Ofgem published a policy consultation on 4 February 2022 setting out proposals to change the wholesale methodology used to set the default tariff cap, including quarterly updates, a reduced notice period and a backwardation mechanism1. The regulator had earlier published a call for input on adapting the price cap methodology for resilience in volatile markets on 15 December 20211.
The consultation followed a period of sustained wholesale price volatility. Ofgem said the changes were intended to address volume risk and the cost of backwardation, which it described as the difference between the index used to set the cap level and the way suppliers are able to purchase energy for their cap customers1. The regulator estimated that moving to quarterly updates would reduce volume risk by 74% compared with a six-monthly index1.
Ofgem set out its decisions in a document published on 4 August 2022, stating:
"We have decided to proceed with implementing quarterly updates, a reduced notice period and updating the wholesale methodology to include backwardation costs, to be recovered over six months."
The reduced notice period was set at 25 working days, with Ofgem having five working days to calculate and publish the new cap level and suppliers having 25 working days to notify customers and implement the new price level1. The lag between the observation period closing and the start of the cap would be a total of 30 working days1. Backwardation costs above a deadband of £9 would be recovered over six months from the start of the corresponding cap period, a change from the 12-month recovery period in the minded to consultation position1.
The changes were to take effect from 1 October 2022, with quarterly updates implemented from October 20221. Ofgem said it would announce the cap level for period 9a on 26 August 20221. The Market Stabilisation Charge came into effect from 14 April 20221. Ofgem also set out its decision on the Contracts for Difference allowance methodology in the default tariff cap on 23 June 2022, and transitioned to the 3-1-12 approach from 6 June 20221.
Ofgem said the high prices and volatility had placed huge pressure on suppliers, with a number of market exits, and that its monitoring showed many of the remaining suppliers were still at risk of failure if it did not act1. It said that by December 2021 it had consented to suppliers of last resort making initial levy claims totalling £1.83 billion1.
Why it matters for households
The price cap sets the maximum a supplier can charge per unit of energy on a default tariff, and the frequency with which it is updated determines how quickly changes in wholesale prices reach household bills1. Moving from six-monthly to quarterly updates means the cap level is recalculated more often, so wholesale price movements are reflected in bills sooner, in both directions1. The shorter notice period of 25 working days reduces the time between the cap level being announced and suppliers having to notify customers and implement the new price level1. The inclusion of backwardation costs in the wholesale methodology means a component of suppliers' purchasing costs is recovered through the cap over a six-month period1. Ofgem said its decisions should reduce the risk that customers pay more for the mutualised costs of supplier failures because efficient suppliers are unable to recover their costs1.
What happens next
Ofgem said it would announce the cap level for period 9a on 26 August 20221. The decisions were to take effect from 1 October 20221. Ofgem said it intended to keep the backwardation recovery period under review and review its decisions in future once it had fully transitioned to quarterly updates and enough time had passed to evaluate the impact1.