How (not) to intervene in energy prices

Every European country is worrying about high energy prices, and as far as I can tell, each has put government money on the table to support those having to pay them. (Readers, let me know of any exceptions!)

But how best to design such support is a thorny question, and an extremely topical one. Just two examples: Germany is setting aside up to €200bn but must now decide how to use that war chest. The UK did things the other way round and adopted an across-the-board price cap, then looked at the price tag and decided — after a bit of ministerial turnover — that the system has to be made more targeted.

A useful starting point is to think in terms of two extremes. At one end are universal price caps, where a maximum or guaranteed price is offered to all users, and the government steps in to pay the difference between it and what it costs to get the energy supplied (the wholesale price, say).

The other extreme is not to regulate prices at all, and just let the market do its work to match supply and demand. Instead, consumers are given cash support so that while people face higher prices, they get financial help to be able to afford them.

Price caps have the advantage of simplicity and generosity. Generosity is also one of their disadvantages: they help everyone, including those who don’t need it (because they are wealthy enough to be consuming more energy to begin with) more than those who do.

Cash compensation, on the other hand, is complicated. How much to give, whether and how to means-test it, which criteria to apply for eligibility all have to be decided. It may be hard to get compensation to the right people in sufficient amounts to prevent serious hardship. It also leaves the sticker shock in place, and with it the stress that rising prices cause.

But again the disadvantages are also advantages. Because cash compensation can be targeted, you can bring more effective help for less taxpayer cost. And sticker shock is what gives an incentive to economise on energy.

For me, the last bit is the decisive difference. Price caps give the wrong incentive — to consume even more of something whose scarcity is the root of the problem. Market pricing with cash compensation will reduce consumption — and leave more money over for reducing total energy costs.

If this sounds like Economics 101, that is a danger sign — because Economics 101 tends to start but also to end with letting prices do the job. This week I debated energy pricing with German economist Sebastian Dullien (do follow him if you are on Twitter), who pointed out the analogy of the energy crisis with famines. With reference to the work by economists Amartya Sen and Jean Drèze, Dullien highlighted that you do not solve famines with the price mechanism — otherwise people die. There always have to be redistributive policies. He encourages us not to be seduced by the standard economic starting point of using price mechanisms to allocate scarce goods in the case of the energy crisis.

I had some quibbles with the analogy. One of Sen’s important points is that famines are not typically caused by shortfalls in the production of food but rather a failure to secure everyone’s entitlement to enough food. It is clear that the current energy crisis, in contrast, is due to a shortfall in energy supply in the form of Russian president Vladimir Putin deliberately turning off the gas taps to Europe. There simply isn’t as much gas available as before.

But Dullien’s bigger point about the price mechanism stands — on its own, it doesn’t get us anywhere near an acceptable outcome. That is precisely why Putin is wreaking havoc with energy prices and why European governments are rightly looking for policy to remedy the consequences. Still, the price mechanism plays an indispensable part in that remedy. Because price incentives work. They really do. Take a look at the European Commission’s latest quarterly reports on energy markets. EU gas consumption was 16 per cent lower in the second quarter than a year earlier. That is inconceivable without the big rise in prices that took place.

Between the extremes are designs that combine the two approaches. One is to compensate a proportion of energy costs above a certain price level, creating a sort of soft price cap. Norway does this — households get 90 per cent of electricity costs above roughly €70/MWh covered in a government-paid rebate on their bills. That blunts a lot of the incentive to save, but at least the rebate only applies up to an allocated amount of energy consumed, so above that allocation the price incentive applies in full.

Another design with a similar effect is a tiered tariff, where a price cap applies up to a certain reasonable but modest allocation of energy, and the market-clearing price to the rest. This is the Norwegian rebate model with a 100 per cent compensation rate. That, of course, also keeps the incentive to economise in place, down to the amount allocated under the cheaper price. The size of that subsidised allocation can be means-tested and tailored according to circumstances and is therefore more cost-effective than a price cap. (Social tariffs, where eligible consumers are offered a lower price up to a certain quantity, are a means-tested version of tiered tariffs.)

Germany seems set to adopt an approach along these lines, after an expert commission recommended it (Dullien has a nice Twitter thread summary in English). It seems an amount of gas — in general, 80 per cent of consumption — will be subsidised so as to cost no more than €120/MWh. A particularly nice feature of the German proposal is that you get to keep the whole rebate that secures the guaranteed price even if you manage to bring consumption down to less than 80 per cent (the full allocation). In theory, you could come out in profit if you reduced your energy use enough as explained here. The market incentive to economise never disappears.

There are, of course, important decisions and trade-offs to make, but they should be within this general sort of design. A crucial decision is how big the subsidised allocation should be. The German reference to past consumption is far from ideal, for example, because it favours those who could afford to be profligate with their energy use — a flat allowance based on household characteristics rather than past behaviour would be better. It is harder still to come up with a reasonable allowance for businesses, where past use may be the best one can get.

This leads us to the last point. We often hear warnings that if we don’t manage to reduce energy use enough by the winter, we risk “rationing”. But whenever you set allocations of energy to be supplied below the market-clearing price, you are already rationing. Any policy intervention that segregates specific quantities out of the price mechanism amounts to rationing. You can only avoid it by picking one of the extreme two options we started out with (or not help at all, and let the energy famine rage). So we shouldn’t let the debate be distracted into “pros and cons of rationing” but focus squarely on the kind of rationing that is best.

Other readables

• The Ukrainian economy may be growing again.

• The Federal Reserve is discreetly asking financial institutions whether the US, too, might face hidden instabilities like the UK’s pension fund meltdown.

• Brussels is increasing the pressure on Poland over the rule of law.

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