The price cap, and what should happen next

The GB energy regulator Ofgem has updated the price cap on default energy tariffs. This process will now be happening every three months. The most recent increases have taken the cap from £1,271 in October 2021, to £1,971 in April 2022, and now to £3,549.

These quoted figures don’t represent an absolute cap on the amount a household will pay. Prices are capped per unit of energy, and the headline figures are indicative of what an average household would pay for an average level of energy consumption.

It’s a slightly odd way to present this information, given most households don’t pay their bill annually. Here’s a breakdown of what the price cap looks like expressed as a monthly amount.

Standing charges have barely changed, but we’ll be paying far more for the energy we use

The price cap sets levels for daily standing charges for electricity and gas, as well as for prices for each unit of energy used. There was a big jump in the electricity standing charge in April, but this time average standing charges have risen only slightly, from 27p to 28p for gas, and 45p to 46p for electricity.

However, the price of gas has more than doubled from 7p to 15p per kWh, while electricity has gone up from 28p to 52p per kWh, an 86% increase.

Wholesale energy costs now make up 70% of the average bill

Rapidly increasing wholesale prices have had a huge effect on energy bills since April 2021. Back then, wholesale costs made up just 33% of the average bill. Now, they account for 70%.

This price crisis arguably began in late 2021, when wholesale prices were pushed up by a combination of low wind output, depleted gas reserves, planned and unplanned nuclear outages, and a sudden uptick in demand globally following the end of COVID-19 lockdown protections.

The invasion of Ukraine in early 2022 added to these pressures, and as the conflict has progressed Russia is increasingly restricting access to its gas to weaken its opponents across the world.

Whilst the UK is not particularly dependent on Russian gas, the imperative for other nations to replace it with other sources is driving up prices. There aren’t many reasons to be optimistic about this trend. Some analysts are predicting the next price cap could pass £5,000.

High gas prices don’t only drive up wholesale costs — they affect other parts of the bill too

High gas prices push up costs across the entire system. As well as setting the ‘marginal price’ for electricity (even for green tariffs — see our previous explainer), they also increase network costs because of the effect of gas prices on electricity balancing markets (which pay for actions by the system operator to prevent power cuts). Network costs jumped up in April 2022 partly for this reason (they’ve stayed flat since then).

Bills also reflect the costs of energy suppliers going out of business. In the winter of 2021–22 as wholesale prices began their rapid climb the UK saw an increase in the number of suppliers failing. When this happens, the supplier’s customers are switched en masse to a new provider. This process is known as ‘Supplier of Last Resort’ or SoLR, and all costs associated with it are then spread across all other customers. These form part of the ‘networks’ section of the diagram above and currently represent around £61 of the total.

A situation where the price cap was ‘too low’ and led to even more market exits would, under the current system, therefore potentially create a feedback loop of ever increasing costs.

It’s the generators who’ve been making money from record wholesale prices — but the cap allows for growth in suppliers’ profits, too

High wholesale energy prices have seen generators — gas and electricity producers — making record profits. Energy suppliers — the companies who buy energy, sell it to households, and bill them for it — understandably point to this as the underlying driver of costs. And as noted above, many suppliers have gone out of business in the last year.

Yet the price cap does allow for suppliers’ profits to increase. The price cap methodology sets suppliers’ profits as a fixed percentage — just under 2% — of the overall amount. This is labelled ‘EBIT’ in the image above — earnings before interest and taxation.

So while the overall proportion of the bill they represent is low, suppliers’ profits could go up as a result of price cap increases. The table below gives a crude estimate of the total profits the supply sector could potentially earn in April 22-March 23 compared with the previous year — and shows nearly a three-fold increase.

Ofgem has just launched a consultation on whether the methodology for calculating EBIT should change.

Levies have received a lot of attention, but now make up a small proportion of bills

Policy costs — which include the now infamous ‘green levies’ — have gone down in real and percentage terms. They now make up just 4% of the average bill, compared with 12% in October 2021, dropping from £159 to £129 per household.

The drop in total policy costs has come about because renewable electricity schemes supported through ‘Contracts for Difference’ (CfDs) are now paying back excess profits to suppliers. CfDs cover around 15% of renewable energy generation, and 8% of total generation (by volume) currently. However, this proportion is projected to increase to more than 30% by 2037 as new schemes come on stream.

Renewable energy developments therefore bring costs down directly, as well as reducing exposure to gas prices long term. Policy costs also cover schemes like the Energy Company Obligation, which provides energy efficiency measures like insulation for households in fuel poverty.

Policy costs are therefore the only component of an energy bill where customers get something back.

HM Treasury’s tax take will increase substantially as bills go up

VAT makes up 5% of bills. Since the total bill has increased, the Treasury will now get a tax windfall. With predictions that bills will rise further in January, HM Treasury could expect to receive a total of around £4 billion in tax for the year April 22 -March 23 — up from an estimated £1.5 billion the previous year.

Current plans are not enough to protect consumers now, or improve the longer term outlook for bills

In May, the Chancellor announced a £15 billion support package for winter 22/23, including a universal £400 discount on energy bills, with extra support for households receiving means-tested benefits, pensioners and those receiving extra-cost disability benefits.

In terms of the immediate financial response for households, so far the policy proposals from the two leading candidates to be the next Prime Minister will only make a small difference. Liz Truss has said she will temporarily suspend ‘green levies’ from bills, while Rishi Sunak would remove VAT.

Added to the £150 council tax rebate that most households have already received, these measures taken together would give £758 back to the average billpayer between April 2022 and March 2023. But over this time period, the average bill is likely to total £3,219. The four measures would reduce the total paid to £2,461 — still 93% more than the average household paid from April 2021 to March 2022.

There are some problems with the proposals too. There’s a good case to move policy costs to general taxation — this would be more progressive, and it would help reduce the cost difference between electricity and gas (policy costs are levied on electricity because nearly everyone has an electricity meter, while around 15% of homes are off the gas grid).

But scrapping levies altogether, as Liz Truss has implied she might, would damage investment in renewables and energy efficiency programmes — both of which help address the problem in the longer term. This would be short sighted.

Whilst the headline figures on Treasury returns are large, cutting VAT would only save the average household £97 over the winter. The Treasury’s unexpected additional revenues might be more usefully redistributed or targeted at those most in need of support.

So what else should the UK government be doing?

A crisis calls for both an urgent response to help people through the immediate hardship, and practical steps to address the underlying issues and prevent the next crisis. Nesta has already called for a ‘COVID-style response’ to rising energy bills, given the sheer scale of the hardship it could cause, and the deeper reforms and investment needed to prevent future crises. It’s clear that many households will need more immediate financial support.

But cash support to families doesn’t fix the underlying problems in the energy market. To protect consumers in the UK from future crises, increasing the supply of renewable energy and decoupling the cost of electricity from gas prices is essential. It’s been disappointing to hear leadership candidates throwing shade at solar farms, just when they’re needed most. Onshore wind should be back on the table. The Review of Electricity Market Arrangements, currently underway, needs to lead to bold, rapid action.

Ministers also need to get over their squeamishness about advising households to save energy. No-cost measures, such as turning down boiler flow temperatures, turning off the pre-heat setting on combi boilers, and turning off radiators in unused rooms, could reduce energy use by up to 20%, with little impact on people’s comfort. Those able to invest up to £200 could save more, for example by switching to energy efficient shower heads or smart thermostats. The government should seriously explore how it can incentivise and support households to make these changes.

Few households will be in the position where they can find over three thousand pounds more to spend since this time last year. Something has to give, and it should not be the wellbeing of households in Britain, nor should it be our net zero ambitions. Fortunately it doesn’t have to be either — the choice is there for our next Prime Minister to make.

This blog was co-written with Nesta’s Andy Regan and Kevin Wiley