Last Thursday, the UK government unveiled a policy package large enough for energy prices to redistribute £15bn plus close to one percent of national production. The fact that a Tory chancellor, Rishi Sunak, presided over such massive redistribution and market intervention illustrates the extent of the challenge faced by most European governments today.
addressing cost of living crisis is their most severe political imperative. It’s tempting to do this with short-term solutions. But this risks exacerbating medium-term challenges: the carbon transition and the need to resist Russian President Vladimir Putin’s plans for the balance of power in Europe. Both require fundamental reform of our energy systems, not financial sticky plasters.
Adhesive plasters are also needed, of course. The rise in energy prices in Europe is breathtaking. Natural gas prices have risen five to ten times more than usual since Putin’s last fall. began to compress the materials. Electricity did the same, as gas-fired power stations often offset the fluctuating energy demand in Europe’s energy markets. Global oil prices are twice their 2019 levels.
Such price movements are politically powerful, as they require two important economic redistributions. An international from energy importers to exporters; the other within countries – even within energy exporters like Norway – from consumers to energy producers. This is regressive – and it gets worse, as energy takes a larger share of the budgets of the lower-income. energy costs raise the price of everything else.
Together this leads to a terrible stalemate. Most countries face a hit to their real incomes at a time when it becomes imperative to help their citizens who are least able to withstand greater hardship. So what principles should guide its policies?
There are roughly four ways governments can reduce higher energy costs. First, they can directly limit prices. Second, they can reduce or eliminate taxes on energy purchases. Third, they can leave prices untouched, but directly offset groups of people for higher costs.
Fourth, prices can remain untouched, but they can change the market structures in which they are determined – especially so that consumers can benefit from the low marginal cost of generation of renewable electricity. For example, there is pressure in the EU to make electricity pricing less linked to the marginal cost of generation, which currently means the cost of using gas in thermal power plants. Another example is to strengthen incentives for energy buyers and sellers to enter into long-term contracts at more stable prices.
What most distinguishes these approaches is whether they work with or against the market and, as a result, align with or frustrate the long-term interests of the governments that adopt them.
The first two try to push prices below their true marginal costs, encouraging consumers to use more of the energy sources whose relative scarcity is responsible for making prices so high: gas for heating and electricity, oil for non-electric transportation. Price caps on energy prices and cuts in taxes like the fuel tax, as Britain’s households pay, are to blame for this flaw.
Trying to blunt fundamental relative price signals to lower average price inflation is bound to accumulate problems for the future. It increases the demand for fossil energy – and by extension, the energy sold by Russia – and reduces the incentive to invest in renewable sources.
Therefore, the third and fourth approaches are preferred. They maintain the incentive to save or switch to substitutes by allowing the marginal prices for the energy source that is getting us into trouble as high as necessary. Direct financial support is easy to design and can be targeted to those who need it most. Structural reform of energy markets is more difficult and may need to include elements of implicit rationing.
But most importantly, compensatory measures must be paired with plans to change how we produce and consume energy: the massive and rapid launch of low marginal cost renewable energies and much more storage capacity to distract people from skyrocketing costs.
How do the UK’s current policies measure up? Good: new direct support announced this week. Bad: Maintaining poorly designed price controls. And it’s ugly: too little to invest in a smarter energy system. As an adhesive plaster it does the job. It fails badly as a sustainable solution to our problems.