How is Ofgem's energy price cap calculated?

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Ofgem announced an increase of the new price cap by £693 a year on energy bills from April 1 2022 for the average household paying by Direct Debit. But, what many may not know is how this amount was calculated.

Ofgem has already said that the increase is driven by a record rise in global gas prices over the last 6 months, with wholesale prices quadrupling in the last year.

However to many this may as well be gibberish! Energy can be confusing at the best of times. ​​​​This is why our Energy Specialists have broken down exactly how the price cap has been calculated without the confusing jargon.

Current breakdown of the price cap:

This is a representation for the average household paying by Direct Debit for both gas and electricity.

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Source: Ofgem

What does this graph mean?

It is a simpler illustration on why and how Ofgem calculated the price cap. Here’s a breakdown.

  • Wholesale.

These are prices that suppliers (like E.ON Next) typically pay when buying gas or electricity to supply our customers. This usually makes up the majority of your energy bill. The supplier purchases energy for their customers on the wholesale market far in advance of when they need to supply that energy to you.

This is what makes up the wholesale allowance of the price cap calculation. Ofgem looks at the cost to buy energy over a predetermined time frame and uses this to set the wholesale allowance within the price cap.

As the wholesale price has increased, this has resulted in an increase in the wholesale cost allowance for the price cap level.

However, there have been some adjustments as mentioned below:

  • Wholesale adjustment.

This was a one-off £15 temporary wholesale adjustment for the current price cap period. This adjustment was put in place after Ofgem was ordered to revisit how it originally calculated the price cap when it first launched.

Please note: Ofgem have decided to make the adjustment by amending the percentage (%) value of the wholesale additional risk allowance, for gas and electricity, to a level that reflects the efficient and material costs incurred by suppliers.

  • Networks.

These costs are for the gas pipes and electricity cables that carry energy across the country into your home or business.

Network companies charge your supplier an Ofgem-regulated price for using the energy network. This money goes towards maintaining, running and upgrading these essential networks.

  • Policy costs.

These costs relate to government led social and environmental schemes, such as the Feed in Tariff and Renewable Obligations schemes which are designed to help reduce emissions, save energy and promote/encourage the transition to renewable energy and more sustainable homes.

  • Operating costs.

Operating costs represent how much your supplier will pay to deliver its services to you, including sales, metering, billing, and general customer service costs.

The increase is because Ofgem's allowance for supplier profits, which is set at 1.9%, is now absorbed into operating costs allowance.

  • Payment uplift/ Direct Debit Uplift

Ofgem have set a Payment Method Uplift, to account for the additional costs associated with providing service to customers who don’t pay by Direct Debit (i.e. standard credit customers). This is because suppliers often incur additional charges for customers who don’t pay by Direct Debit, including debt, working capital, and extra administrative costs.

This allowance also includes a ‘Payment Method Uplift’ for other payment methods. This is to recover the additional efficient cost of serving an average proportion of standard credit customers, and to set a higher cap for standard credit customers than for Direct Debit customers.

Consumers paying for energy by Direct Debit tend to pay less than consumers paying for energy by standard credit.

  • Smart.

The Government is committed to making sure all households and small businesses can benefit from smart meters as soon as possible. This is why the Smart meter rollout allowance has been introduced in June 2020, to help cover the cost of supplying them to customers.

Don’t have a smart meter yet? Take a look at if you might be eligible and how to get one.

  • Headroom.

Ofgem is allowing a headroom allowance between efficient costs and the default tariff cap in the baseline (2017) of £10 (Dual Fuel, Single Rate, Direct Debit).

This allowance is set at 1.46% of all cost components, excluding networks under the default tariff cap 2.14. The headroom allowance is one of the ways to help the net cost pressure of uncertainties not already included.

  • VAT.

VAT is set at 5% for energy bills, which under the new energy price cap is around £98.

What does this mean for you?

If you pay your energy bills on either a standard variable tariff or fixed energy tariff, the energy price cap will have an impact on your energy bills.

Households on fixed rate tariffs with their energy supplier will not be affected by the price cap until their contract ends.

The energy price cap itself doesn’t limit how much you will pay for your bills as it applies to unit rates and suppliers, so you could find yourself paying more than the energy price cap amount in 2022 if you use more energy than what Ofgem defines as average household usage.

For more information on how the price cap might affect you, our Energy Specialists have created a guide here.