Chris's test research

When Ofgem announced the level of the energy price cap from July — a welcome reduction but still double pre-energy crisis levels — it also announced a proposed increase to the supplier profit margin included within the cap. In the context of bills remaining over £2000 the £10 uplift is not huge but still needs to be justified. Our full response to the proposals to increase supplier profit margin can be found here.

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How risky a business is energy supply at the moment?

It’s true that higher wholesale energy prices increase the risks that suppliers face. But the retail price cap already allows for that. Profit margins are hard-coded as a % of the costs covered by the cap. The allowed profit margin has increased as wholesale

How well justified is this increase in profit margins?

The balance of evidence shows that risks have increased by less than energy prices and so profit margins should actually reduce. So, how has Ofgem justified increasing profit margins?

Well, firstly there is an attempt to explain why suppliers should be viewed as more risky than companies more generally. This is reflected in the profit margin calculation by the ‘asset beta’. An ‘asset beta’ of 1 means the suppliers are as risky as other companies, above 1 means they are more risky (below 1 less). Ofgem is proposing to move from a previous asset beta range of 0.7–0.8 to 1–1.2.

Ofgem describe this as relying, in part, on ‘narrative stakeholder arguments’ and ‘regulatory judgement under uncertainty’. Here, we should bear in mind the stakeholders in question are basically the suppliers who stand to benefit. We have warned about the risk of the price cap becoming a lobbyist’s charter in our discussion paper about the future of the energy supply market. In terms of actual evidence, the decision ignores all the comparators within the energy sector (the highest of which gives an asset beta of 0.66), instead preferring to compare to airlines. Indeed, the asset beta of Good Energy — which Ofgem’s assessment shows never going above 0.7 — is presented as evidence for an asset beta in the range 1.0–1.2.

Secondly, Ofgem seems to have worked on the basis of how it would like suppliers to behave rather than how it requires them to behave, or how they behave in practice. The profit margin calculation assumes that suppliers will have enough capital to withstand a 1-in-20 event in terms of high wholesale energy prices. Ofgem has set the actual minimum capital requirement on an entirely different basis and the requirement doesn’t need to be met until the 31st March 2025 in any case. It is in consumers’ best interest to ensure suppliers are financially resilient but providing funding for a certain level of resilience does not mean it will happen.

The calculation also assumes that customer credit balances will average out to zero. Ofgem offers no evidence that this is the case. If customers are in credit on average, this means suppliers are getting free working capital. For example, the terms and conditions of some large suppliers, see here and here, require that customers keep their account in credit. If this is not taken into account, the level of working capital that requires funding will be overstated. Ofgem says this reflects ‘…our anticipation that the notional supplier should not finance its activities through systematically high direct debit charges’.

A kind interpretation of all this is that increasing profit margin is not an evidence-based decision. More realistically, it is a decision that is contrary to the evidence.

Will suppliers get rewarded for poor customer service?

Separately, Ofgem is looking at whether allowances for supplier operating costs should be reviewed. There, Ofgem has flagged ‘some priority changes to our customer service rules for this winter, which could have an impact on suppliers’ operations’.

In effect, Ofgem will force suppliers to improve customer service but increase allowances under the retail price cap to fund it. Suppliers will then make a profit on this increase in allowance — and at this higher profit margin. So the end result of poor customer service could well be increased profits for suppliers.

The retail price cap brought benefits to people as it provided initial protection as wholesale prices increased. But the original aim of the price cap was to ensure consumers paid a fair price. This will be undermined if the balance of risk and reward is changed without robust evidence.