Ofgem's revision of its energy price cap and tariff methodology, which was announced Feb. 3 and takes effect on April 1, follows a record rise in gas and power prices over the past six months, with wholesale gas prices quadrupling in the past year. The cap, first implemented in November 2019, limits the amount suppliers can charge certain consumers for a unit of energy with the aim of protecting more vulnerable customers. It applies to domestic consumers on the standard variable tariff (SVT; the default for the majority of energy tariffs) by direct debit or prepayment meters, totaling approximately 22 million households.

Given the surge in wholesale energy prices since the last cap update was announced in August 2021, and the current cap methodology, the 54% increase does not come as a surprise (see "The Energy Price Crisis: Examining The Impact On U.K. Suppliers," published Sept. 30, 2021, on RatingsDirect). The higher limit aims to ensure that energy suppliers can pass through a much larger portion of their costs. This is because wholesale cost allowances in the current tariff cap have been far below that needed to counter the unsustainably high and structurally volatile price environment since the second half of 2021. That situation led to a wave of supplier exits (29 since the start of 2021), of mostly small to midsize operators with limited hedging abilities, and significant working capital outflows for those remaining.

Despite the revised tariff cap and methodology, U.K. energy suppliers will still feel some pressure. The government has introduced measures to ease the immediate burden of increased electricity costs on households, but if energy prices stay high for a long period, this might not be sustainable. S&P Global Ratings believes the authorities' decisions during the next tariff review will be critical to the credit quality of both energy suppliers and power generators.

The Price Cap Hike And Proposed Reforms Don't Fully Insulate Energy Suppliers

From April 1, 2022, the cap update introduces a twofold rise in the allowance for wholesale energy costs, to about 55% of the cap level from an historical average at about 35% (see chart 1). This is by far the biggest increase since the cap's implementation, far exceeding the 12% rise in October 2021, with the cumulative increase at 73% between April 2021 and 2022. However, in our view, it does not fully reflect forward energy prices for the summer. In particular, the index price used for the current price cap determination is about £130 per megawatt hour (/MWh), but the forward power prices for the same time period (the next two quarters) currently point to about £170/MWh-£180/MWh, implying the wholesale cost allowances embedded in the updated cap will be insufficient during that period.

Chart 1

That said, along with the updated cap level, Ofgem also proposed changes that should bring additional flexibility in the price cap determination, which could support U.K. suppliers, namely:

• A change in the methodology to determine wholesale cost allowances. The revised calculation led to a £61 increase (about 11%) of the allowance for the cap from April 2022 to reflect wholesale costs incurred during the current price cap period, following the unprecedented rise in wholesale energy prices and volatility, bringing additional headroom for suppliers in future periods.
• More frequent price cap updates--quarterly instead of semi-annually--from October 2022, to reduce the time lag between market price changes and their reflection in the price cap.
• A change in license conditions from October 2022 to give Ofgem more flexibility to update the price cap level at any time if "exceptional circumstances" warrant it.

Political Intervention Leaves Suppliers And Generators Unscathed

Shortly after the higher price cap was announced, the U.K. Chancellor of the Exchequer announced a series of measures, costing the government about £9 billion, to mitigate the shock for SVT customers. These include:

• £200 of credit on energy bills, to be repaid in annual instalments of £40 over the next five years.
• A £150 one-off rebate on council tax, applicable to most (80%) of the U.K. population.
• Extension of the "warm home" discount scheme targeting the most vulnerable customers, to reach three million people.

We consider these measures to be rather neutral for suppliers' financial positions, although we don't yet know how the bill rebate mechanism will be implemented. However, we believe they indicate that political intervention will be geared toward easing the burden of energy costs on households, rather than shifting it to the suppliers. Notably, this move points to a change in the government's stance, following adverse intervention in the sector over the past few years.

That said, we expect energy costs will remain a highly sensitive topic in 2022, given its significant political, economic, and social implications. First and foremost, the support package (£350 for the majority of energy customers) will cover only about half of the total increase (£693) of end users' energy bills. The high cost of living is further exacerbated by record inflation, a recent hike in interest rates, and increase in the U.K. annual tax bill from April.

Would Household Support Be Sufficient If Current Conditions Persist?

Given the current level of forward energy prices, Ofgem may announce another increase in its price cap in August 2022 for its October reset if it were to follow the current cap methodology. Unless energy prices and inflationary pressure subside, the government will face a tough decision that will test its ability to provide additional support to households. This would inevitably reignite the debate regarding the government's obligation to address the rising cost of living for the U.K. population.

We note that the current remedy packages do not affect power generators, which are partially benefitting from the currently high power prices (taking into account that the 2022 volumes are almost fully hedged). Based on measures implemented in France, Italy, and Spain, where governments took steps to claw back profits from power producers to decrease the pressure on fiscal budgets, we cannot exclude an impact on U.K. power generation companies in the coming months should prices remain elevated.

The Energy Crisis Is Gradually Changing The U.K. Energy Supply Market

As a result of the unprecedented high energy prices, the number of retail power suppliers in the U.K. dropped to 23 by the end of last year from 49 as of June 30, 2021. We expect market consolidation will continue, albeit to a significantly lesser extent, as energy prices remain high and currently above the wholesale costs allowance. In the current situation, customer churn rates also declined markedly by the end of 2021, given that high commodity prices limit suppliers' ability to offer deals below the price cap level.

Chart 2

Ofgem will also implement reforms to ensure greater resilience for suppliers. New license conditions will allow Ofgem to stop suppliers from taking on new customers temporarily once they reach the 50,000 and 200,000 domestic customers milestones if they don't meet specific requirements. In addition, the regulator launched financial stress testing for suppliers from January 2022, while also reducing its focus on encouraging customers to shop around for the best provider. All these factors will likely help ease competitive pressure and improve profit margins for the sector, after years of challenging operating conditions.

We rate four of the largest energy suppliers in the U.K.:

• Centrica PLC (BBB/Stable/A-2);
• EDF Energy Ltd. (BB+/Watch Neg/B);
• E.ON U.K. PLC (BBB/Stable/A-2); and
• Scottish Power Ltd. (BBB+/Stable/A-2).

Since the beginning of 2021, these suppliers have taken over about 60% of exiting suppliers' customers via the supplier of last resort (SoLR) process. Since the start of 2021, about 2.7 million customers of defunct energy supply companies went through the SoLR process in order to be reallocated to other suppliers; this number excludes Bulb's special administration regime for its 1.7 million customers, which are yet to be allocated.

The remaining suppliers, while increasing their market shares due to taking over such customers, will face material working capital outflows in the first quarter of 2022, as was the case in the fourth quarter of 2021. This is due to commodity purchases in the spot energy market at the current elevated prices to meet additional demand from the new customers, which will only be recovered with a time lag through future price cap changes. The price cap from April 2022 notably includes a £68 SoLR levy in the network costs allowance. The distribution network companies will pay levy claims (totaling about £1.83 billion) to energy companies and recover them from consumers via their charges.

We expect the current high energy prices will likely benefit large, well-established suppliers, due to, among other factors, healthy liquidity, access to capital, and efficient hedging. As an illustration, these elements were among the factors that led to the recent revision of our outlook on Centrica PLC to stable from negative (see "U.K. Energy Supplier Centrica Outlook Revised To Stable On Continuous Deleveraging; 'BBB' Rating Affirmed," published Dec. 15, 2021).

Related Research

• U.K. Energy Supplier Centrica Outlook Revised To Stable On Continuous Deleveraging; 'BBB' Rating Affirmed, Dec. 15, 2021
• U.K. Energy Reforms Unlikely To Prevent Imminent Supplier Failures But Will Boost Resilience Over Time, Nov. 2, 2021
• The Energy Price Crisis: Examining The Impact On U.K. Suppliers, Sept. 30, 2021