The default tariff cap and the law of unintended consequences

With all eyes on the immediate challenges facing the energy supply market and the impact of the default tariff cap as a contributing factor, it is important to note that the cap for the coming winter period should not be considered in isolation and that attention will swiftly turn to the impact of the increase in the level and volatility of the wholesale market on the cap for Summer 2022.  

Although the Winter 2021-22 cap was a new record (£1,277 for a typical dual fuel direct debit customer), Cornwall Insight modelling indicates that – given the extent of the increases in the wholesale market and the manner in which the cap is set – this is set to be surpassed by that for Summer 2022.  

Our current modelling indicates that the Summer 2022 cap is set to see an approximate 14% increase against the Winter 2021-22 cap to over £1,450 per annum for a typical dual fuel customer, while the Winter 2022-23 cap is not too far behind. These figures reflect material increases in the period since our most recent default tariff cap forecast at the end of July 2021, and while there is lot of uncertainty regarding the wholesale market – and a long way to go before future default cap levels are confirmed – the nature of the cap methodology means that some of the recent wholesale increases are already being priced into Ofgem’s formulae.  

The wholesale price methodology for the default tariff cap changes on a seasonal basis and effectively uses a 12-month rolling hedging strategy applied on a continuous quarterly (gas) or seasonal (electricity) basis. This is referred to by Ofgem as a “6-2-12 semi-annual” approach, i.e. the six-month observation window which ends two months prior to the start of the cap period and for which a 12-month price is used. The cap uses a representative hedging profile for a typical domestic customer with weightings applied to quarterly and/or seasonal prices as required, and although a supplier could in theory map the hedging requirements for its customers on a default tariff product to the Ofgem profile, there is no evidence of this practice having been adopted. 

This means that, in the case of the Winter 2021-22 cap the observation window closed at the end of July 2021, with those energy suppliers that had not been able to hedge their positions in line with the cap methodology retaining an element of exposure to the wholesale market. It also means that we are already in the six-month window for the Summer 2022 cap, and with record wholesale prices now being priced in, we would need to see a material and sustained reduction in the wholesale market to avoid the kind of cap levels we are predicting for the period.  

While there is no “good” or “bad” hedging approach for a supplier, the need to align that hedging strategy with a company’s tariff proposition and its credit and collateral requirements has been highlighted by the effective Black Swan conditions in which the market finds itself.  

In particular, smaller suppliers which – potentially due to costly collateral requirements and fees associated with trading – are not able to hedge in the medium to longer-term manner implied by the methodology have found themselves at a comparative disadvantage against their typically larger counterparts that are in a position to hedge in line with the cap. However, the conditions would be reversed in a falling market, with those smaller suppliers using a more flexible, shorter-term hedging strategy being at a comparative advantage against those companies that had adopted a longer-term hedging strategy. 

When the default tariff cap was introduced, the underlying legislation stated that – in setting the cap – Ofgem is required to consider the need to set it at a level that enables suppliers to “compete effectively for supply contracts1, as well as “the need to maintain incentives for customers to switch and the need to ensure that efficient suppliers are able to finance their supply activities”. Furthermore, the impact assessment for the cap2 states that, “Strong competition is the best way to protect the interests of customers, drive good service, improve value and incentivise innovation.”  

The prospect of the greatest enforced consolidation in the retail supply market since that triggered by the collapse of TXU Energi in October 2002, due paradoxically to a record slump in wholesale prices and its effects on that company’s hedging strategy, risks compromising the overarching objectives of the default tariff cap – competition and customer choice – and turning back the clock to an oligopoly retail supply market. 

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