Standing charges: domestic retail options

We are seeking views on the options to reduce household standing charges. ## Who should respond We would like views from energy suppliers, consumer groups and household bill payers. We would also like to hear from industry groups and network companies. ## Background Last year we started a review of standing charges. Our [call for input](https://www.ofgem.gov.uk/call-for-input/standing-charges-call-input) had feedback from over 30,000 customers, consumer groups, charities and others. We have now reviewed the feedback and have set out our options to reduce standing charges for households, called ‘domestic standing charges’. This options paper talks about reducing domestic standing charges by moving some charges to the unit rate. It also considers options to increase consumer choice by increasing the range of standing charges offered by suppliers. The paper also outlines what we will consider as part of a broader review of how network costs are recovered from users. We think that there is an overall benefit from the changes discussed in this paper, but some consumers’ bills would increase. We are working together with government on how the impact on households in the domestic retail market could be reduced. Standing charges are set by your energy supplier and are also included in the energy price cap. Your supplier will charge you this cost each day, even if you do not use any energy on that day. The charge covers the cost to maintain the energy supply network, take meter readings, and support government social and environmental schemes. You can find information to help [understand your electricity and gas bill on our website](https://www.ofgem.gov.uk/understand-your-electricity-and-gas-bills). ## Before you start Read the standing charges in the domestic retail market options paper. You'll find it in the 'Related' section on this page. The paper contains the full background for this discussion. Please refer to it when giving us your views. --- Options Paper Standing charges: domestic retail options Publication date: 23rd August 2024 Response deadline: 20th September 2024 Contact: Dan Norton Team: Email: Retail Pricing Strategy StandingCharges@ofgem.gov.uk This options paper considers feedback provided in response to our call for input on Standing Charges. We discuss reducing domestic standing charges by moving some charges to the unit rate (via the operating costs review) and further consider options to increase consumer choice by increasing the diversity in standing charges offered by suppliers. We also lay out longer term considerations relating to the assignment of network costs as a part of a broader review of how electricity and gas system costs are recovered from users. We expect consumers as a whole to benefit from the changes discussed in this paper, but some consumers’ bills would increase, and we are working together with government on how the impact across households in the domestic retail market could be mitigated. We welcome responses to this options paper. Once the response period is closed, we will consider all responses. 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. Standing charges: domestic retail options © 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 Standing charges: domestic retail options Contents Foreword ................................................................................................ 4 Executive summary ................................................................................. 5 1. Introduction ...................................................................................... 7 Document summary ............................................................................ 7 Related publications ............................................................................ 7 2. Case for change ................................................................................. 8 What makes up standing charges .......................................................... 8 Electricity standing charges have risen and may continue to do so .............. 9 What we heard in response to our standing charges call for input ............. 11 Abolishing standing charges ............................................................... 12 Approach to standing charge reform .................................................... 14 3. Considerations for shifting operating costs to unit rates ................. 19 Context – cost allocation within the price cap ........................................ 20 Scope for standing charge reductions ................................................... 22 Trade-offs and distributional impact ..................................................... 23 4. Increasing consumer choice through tariff diversification .............. 27 Context ........................................................................................... 27 Case for change ............................................................................... 31 Increasing tariff diversity in the fixed term contract market ..................... 32 Options to increase tariff diversity in SVTs ............................................ 34 Smoothing spend for pre-payment customers........................................ 36 5. Network and policy cost allocation .................................................. 39 Context ........................................................................................... 39 Targeted Charging Review (TCR) and network costs allocation ................. 40 Policy cost allocation ......................................................................... 43 Longer term view .............................................................................. 43 6. Conclusion and next steps ............................................................... 44 Standing charges options next steps .................................................... 44 Interrelated workstreams ................................................................... 44 Appendix 1 – Summary of questions ..................................................... 46 Appendix 2 – Draft impact assessment of reducing standing charges in the default tariff cap ............................................................................. 47 Scope and approach .......................................................................... 47 Summary of findings ......................................................................... 48 Impact on consumers ........................................................................ 49 Debt impacts ................................................................................... 56 Impacts on suppliers ......................................................................... 57 Impact on competition and innovation .................................................. 60 Risks, assumptions, and limitations ..................................................... 63 Wider impacts .................................................................................. 64 Appendix 3 – Privacy notice on consultations ....................................... 66 3 Standing charges: domestic retail options Foreword The response to our call for input on standing charges was extraordinary. Over 30,000 people raised their voices, overwhelmingly calling on us to reduce standing charges. The responses made it clear that standing charges are a significant part of the challenge that consumers face in affording their energy bills. Consumers highlighted how standing charges have prevented them from taking full control of their energy costs because no matter how much they reduce consumption, fixed costs do not reduce. This is felt acutely by customers on pre-payment meters, who may have cut back their use over summer, only to find that new credit is used up paying their accumulated standing charge. This is doubly difficult for those who are also paying off energy debt. Over the last few years standing charges have increased. The increase has been principally driven by past changes to electricity network charges aimed at making sure that all users make a fair contribution to the fixed cost of the network, whilst avoiding disproportionate impacts on certain low-income groups. We have explored all the elements of standing charges, and this document lays out the case and potential options for change, considering the risks and benefits. This includes reallocating some operating costs to the unit rate and exploring supplier ability to offer lower standing charge tariffs. We also commit to a review of allocation of network charge and broader system costs to understand whether further changes are needed that would benefit consumers. Making change is not cost free. The costs that make up standing charges still need to be recovered. For example, to deliver net zero we need to maintain and build our networks at pace, to improve customer service companies need to cover their operational expenses, and policies, such as the Warm Home Discount (WHD), need to be funded. Within Ofgem’s powers, we are not able to remove these costs and therefore these options move costs around the bill, which leads to two challenges: • Customers on the default tariff cap who use more than average would see increased costs. Many low-income customers could see a noticeable bill rise, which may increase the already significant affordability challenges for this group. • The price cap as a whole should allow for fair cost recovery to prevent unfair profits and maintain the financial resilience of energy suppliers. These considerations mean that any changes to the way energy prices are constructed are fundamentally linked to the significant debt and affordability challenges that consumers face. Therefore, we are working closely with government on these issues and will return to stakeholders for further consultation later this year. Tim Jarvis, Director General 4 Standing charges: domestic retail options Executive summary The cost of energy has increased as a significant contributor to the broader cost of living crisis. Energy bills remain a higher proportion of household spending than they did pre- 2021, particularly for those on the lowest incomes and, without intervention, this is unlikely to change in the short term. Standing charges have a role to play in the retail energy market. They help suppliers recover the fixed operational costs of serving each consumer, and fund important network build, upgrade and maintenance costs that are necessary to keep consumers connected and to drive progress towards net zero. Our call for input on standing charges highlighted that many consumers find them confusing, do not agree that they are needed, and think that they penalise low-income, low-usage customers. Of the 30,000 individuals that responded, 90% stated that standing charges are unfair and almost two-thirds called for their abolition. Abolishing standing charges in the absence of more fundamental market reform risks increasing costs for a significant proportion of consumers, in particular low income, high demand households. Our broader cost allocation review (set out in Chapter 5) will explore the reforms needed to open up a wider range of options on the future of standing charges We cannot make fixed system costs go away, but we can allocate them differently and work to give customers more choice in how they pay these costs. As an economic regulator, we must work to ensure costs are allocated efficiently and fairly and can allocate costs under the price cap between unit rates, standing charges, or different payment method types. For example, we have already acted to make standing charges for prepayment meter customers the same as those paid by direct debit customers. Despite this, standing charges continue to create challenges for prepayment meter customers, especially those in debt, as well as for many other low-income households. We are therefore focusing on, in particular, supporting customers so that when they put money onto their prepayment meter, it is not used up on unpaid standing charges. This document sets out further options that could be delivered in the coming months to improve consumer choice in the balance of standing charge and unit rate that is right for them and reduce key components of standing charges. Through this document, we are seeking views on two core near-term options: • Changing the price cap allocation methodology to move some supplier operating costs from the standing charge to the unit rate: Earlier this year we published our policy consultation on the operating cost review.1 In it we set out 1 Ofgem (2024), Operating cost allowances review, https://www.ofgem.gov.uk/consultation/energy-price-cap-operating-cost- allowances-review 5 Standing charges: domestic retail options that we would be considering a number of options for changes to how supplier operating costs are recovered. This included increasing the allocation of costs to the standing charge or moving all costs to the unit rate. This document outlines a range of options for moving £20 - £100 of operating costs from standing charges to unit rates, but we are seeking views on whether this is sufficient and what mitigants might be required to enable this. • Increasing consumer choice by increasing tariff diversity: We are considering multiple options for how to increase the diversity in standing charge tariff offerings. These include encouraging suppliers to offer tariffs with more diversity in standing charges and considering mandating such offerings if action is not forthcoming. We are also looking at options for prepayment meter customers in how and when they pay standing charges to reduce the impact of seasonal variation, mitigating harm for prepayment meter customers who experience affordability challenges when energy consumption is higher, i.e. in the winter. Electricity network costs make up the other significant portion of the standing charge. Looking ahead, we need to invest in our electricity networks to reach net zero and reduce our dependency on imported gas. We expect this to result in lower bills overall, but unless we change how these costs are allocated, a higher portion of that bill is likely to be made up of fixed costs and collected through the standing charge. Therefore, we are also committing to look again at the allocation of electricity network costs and some of the decisions we took in the Targeted Charging Review (TCR). These decisions were made in a different economic environment and in the context of different levels of expected network investment, so we will consider whether alternative options, including those previously discounted, would perform better under an updated assessment. This will form part of a broader and more holistic review of how system costs are recovered, with a view to presenting options for reform next year. While standing charge reform can be an overall progressive measure that improves affordability for those with below average consumption, particularly those that manage their energy bills through rationing energy use, it will not address affordability for all consumers. It would increase bills, potentially worsening affordability challenges, for consumers with above average consumption, which can be for a range of necessary reasons such as low energy efficiency housing and/or reliance on medical equipment. There is a risk that these consumers fall further into debt, causing direct consumer harm and posing challenges to the functioning of the retail market. We are working closely with government on options to address affordability concerns, and should we determine that Ofgem intervention is required, we will consult with stakeholders in due course. 6 Standing charges: domestic retail options 1. Introduction 1.1 Through the call for input, we have heard overwhelmingly from consumers that they want action on standing charges. We recognise that the increased level of standing charges, alongside growing debt and affordability challenges exacerbated by extraordinary market conditions, are increasingly causing consumer harm. In this paper we describe our options to reduce standing charges and increase the diversity in tariffs available to consumers. We make the case to work with government on longer term options to introduce further changes that will deliver positive outcomes for consumers. Document summary 1.1 Chapter 1 introduces the options paper 1.2 Chapter 2 describes our case for change 1.3 Chapter 3 details options to reduce standing charges in the default tariff cap 1.4 Chapter 4 describes short term options to increase tariff diversity 1.5 Chapter 5 sets out the long-term options to address standing charge concerns 1.6 Chapter 6 concludes the options paper and provides next steps 1.7 Appendix 1 provides a summary of questions asked in this options paper 1.8 Appendix 2 assesses the impact of intervening on standing charges 1.9 Appendix 3 provides the privacy notice on consultations Related publications Alongside this document, we have published a summary of responses for the standing charges call for input. This can be found on our website alongside our call for input. 1.10 More broadly, this options paper is impacted by the following documents: Standing charges – call for input Energy price cap operating cost allowances review Affordability and debt in the domestic retail market – a Call for Input Putting consumers first: empowering and protecting energy consumers Targeted Charging Review: Decision and Impact Assessment • • • • • 7 Standing charges: domestic retail options 2. Case for change Section summary The cost of energy has fallen since the height of the cost-of-living crisis but both standing charges and unit rates are likely to remain above pre-crisis levels. Standing charges play a key role in retail pricing but recent increases are causing affordability and debt challenges for some consumers and these charges are unpopular with consumers. This chapter sets out the case for change for reducing standing charges and the impact on broader affordability and debt challenges. Questions Q1. Do you have any views on our case for change? What makes up standing charges 2.1 Energy tariffs typically consist of two components: standing charges (fixed charges unrelated to energy use) and variable unit rates (charges per unit of energy sold). Standing charges have been a feature of energy bills for as long as there has been a retail energy market. This two-part tariff structure is common in other sectors too, such as the water industry. 2.2 Standing charges play a legitimate role in the retail energy market. They recover the ‘fixed’ costs of the system, by which we mean costs that do not vary by energy use. This includes suppliers’ fixed operational costs of serving each consumer, the cost of network upgrades and maintenance necessary to keep all consumers connected and fund the technologies to drive progress towards net zero targets. It also includes the cost of providing Warm Home Discount payments to eligible customers. These costs cannot be avoided; they must be paid for, but there is some optionality in how these costs are recovered. 2.3 To an extent, suppliers are free to determine the balance between standing charges and unit rates (including whether their tariffs include a standing charge at all). But on domestic variable tariffs, the total level of the standing charge (and the total tariff including the unit charge) is currently capped by the Default Tariff Cap (the price cap). 2.4 We set the price cap to allow an efficient supplier to recover their supply costs and make a reasonable return. Therefore, the balance between the standing charge and the variable unit rate within the price cap is generally determined by whether suppliers face fixed or variable costs for supplying their customers. 8 Standing charges: domestic retail options 2.5 The current standing charge component of the cap includes the cost of electricity networks, metering costs, some policy costs, and some supplier operational costs. Figure 2.1, Composition of standing charges in the price cap, Jul-Sept 2024 Alternate format: Table of values Bill component Operating Costs Network Costs Policy Costs Other Costs2 Electricity Standing Charge Gas Standing Charge £62 £121 £11 £26 £84 £0 £11 £20 Electricity standing charges have risen and, without intervention, may continue to do so 2.6 The average electricity standing charges for domestic direct debit consumers on standard variable tariffs have risen from £86 per year in October 2021 to £219 2 ‘Other costs’ largely consist of uplifts that apply to both standing charges and unit rates such as VAT, EBIT and headroom. Increases in this costs are driven by underlying increases to the overall price cap level 9 Standing charges: domestic retail options per year in July 2024.3,4 This coincided with sharply rising energy costs and household inflation. The primary cause of increased standing charges on domestic contracts has been the reallocation of electricity network costs following the Targeted Charging Review (TCR) in which we took the decision to move charging of certain types of network costs from a unit cost basis to a fixed basis.5 Additionally, more temporary effects like Supplier of Last Resort (SoLR) costs have also had an impact on the increase to standing charges. Figure 2.2, Change in the standing charge from Oct 21-Mar 22 to Jul-Sep 24 Alternate format: Table of values Data Point Total Standing Charge: Oct 21 - Mar 22 Change in policy costs Change in operating costs Change in network costs Change in other costs Total Standing Charge: Jul 24 - Sept 24 Value £186 £8 £14 £103 £22 £334 2.7 The TCR sought to ensure that all consumers make a fair contribution to the costs of the networks, and that the structure of charges enabled efficient recovery of residual costs. It aimed to prevent non-domestic consumers from avoiding these fixed costs and therefore delivered a significant benefit to all domestic consumers. As a result, fixed elements of network costs (distribution and transmission “residuals”) are borne by all domestic consumers, without 3 Gas standing charges have remained relatively constant over the same period 4 We heard in response to our discussion paper on standing charges that the TCR has driven similar increases to the standing charges that suppliers are offering to non-domestic consumers. This paper focusses on the domestic consumers. 5 Targeted Charging Review: Decision and Impact Assessment | Ofgem 10 Standing charges: domestic retail options regard for consumption, household income, or consumers’ ability to pay, which may be seen as regressive. The same can be said about other fixed elements such as operating costs. 2.8 We expect that fixed system costs, such as network costs, will continue to grow, meaning that without reform, standing charges are likely to follow the same upward trajectory. While commodity costs remain uncertain, and subject to volatility, we broadly expect that the transition to a net zero system will drive a reduction in the unit price of energy. This means that, without intervention, standing charges will represent an even greater proportion of bills. What we heard in response to our standing charges call for input 2.9 Our standing charges call for input received over 30,000 individual responses from consumers and other stakeholders. Of these responses, over 90% cited standing charges as unfair and almost two-thirds of consumer responses explicitly called for their abolition. Respondents argued that these charges specifically disadvantaged vulnerable customers, who tend to be low-users and on low-incomes. They further argued that the rationale for how standing charges were recovered was not clear or justified. Specifically, stakeholders considered regional differences in standing charges to be fundamentally unfair. 2.10 The extent of the response indicates that we may have reached the point where this perception of inequity is damaging confidence in the market. This could further impact consumer engagement across the energy system, including for the transition to net zero. Our outcomes are better achieved when consumers have confidence that they are being treated fairly. 2.11 We received feedback that the current magnitude of standing charges acts as a barrier to many low-income consumers accessing the energy that they need. Many consumer respondents expressed concern that rising standing charges lessen their ability to influence their bills through their behaviour, with some respondents observing that standing charges made up more than half of their total energy bill. 2.12 Consumers noted that the fixed nature of standing charges made them feel powerless in the face of rising energy prices; even if they turned off their electrical equipment or heating, they still incurred costs that they considered unacceptable. Many individuals perceived standing charges as the reason they had to resort to drastically reducing consumption to cut their energy 11 Standing charges: domestic retail options bills. Likewise for customers in debt, the high standing charges made it harder for them to reduce their debt or avoid it increasing further. 2.13 We received insight into individual consumer circumstances, such as a single parent (specifically an NHS nurse) who avoided using their heating for a year. They explained that the choice was between warmth or feeding their children. 2.14 Further examples explained how the increase in standing charges had impacted consumers’ health. One person explained that the increased cost on their energy bill, which is difficult to reduce due to electrically powered medical equipment, meant purchasing lower quality food and using less heating, resulting in detriment to their already challenging physical health. 2.15 Going beyond affordability considerations, many consumers said that they felt standing charges discouraged them from making changes to their consumption habits as it would not substantially reduce their energy bills. 2.16 While most consumers and consumer groups were supportive of reducing standing charges, some warned of the consequences particularly on low-income high-consumption households, such as those with a chronic illness or disability, who would experience detriment as a result of a higher unit rate. Abolishing standing charges 2.17 Almost two thirds of individual consumers who responded to the call for input asked for us to abolish standing charges altogether. There was a clear message that the current structure of pricing is seen as unfair and the rationale for it is not well understood. We are therefore undertaking a fundamental review of cost allocation that will enable us to explore a broad range of options considering the balance between cost efficiency and fairness (chapter 5). This review will closely link to our work with government looking at more holistic solutions to energy affordability and debt. We are approaching this review with an open mind and will consider whole system reforms that might change the way consumers are charged for their energy use as we move to a cleaner energy system. 2.18 In the meantime, we have decided to look at what we can do within the current structures and regulatory framework to bear down on standing charges. In doing so, we recognise that there are constraints to how far we can reduce standing charges in the short term. For example, we have looked at changing the design of the price cap so that it is purely set on a unit rate basis. We have decided not to do this at this stage because of significant concerns around 12 Standing charges: domestic retail options fairness, cost efficiency, and price incentives for the uptake of low carbon technologies (like EVs and heat pumps). We explore each of these in turn below. 2.19 Moving all costs from the standing charge to the unit rate, without other changes to the system, would have significant distributional consequences for consumers, in particular driving up costs for households who have above average energy needs – this includes a number of low-income and vulnerable consumers who are likely to be unable to adjust their usage to manage these additional costs. We set out the distributional impacts of shifting different proportions of costs between the standing charge and unit rate in chapter 3. Our estimates suggest that if we were to abolish standing charges and shift all costs to unit rates roughly half a million low-income households/customers would see a bill increase of c. 10%. This would have negative impacts on those consumers but also on the market as a whole as more people would fall into unmanageable debt. 2.20 This could have knock on impacts on supplier resilience in the current market. Recovering costs through the unit rate introduces a risk of under-recovery for suppliers if their consumer base has below average consumption, and for the market as a whole if demand is lower than expected, for example due to warm weather. For costs outside a supplier’s control a risk premium may be deemed necessary to address this uncertainty, increasing immediate costs for all consumers. Furthermore, recovery via unit rates risks some customers avoiding making a cost-reflective contribution to the fixed costs of the system, increasing the burden on those less able to adjust their usage. 2.21 Finally, allocating all costs to the electricity unit rate would benefit owners of solar panels but would increase the costs of running heat pumps and electric vehicles (EVs). This approach risks being detrimental to broader net zero ambitions. We have seen this challenge faced by other jurisdictions. For example, California did not include fixed charges on bills but has recently decided to introduce them due to concerns around ability to recover system costs and reduced incentives for the uptake of low carbon technologies.6 In doing so, California expects to make home and vehicle electrification more affordable for everyone but has recognised the risks associated with high fixed 6 CPUC (2024), Decision addressing assembly bill 205 requirements for electric utilities https://docs.cpuc.ca.gov/PublishedDocs/Published/G000/M531/K686/531686019.PDF 13 Standing charges: domestic retail options costs and is seeking to allocate costs in a way that takes account of consumer ability-to-pay (i.e. income-weighted recovery). 2.22 There are counter arguments to these considerations. It could be that the higher unit rate (as a result of abolishing standing charges) drives consumption reduction that outweighs the negative impact to net zero price incentives. The higher unit rate could create space for suppliers to compete both under the cap and in the fixed term market, resulting in improved competition, engagement and prices for customers. Suppliers could also be driven to improve their operational efficiency to mitigate the risk that under-recovery of costs (as a result of lower-than-expected demand) impacts their stability. 2.23 It is, however, our view that a simple change to the price cap formula at the current time without other, more fundamental changes to the market (such as measures to mitigate both consumer affordability challenges as well as approach to the price cap and supplier resilience) mean that the negative impacts would outweigh any positive benefits. Therefore, as a first step towards reform we are looking at what incremental changes could be made to bear down on the costs in the standing charge and give consumers more choice in the tariffs available to them (chapters 3 and 4). Our more fundamental review of cost allocation will enable us to explore a broader range of options for the longer term (chapter 5). This review will closely link to our work with government looking at more holistic solutions to energy affordability and debt. Approach to standing charge reform 2.24 Recognising that pure abolition could have unintended effects, we have considered how we could reform standing charges to balance the risks with the clear consumer interest in increased control over their energy bills. Standing charge reform can be approached in different ways (and these are not mutually exclusive). Reforming our approach to setting the notional level of standing charges in the price cap 2.25 Our most direct route to deliver change is through shifting some (but not all) cost recovery between the unit rate and the standing charge. We can either do this through the price cap or through the assignment of the underlying costs that contribute to standing charges. 14 Standing charges: domestic retail options 2.26 We can mitigate the risk of stability impacts and cost increases by focussing on costs that suppliers are able to control and considering a reduced range for cost transfer. Therefore, we are exploring whether our approach to setting the notional level of the standing charge in the price cap should be reformed to separate more clearly unavoidable pass-through costs (such as network costs) from costs that are within suppliers control (such as aspects of operating costs). 2.27 We think that a net customer benefit can be derived from moving £20-£100 from standing charges to unit rates, relative to the current allocation, but welcome stakeholders’ views on whether we should go further, and what mitigations should be considered to address issues identified. 2.28 Our draft impact assessment shows this would be a progressive change. We estimate that more low-income households would financially benefit, than would lose out, from moving of £20-£100 from standing charges to unit rates. However, the benefits of the winners and costs of the losers are broadly similar in terms of scale. We find that there are there are approximately 3.7 to 3.8 million low-income households that would be classified as winners with an average bill reduction of -£4 to -£19 per household per year. There are approximately 2.3 to 2.4 million low-income households that would be classified as losers with an average bill increase of +£4 to +£18 per household per year. Our income weighted analysis also indicates an annual net positive income- weighted saving to customers of around £140m for our central £60 transfer scenario. We welcome views from stakeholders on whether they would want to see a greater transfer of costs, and what mitigations they would propose for the issues we identify. For further details on our draft impact assessment please refer to Appendix 2. Increasing Tariff Diversity 2.29 Consumers have made it clear to us that they want to be able to make an active choice on what level of standing charge they pay. Therefore, we are considering whether there are actions that we can take to generate the right market conditions and/or commercial incentives to drive more diversity in the standing charges that suppliers are offering to consumers. 2.30 We are beginning to see greater variance in standing charge offerings and in chapter 4 we welcome feedback on mechanisms to facilitate greater tariff diversity in competitive offers. 15 Standing charges: domestic retail options Smoothing spend for prepay customers 2.31 We recognise that affordability challenges tied to standing charges can be particularly acute for prepayment meter customers, as they are unable to smooth the seasonal variation in energy costs over the course of a year. This can mean considerable build-up of standing charge debt during the summer months if consumers are not topping up (based on the assumption that they do not need to due to low consumption). This build-up of debt also makes it more challenging for these consumers to get back on supply after periods of self- disconnection, such is the case for many prepayment gas meters during the summer. Therefore, we are considering options for smoothing spend for prepayment meter customers Longer term reform 2.32 In the longer term, we are reviewing how policy and networks costs are allocated, including how we could keep standing charges down given the expected growth in fixed costs such as for electricity network investment. In particular, we are considering decisions made in the TCR that have driven increases to the standing charge. We discuss this further in chapter 5. Reducing standing charges will not address broader affordability or debt challenges in the domestic retail market 2.33 Standing charge reform is an important step towards helping consumers have greater control over their bills and may improve energy affordability, particularly for low consumption users who are vulnerable and at risk of disconnection. But standing charge reform will not directly reduce the total cost of energy faced by consumers as a whole and will not remove the standing charge entirely. Furthermore, in some cases reducing standing charges may increase costs where the customer has high usage. This is of particular concern for those with specific vulnerabilities for whom high consumption is required and for whom standing charge reform would make energy less affordable. 2.34 In response to our call for input on debt and affordability, we heard from multiple stakeholders that, despite the magnitude of support made available by government during the recent energy crisis, energy bills remain above an affordable level for many consumers. Consumer groups noted that the number 16 Standing charges: domestic retail options of households with negative budgets is increasing.7 Suppliers expressed similar views noting that income had not kept pace with the cost of living, and that existing support schemes had not kept pace with inflation and are now insufficient. 2.35 Consumer groups and charities as well as individual responses noted the increase in energy prices has driven energy to become unaffordable for many consumers. They noted that the rise in energy prices since 2021 has led to a significant increase in household debt levels and some vulnerable consumers with higher levels of consumption that they cannot safely reduce have been especially impacted. 2.36 When the energy required to maintain a consumer’s health and wellbeing is unaffordable it can lead to unsafe self-rationing and self-disconnection, which has negative health and wellbeing impacts. It can also lead to the unsustainable build-up of debt which may ultimately be socialised, therefore driving up costs for other consumers.8 It may ultimately lead to higher healthcare or welfare costs which are borne by society (including other consumers as taxpayers). 2.37 Future prices are uncertain, but our analysis suggests high prices could be sustained because there is a continuing risk that commodity costs remain susceptible to global shocks while our system remains dependent on imported gas. Network and policy costs will continue to increase as we transition to a net zero energy system. 2.38 Levels of debt tell a similar story and continue to trend upwards. Our data from Q1 2024 shows a total of £3.3bn9 (a 53% increase compared to April 2023) in domestic debt and arrears, with our (unpublished) data for Q2 2024 showing further increases. Between April 2023 and April 2024, arrears (households without a repayment plan in place) have grown from around £1.5bn to over £2.5bn (a 72% increase). Our data also shows average household debt and arrears are increasing, with average household debt reaching £900m in Q1 2024. This has increased both for customers with an arrangement to repay the debt, but also for those without any arrangement (which has a higher propensity 7 A negative budget is where, after a budgeting session with a money adviser, a household’s essential outgoings exceeded their income. 8 Such as the temporary adjustment made to the price cap in February 2024 to allow recovery of additional debt related costs: Ofgem (2024), Energy price cap: additional debt costs review decision, https://www.ofgem.gov.uk/decision/energy-price-cap-additional-debt-costs-review-decision 9 Ofgem Debt and Arrears indicators, https://www.ofgem.gov.uk/publications/debt-and-arrears-indicators 17 Standing charges: domestic retail options to turn into bad debt). This indicates the growth in debt and arrears is being driven by households already behind on their bills. The significant increase in arrears also raises questions around how effective suppliers are at proactively engaging consumers in payment difficulty and what the barriers to accessing support are. 2.39 In any case, support will continue to be needed for consumers who struggle to pay, and it will be important for the future of the market to ensure that future volatility does not result in another or ongoing affordability crisis.10 While the Energy Price Guarantee (EPG) and the Energy Bills Support Scheme (EBSS) worked well in directly reducing consumer bills, as support was provided to all consumers, the schemes were much more expensive than if they had been targeted at those who needed help the most.11 2.40 It remains clear that standing charge reform alone is insufficient to address the broader challenge of affordability and debt, and we will publish our next steps on debt in Autumn. We consider that, due to the impact of recent rises in the standing charge, reducing them by a £20-100 could be in consumers’ interest, even in the absence of further support, but we will continue to work alongside government to address these challenges. We set out these considerations and seek stakeholder views on the potential mitigations needed at different levels of cost transfer in chapter 3. We also set out short-term options to improve consumer choice through increased tariff diversity in chapter 4. 2.41 Over the coming months, we will work closely with government on potential long-term options and solutions for addressing the challenges of standing charges. Chapter 5 below discusses long-term considerations on network costs. 10 Wholesale markets have experienced record high prices and unprecedented volatility over the past few years, following the economic recovery from the Covid-19 pandemic in 2021, Russia’s invasion of Ukraine in February 2022 and Europe’s subsequent shift away from Russian gas. As a result, suppliers stopped offering competitive fixed term contracts and most domestic consumers moved onto standard variable default tariffs (SVTs) covered by the price cap. The cap increased, reflecting the higher underlying cost of supplying energy, from pre-crisis levels of around £1,300 per year (in the October 2021 to March 2022 period) to around £4,000 per year (in the period January to March 2023, without government support). 11 NAO (2023), Energy Bills Support, https://www.nao.org.uk/reports/energy-bills-support-schemes/ ‘their universal nature meant that a significant number of households received financial support they did not need’. 18 Standing charges: domestic retail options 3. Considerations for shifting operating costs from standing charges to unit rates This chapter discusses the advantages and disadvantages of shifting recovery of a portion of operating costs from standing charges to unit rates, including the key trade- offs that would be involved for both consumers and suppliers. This section builds on the considerations we have set out in the May 2024 policy consultation on the operating cost review. Questions Q2. What are your views on the range (£20-£100) of operating costs we are considering shifting from standing charges to unit rates? Should it be higher? Within this range, is there a value you would favour and why? Q3. What are your views on the trade-offs and impacts we have identified for consumers and suppliers? Should any of these take more or less significance in our assessment, and are there any important impacts we have not considered? Q4. What are the changes required, if any, to the price cap to facilitate a reduction in the level of the operating costs charged through the standing charge? 3.1 As discussed in the case for change, we do not consider there to be a case for abolishing standing charges in the price cap due to the detrimental financial impact on low-income, high-using consumers as well as the potential impacts to supplier stability, discussed in our draft impact assessment. 3.2 There are, however, some tools at our disposal to improve consumers’ ability to control bills by reducing standing charges by a considered amount within the price cap. One of these tools is shifting a portion of supplier operating costs within the cap from standing charges to unit rates. 3.3 Although operating costs have remained relatively stable over the last few years across gas and electricity, they form a significant portion of standing charges. Supplier operating costs currently form roughly £135 (c.40%) of annual standing charges (dual fuel). Our May 2024 policy consultation on the operating costs review set out our initial considerations on the balance of costs on the standing charge versus unit rate. 12 This document builds on the consultation and responses we received from stakeholders. 12 Ofgem (2024), Energy Price Cap: Operating cost allowances review, https://www.ofgem.gov.uk/consultation/energy-price-cap-operating-cost-allowances-review 19 Standing charges: domestic retail options 3.4 Moving the entirety of operating costs to the unit rate would have significant distributional consequences and we do not think this would be in the consumer interest as a whole. Nonetheless, we invite comments from stakeholders on what mitigations would be necessary in order to move the entirety of supplier operating costs from the standing charge to the unit rate if this were a desirable approach. Based on the current allowance of roughly £135, we consider that moving between £20 to £100 of operating costs from the standing charge to unit rates could be achieved. 13 Context – cost allocation within the price cap 3.5 The price cap is a cap, rather than a regulated tariff, but the way that Ofgem sets the price cap strongly influences how retail suppliers recover fixed costs. This is particularly relevant in a market where around 85% of consumers are on the default tariff. 3.6 The licence includes two specific consumption benchmarks setting maximum charges under the cap: nil–consumption (intended to reflect fixed costs of supply, representing the cost of supplying a consumer with zero usage); and benchmark (which is aligned to 2017 typical customer demand and intended to reflect overall costs of supplying customers). The cap level for all other consumptions is reflected by a straight line between nil and benchmark (and beyond). 3.7 What constitutes a fixed cost is not always consistently defined. Some costs, such as network charges, are, from a supplier’s perspective, clearly fixed as they are subject to a per consumer charge from network companies. Other charges, particularly relating to operating costs, are not so straightforward. Most of these costs do not scale directly with consumption but there may be some relationship, and suppliers do generally have more control over these. Nor are these costs attributable on a per-customer basis as the marginal cost of an extra customer is negligible. For example, a ‘fixed’ operating cost might relate to the cost to run a call centre. Generally, the call centre capacity (and therefore cost) is driven by the number of consumers and the rate of consumer calls. Consumers may, however, call more frequently if their usage and therefore bills 13 The operating cost review will however set a new overall level of allowance for operating costs within the cap. We will seek to evaluate what an appropriate level of transfer may be following the outcome of the review. 20 Standing charges: domestic retail options are higher. Suppliers can, however, try to reduce their call centre costs through efficiencies. 3.8 Many businesses in other sectors recover fixed operating costs through variable charges. Suppliers are not obliged to pass fixed costs onto consumers through the standing charge (as opposed to a unit rate), but they can under Ofgem’s rules. 3.9 In broad terms, supplier operating costs include costs associated with billing, metering, and company premises. Suppliers have greater control over operating costs than they do network and policy costs (e.g. Warm Home Discount) where suppliers are price-takers. 3.10 The price cap operating cost allowance is currently made up of three distinct components: the core operating cost allowance, payment method uplift and Smart Metering Net Cost Change (SMNCC). Together, these components allow for the operational costs of a notional efficient supplier. 3.11 The core operating cost allowance reflects the operational costs of serving a direct debit consumer 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, allow suppliers to adequately recover costs, and provide protection to consumers. 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. The payment method uplift (PMU) reflects the additional costs of serving standard credit and prepayment meter consumers relative to direct debit consumers, and the SMNCC allowance captures the transitional costs of the smart meter rollout. Hence, operating costs and subsequently standing charges have historically varied across different payment methods. 3.12 In February 2024, we announced our decision on “levelising” standing charges for prepayment and direct debit consumers from April 2024, with an accompanying reconciliation mechanism. This means that prepayment meter and direct debit consumers pay the same level of standing charges, whereas prior to April 2024, prepayment meter consumers paid higher standing charges due to higher operating costs being associated with them for suppliers. Levelisation is intended to support prepayment meter customers who have proportionally higher levels of vulnerability than direct debit customers. 21 Standing charges: domestic retail options 3.13 With prepayment and direct debit standing charge levelisation in place we do not consider it necessary to evaluate different levels of standing charge reduction by payment type in this document. But this policy may itself be affected by a change in standing charges resulting from our operating cost review. Any impacts on levelisation will form part of the review of Phase 1 levelisation due in winter 2025. 3.14 When initially setting the price cap in 2018, we noted that supplier practice was to split operating costs between the unit rate and standing charge. We set the initial levels of the cap benchmark in a way that reflected the market split at the time to avoid significantly diverging from the default tariffs available. We therefore included some operating costs in the standing charge and the remainder (around 69%) in the unit rate. 3.15 With most customers now on tariffs covered by the price cap, there is no longer a market benchmark to reflect, and so we need to make a judgement on the appropriate balance. Earlier this year we published our policy consultation on the operating cost review. This review looks to update the level and structure of the operating cost allowance within the price cap. Scope for standing charge reductions 3.16 In the May 2024 consultation on the operating costs review we set out that we would be considering several options around the balance of standing charge and unit rate allocation of operating costs. This included increasing the allocation of costs to the standing charge as well as moving all costs to the unit rate. 3.17 In response to the consultation several consumer responses noted the unfairness of the standing charge, and that standing charges were too high. In addition to this we received responses from three suppliers that noted their support for moving more costs from the standing charge to the unit rate. Responses to the consultation did not however engage with the level of costs that could reasonably be moved. This options paper provides more detail for stakeholders to respond to as we progress with policy development. 3.18 We have assessed the impacts of shifting operating costs to the unit rate in terms of improving consumer control, distributional impacts on consumers, the impact on suppliers and their different average levels of consumption, and the impact on supplier efficiency and ability to finance their operations. Any shift in these costs does not lead to an absolute reduction in costs. This presents us 22 Standing charges: domestic retail options with a zero sum change where, in financial terms, some consumers will benefit, and other consumers will not. We also need to take supplier distributional impact into consideration. The more operating costs we shift to unit rate, the more low demand customers may not be able to contribute an equal share of fixed costs for suppliers. 3.19 We have considered stakeholder views shared in our May 2024 consultation on the operating costs review and following feedback from this options paper we will come forward with more detailed proposal in a statutory consultation. These proposals may include suggesting no changes to the current method of allocating these costs. Trade-offs and distributional impact 3.20 We have assessed the distributional impact on consumers and suppliers of moving operating costs to the unit rate. We considered shifting all of the operating costs to the unit rate, but do not consider this feasible due to the magnitude of the detriment to low-income customers with inflexible high demand and are mindful of the potential risk to supplier resilience. We welcome stakeholder views on any mitigations that could be implemented in order to make this feasible if this were a desirable outcome. 3.21 However, we consider that net customer benefit can be derived from moving in the range of £20 to £100, using a ratio of 38:62 for electricity to gas, and present the impacts below. This ratio represents the current proportions of standing charge operating costs between electricity and gas in the price cap and hence we think it is an appropriate ratio to use. We set out some of the key points of our assessment below, with further detail in the draft impact assessment in Appendix 1. Consumer impacts 3.22 Shifting a portion of operating costs onto the unit rate gives households more control over their energy bills by making them more consumption driven. However, this shift will be advantageous to some consumers (“winners”) who have lower consumption or are able to more easily reduce their consumption. 23 Standing charges: domestic retail options Consumers that have higher than average consumption14 and are less able to reduce their consumption may face higher bills as a result (“losers”). 3.23 We have used Ofgem’s energy consumer archetypes15 to understand the impacts of an operating cost shift on different groups of consumers. The archetypes were designed to identify and understand different types of energy consumers, including those in vulnerable situations, and to model the impacts of future policy changes. We have adjusted the average electricity and gas demand for each archetype in line with 2022 consumption data. The adjusted consumption by archetype and decile feeds into future calculations. 3.24 Our draft impact assessment indicates that there are more low-income households that would win rather than lose with a shift of operating costs from standing charge to unit rate. However, the benefits of the winners and costs of the losers are broadly similar in terms of scale. For the purposes of our analysis, we have defined low income as £19,50016 and used our 24 archetypes to estimate the share of these low-income users with higher and lower levels of consumption. We find that there are approximately 3.7 to 3.8 million low- income households that would be classified as winners with an average bill reduction of -£4 to -£19 per household per year. There are approximately 2.3 to 2.4 million low-income households that would be classified as losers with an average bill increase of +£4 to +£18 per household per year. For further details on our draft impact assessment please refer to Appendix 1. 3.25 We have also considered the effects of standing charges reform on an income- weighted basis.17 After applying income weights, our analysis shows that low- income households (particularly archetypes A1 – A3) realise the largest gains. Higher income archetypes tend to see smaller income-weighed gains from this policy. Summing all of the impacts across the consumer archetypes we find a net positive income-weighted saving to customers of c.£140m for our central £60 transfer scenario, implying that standing charges reform is more progressive than the status quo. 14 For the purposes of our analysis we have assumed average consumption is in line with benchmark consumption within the price cap i.e. 3100kWh for electricity and 12,000kWh for gas. 15 Ofgem (2024), Consumer archetypes update 2024, https://www.ofgem.gov.uk/sites/default/files/2024- 02/Ofgem_archetypes_update_2024_FinalReport_v4.1.3.pdf 16 We have calculated this based on median household disposable income (£32,300) in the UK for FYE 2022 as published by the office for national statistics. We have taken 60% of median income as our definition of low income, in line with the ONS definition of the poverty line. 17 Income-weighted analysis considers how a £1 cost or saving has a different marginal utility depending on a household’s income. For more details see Appendix 2. 24 Standing charges: domestic retail options 3.26 We are particularly concerned about the impacts these shifts may have on vulnerable households, especially those on low income with inflexible high demand. Lower income households do not necessarily have lower energy consumption, particularly when they are living in poorly insulated homes, or have medical needs that lead to increased energy use. 3.27 To demonstrate how the impacts vary across different types of consumers, we have considered seven case studies in our draft impact assessment. Each case study covers a particular consumer type with different levels of consumption between gas and electricity. Table A7 in the draft impact assessment describes each case study and the dual fuel bill impact of shifting £20 to £100 of operating costs from standing charge to unit rate, for an average direct debit consumer. 3.28 The analysis demonstrates that households with lower-than-average consumption (e.g. small flat with low consumption) will benefit from the transfer of a portion of operating costs from standing charge to unit rate, while households with higher-than-average consumption (e.g. those with primarily electric heating or poor energy efficiency) will see their bills increase. 3.29 Our analysis demonstrates that there are benefits to low-income customers as a whole and the added ability for all customers to have a greater degree of control over their bills. Despite this we recognise that there will be a group of lower- income customers who are negatively affected, as they have higher use than typical users. Our archetypes analysis, which is based on the Living Costs and Foods Survey (LCFS), does not in itself identify the size of this group, which cannot be directly measured without the use of enhanced data matching of high- usage customers with markers of vulnerability. However, an initial review suggests there is likely to be an important subgroup of low-income users that use more than 50% higher than typical consumption values. These users could be particularly adversely affected by a change to standing charges. 3.30 We will consider options for how to better identify the size of this group and work with government to consider whether those on low incomes, who might be adversely affected by changes to standing charges, require additional protection. We welcome views from stakeholders on what, if any, additional consumer protections are required to support these customers. 25 Standing charges: domestic retail options Supplier impacts 3.31 In addition to the impacts on consumers, moving operating costs from standing charges to unit rates will have an effect on suppliers. The effect will be different between suppliers with customer bases that have significantly different energy consumption levels. For example, suppliers with higher-than-average consumption per customer may over-recover fixed costs if volumetric unit rates rise. Conversely, suppliers with below average consumption per customer may be less certain that fixed costs would be recovered. 3.32 Supplier financeability (the need for suppliers that operate efficiently to be able to finance activities authorised by their supply licence) is something we must consider when setting price cap conditions. Our overriding duty is to protect customers who pay standard variable tariffs (SVT) and default tariffs, and we recognise that the interests of customers as a whole are protected by regulating in a way that allows a notional efficient supplier to make a reasonable profit over time. However, there cannot be any guarantee that individual suppliers will always be profitable. In having regard to supplier financeability we look at a notional efficient supplier and for this policy change we have stress-tested this based on some of the variation we observe between real suppliers. 3.33 We have considered whether it would be necessary to provide a reconciliation mechanism to mitigate the impact of this reduction in allocation of charges to the standing charge on suppliers. As noted above, there is uncertainty on the extent to which supplier operating costs should be considered fully fixed costs and operating costs are a category within suppliers’ control. We will consider the degree to which operating costs are fixed through the operating cost review, in the context of our assessment of notionally efficient costs. There are also issues when assessing average customer demand in that it will change from period to period and over time which would make designing an appropriate mechanism very challenging. We consider that changes within the range £20-100 could be absorbed without the need for a reconciliation mechanism but would welcome feedback from suppliers. 3.34 Our draft impact assessment in Appendix 2 sets out indicative analysis of the impacts on suppliers resulting from a £20 - £100 shift from standing charges to unit rates. We welcome views from stakeholders and consumers on what magnitude of operating costs shift they consider desirable within our stated range, and whether there are any additional changes required to enable this (within or outside of the price cap). 26 Standing charges: domestic retail options 4. Increasing consumer choice through tariff diversification This chapter considers how the diversity of standing charge and unit rate combinations across tariffs has changed over time and what, if any, interventions could result in consumers having access to a greater variety of tariff offerings. Questions Q5. Could mandating suppliers to have at least one low or no standing charge tariff available to customers help promote competition in this area of the market? Q6. How could we create flexibility in how costs are recovered between the unit rate and standing charge without reducing the protection provided by the cap? Q7. In enabling greater diversity in standing charges on default tariffs, what, if any, safeguards would be needed to protect vulnerable consumers? Q8. What are the key considerations we should take into account in developing options for smoothing spend for prepayment meter customers? Context 4.1 The response to our call for input made it clear that many consumers would like to see greater variation in the standing charges offered by suppliers and, in particular, more tariffs with low or no-standing charges. Several such tariffs exist in the market, but despite this, the proportion of customers on no-standing charge tariffs has remained low over time – see Figure 4.1. Figure 4.1 – Proportion of domestic customers on a zero standing charge tariff by tariff type Source: Ofgem Tariff and Customer Account RFI 27 Standing charges: domestic retail options 4.2 Some of the no-standing charge options include high priced first few units of energy, acting as an effective standing charge if any energy is used. For example, currently there are prepayment meter tariffs available with no standing charge but