The energy price cap — an explainer

Ofgem, the GB energy regulator, has just announced an increase to the energy price cap, which will take effect in October 2024. This will raise the average home’s annual energy bill from £1,568 to £1,717.

What is the price cap, again?

The price cap was initially introduced in 2019 to put a limit on the amount of energy retailers can charge on their standard variable tariffs.

It was brought in to combat the ‘loyalty penalty’ — the practice of charging customers more when they don’t switch tariffs. It doesn’t cover customers on fixed deals and only applies to homes, not businesses.

In setting the price cap, Ofgem, the energy regulator, sets maximum amounts for daily standing charges, which everyone with a gas or electricity connection has to pay regardless of how much they use, and for units of energy used.

The price cap is updated quarterly. It is set according to a detailed formula, which takes into account the anticipated wholesale cost of energy, costs for transporting it to homes, operating costs for suppliers, ‘policy costs’ levied by the government, some other costs of managing the energy system, and VAT at 5%.

How will the price cap change in October?

From October, standing charges will stay pretty much the same, at 61p per day for electricity and 32p per day for gas.

However, the price per unit of gas will increase from 5.5p to 6.2p per kWh, while electricity will go up from 22.4p to 24.5p per kWh.

The figures quoted in this piece all apply to customers billed using direct debit — the price cap is slightly different for those on standard credit and prepayment meters.

What difference will this make to monthly bills?

The annual figure for an average bill — £1,717 — doesn’t represent an absolute cap on the amount a household will pay. It’s an indicative figure, intended to show what an average household would pay for an average level of energy consumption over a year.

It’s a slightly odd way to present the information, given most households don’t pay their bill annually. Monthly bills are currently around £131 a month for an average ‘medium’ home, and will go up to £143 a month from October 2024.

Here’s how monthly bills could change for households with different levels of energy use

Source: Ofgem typical consumption values; Nesta calculations based on June and October price caps. This table assumes monthly bills are 1/12 of average annual bills — energy use is higher in the winter, but energy suppliers tend to bill direct debit customers in a way that smooths costs over the year, rather than billing for actual usage.

Why is it going up?

Of the £149 increase to average bills, £130 — or 87% of the rise — is due to wholesale energy prices. From October, wholesale costs will make up around 44% of the bill, up from 40% now.

Here’s how the price cap breaks down by its different inputs

Source: Ofgem Final levelised cap rates model (Annex 9)

The increase is driven by rising wholesale gas prices.

Gas has become more expensive because of rising demand and constraints to supply. Supply of Russian gas to Europe has declined owing to the war in Ukraine, and as a result there is more competition for imports of liquified natural gas (LNG) between European countries. Demand is predicted to be higher than average this winter too, as long term weather forecasts suggest it will be colder than normal.

Gas prices are the key driver of energy bills for two main reasons. The majority of household energy use is gas — an average home uses 11,500 kWh or gas per year, compared with 2,700 kWh of electricity, according to Ofgem.

Gas also sets the electricity price nearly all the time. The market price for wholesale electricity is set by the most expensive form of generation in each half hourly period. Gas-fired electricity generation is more expensive than renewable energy, because gas power stations have to pay for the fuel they use to produce electricity.

In most half-hourly periods, some gas-fired generation is needed to top up supply. So even if most electricity at any one time comes from renewable sources, if some gas-fired generation is needed as well, then that sets the price for the whole market. Data from 2023 showed that gas set the GB electricity market price 97% of the time — higher than in other European countries.

Who is making a profit?

High wholesale prices primarily benefit the companies that sell gas on wholesale markets, and some electricity generators.

This includes some generators of renewable energy, although for others, high wholesale prices don’t affect profits. Since 2017, most new renewable schemes (e.g. offshore wind farms) have entered into ‘contracts for difference’ with the UK government. This effectively fixes the price they get paid for the electricity they produce, so that when prices fall they get a top-up, but when prices rise, they pay back the difference. So these schemes don’t make ‘windfall profits’ when prices rise.

Energy retailers — the companies that buy energy, sell it to households, and bill them for it — generally make a fairly small margin on the energy they sell. The price cap methodology sets suppliers’ profits as a fixed percentage — 2.6% — of the overall amount. This isn’t a cap on profits as such — suppliers can increase their margins if, say, their operations are very cost-effective — but it effectively means that suppliers can’t add a big mark-up to bills.

However, since the profit allowance is a fixed percentage, while the overall proportion of the bill it represents is low, retailers’ total profits could go up a bit as a result of price cap increases.

What can be done to bring bills down?

In the short term, the main way to reduce bills is to help households use energy efficiently. The government will also need to find effective ways to support households that are struggling. The key challenge is in targeting support effectively. Citizens Advice recommends that the best way to do this in the short term is to extend the Warm Homes Discount.

Ofgem is also currently considering whether and how to reform standing charges. This could help reduce bills for some lower-income households. At the moment, everyone pays the same standing charges regardless of how much energy they use. Lower-income households on average use less energy, so they pay proportionately more in standing charges — which is widely seen as unfair. Ofgem is considering moving some of the costs currently in standing charges into the unit rate of electricity, although it’s unlikely to abolish standing charges completely.

In the medium term, reducing reliance on gas both for directly heating homes, and for generating electricity, is the key way to reduce bills.

Because wholesale gas prices are affected by geopolitical events, they can be very volatile, as we’ve seen in the last three years.

And as noted above, gas-fired power generation is almost always more expensive than renewable electricity because gas power stations have to pay for their fuel, while renewable generators do not. Ramping up renewable energy, so that there are fewer time periods where gas-fired generation sets the market price, can help reduce costs of electricity.

The government is also considering reforms to the energy market that could help reduce costs, although these will take some time to introduce.

Ending the annual cycle of ‘winter anxiety’

The price cap was designed to make energy tariffs fairer — but cannot on its own ensure that energy is affordable. And for the last few years, winter price cap announcements have brought considerable anxiety for many households who already have energy debt, and are worried about being unable to afford to heat their homes over the winter.

The issues underpinning volatile and unaffordable energy prices have been well understood for a long time, but progress in resolving them has been slow. The new government has set a more ambitious timetable for ramping up renewable energy. It needs to bring the same level of ambition to reforming energy markets, solving the problem of how to target bill support and crucially, helping households move off gas.