What makes up an energy bill?

Most energy bill rises are due to rising wholesale costs and, equally, when we see reductions in our bills, this is usually due to falling wholesale energy prices too.

Other factors affecting our bills include the network costs of delivering energy to our homes and the policy costs associated with turning our energy greener.

Although energy suppliers and network operators are allowed to make a profit from selling energy to customers, this return is limited by regulations.

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What makes up energy bills?

The energy bills we receive from our energy suppliers are made up of several elements.

While the wholesale costs of energy are the biggest element of our bills, suppliers also factor other costs like network and operating costs into their calculations.

Thanks to Ofgem's price cap calculations, we can see what made up an energy bill in October 2021:

So, while wholesale costs made up the largest portion of our bills, there were significant portions for network and operating costs, policy costs (environmental and social obligations) and the smart meter rollout.

There's also 5% VAT added to energy bills that helps to make up the final figure.

As the pie chart above shows, other costs are also covered in bill calculations. During the cap period above, that included headroom and the direct debit uplift allowance, but this can vary from time to time.

For example, the price cap from April to October 2021 included an allowance for bad debt in the wake of the coronavirus crisis.

The percentage of the pie made up by each element isn't static, then, and it's predominantly made up of costs that are outside an energy supplier's control such as:

• Cost of wholesale energy
• Cost of delivering energy to homes
• Cost of implementing Government policies

We look at these in detail below.

Energy suppliers are also allowed to make a profit from our bills, although it isn't as much as we might expect.

It's bundled into the operating costs portion of the pie and changes when Ofgem adjust their calculations. However, it's less than 2% of the overall bill.

This is a high-level analysis of what makes up a dual fuel energy bill under the energy price cap, but there are also differences if we look more closely at electricity and gas bills.

Single fuel bills

Most of us take both electricity and gas from our energy suppliers, but the way the two bills are calculated can be different.

This is because more Government levies are placed on electricity bills, including green levies that go towards improving renewable energy.

As the table below shows, this has an impact in how a bill is made up:

Note: Data taken from Ofgem website and covers 2020 financial year from major suppliers across all bills.

Because gas bills have so few policy costs associated with them, it makes a substantial difference to how a gas bill is made up compared to an electricity bill.

There are regular calls for green levies to be moved to gas bills instead of their current placement on electricity bills.

It's argued that including such levies on the electricity element of bills penalises those who use more electricity and subsidises cheaper gas when households should be trying to cut down on usage of non-renewables.

The Government continues to look at rebalancing energy levies, although it doesn't seem to be a short-term priority, so we won't see changes to our electricity bills anytime soon.

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Elements of our energy bills

It's worth taking a closer look at some of the key elements that make up our energy bills.

The way these elements factor into our bills are often misunderstood or mischaracterised, so what are we paying for?

Wholesale prices of energy

As it's the biggest piece of the pie, it's unsurprising that wholesale energy costs make a huge difference to how much our energy bills are.

It should work like this:

• Wholesale prices go up, our energy bills go up
• Wholesale prices do down, our energy bills go down

Criticisms have been levelled at suppliers in the past for not bringing down energy bills quickly enough if wholesale prices fall.

Yet something that isn't seen from the customer side is how far in advance energy suppliers buy their energy to lock in prices in a process known as hedging.

Suppliers forecast how much energy they're going to need and buy at what they perceive is the right time to keep costs low (for both them and their customers).

When markets are volatile and wholesale prices spike, we see energy suppliers forced to buy at those higher prices and pass those costs on to customers in the form of higher bills.

The graphic below from Ofgem published in August 2022 shows the gradual rise of forward (advance) pricing for gas:

So, buying wholesale gas on the market in advance cost much more in August 2022 compared to April 2021, indicating why energy bills have gone up so much in the intervening period.

Controlling wholesale energy prices is beyond suppliers, regulators and Governments. In recent years, we've seen the effects of weather, Brexit, coronavirus and the invasion of Ukraine all impact wholesale energy prices.

Network costs

Network costs, also known as transportation costs, cover the costs associated with building, maintaining and operating the gas and electricity infrastructure in the UK.

Our energy suppliers are charged by network companies to undertake these tasks, but the amount they can charge is limited by Ofgem because customers don't have a choice in which energy network runs their infrastructure in the same way they choose their home energy provider.

In 2020, these combined network costs account for around a quarter of a dual fuel bill.

Ofgem have published estimates of how of a bill goes on energy transmission and distribution, to demonstrate the impact these costs have on our monthly payments.

This is a snapshot of five months over six years to show the impact on the average bill:

Although there are minor fluctuations, network costs don't rise as much as wholesale costs, meaning this element of our energy bill is fairly static.

Bigger profits are permissible for operating companies, however.

Following wrangling over a new framework and warnings that customers should be protected in any funding agreement, Ofgem finalised their network price controls in a way that would cap shareholder returns at around 4.3%.

This is lower than the 7% previously seen before 2021, but it does mean that shareholders in network distribution companies are making double the percentage returns of shareholders in energy suppliers themselves.

Operating costs

Operating costs are the third biggest element in our energy bills.

These costs cover anything that a supplier needs to run an energy business such as:

• Customer service
• Billing
• Staffing

As we've already discussed, profit is considered in this part of the pie.

Often, operating costs are one of the most contentious elements of a customer's bill because it's the element where profits for energy suppliers are included.

However, it's important to remember these costs also cover those things that keep our energy services running smoothly such as accurate bills, dealing with payments and handling customer service.

Environmental and social obligations

Environmental and social obligations, sometimes known simply as policy costs, are applied to energy bills.

These cover the cost of the schemes energy customers fund including:

• Home insulation (ECO) and other energy efficiency improvements
• Encouraging take-up of renewable technology
• Support for vulnerable energy customers

Again, these costs can be contentious, and we've already mentioned the fact that green levies are currently placed on electricity rather than gas bills to the frustration of some.

Others would like to see green levies ditched altogether. However, it's difficult to see how that would work in relation to Ofcom's plan to reach net zero by 2050 and the climate commitments the UK has made.

Mutualisation and bad debt costs

Two things that aren't noted directly in Ofgem's graphic are nonetheless important because they have the capacity to affect all our bills: the impact of mutualisation and the costs of bad debt.

We've talked about mutualisation before when Spark Energy and Extra Energy collapsed in 2018 and in other articles on suppliers who have folded.

When energy companies collapse without paying their share of the Renewables Obligation (RO), the shortfall needs to be covered by other suppliers - even if those suppliers have already paid their share of the RO in full.

Other costs that are incurred by suppliers taking on customers of failed suppliers such as honouring credit balances are also passed on in the form of higher bills for all energy billpayers.

Although Ofgem implemented proposals to improve the regulation of existing energy suppliers to try and avoid collapses, a staggering number of suppliers were caught out by the spike in wholesale energy costs in 2021 and collapsed.

The default price cap calculation for April to October 2022 included £94 to cover the costs of these collapses.

Bad debt is another problem that can add to all our bills. If customers are unable to pay and default on their debts, energy companies are forced to make up the shortfall by raising prices for other customers.

The energy industry braced itself for higher levels of consumer debt in 2021 following the coronavirus crisis. However, the 2022 cost-of-living crisis is likely to fuel bad debt, with many customers concerned about paying their energy bills.

Differences in energy tariffs

With all these external factors affecting energy bills, customers may understandably question whether there are any differences between energy providers and their tariffs.

Wholesale price increases have led to energy deals increasing in price across the board, but it's still important to understand the differences between tariffs and how that can help you find the right energy deal for you.

Let's take a quick look at the difference between the two tariff types: variable and fixed.

Variable tariffs

Variable energy tariffs are also known as standard variable tariffs (SVTs) or default tariffs. Whichever label is used, it means the same thing - these tariffs aren't fixed and can rise and fall at any point.

There is an important caveat to this though. Since January 2019, Ofgem have set a default tariff price cap which limits the amount an energy company can charge per unit of energy.

Every three months the cap is reassessed and Ofgem issue fresh guidance to energy suppliers at the same time as suggesting what the average bill would be per household under the cap.

It's important to note that this is just an average based on the annual energy usage of a typical home, so it isn't the maximum a customer will pay. Instead, it's the price a household using Ofgem's average consumption estimates of 12,000kWh of gas and 2,900kWh of electricity per year.

While we've seen the price cap set at low levels in the past, the wholesale energy price spike in 2021/22 has led to a significant increase in the energy price cap, often making it the cheapest tariff on the market.

This is in contrast to the original aim of the cap which was to stop customers on SVTs paying far more than households on fixed energy deals.

Fixed term deals

As the name suggests, fixed term energy deals keep fuel prices at a set level for a set period of time.

They're often cheaper in the long term than variable tariffs and customers don't receive the same shocks of price rises during the fixed term period.

However, when a fixed term energy deal ends, customers are automatically rolled on to their supplier's SVT unless they act to prevent it.

If a fixed deal is coming to an end, compare cheap energy deals from other suppliers and switch to a cheap tariff to avoid unwanted price rises.

Learn more about how to switch your energy supplier.

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Summary: Wholesale costs drive bills

There are plenty of factors affecting how our energy bills rise, many of which are out of our control.

While it might be frustrating to see the fluctuating wholesale costs of energy, there's very little customers can do about it.

Similarly, while we can make our feelings known (positively or negatively) about environmental policies and network costs, we can't have much of an impact on these either.

There are a few things to remember about what makes up an energy bill:

1. Wholesale costs are the biggest driver of bill increases
2. Network costs and operating costs are the second and third biggest contributors
3. Policy costs make up a smaller portion of our bills along with other costs such as the smart meter rollout and VAT

As the costs of our energy bills are largely out of our control, one of the best things we can do is try to monitor our energy usage and cut down on the amount of energy we're using.

Learn more about the best home improvements for energy efficiency or seven cheap ways to cut energy bills.