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Price cap update: opportunities & challenges for the UK energy retail market

Price cap update: Opportunities & challenges

We outline the impact and opportunities on UK energy retail suppliers following Ofgem's announced price cap level on 6 September 2018.

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Partner and UK Head of Energy & Natural Resources

KPMG in the UK

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Price cap update: opportunities & challenges for the UK energy retail market - bulb currency

On 6th September Ofgem published their statutory consultation on the default tariff cap which provides further clarity on their methodology and the value of the proposed cap when it comes into force. Ofgem are now seeking responses to their consultation by 8 October, with the intention of implementing the cap by the end of December 2018 on all standard variable tariffs (SVTs) and fixed term default tariffs. Ofgem’s current estimated cap levels are:

Payment scheme
Fuel
Annualised bill at typical domestic consumption
(£)

Direct debit Gas 539
Electricity 597
Dual fuel 1,136
Standard credit Gas 573
Electricity 646
Dual fuel 1,219


On average the cap will save consumers who use a typical amount of electricity £75 per year. Savings for those on the highest default tariffs will be up to £120 per year. Ofgem estimate that 10.7 million customers will be affected by the cap when it comes into force, and that total annual savings will be around £1 billion.

The cap has been set higher than what most analysts have been estimating since the announcement of the cap. Ofgem has also confirmed that suppliers, under certain circumstances, can apply for an exemption for tariffs that provide additional support to renewable energy. The cap does not impact customers who are already covered by the PPM cap or those who benefit from an existing price cap due to vulnerability.

Ofgem publishes its consultation in the context of all the ‘Big Six’ having raised their SVTs during the course of the year. It is not clear how much of this price rise is a reaction to the impending price cap, given they have taken place against a backdrop of increasing wholesale costs.

Supplier SVT price increase in 2018
E.On 2.7%
British Gas 5.4%
EDF 1.4%
Scottish Power 5.6%
Npower 5.5%
SSE 7.9%

What does this mean?

Players within the UK energy retail market may face a number of challenges and/or opportunities upon implementation of the price cap. This includes:

  • Bigger suppliers being required to cut costs
  • Potential opportunities for independent suppliers
  • Regulatory risk for investors and new entrants
  • Incentives for switching being reduced
  • Default tariffs and SVTs remaining in place
  • Green tariffs being exempt from the cap

We discuss these points below.

Bigger suppliers will need to cut costs

The proposed cap level will have a medium-high impact on profits for suppliers reliant on SVT customers (generally larger suppliers). This could result in new tariff strategies.

At the cap level Ofgem report that most larger suppliers will need to lower their default tariff costs to be compliant. Whilst it is not anticipated that this cap level is low enough that a significant number of suppliers will exit the market, the suppliers who need to reduce their prices will see a fall in revenue and profit. This is likely to be more significant for the larger suppliers who have more reliance on SVT tariffs than independents (in terms of % of customers and total number of customers). In addition, there will be operational considerations around updating price levels and monitoring the cap level to ensure compliance which may result in additional costs.

In order to maintain current profit margins (or reduce the level of loss of profit), a number of strategies may emerge. It is expected that suppliers will seek cost efficiencies to increase margins, and this could be implemented through the deployment of improved systems and processes. Where such improvements are not feasible, suppliers may choose to:

  • Cross-subsidise (where permissible) from other business areas (particularly vertically integrated suppliers who have the ability to do this).
  • Increase the level of lower priced fixed term tariffs to cover losses of default tariffs.
  • Move customers from SVT default tariffs.
  • Focus on cross-selling additional products and services.
  • In extreme cases, merging with or acquiring other retail businesses to gain efficiencies.

An opportunity for independent suppliers

The opportunity remains for suppliers to gain customers through lower price, innovation, high quality customer service and by capturing other competitive advantages


Although the proposed cap level reduces the differential between SVTs and the cheapest tariff in the market, there remains a large enough differential for suppliers to continue to be incentivised to compete on price, innovation and quality to win customers. It is likely that the independent suppliers who have lower cost bases will be able to continue the trend of acquiring customers from the larger players.

In addition, there is a potential opportunity for those with default tariffs below the cap to raise default prices to the cap levels to increase revenue of these tariffs. We note that the smaller suppliers will still need to consider the operational implications of monitoring and updating prices in line with the cap level.

Regulatory risk

The price cap exacerbates regulatory risk, particularly because the cap level can update every 6 months. It should be noted that the price cap is a time-limited intervention (it will last between two and five years) and therefore the risk is not an open-ended risk and is not expected to stifle long-term investment.

Incentives for switching may be reduced

If consumers on SVTs believe the price cap is protecting them from excessive prices, they may not seek out a better value deal and engage in the market.

The tariff will reduce incentives for switching by reducing the price differential between SVTs and fixed price tariffs (and hence the financial benefits from switching).

In its impact assessment, Ofgem estimates that switching may reduce by 30%. Ofgem has put various measures in place to encourage and increase customer switching (in particular price comparison websites and their ‘be an energy shopper’ campaign). These measures, alongside the continuing existence of price differentials (although not as high as before) suggest that the market can still remain competitive.

Default tariffs and SVTs will remain

Although we expect suppliers to deploy new tariff strategies in response to implementation of the price cap, the elimination of default tariffs and SVTs in their current form is not expected in the short to medium term. There will remain a need for some form of default tariff for customers who do not actively shop around at the end of their deals.

It is noted that there is an existing trend away from SVTs, for example, Scottish Power’s decision to remove SVTs in favour of a fixed default tariff. A move to fixed price default tariffs could potentially create issues around differentiating between fixed price default tariffs versus those that a customer has actively sought out.

Green tariffs are protected

Ofgem have confirmed that tariffs that support renewable energy can be exempt from the price cap, however, these exemptions will be applied by Ofgem on a stringent case by case basis. To obtain an exemption suppliers will need to provide detailed evidence to demonstrate that the tariff:

  • provides support for renewables, materially beyond support already provided through existing government schemes; and
  • incurs materially higher costs associated with the renewable element of the tariff.

Ofgem is cautious to ensure that suppliers are not in a position to ‘game’ an exemption by using it to avoid the default tariff cap without in practice providing any additional support for renewable energy over and above that already imposed through subsidies, obligations or other mechanisms. This could, for example, occur if a supplier re-allocated their existing quota of renewable energy from one tariff to their proposed ‘exempt tariff’ without increasing their total level of support for renewable energy.

What happens next?

Ofgem are expected to announce their final decision on the price cap level in October 2018. The cap can then be updated periodically (every 6 months) to reflect changing market costs such as wholesale prices.

Cap period Cap in force Announced
First cap period Inception to 31 March 2019 Final decision
Summer Cap Period 1 April to 30 September
February
Winter Cap Period 1 October to 31 March August
Last Cap Period 1 October to 31 December August


Recently Ofgem raised the level of the PPM cap by £47 in line with rising wholesale prices which sets a precedent for the SVT cap. Wholesale prices are not expected to fall in 2019.

The cap is a temporary measure. It will be maintained at least until 2020 when the Secretary of State will decide whether to extend the cap. The cap can be extended for one year up to three times, therefore, it could continue until the end of 2023 (the current legislation does not allow for continuation beyond this point).

It is likely that the eventual removal of the cap will face strong public opposition resulting in an extended period under price regulation. The position of the market once the cap is removed will be determined by the cap’s impact on competition. If the cap results in a lower level of market competition, this may be detrimental to customers once the cap is removed.

A key factor in determining when it is right to remove the cap will be the move away from the ‘supplier hub’ model. As the energy system becomes more decentralised, it will grow increasingly common for customers to buy and trade energy from multiple suppliers (for example through peer-to-peer trading schemes), meaning that the price cap becomes unworkable.

How will Ofgem assess when conditions are right to remove the cap?

Ofgem will begin a review of the price cap in 2020, they state that they will move to remove the cap when there is sufficient evidence that competition in the market is at a level that is capable of protecting consumers in the absence of a cap. This will include evidence for:

  • Rivalry between suppliers who are offering differentiated products that meet customer requirements.
  • Unrestricted market entry and exit for energy suppliers.
  • Informed and engaged consumers that are able to shop around easily for better prices.

Ofgem have acknowledged that it will be difficult to assess the above while the cap is still in place (see points above about the potential for reduced switching) so they have specified that they will review the following areas when considering removal of the cap:

  • Issues that frustrate customers, and thereby disincentivise them from switching.
  • The time it takes to switch and the effectiveness of switching.
  • Secure sharing of data (facilitating easier switching).
  • The level of engagement with customers.
  • Barriers to market entry or exit.
  • The level of competition between firms, and the range and quality of service offerings.
  • The use of innovative business models.
  • Technological developments, for example, smart metering and easy-to-use mobile phone apps.

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