How will the energy price cap change?
Ofgem has confirmed that the energy price cap will be updated quarterly rather than every six months as it warned customers were facing a “very challenging winter”.
The regulator said the change would “help in some ways to ensure the stability needed in the energy market,” adding, “It’s not in anyone’s interest to see more providers fail and exit the market.”
It said Russia’s actions in Ukraine had led to volatility in the global energy market, which was experienced last winter and is “lasting much longer, with gas and electricity prices much higher than ever before”.
As expected, Ofgem warned that market conditions would mean increasing the price cap later this month to reflect increased costs.
However, the changes would mean that a fall in wholesale prices would be passed on to customers fully and more quickly with the quarterly price cap.
Ofgem Chief Executive Jonathan Brearley said: “I know this situation is of deep concern to many people. As a result of Russia’s actions, the volatility in energy markets that we experienced last winter is lasting much longer, with prices much higher than ever. And this means that the cost of supplying households with electricity and gas has increased significantly.
“The trade-offs we have to make in favor of consumers are extremely difficult, and there simply aren’t any easy answers right now. Today’s changes ensure that the price cap does its job, ensuring customers only pay the true cost of their energy while also being able to adapt to the current volatile market.
“We will continue to work closely with government, consumer groups and energy companies to determine what further support can be provided to help with these higher prices.”
However, Martin Lewis accused Ofgem of “bowing to industry lobbying” as he said the move to quarterly changes would benefit energy companies more than consumers.
The price cap is legally in place until 2023, but the government has indicated it could be extended.
Ofgem is also advising on changes that could add £40 to £80 to annual bills from October.
As a rule, utilities take on an additional cost burden in the winter months, when energy consumption is at its highest, which they recoup in the summer.
However, given current record prices, Ofgem could allow companies to recoup those additional costs throughout the year.
How high could the Ofgem cap go?
The Ofgem price cap is currently £1,971 for people on variable plans paying by monthly direct debit.
For those with prepayment meters it’s £2,017 because Ofgem says it costs suppliers more to process these payments than monthly direct debits.
The next price cap announcement is scheduled to be made in August and will come into effect for three months in October.
From January 2023, another three-month cap will then be introduced, which will apply for a further three months.
Post-Covid demand from major economies like China, which has already been responsible for much of the rise in wholesale prices globally, could mean there is even less gas circulating.
Markets are raising prices because they take into account that demand may need to be met by a smaller pool of supply in the coming months.
In May, Ofgem boss Jonathan Brearley said the cap could rise to “in the region of £2,800” in October – a rise of more than 42%.
However, that number now appears to be well below target.
A new forecast from Cornwall Insight – an energy consultancy which has so far correctly predicted how the cap will rise – predicts it will hit £3,582 in October and £4,266 in January.
These numbers represent increases of 82% and 116%, respectively, from the current limit.
“While our price cap forecasts have been rising steadily since the summer 2022 cap was set in April, a hike of over £650 in January forecasts comes as a fresh shock,” said Craig Lowrey, principal adviser at Cornwall Insight.
“The cost of living crisis has already been high on the news agenda as more and more people face fuel poverty – this will only add to concerns.
“Many may find the changes made by Ofgem to the hedging formula, which have contributed to the projected increase in bills, unwise at a time when so many people are already struggling.”
What have MPs said about the Ofgem price cap?
A report released in July by MPs sitting on the Business, Energy and Industrial Strategy Committee called the price cap outdated.
It urged the government to consider lifting the limit and replacing it with a reduced social fare for the most vulnerable households.
“We’ve been told by a number of witnesses, ‘If you think things are bad now, you haven’t seen anything,'” said committee chair Darren Jones.
“This winter will be extremely difficult for family finances and it is therefore crucial that public funds are better targeted to those who need them most.”
It has since been endorsed by Cornwall Insight’s Craig Lowrey, who said the cap “doesn’t work for consumers, suppliers or the economy”.
The BEIS committee report also criticized Ofgem and the government for their response to the energy bills crisis.
She accused the energy regulator of “longstanding incompetence” in allowing poorly run and funded companies to set up energy companies.
Ofgem said the massive rise in gas prices would have “led to market exits under almost any regulatory regime” but acknowledged his previous regime was “not robust enough” and this helped some suppliers fail.
Meanwhile, the government has been criticized for letting the energy bills crisis “precede” it.
“To prevent millions from spiraling into unmanageable debt, it is imperative that the support package is updated and implemented before October, when the squeeze turns into a full fiscal freeze and pushes the economy further towards recession,” it said the report.
The government said: “No national government can control global inflationary pressures; However, we have introduced an exceptional support package to help households.”