Energy price cap operating cost allowances review

We are reviewing operating cost allowances within the energy price cap, including setting allowances based on up-to-date information, different methods and updating allowances in the future. ### Who should respond We would like views from people who have an interest in how we set the operating cost allowances in the energy price cap. This includes energy suppliers and energy industry bodies. We also welcome responses from consumer groups and charities. ### Background An energy supplier's own costs for retailing energy are called operating costs. Examples of costs include running call centres and IT costs. Operating costs do not include the cost to buy energy for customers, government social and environmental schemes, or costs to fix and repair pipes and wires to transport energy (network costs). An energy supplier's operating costs will vary between different types of customers. For example, these costs vary depending on how customers pay for the energy they use, such as by Direct Debit, Standard Credit or prepayment meter. Operating costs make up about 15% to 20% of an energy bill within each price cap period for energy bill payers who pay for their electricity and gas by Direct Debit. It is spread across three parts of the price cap. The different operating cost allowances are: * operating cost allowance, an allowance for running an energy supplier’s business to serve Direct Debit customers, for example billing and payments * payment method uplift, an allowance for extra costs to serve Standard Credit and prepayment meter customers * Smart Meter Net Cost Change (SMNCC), an allowance for the rollout of smart meters ### Our review and options Our role is to protect consumers now and in the future by working to deliver a greener, fairer energy system. This review covers the operating cost allowance and options around: * core operating costs * debt-related costs * smart metering costs * pass-through industry charges We are carrying out this review in response to some significant changes in the energy market since 2019. For example, changes seen in response to the coronavirus pandemic and the gas crisis, changes to how often the energy price cap is reviewed, and a range of suppliers joining and leaving the market. The data that the allowances are based on is from 2017 or earlier. ### Before you start Read the Energy price cap operating cost allowances review consultation paper. You'll find it in the 'Related' section on this page. The paper contains the full background for this consultation. Please refer to it when giving us your views. ### Responding to this consultation We’d like you to answer all the questions in this consultation that are relevant to you, or where you have an interest. If you do not feel comfortable answering any of the questions, you can leave them blank. If you have any other views or comments you’d like to feedback to us on, you can also add these after the questions section. After you have answered the questions, select the ‘Save and come back later’ option found at the bottom of each page. If you start responding to the consultation and want to return to it later, select 'Save and come back later' to save your answers. You need to answer the questions on the 'About you' page before submitting your response. Your responses will not be included as part of the consultation if you do not submit them using our online form before the closing date. If you miss the deadline we will still accept your responses sent to us by email. #### Other ways to give us your views If you would prefer to give us your views in another way or send us extra information such as diagrams or charts as part of your response, please email them to priceprotectionpolicy@ofgem.gov.uk. --- Consultation Energy Price Cap: Operating cost allowances review Publication date: 14 May 2024 Response deadline: 11:59 pm on 14 June 2024 Contact: Chris McDermott Team: Email: Consumer Protection & Retail Markets priceprotectionpolicy@ofgem.gov.uk We are consulting on our review of the operating cost allowances in the cap, which includes core operating costs, debt-related costs, smart metering costs and pass-through industry charges. In this consultation, we set out options across these four areas, covering key strategic themes such as how we benchmark costs across suppliers and allocate costs across groups of customers. We would like views from stakeholders with an interest in how we set the operating cost allowances in the cap. We particularly welcome responses from consumer groups and charities, energy suppliers and industry bodies. We would also welcome responses from other stakeholders and the public. This document outlines the scope, purpose and questions of the consultation and how you can get involved. Once the consultation is closed, we will consider all responses. We expect to implement any decisions from this review for the April 2025 cap period. We want to be transparent in our consultations. We will publish the non-confidential responses we receive alongside a decision on next steps on our website at ofgem.gov.uk/consultations. If you want your response – in whole or in part – to be considered confidential, please tell us in your response and explain why. Please clearly mark the parts of your response that you consider to be confidential, and if possible, put the confidential material in separate appendices to your response. If you are responding using our online form, please tell us at the end of the form if some or all of your responses are confidential. OFG1163 Consultation – Energy Price Cap: Operating cost allowances review © Crown copyright 2024 The text of this document may be reproduced (excluding logos) under and in accordance with the terms of the Open Government Licence. Without prejudice to the generality of the terms of the Open Government Licence the material that is reproduced must be acknowledged as Crown copyright and the document title of this document must be specified in that acknowledgement. Any enquiries related to the text of this publication should be sent to Ofgem at: 10 South Colonnade, Canary Wharf, London, E14 4PU. This publication is available at www.ofgem.gov.uk. Any enquiries regarding the use and re-use of this information resource should be sent to: psi@nationalarchives.gsi.gov.uk 2 Consultation – Energy Price Cap: Operating cost allowances review Contents Energy Price Cap: Operating cost allowances review .............................. 1 Executive Summary ................................................................................ 5 Context of this review alongside other strategic workstreams .................... 5 Price cap background ........................................................................... 7 Case for review ................................................................................... 7 Areas of review ................................................................................... 8 1. Introduction .................................................................................... 10 What are we consulting on? ................................................................. 10 Related publications ........................................................................... 11 Consultation stages ............................................................................ 13 How to respond ................................................................................. 14 2. Context ........................................................................................... 17 Background ....................................................................................... 17 Case for change ................................................................................. 22 Scope of the review ............................................................................ 26 Overarching themes ........................................................................... 27 3. Core operating costs ....................................................................... 30 Context ............................................................................................ 30 Benchmark approach .......................................................................... 37 Allocating costs across customer groups ................................................ 52 Updating the core operating cost allowance ........................................... 59 4. Debt-related costs ........................................................................... 64 Context ............................................................................................ 64 Cost components to include in the allowance .......................................... 70 Measuring cost components ................................................................. 72 Benchmarking approach ...................................................................... 79 Cost allocation ................................................................................... 86 Setting the allowance and updating mechanism ...................................... 94 5. Smart metering costs ...................................................................... 98 Context ............................................................................................ 98 Setting the smart metering costs allowance ......................................... 105 Setting the SMNCC between October 2024 and March 2025 ................... 112 6. Pass-through industry charges...................................................... 115 Context .......................................................................................... 115 Setting the allowance ....................................................................... 118 Appendices ......................................................................................... 124 Appendix 1 – Information request breakdown .................................... 125 Information request ......................................................................... 125 Appendix 2 – Summary of areas for feedback ..................................... 129 Chapter 3 - Core operating costs ........................................................ 129 3 Consultation - Energy Price Cap: Operating cost allowances review Chapter 4 - Debt-related costs ........................................................... 130 Chapter 5 - Smart metering costs....................................................... 130 Chapter 6 - Pass-through industry charges .......................................... 131 Appendix 3 – Privacy notice on consultations ..................................... 132 Personal data .................................................................................. 132 4 Consultation - Energy Price Cap: Operating cost allowances review Executive Summary We introduced the default tariff cap (‘the cap’) on 1 January 2019, which currently protects 29 million customers on standard variable and default tariffs. The cap ensures that default tariff customers pay a fair price for their energy that reflects the efficient underlying cost to supply that energy. One component of the cap is operating costs. We have previously defined operating costs as a supplier’s own costs of retailing energy (eg the cost of running call centres, the cost of IT systems etc), excluding the costs of purchasing energy; the cost of meeting environmental and social obligations; and network charges. The operating cost allowance plays an important role across a number of strategic areas in the cap, such as providing suppliers with incentives to improve efficiency and covers areas such as smart metering and debt-related costs. They are a key area of the cap because these are the costs suppliers have most control over. Additionally, the operating costs can vary by customer type, so can influence variation in bills between customers. Context of this review alongside other strategic workstreams This review is being undertaken within the context of a number of wider interrelated reviews of pricing reforms, which we outline below. When carrying out this review alongside the wider suite of strategic packages, we recognise that there may competing objectives and demands, for example to facilitate an investable and resilient retail market and to ensure the cap maintains an appropriate level of protection for default customers. There may also be trade-offs across all workstreams around the allocation of costs and benefits between different groups of customers. For example, in considering the allocation between the standing charge and unit rate, which may deliver different outcomes for consumers based on how much energy they use. Across all of these inter- related workstreams, where possible and appropriate, we will seek to align positions with those wider reviews to facilitate a consistent and co-ordinated package of policy reforms, and ensuring they deliver positive benefits for consumers as a whole. We are exploring pricing reform through a number of reviews, these include: Standing charges – We published a call for input to explore what interventions may be required to mitigate recent increases in standing charges and whether we need to reform 5 Consultation - Energy Price Cap: Operating cost allowances review the role of standing charges in the retail market.1 Currently the costs associated with supplier operating costs fall on the standing charge. Operating costs are the second largest single contributor to the standing charge (after network costs). As part of this operating cost review, we want to ensure we are scrutinising the component parts of operating costs. In addition, we want to explore whether these costs continue to be appropriately allocated to the standing charge, or whether a unit-rate based approach could be more appropriate and the trade-offs involved. Debt and affordability – We published a call for evidence on debt and affordability across energy customers.2 The call for input sets out the challenges debt and affordability pose to the current and future market and that debt must be managed in a compassionate and sustainable way. We recognise the impact debt has on consumers and the debt and affordability review is a pathway for consumer focused solutions. The operating cost allowance is the primary route through which we assess and capture the costs suppliers incur to manage debt efficiently. We have provided a number of separate uplifts for debt-related costs over time. We want to ensure that this operating cost review takes a holistic look at the costs of debt that suppliers face. This will allow us to provide an allowance that represents efficient costs and ensures appropriate incentives on suppliers, alongside potential other interventions on debt. Future price protection – In March, we published a discussion paper to set out how the cap may need to evolve to respond to the future energy market and enable greater flexibility in pricing (eg in light of Market wide Half Hourly Settlement).3 The paper outlines how it may become increasingly challenging for Ofgem to maintain a flat, stringent and universal price cap as the costs faced by suppliers become increasingly differentiated. This followed a related publication from DESNZ on “Future Default Tariff Arrangements”.4 An updated understanding of operating costs would contribute to the design of some of the options for future price protection. This document sets out our proposal to conduct a review of the operating cost methodology within the price cap and outlines our considered options regarding the various allowances for suppliers' operational costs. 1 Ofgem (2024), Standing charges – call for input. https://www.ofgem.gov.uk/publications/standing-charges-call-input 2 Ofgem (2024), Affordability and debt in the domestic retail market – a call for input. https://www.ofgem.gov.uk/publications/affordability-and-debt-domestic-retail-market-call-input 3 Ofgem (2024), Future Price Protection Discussion Paper. https://www.ofgem.gov.uk/publications/future-price-protection-discussion-paper 4 Department for Energy Security and Net Zero, Default energy tariffs for households: call for evidence. https://www.gov.uk/government/calls-for-evidence/default-energy-tariffs-for-households-call-for-evidence 6 Consultation - Energy Price Cap: Operating cost allowances review Price cap background The operating costs account for up to 21% of the overall bill in a given cap period and are currently spread across three cost components in the cap: • Operating cost allowance: This allowance reflects the operational costs associated with serving a Direct Debit customer. It includes costs such as metering, billing and payments, central overheads and amortised costs. • Payment method uplift: This allowance accounts for the additional costs of serving Standard Credit and prepayment meter (PPM) customers respectively. • Smart Meter Net Cost Change (SMNCC): The SMNCC provides an allowance for the smart meter rollout. The benchmark operating cost based on 2017 data includes some costs for smart metering, but these costs change differently to others as the rollout progresses. We calculate the allowance as a change between 2017 and later periods to capture this difference. Case for review Since the cap was introduced and these allowances were set (based on 2017 or older data), the market has gone through several changes, such as market consolidations (eg acquisitions and exits), introduction of regulatory changes (eg quarterly cap updates) and external events (eg the Covid-19 pandemic and the gas crisis). Additionally, the cap has now been in place longer than originally envisaged. In our 2018 decision, we deliberately set a stringent operating cost benchmark for suppliers to meet, thus requiring the market as a whole to make considerable efficiency improvements in how they run their businesses. With consideration given to the efficiency improvements made by suppliers since then, the operating costs suppliers now face may be very different. Additionally, as set out in our March 2023 programme of work update, the operating cost review forms part of a package of work including the debt-related cost true-up and the next phase of levelisation.5 We will need to be mindful of the interactions between these workstreams when conducting this review. For these reasons, we think it is an ideal time to review the operating cost allowances and if appropriate consider updating the methodology underpinning the allowances, using more recent cost information. 5 Ofgem (2024) Energy price cap programme of work for 2024 and 2025. https://www.ofgem.gov.uk/publications/energy-price-cap-programme-work-2024-and-2025 7 Consultation - Energy Price Cap: Operating cost allowances review Areas of review We have split the review into four component areas: core operating costs, debt-related costs, smart metering costs and pass-through industry charges. The four areas have different factors and requirements that may determine the best approach for setting the methodology. Splitting them allows us to consider different sets of options and approaches, enabling us to set a more flexible cap: Core operating costs – the review covers all operational costs except for debt-related costs and industry charges. We set out options covering benchmarking costs across suppliers (ie the stringency at which we set the allowance), allocating costs across different customer groups (eg payment methods). As part of this, we also consider how we allocate costs across the standing charge and unit rate, acknowledging the interaction with the wider standing charge review. Finally, we explore options for updating the allowance over time. Debt-related costs – the review covers bad debt, debt administration and working capital costs. We set out options for how we measure the three costs, benchmarking costs across suppliers (covering both stringency and how we account for interactions between the three debt-related costs) and allocating the costs across payment methods given some customers may have a higher propensity to build up debt. We also consider how we could update the allowance over time, particularly given the current uncertainty of debt costs. Smart metering costs – the review covers the transitional costs for suppliers installing and operating smart meters. We set out options for reviewing and setting the transitional smart meter allowance. We also propose to use the current model to set the allowance between October 2024 and March 2025 without carrying out an update. Pass-through industry charges – covers costs of industry bodies such as Elexon, Xoserve and RECCo. We discuss an option to set pass-through industry charges as a separate allowance based on industry body charging statements rather than incorporating these costs into the core operating cost element of the allowance. We are inviting views and evidence from all interested parties to help us shape this operating cost review. We particularly welcome responses from consumer groups and charities, energy suppliers and industry bodies. We also welcome views from other stakeholders and public. We are seeking written comments to the questions and detail set out in this consultation by 11:59 pm on 14 June 2024. Please tell us your views and answer the questions using 8 Consultation - Energy Price Cap: Operating cost allowances review our online survey6 or send us your views, answers to the questions and extra information such as diagrams or charts by emailing priceprotectionpolicy@ofgem.gov.uk. 6 https://consult.ofgem.gov.uk/energy-supply/energy-price-cap-operating-cost-allowances-review 9 Consultation - Energy Price Cap: Operating cost allowances review 1. Introduction Section summary In this chapter, we set out the steps of our operating cost review, including an overview of this consultation, related publications and consultation steps. What are we consulting on? 1.1 This consultation sets out the options under consideration for four key areas of our operating cost review: core operating costs, debt-related costs, smart metering costs and industry charges. At this stage, we are not setting out preferred position or decisions on these policy areas, but rather discussing a range of options and key considerations. We are seeking stakeholder feedback on these options and invite views to help us inform our positions. 1.2 The structure of this consultation is set out as below. Chapter 1: Introduction 1.3 In this chapter, we set out a high-level overview of what we are consulting on in respect of the operating cost review and an outline of our consultation process. Chapter 2: Context 1.4 In Chapter 2, we provide background to the legislative framework that underpins the default tariff cap (the “cap”), setting out the objectives and matters we must have regard to. We also set out the wider market context in which we are carrying out this review and the other relevant work Ofgem is doing over the retail market that may interact with this review. Chapter 3: Core operating costs 1.5 In Chapter 3, we set out the first of the four areas we are reviewing – core operating costs. We provide context on how the operating cost allowance is set in the cap, which closely aligns with the cost lines we are considering under core operating costs. 1.6 We set out options in a number of areas, such as how we benchmark costs over the market, how we allocate costs across groups of customers (eg those who pay by different payment methods and recovering costs across the standing charge and unit rate) and how we update the allowance over time. We also set out key 10 Consultation - Energy Price Cap: Operating cost allowances review considerations for topics that relate to the options we discuss. For example, we discuss the role of non-efficiency factors in setting the benchmark. Chapter 4: Debt-related costs 1.7 In this chapter, we discuss setting an enduring allowance for debt-related costs (including bad debt, debt administration and working capital). We describe how the current allowances for these costs are set in the cap and note the several adjustments we have made for debt-related costs since the cap was introduced (eg to cover the additional costs for COVID-19). We define enduring as the base allowances in the cap for this cost area, excluding ad-hoc adjustments we have made for debt-related costs. 1.8 Similar to Chapter 3, we discuss options for benchmarking costs across the market and allocating costs across groups of customers. In addition, we also discuss options for defining how we calculate these costs and a varied option set for how we update the costs over time. Our discussion of these options includes key considerations such as uncertainty in debt-related costs when benchmarking, cost reflectivity when allocating costs, as well as the accuracy with which we can update allowance over time. Chapter 5: Smart metering costs 1.9 In Chapter 5, we set out how we model costs associated with the smart meter rollout in the Smart Metering Net Cost Change (SMNCC) allowance. We also set out broad options for modelling the costs of the rollout. 1.10 We also propose to use the current model to set the allowance between October 2024 and March 2025 without carrying out an update. Chapter 6: Pass-through industry charges 1.11 In Chapter 6, we describe how the operating cost allowance captures two key industry charges – Elexon and Xoserve charges. We also set out the pass-through industry charges set by the SMNCC. 1.12 We mainly discuss whether to retain the current approach – ie whether we include industry charges in the core operating cost allowance or whether we set a separate pass-through industry charges component. Related publications 1.13 The main general documents relating to the cap are: 11 Consultation - Energy Price Cap: Operating cost allowances review • Domestic Gas and Electricity (Tariff Cap) Act 2018: https://www.legislation.gov.uk/ukpga/2018/21 • 2018 decision on the cap methodology (‘2018 decision’): https://www.ofgem.gov.uk/publications/default-tariff-cap-decision-overview • Energy Prices Act 2022: https://www.legislation.gov.uk/ukpga/2022/44 1.14 The main documents relating to this consultation are: • November 2018 – Decision tariff cap: decision – overview, Appendix 1 – Benchmark methodology https://www.ofgem.gov.uk/publications/default-tariff- cap-decision-overview • November 2018 – Decision tariff cap: decision – overview, Appendix 6 - Operating costs https://www.ofgem.gov.uk/publications/default-tariff-cap- decision-overview • November 2018 – Decision tariff cap: decision – overview, Appendix 8 – Payment method uplift https://www.ofgem.gov.uk/publications/default-tariff-cap- decision-overview • November 2018 – Decision tariff cap: decision – overview, Appendix 7 – Smart metering costs https://www.ofgem.gov.uk/publications/default-tariff-cap- decision-overview • February 2023 – Price cap – Decision on the true-up process for COVID-19 costs https://www.ofgem.gov.uk/publications/price-cap-decision-true-process- covid-19-costs • February 2023 – Price cap – February 2023 decision on approach to reviewing the SMNCC allowances https://www.ofgem.gov.uk/publications/price-cap- february-2023-decision-approach-reviewing-smncc-allowances • April 2023 - Levelisation of payment method cost differentials: a call for evidence https://www.ofgem.gov.uk/publications/levelisation-payment-method- cost-differentials-call-evidence • May 2023 - Call for Input on the Operating Cost Allowances Review https://www.ofgem.gov.uk/publications/price-cap-call-input-operating-cost- allowances-review • December 2023 – Energy price cap: additional debt costs review consultation https://www.ofgem.gov.uk/publications/energy-price-cap-additional-debt-costs- review-consultation 12 Consultation - Energy Price Cap: Operating cost allowances review Consultation stages 1.15 In May 2023, we published a call for input in which we outlined the key areas we intended to consider as part of this operating cost review. The document was high level and we did not set out a detailed set of options for each area. However, stakeholder responses have helped us refine options for each area in this consultation. 1.16 In July 2023, we issued a request for information to collect supplier operating cost data for the calendar years 2019 and 2022. This covered a breakdown of key activities suppliers carry out, split by fuel, payment method and meter type (ie smart or traditional). We asked suppliers to reconcile costs to their statutory accounts. 1.17 We also published a working paper on benchmarking costs in October 2023. The working paper set out how we could link the benchmark approach (and consequential view on stringency of the allowance) with outcomes we seek to achieve in the market. 1.18 This policy consultation continues this process and is the first stage of seeking stakeholder feedback on our option set. We set out four areas of the review and ask accompanying questions to help inform our proposed positions for our next consultation. 1.19 We intend to carry out further stakeholder engagement over the summer, which will focus on key areas where the options are more complex (eg smart metering costs and debt-related costs). This may be in the form of working papers or stakeholder workshops. Alongside this engagement, we have also issued another RFI to collect operating cost data for the calendar year 2023. 1.20 We intend to publish our next and final consultation for this review in Autumn of this year. Our aim is for that consultation to set out our proposed position in each of the areas covered by this review. We also intend to carry out a disclosure exercise alongside that consultation. 1.21 We intend to issue a decision in February 2025, which should allow us to implement any updates to the operating cost allowance in April 2025. However, our ability to make a decision at this stage will be contingent on the feedback we receive from the Autumn consultation. 13 Consultation - Energy Price Cap: Operating cost allowances review Figure 1.1: Consultation stages Stage 1 Stage 2 Stage 3 Stage 4 Policy consultation Working Final consultation Decision papers/stakeholder engagement May 2024 Summer 2024 Autumn 2024 February 2025 How to respond 1.22 We want to hear from anyone interested in this consultation. You can respond in one of two ways: • • tell us your views and answer the questions using our online survey.7 send us your views, answers to the questions and extra information such as diagrams or charts by emailing priceprotectionpolicy@ofgem.gov.uk. Your response, data and confidentiality 1.23 You can ask us to keep your response, or parts of your response, confidential. We will respect this, subject to obligations to disclose information, for example, under the Freedom of Information Act 2000, the Environmental Information Regulations 2004, statutory directions, court orders, government regulations or where you give us explicit permission to disclose. If you do want us to keep your response confidential, please clearly mark this on your response and explain why. 1.24 If you wish us to keep part of your response confidential, please clearly mark those parts of your response that you do wish to be kept confidential and those that you do not wish to be kept confidential. Please put the confidential material in a separate appendix to your response. If necessary, we will get in touch with you to discuss which parts of the information in your response should be kept confidential, and which can be published. We might ask for reasons why. 1.25 If the information you give in your response contains personal data under the General Data Protection Regulation (Regulation (EU) 2016/679) as retained in domestic law following the UK’s withdrawal from the European Union (“UK GDPR”), the Gas and Electricity Markets Authority will be the data controller for the purposes of GDPR. Ofgem uses the information in responses in performing its 7 https://consult.ofgem.gov.uk/energy-supply/energy-price-cap-operating-cost-allowances-review 14 Consultation - Energy Price Cap: Operating cost allowances review statutory functions and in accordance with section 105 of the Utilities Act 2000. Please refer to our Privacy Notice on consultations, see Appendix 4. 1. 26 If you wish to respond confidentially, we will keep your response itself confidential, but we will publish the number (but not the names) of confidential responses we receive. We will not link responses to respondents if we publish a summary of responses, and we will evaluate each response on its own merits without undermining your right to confidentiality. General feedback 1.16. We believe that consultation is at the heart of good policy development. We welcome any comments about how we have run this consultation. We would also like to get your answers to these questions: 1. Do you have any comments about the overall process of this consultation? 2. Do you have any comments about its tone and content? 3. Was it easy to read and understand? Or could it have been better written? 4. Were its conclusions balanced? 5. Did it make reasoned recommendations for improvement? 6. Any further comments? Please send any general feedback comments to stakeholders@ofgem.gov.uk How to track the progress of the consultation You can track the progress of a consultation from upcoming to decision status using the ‘notify me’ function on a consultation page when published on our website. Ofgem.gov.uk/consultations 15 Consultation - Energy Price Cap: Operating cost allowances review Once subscribed to the notifications for a particular consultation, you will receive an email to notify you when it has changed status. Our consultation stages are: Upcoming > Open > Closed (awaiting decision) > Closed (with decision) 16 Consultation - Energy Price Cap: Operating cost allowances review 2. Context Section summary In this chapter, we set out the background to the cap and the legislative framework under which we set it. We outline the case for change and scope of the operating cost review. We also set out our views on overarching themes such as data collection, disclosure and implementation. Background Default tariff cap 2.1 The cap was introduced on 1 January 2019 and protects existing and future domestic customers on standard variable and default tariffs (which we refer to collectively as ‘default tariffs’), ensuring that customers pay a fair price for their energy that reflects the efficient underlying cost to supply that energy. The cap is provided for in legislation through the Domestic Gas and Electricity (Tariff Cap) Act 2018 (the ‘Act’). 2.2 We are required to exercise our functions under the Act with a view to protecting existing and future domestic customers who pay standard variable tariffs and default tariff rates (together we refer to these as default tariffs). We must have regard to five matters when setting the cap: • The need to create incentives for holders of supply licences to improve their efficiency. • The need to set the cap at a level that enables holders of supply licences to compete effectively for domestic supply contracts. • The need to maintain incentives for domestic customers to switch to different domestic supply contracts. • The need to ensure that holders of supply licences who operate efficiently are able to finance activities authorised by the licence. • The need to set the cap at a level that takes account of the impact of the cap on public spending. 2.3 The requirement to have regard to the five matters identified in section 1(6) of the Act does not mean that we must achieve all of these. In reaching decisions on particular aspects of the cap, the weight to be given to each of these 17 Consultation - Energy Price Cap: Operating cost allowances review considerations is a matter of judgement. Often, a balance must be struck between competing considerations. 2.4 The cap sets the maximum amount a supplier can charge default tariff customers for energy. It varies based on several different parameters, including fuel type, benchmark consumption, electricity meter type, regional differences and payment method. 2.5 We calculate the cap using a bottom-up assessment of a notionally efficient supplier’s costs (ie we calculate each cost component individually and then add them together) and set it to reflect the notionally efficient energy supply costs. In the aggregate, this approach ensures our benchmark (and cap) reflects the underlying efficient costs of supplying customers with energy. Operating cost related allowances 2.6 The operating cost related allowances are currently made up of three distinct components in the cap: the operating cost allowance, payment method uplift and SMNCC. Together, these components allow for the operational costs of a notionally efficient supplier. Typically, these are costs we deem suppliers to have greater control over based on the commercial decisions they make. 2.7 The operating cost allowance reflects the operational costs of serving a Direct Debit customer and is set using 2017 supplier cost data. We use a stringent approach to benchmarking costs (taking the lower quartile minus £5) to set the allowance to incentivise efficiency improvement. We update the allowance by indexing it against the Consumer Prices Index including owner occupiers' housing costs (CPIH). This means that the allowance remains the same in real terms but allows for inflationary pressures. We explain how the operating cost allowance is calculated in Chapter 3. 2.8 The payment method uplift reflects the additional costs of serving Standard Credit and Prepayment Meter (PPM) customers relative to Direct Debit customers. The additional costs of PPM customers are set as a flat allowance and indexed by CPIH over time to update. The allowance for Standard Credit customers is mostly set as a percentage of the other cap allowances and therefore varies over time relative to the overall bill size. A smaller proportion of the costs are set as a flat allowance and indexed by CPIH over time. We describe the payment method uplift allowance in more detail in Chapter 3 for PPM and the element of Standard Credit that relates to customer contact. In Chapter 4 we describe the Standard Credit payment method uplift that relates to debt-related costs. 18 Consultation - Energy Price Cap: Operating cost allowances review 2.9 The SMNCC allowance captures the transitional costs of the smart meter rollout. We take a modelled approach to set this allowance, rather than solely relying on supplier cost data. The allowance changes over time as more smart meters are rolled out. The allowance is set at different levels for PPM relative to Direct Debit and Standard Credit. This reflects the differences in metering costs between traditional PPM meters and traditional credit (capturing Direct Debit and Standard Credit) meters. In Chapter 5, we set out in more detail the approach to modelling smart metering costs. 2.10 Together, these allowances typically make up around 15-20% of the overall cap level for a dual fuel Direct Debit customer. Figure 2.1 below shows that the allowance is stable over time (constant in real terms given we update it for inflation). However, the allowance as a proportion of the overall cap dropped when the cap level sharply rose in line with commodity costs during the gas crisis. Figure 2.1 – Operating cost allowance per cap period8 2.11 Typically, Standard Credit is the most expensive payment method due to the increased cost of paying in arrears and the increased risk of bad debt that brings. The additional costs of Standard Credit are indexed against the other cap 8 £ per typical dual fuel Direct Debit customer, pre levelisation. These values are at benchmark consumption (electricity 3,100 kWh, gas 12,000 kWh) – this is different to the TDCV (Typical Domestic Consumption Value) at which we announce the cap as part of our press material. All figures where we present cap allowances in this document are at benchmark consumption level. 19 Consultation - Energy Price Cap: Operating cost allowances review components (ie set as a percentage of other costs such as the wholesale allowance) so changes in scale relative to the overall cap level. This means the differential also increases at times where bills are high. Figure 2.2 shows this trend over time. Notably the differential is at its highest in cap period 9b when the wholesale allowance in the cap was at its highest. 2.12 By comparison, the additional costs of PPM customers driven by operating costs are relatively flat given the additional costs are indexed by inflation and do not differ by consumption. Figure 2.2 – Operating cost allowance differential relative to Direct Debit by payment method9 2.13 To note, Figure 2.2 only reflects the differential driven by the payment method uplift and SMNCC. There are other components outside of operating costs that also impact the PPM cap level, in particular. For example, we applied ad-hoc wholesale adjustments to Direct Debit and Standard Credit customers but not to PPM customers as we deemed the additional wholesale costs were not incurred by PPM customers. Also, the allocation of Unidentified Gas costs as part of the wholesale allowance was weighted more heavily to PPM customers over a certain period as set out by the Allocation of Unidentified Gas Expert (AUGE) statement. Economic situation 2.14 Energy prices are falling following two years of extraordinary price rises. However, prices remain materially higher than before the crisis and even when 9 £ per typical dual fuel customer, pre levelisation. 20 Consultation - Energy Price Cap: Operating cost allowances review accounting for wage growth over the period, energy accounts for a much higher share of household income than before the crisis. 2.15 We have seen an increase in cost of living pressures driven by more than just energy costs, which have contributed to financial difficulties for customers, particularly those in vulnerable situations. Government support helped to mitigate affordability issues while the gas crisis was at its height, but we have nevertheless seen debt levels rise as people struggle to meet the costs of higher bills. Our latest data shows there is £3.1 billion of debt and arrears across the energy market (as of December 2023), an increase of over £1 billion since the start of 2023. 2.16 In light of these challenges, we have made substantial changes to the market in the last year to support customers, which include: • New customer services standards for energy suppliers aimed at making it easier for customers to contact their energy supplier and help support those who may be struggling with their bills last winter; 10 • A voluntary pause on forced prepayment meter installations and a market compliance review focused on forced installation and remote mode switches; • Introducing new rules for suppliers in relation to involuntary prepayment meter installations.11 We have also set out our expectations to energy suppliers meeting restart conditions for involuntary installations;12 • Levelising standing charges between Direct Debit and PPM customers to reduce the impact of otherwise higher standing charges on prepayment meter customers and the impact this can have on debt during low or no consumption periods. This will help ensure there remains support for prepayment meter customers, following the end of the Energy Price Guarantee (EPG) at the end of March 2024; and • Introducing an initial adjustment for additional debt-related costs.13 While this increased the cap, it also enables suppliers to offer better support to customers in payment difficulties. 10 Ofgem (2023), Consumer standards decision. https://www.ofgem.gov.uk/publications/consumer-standards-decision 11 Ofgem (2023), Involuntary prepayment meter decision. https://www.ofgem.gov.uk/publications/involuntary-prepayment-meter-decision 12 Ofgem (2024), Expectations to energy suppliers on prepayment meter restart conditions. https://www.ofgem.gov.uk/publications/ofgem-sets-out-prepayment-meter-expectations-energy-bosses-edf- octopus-and-scottish-power-meet-regulators-restart-conditions 13 Ofgem (2024), Energy price cap: Additional debt-related cost review decision. https://www.ofgem.gov.uk/publications/energy-price-cap-additional-debt-costs-review-decision 21 Consultation - Energy Price Cap: Operating cost allowances review 2.17 Our work in the retail market continues, and we are carrying out reviews in a number of areas to continue supporting customers. These areas include, standing charges, debt and affordability, future price protection and wider price cap work. We describe these areas and their interaction with this review later in the chapter. Case for change 2.18 As our work over the last year highlights, there have been a number of changes in the market since the cap was introduced. This ranges from the support measures we have introduced to the wider industry changes occurring such as the ongoing smart meter rollout and the planned introduction of Market Wide Half-Hourly Settlement (MHHS). The case for change and carrying out this review is informed by two areas: changes in the market/regulatory space and interaction with other work areas. 2.19 For added context, the current allowances were set using data from 2017 (or older in the case of the PPM uplift). Given this and the other factors mentioned above, we consider it is appropriate to carry out this review. 2.20 We do not propose to true-up any differences between the current allowance and the outcome of this review (in either direction). We balance various factors and look over time to make judgements in the round. In particular for this review, we balance passing through any cost savings to customers and allowing suppliers to keep any return on investing in efficiency improvements, but also to ensure the cap does not drift from efficient costs to the detriment of customers. In principle, we anticipate any changes resulting from his review to apply on a forward looking basis. Changes in the market and regulatory space Market structure 2.21 Over the last few years, there has been significant consolidation in the market. There have been several large scale mergers and acquisitions such as E.ON’s acquisition of Npower, OVO Energy’s acquisition of SSE and Octopus Energy’s acquisition of Bulb. In addition to this, there have also been a number of suppliers exits leading to further consolidation through the Supplier of Last Resort process. In December 2017, there were 68 active domestic suppliers offering gas and/or electricity in the market, but this number has dropped to 20 as of December 2023. 22 Consultation - Energy Price Cap: Operating cost allowances review 2.22 Given the number of suppliers entering and exiting the market since the allowance was set means that if we were to benchmark costs again today, the make-up of the data and suppliers in the sample would likely be different to our process in 2018. This supports the view that it is an appropriate time to carry out a review of the operating cost allowance. External events 2.23 There have been a number of economic events that have impacted the market and may have impacted suppliers’ efficient costs. For example, the COVID-19 pandemic is likely to have impacted suppliers both operationally (eg central overheads from staffing costs) as well as from serving customers (eg customer contact frequency). The gas crisis and rising bills, followed by the current cost of living pressures are likely to have also had an effect. 2.24 We have already made a number of adjustments to the cap to reflect these events, for example our decision on the COVID-19 float and more recently the additional debt-related costs float.14 Some of these impacts may have an enduring effect on suppliers’ costs, making it an appropriate time to review the allowances. However, in assessing the options, we will be mindful of where cost impacts could be temporary and captured in our data. Regulatory and cap changes 2.25 As outlined in the previous section, we have made a number of recent regulatory changes. We expect some of these changes may have a knock-on effect on a notionally efficient supplier’s costs. For example, the enhanced customer service standards rules might incur additional costs. 2.26 We have also changed how the cap functions over the last couple of years. For example, from October 2022, we changed from six-monthly cap updates to quarterly cap updates. We introduced this change to the cap to reduce the lag between observing prices and factoring them into the wholesale allowance so the cap reflects changes in wholesale prices quicker. This change could have an impact on suppliers’ operating costs as it increases the frequency at which suppliers send out communications on price changes to their customers. 14 Ofgem (2024), Energy price cap: additional debt costs review decision. https://www.ofgem.gov.uk/publications/energy-price-cap-additional-debt-costs-review-decision Ofgem (2023), Price Cap – Decision on the true-up process for COVID-19 costs. https://www.ofgem.gov.uk/publications/price-cap-decision-true-process-covid-19-costs 23 Consultation - Energy Price Cap: Operating cost allowances review 2.27 On the horizon, there will continue to be change in the market. We are carrying out reviews in key parts of the retail market, which may lead to consequential changes in regulation and could impact suppliers’ costs. Additionally, as we continue to move towards the future retail market and enabling net-zero through changes such as MHHS, operating costs may also continue to change. For example, new technologies may become available which help suppliers reduce their operating costs. Whist we may not be able to capture all future changes in costs through this review, we will consider how we best update the allowance to better ensure it remains appropriate over time. Interaction with other work areas 2.28 The operating cost review is a core part of our price cap work. In March 2024 we published our updated price cap programme of work.15 In this document, we set out key updates since our last published programme, our package of workstreams intended for an April 2025 delivery (debt-related cost true-up, operating cost review and our next phase of levelisation), our work on future price protection and our wholesale allowance review. In addition to these areas, we are also carrying out reviews of standing charges and debt and affordability. 2.29 All of these areas interact with the operating cost review. Across these areas we seek to develop an approach to retail pricing that enables fair pricing and price signals, whilst setting appropriate incentives for suppliers (eg to improve efficiency and support customers). 2.30 Therefore, this review is being undertaken within the context of a number of wider interrelated review of pricing reforms. Many of the choices across these interrelated areas weigh up often competing objectives and demands, so we may not always reach the same conclusions in consistent circumstances. When carrying out this review, where possible and appropriate, we will seek to align positions with those wider reviews to manage any interactions and seek to achieve a coordinated policy outcome. However, given that timelines across those reviews may change as the workstreams evolve, the options in this consultation, will also be assessed on their own merits. Our decision making in this area does not – and is not intended to - fetter our future decision making in other reviews or reforms. 15 Ofgem (2024), Energy price cap programme of work for 2024 and 2025. https://www.ofgem.gov.uk/publications/energy-price-cap-programme-work-2024-and-2025 24 Consultation - Energy Price Cap: Operating cost allowances review 2.31 The table below outlines each workstream and describes the interaction with this review. Table 2.1 – Interactions between workstreams and the operating cost review Workstream Description Interaction Debt-related cost true-up We will carry out a review for the need of a ‘true-up’ of the temporary debt-related cost adjustment ‘Float’, that was implemented in April 2024.16 We will also monitor if any interim adjustments may be appropriate for the period up to April 2025 and whether to extend the float provided for Additional Support Credit. In the operating cost review, we intend to set an enduring allowance (ie the base allowance excluding any additional adjustments) for debt- related costs and consider how we allocate those costs across payment methods (including the amount PPM customers should bear for additional support credit). We will need to be mindful of considering similar issues and options (eg how we account for differences in suppliers costs or provisioning approaches), though we may take separate approaches where appropriate. Levelisation of bad debt between Direct Debit and Standard Credit Future price protection In the next phase of levelisation, we will consider whether we should proceed with levelising bad debt costs between Direct Debit and Standard Credit. This difference makes up a significant part of the payment method differential. We will also be undertaking a review of the impact and operation of Phase 1 of levelisation.17 The operating cost review will consider the enduring allowance for bad debt and set the allowances that are used for levelisation. We may consider different options for allocating debt over payment methods depending on whether we proceed with levelisation. The operating cost review will consider how to allocate costs, which will feed into the outcome of the Phase 1 review as well as allowances going forward for levelising standing charges between PPM and Direct Debit. This workstream will evaluate the impact of the current cap in context of the current and future market and explore options for evolving price protection.18 Our approach to future price protection may influence key strategic themes within reviewing the operating cost allowance such as the stringency at which we benchmark costs. 16 Ofgem (2024), Energy price cap: additional debt costs review decision. https://www.ofgem.gov.uk/publications/energy-price-cap-additional-debt-costs-review-decision 17 Ofgem (2024), Decision on adjusting standing charges for prepayment customers. https://www.ofgem.gov.uk/publications/decision-adjusting-standing-charges-prepayment-customers 18 Ofgem (2024), Standing charges – call for input. https://www.ofgem.gov.uk/publications/standing-charges-call-input 25 Consultation - Energy Price Cap: Operating cost allowances review Standing charges review The review will consider whether we need to reform our approach to standing charges in the retail market.19 Debt and affordability review The review will set out the challenges affordability and debt pose to the current and future market. We intend to develop options which will ensure a sustainable, investible market that protects and supports those in debt and struggling with bills.20 Scope of the review Within the operating cost review, we intend to consider how we allocate costs between the standing charge and unit rate. We intend the operating cost review to be one tool for implementing any outcomes or recommendations from the standing charge review. We will consider any recommendations from the review that impact how we set the operating cost allowance. In particular, there may be an interaction with the stringency of the allowance or how we update based on whether we expect suppliers to take on additional responsibilities to support customers. 2.32 The intention of this review is to update the operating cost allowances in the cap to reflect the efficient costs of a notional supplier in serving customers. When considering changes, we will also consider structural changes to how the operating costs allowances are set in the cap. We consider that this would enable us to select the most appropriate benchmark level and/or how costs are updated over time across cost components that are treated separately. 2.33 In order to achieve our objective, and taking into consideration the stakeholder feedback to our May 2023 Call for input on the scope of the review, our scope of the operating cost review includes: • Core-operating costs: We are considering updating the core operating costs baseline based on re-benchmarking the core operating costs and exploring options for updating the allowance over time. We also consider how we allocate costs across customers (eg across payment methods and across the standing charge/unit rate). • Debt-related costs: We are considering setting a separate allowance in the cap for debt-related costs due to the inherent uncertainty in these costs, which we have observed over the past few years. Our considerations include how we define and benchmark debt-related costs, as well as allocating costs 19 Ofgem (2023), Standing charges – call for input. https://www.ofgem.gov.uk/publications/standing-charges-call-input 20 Ofgem (2024), Affordability and debt in the domestic retail market – a call for input. https://www.ofgem.gov.uk/publications/affordability-and-debt-domestic-retail-market-call-input 26 Consultation - Energy Price Cap: Operating cost allowances review over groups of customers. We also explore options on how we could set this allowance and update it over time. • Smart metering costs: We are exploring options for reviewing and setting the transitional smart meter allowance. We also propose to use the current model to set the allowance between October 2024 and March 2025 without carrying out an update. • Industry charges: We are considering setting a separate allowance in the cap for pass through industry charges. We discuss what industry charges we would include in this allowance and the options on how we could update the allowance over time. 2.34 We set out this review across these four components as they all require different considerations and approaches. For example, the approach to setting industry charges using charging statements does not require benchmarking costs across suppliers like core operating costs or debt-related costs. Setting out the review in this way provides us flexibility in the options we consider. Overarching themes 2.35 There are a number of areas that cut across all elements of this review, these include: operating cost data collection, disclosure and implementing a change in allowance. Data collection 2.36 To assess suppliers’ operating costs, we carried out a Request for Information (RFI) to collect supplier cost data for calendar years 2019 and 2022, as well as forecast data for calendar year 2023. This provided the latest view of audited costs (linked either to the supplier’s consolidated segmental statements or statutory accounts). Collecting 2019 data provided us with a comparison point prior to the gas crisis and COVID-19, which allows us to compare against the 2022 data and consider trends over time. 2.37 In our May 2023 call for input, we said that we considered it appropriate to use the most recent data where possible. However, we noted that we would need to be mindful of the impact recent external events could have on the data. We highlighted the trade-off between using a single year’s data to reflect the cost levels against using an average of multiple years’ data which would not reflect the latest costs but may smooth out any shocks. In response to our call for input, three stakeholders suggested we should collect 2023 data to use for any updates 27 Consultation - Energy Price Cap: Operating cost allowances review to the allowance. They considered that 2023 data would be less impacted by some of the external events such as the numerous supplier failures. 2.38 We have analysed 2023 forecast data against the 2022 data we collected. We found there are some significant differences in reported costs between the two years which could partly be explained by the external events. We intend to collect actual 2023 cost data and use this to assess the options we set out in this consultation. 2.39 In our RFI to collect 2023 data, we request largely similar information to our previous request, with potential supplementary questions. However, we will look to make changes based on clarification questions to suppliers and experience of the previous RFI process. 2.40 In this consultation, we use our analysis of 2022 costs in places as an illustrative example of the difference between options. We note that these numbers are likely to change as we use 2023 data. We expect to use the updated numbers in our final consultation later this year. We do not consider this affects our ability to assess the options put forward from a principle’s perspective and expect positions to be informed by more than just a pure numbers perspective. Disclosure 2.41 We understand the importance of transparency in our analysis and calculations to enable good policy making and facilitate a useful consultation process. Whilst we always aim to explain our methodology and analysis in our consultation documents in a way that is transparent and meaningful, we acknowledge there may be circumstances where it may be helpful to disclose additional information eg if the subject matter is complex / highly technical or is commercially sensitive information. 2.42 A disclosure process can be a useful tool to provide stakeholders with further detail. In the case of this operating cost review, we intend to carry out a disclosure process alongside the final consultation given the potential complexity of our methodology and volume of commercially sensitive information used in setting the allowance. We consider this should help stakeholders to better understand the matters being consulted on in this review. 2.43 Whilst the disclosure process should facilitate a deeper understanding of our approach and assumptions, the purpose of it is to understand and engage with the matters being consulted on rather than the process being used to check our calculations. 28 Consultation - Energy Price Cap: Operating cost allowances review 2.44 We consider whether to carry out a disclosure exercise on a case by case basis given the benefits of carrying out such an exercise differ depending on the matter for consideration. Implementing updated allowances 2.45 The cap is set out in Standard Licence Condition (SLC) 28AD of the gas and electricity supply licences. SLC 28AD sets out how the cap is calculated and how it functions. In addition, several models annexed to the SLCs calculate the different components of the cap (eg Annex 5 is the SMNCC allowance model). We may make changes to the cap models and licence conditions from time to time. For example, in August 2022, we updated SLC 28AD and Annex 2 of the licence conditions to reflect the change from six-monthly cap updates to quarterly cap updates. 2.46 Some of the options we consider through this consultation may require structural changes to the cap (through the annex models) and changes to the licence conditions. For example, the option of setting a separate allowance for pass- through industry charges would involve moving some costs to a different annex model and updating the definition of this component in the licence conditions. 2.47 As we refine our options and form proposed positions in the next consultation, we will provide further information on these structural changes. Where appropriate, we will publish a draft modification notice for the licence conditions and draft models for changes to annex models. 29 Consultation - Energy Price Cap: Operating cost allowances review 3. Core operating costs Section summary In this chapter, we discuss options for setting the core operating cost benchmark and allocating costs across different groups of customers (eg those on different payment methods). We also cover approaches for updating the core operating cost allowance. Context Current approach 3.1 The operating cost allowances are currently split between three components in the cap: (i) the operating cost allowance, (ii) the payment method uplift and (iii) the SMNCC. The operating cost allowance reflects the operational cost of serving a Direct Debit customer. In designing the original price cap methodology, we calculated the incremental cost of serving customers paying by Standard Credit or PPM above a Direct Debit customer – this is captured in the payment method uplift.21 3.2 The third component, the SMNCC, captures the transitional costs of rolling out smart meters. We treat these costs separately as they are more variable over time, with greater change driven by the rollout of smart meters. Therefore, to set these costs, we model the allowance over time, relying on a combination of supplier costs and industry data rather than a purely top-down approach based on a snapshot of supplier costs. The SMNCC differs by payment method with a separate level for PPM and the same level for Direct Debit and Standard Credit. It contributes to the differential between payment methods. 3.3 As specified in the previous chapter, we are breaking down this review into four parts: (i) core operating costs, (ii) debt-related costs, (iii) smart metering costs and (iv) pass-through industry charges. This chapter focuses on the core operating costs element of the review. 3.4 The core operating costs relate most closely to the operating cost allowance and some elements of the payment method uplift. We explain the similarities and differences below. 21 There is also a payment method uplift for Direct Debit, reflecting our decision on how to allocate costs between Direct Debit and Standard Credit customers. 30 Consultation - Energy Price Cap: Operating cost allowances review Current operating cost allowance 3.5 To set the current operating cost allowance we collected 2017 cost data from suppliers.22 The data was broken down across several cost areas including: metering, billing, contact, central overheads, depreciation, and amortisation. We did not collect the data broken down by payment method, so to isolate the Direct Debit costs, we used information on the additional costs to serve PPM and Standard Credit customers.23 Additionally, we made a number of adjustments to the data to improve comparability between suppliers (for example, standardising the cost estimate of Xoserve and Elexon charges using the published charging statement).24 3.6 We benchmarked the operating cost allowance at lower quartile as we considered that setting the benchmark at the frontier would be unlikely to sufficiently cover the costs of an efficient supplier with a typical customer base.25 We found that – compared to frontier suppliers – those suppliers closest to the lower quartile had proportions of PSR and single fuel customers that were much closer to the market average.26 We considered the lower quartile supplier could still achieve efficiency savings, so we reduced the benchmark by £5 to reflect an efficiency saving incentive. 3.7 For the core operating cost element of this operating cost review, we are using a similar breakdown of cost lines to our 2018 decision. Table A1.1