The Ofgem energy price cap is revised every three months, but most people have no idea how Ofgem actually arrives at the figure. This explainer breaks down the methodology in plain English — so you can understand why your bills move, and what would need to change for them to fall further.
For the consumer-focused guide to how the cap affects your bill, see Energy Price Cap Guide.
The five components of the price cap
Ofgem builds the cap from five main cost allowances:
| Component | What it covers | % of typical bill |
|---|---|---|
| Wholesale energy costs | Gas and electricity purchased in commodity markets | ~35–40% |
| Network costs | Pipes, cables, distribution infrastructure | ~25–30% |
| Policy costs | Renewables subsidies, ECO4, WHD obligation | ~20–25% |
| Supplier operating costs | Admin, metering, customer service | ~10–12% |
| Supplier profit allowance | Return on equity | ~1.5–2% |
| VAT | 5% applied to the total | 5% |
1. Wholesale energy costs (the most variable component)
This is what suppliers pay to buy gas and electricity in the wholesale commodity markets. It is the main driver of cap changes.
Gas is purchased from a mix of North Sea production, Norwegian imports, and liquefied natural gas (LNG) terminals. The UK is partly exposed to global LNG prices (which surged after Russia’s invasion of Ukraine cut off European gas supply in 2022).
How Ofgem calculates the wholesale element: Ofgem uses a reference period of approximately 6 months of forward (futures) market prices, averaged to smooth out short-term volatility. The futures prices are observable from commodity exchanges (ICE, EEX). This means the cap announced for Q3 (July) is calculated from prices traded approximately February to May.
The lag between market prices and the cap means there can be a significant difference between real-time market prices and the cap level at any given moment.
2. Network costs
Network costs pay for:
- Electricity transmission: National Grid’s high-voltage network (pylons)
- Electricity distribution: Local network operators delivering power to streets and homes
- Gas transmission: National Gas (formerly National Grid Gas) pipelines
- Gas distribution: Local gas network operators
Network charges are set by Ofgem under RIIO (Revenue = Incentives + Innovation + Outputs) price controls, which run for multi-year periods. They are relatively stable and do not respond to wholesale gas prices — they are essentially a fixed infrastructure fee per household.
3. Policy costs
Energy bills fund multiple government policy programmes through obligated levies:
| Levy | Purpose |
|---|---|
| Renewables Obligation (RO) | Pays for historical renewable generation contracts |
| Contracts for Difference (CfD) | Pays for new offshore/onshore wind and solar |
| Feed-in Tariff (FiT) | Legacy small-scale renewable payments |
| Capacity Market | Keeps gas power stations on standby for peak demand |
| Warm Home Discount obligation | Cost of the £150 annual rebate scheme |
| Smart metering obligation | Cost of smart meter rollout |
| ECO obligation | Cost of energy efficiency improvements (ECO4) |
Policy costs are controversial because they sit on electricity bills (not gas bills) — meaning that households switching from gas to heat pumps pay both the gas policy costs (lower) and the full electricity policy costs (higher per kWh). This is a structural issue Ofgem has flagged but not yet resolved.
4. Supplier operating costs
Ofgem allows suppliers a cost for:
- Billing and customer service
- Smart meter installation and operation
- Debt management
- Regulatory compliance
- Metering and market data
The operating cost allowance is based on an efficiency benchmark — it assumes suppliers are operating at a certain level of efficiency. Suppliers that operate more efficiently than the benchmark keep the difference; less efficient suppliers absorb the shortfall.
5. Supplier profit allowance
Ofgem allows suppliers a return on equity — essentially a profit margin. This was set at approximately 1.7–2% of revenues (EBIT margin) under the methodology from 2023. This is lower than the profit margins historically earned by large energy companies, but is intended to attract competitive entry and investment in the market.
During 2021–2022, many smaller suppliers went insolvent because wholesale prices exceeded the cap and there was effectively no profit or margin at all.
Why doesn’t the cap fall faster when wholesale prices fall?
Three reasons:
- Lag in methodology: The cap reflects historical futures prices, not real-time spot prices. If prices fall rapidly, the next cap reflects the fall only after the reference period
- Hedging: Suppliers buy energy months in advance (hedging) — they may be committed to higher-priced forward contracts even when spot prices are lower
- Non-variable costs: Network, policy, and operating costs are relatively fixed. Even if wholesale costs halve, these fixed components prevent the cap falling by more than their share (~35–40% of the total)