Tag: Energy Price Guarantee

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Rising UK energy prices

The UK energy regulator, Ofgem, has announced that the UK energy price cap will rise in October by an average of 2%. The energy price cap sets the maximum prices for electricity and gas that can be charged by suppliers to households. For those paying by direct debit, the maximum electricity price per kilowatt-hour (kWh) will rise from 25.73p to 26.35p, with the maximum daily standing charge rising from 51.37p to 53.68p. As far as gas is concerned, the maximum price per kWh will fall slightly from 6.33p to 6.29p, with the maximum daily standing charge rising from 29.82p to 34.03p. Ofgem estimates that this will mean that the capped cost to the average household will rise from £1720 to £1755.

The average capped cost is now much lower than the peak of £4279 from January to March 2023. This followed the huge increase in international gas prices in the aftermath of the invasion of Ukraine and the cutting off of gas supplies from Russia. Note that although the suppliers received these capped prices, average consumers’ bills were limited to £2500 from October 2022 to March 2024 under the government’s Energy Price Guarantee scheme, with suppliers receiving a subsidy from the government to make up the shortfall. But despite today’s cap being much lower than at the peak, it is still much higher than the cap of £1277 prior to Russia’s invasion of Ukraine: see Chart 1 (click here for a PowerPoint).

So is the capped price purely a reflection of the international price of gas, or is it more complicated? The picture is slightly different for gas and electricity.

Gas prices

As far as gas prices are concerned, the price does largely reflect the international price: see Chart 2 (click here for a PowerPoint).

The UK is no longer self-sufficient in gas and relies in part on imported gas, with the price determined in volatile international markets. It also has low gas storage capacity compared with most other European countries. This leaves it highly reliant on volatile global markets in periods of prolonged high demand, like a cold winter. Is such cases, the UK often has to purchase more expensive liquefied natural gas (LNG) from global suppliers.

Additionally, taxes, environmental levies and the costs of the nationwide gas distribution network contribute to the overall price for consumers. Changes in these costs affect gas prices. These are itemised below in the case of electricity.

With electricity pricing, the picture is more complex.

Electricity prices

Electricity generation costs vary considerably with the different methods. Renewable sources like wind and solar have the lowest marginal costs, while natural gas plants have the highest, although gas prices fluctuate considerably.

So how are consumer electricity prices determined? And how is the electricity price cap determined? The price cap for electricity per kWh and the daily standing charge for electricity are shown in Chart 3 (click here for a PowerPoint).

Marginal cost pricing.  The wholesale price of electricity in the UK market is set by the most expensive power source needed to meet demand on a day-by-day basis. This is typically gas. This means that even when cheaper renewables (wind, solar, hydro) or nuclear power generate most of the electricity, high gas prices can increase the cost for all electricity. The wholesale price accounts for around 41% of the retail price paid by households.

It also means that profits for low-marginal-cost producers could increase significantly when gas prices rise. To prevent such (low-carbon) suppliers making excess profits when the wholesale price is high and possibly making a loss when it is low, the actual prices that they receive is negotiated in advance and a contract is signed. These contracts are known as Contracts for Difference (CfDs). CfDs provide a fixed ‘strike price’ to low-carbon generators. The strike price is set so as to allow low-carbon generators to recoup capital costs and is thus set above the typical level of marginal cost. If the wholesale price is below the strike price, payments to generators to cover the difference are funded by amounts collected from electricity suppliers in advance using the CfD Supplier Obligation Levy. If the wholesale price is above the strike price, the difference is returned to consumers in terms of lower electricity bills.

Policy costs.  Electricity bills include an element to fund various social and environmental objectives. This element is also included in the cap. From October to December 2025, this element of the cap will be 11.3%. The money helps to subsidise low-carbon energy generation and fund energy efficiency schemes. It also funds the Warm Home Discount (WHD). In the October to December 2025 price cap, this amounted to a discount for eligible low-income and vulnerable households of £150 per annum on their electricity bills. The WHD element is included in the standing charge in the price cap. From October 2025, more generous terms will mean that the number of households receiving WHD will increase from 3.4 million to 6.1 million households. This is the main reason for the £35 increase in the cap.

Network costs.  These include the cost of building, maintaining and repairing the pipes and wires that deliver gas and electricity to homes. From October to December 2025, this element of the cap will be 22.6%.

Supplier business costs.  These include operating costs (billing, metering, office costs, etc.) and servicing debt. From October to December 2025, this element of the cap will be 15.4%.

Profit Allowance.  A small percentage is added to the price cap for energy suppliers’ profits. This is known as the Earnings Before Interest and Tax (EBIT) allowance and is around 2.4%. This has a fixed component that does not change when the overall price cap is updated and a variable component that rises or falls with changes in the cap.

Reliance on gas, low gas storage facilities, marginal cost pricing and the commitment to invest in low-carbon electricity and home heating all add to the costs of energy in the UK, making UK electricity prices among the highest in the world.

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Questions

  1. Why are the UK’s energy prices among the highest in the world?
  2. What are the arguments for and against subsidising wind power?
  3. What is the Contracts for Difference scheme in low-carbon energy. What CfDs have been awarded? Assess the desirability of the scheme.
  4. Is the capping of gas and electricity prices the best way of providing support for low-income and vulnerable consumers?
  5. How are externalities relevant in determining the optimal pricing of electricity?