UK’S ENERGY SUPPLY MARKET – BRIEF EXPLAINER OF THE ROLE OF THE DEFAULT TARIFF CAP AS OFGEM ANNOUNCES NEW ACTIONS IN RESPONSE TO THE ENERGY CRISIS

There is an ongoing global energy crisis with record prices for natural gas, coal and electricity.

One aspect specific to the UK, including in relation to the large number of electricity suppliers that have ceased trading this year (21 as of the date of this briefing), is the default tariff cap introduced in 2019. Also see our briefing here which looks at the supplier of last resort process under which the customers of the electricity suppliers that become insolvent transfer to a new supplier.

The introduction of the Default Tariff Cap

The Domestic Gas and Electricity (Tariff Cap) Act 2018 requires Ofgem to set a cap (Default Tariff Cap) on all standard variable and default tariffs for domestic supply contracts.

The Default Tariff Cap was intended as a temporary limit on prices, initially set to last until the end of 2020, with the possibility of 12-month extensions until the end of 2023. Following Ofgem's review findings that the necessary conditions for competitive market were not in place, the Secretary of State announced the Default Tariff Cap would be extended until the end of 2021. On 23 July 2021, the Government published an open letter stating its intention to extend it again beyond the original 2023 longstop. Separately, Ofgem released the outcome of its 2021 review on 6 August 2021, concluding the Default Tariff Cap should be extended until the end of 2022.

The Default Tariff Cap first came into force on 1 January 2019.

How is the Default Tariff Cap determined?

When determining the level of the Default Tariff Cap, Ofgem must take into account the need to: (i) create incentives for holders of supply licences to improve their efficiency; (ii) be set at a level that enables holders of supply licences to compete effectively for domestic supply contracts; (iii) maintain incentives for customers to switch and (iv) ensure that efficient suppliers are able to finance their supply activities. The last of these factors underlines a key point. The Default Tariff Cap is not meant to prevent wholesale costs being passed through or a reasonable profit. The purpose is to deal with what was considered the unfair result of the way suppliers were competing which left a large proportion of consumers who did not frequently switch suppliers (often the more vulnerable) paying considerably more than those that did.

Suppliers need to ensure that at all times the total amount of all charges for supply activities does not exceed the relevant maximum tariff for the relevant period. The Default Tariff Cap does not relate to charges that are not part of regular bills, for example, for late payment. There are also certain exemptions from the Default Tariff Cap, such as renewable tariffs where certain conditions are met.

How frequently is the Default Tariff Cap reviewed?

Ofgem must review the level at which the Default Tariff Cap is set at least every six months. So far, Ofgem has been reviewing the Default Tariff Cap twice a year, with the latest (seventh) charge restriction period running from 1 October 2021 to 31 March 2022. The next update is expected to be announced in February 2022.

Given the extreme movements in natural gas and electricity markets in recent months it might have been expected that the next review would be heard sooner. However, both Ofgem and the Government have stated their intention that the practice of keeping reviews to the minimum frequency required will continue. This was reiterated by Ofgem in its 29 October letter discussed below.

Consumers will not ultimately be shielded from the energy crisis by the Default Tariff Cap (although the Government might find other ways to provide mitigations). Analysts are currently estimating increases to the Default Tariff Cap from April 2022 could be over 30%.

The Centrica challenge

The level of the Default Tariff Cap has been challenged only once so far – Centrica applied for judicial review of Ofgem's 6 November 2018 decision on the level of the Default Tariff Cap (and not on the introduction of the Default Tariff Cap itself), challenging the method used to reflect the wholesale cost of energy when determining the Default Tariff Cap. In November 2019, the High Court granted Centrica declaratory relief and requested Ofgem reconsider the allowance for Q1 2019 on the basis of the information it now had from suppliers and make adjustments, if it considered appropriate. In May 2020, Ofgem confirmed that it should have calculated the allowance on a different basis and corrected the Default Tariff Cap for the period 1 October 2020 – 31 March 2021 to balance the impact of its original decision.

Ofgem's response to the energy crisis

On 29 October Ofgem wrote to all energy suppliers about actions it would take in response to the current energy crisis. The Ofgem letter announced that there would be a consultation on the Default Tariff Cap on whether the existing mechanism to allow suppliers to recover uncertain costs "should be adjusted in light of the increased costs and risks facing suppliers". The consultation will be published in November 2021 and a decision published in February 2022 to allow implementation for the (unchanged) new period from 1 April 2022. The letter also announced steps it would take to expedite supplier of last resort cost reimbursements and increased financial oversight of suppliers.

Ofgem's letter falls short of the substance and urgency called for by many of the smaller and more at risk energy suppliers who argue that the current regulatory set up is not adequate for the current crisis and further support is required even for efficiently run companies. On the other hand some of the larger and less at risk suppliers welcome the approach which they see as reflecting that risky strategies are to blame for the extraordinary number of supply company failures.