The good, the bad and the ugly of government energy policies

Last Thursday, the UK government unveiled a £15bn-plus policy package to address energy prices, big enough to redistribute close to one per cent of national output. That a Tory chancellor, Rishi Sunak, should preside over such massive redistribution and market interference illustrates the scale of the challenge faced by most European governments today.

Addressing the cost of living crisis is their most acute political imperative. It is tempting to do so with short-term solutions. But this risks aggravating even greater medium-term challenges: the carbon transition and the need to resist Russian President Vladimir Putin’s designs on the balance of power in Europe. Both require fundamental reform of our energy systems, not financial sticking plasters.

Sticking plasters are needed too, of course. The rise in energy prices in Europe has been breathtaking. Prices for natural gas have grown five to tenfold higher than normal since last autumn, when Putin began to tighten supplies. Electricity has followed suit, because gas-fired power plants often provide the balance of fluctuating energy demand in Europe’s power markets. Global oil prices are double their 2019 levels.

Such price movements are politically potent because they entail two significant economic redistributions. One international, from energy importers to exporters; the other within countries — even within energy exporters such as Norway — from consumers to producers of energy. Since energy takes a larger bite out of the budgets of those on lower incomes, this is regressive — and is made worse as energy costs push up the price of everything else.

Together this makes for a dire predicament. Most countries face a hit to their real incomes just when it becomes indispensable to help those of their citizens who can least bear greater hardship. So what principles should guide their policies?

Governments have, roughly, four ways of mitigating higher energy costs. First, they can directly cap prices. Second, they could reduce or eliminate any taxes on energy purchases. Third, they might leave prices untouched, but directly compensate groups of people for the higher costs.

Fourth, they could leave prices themselves untouched, but change the market structures through which they are set — in particular so that consumers can benefit from renewable electricity’s low marginal generation cost. For example, in the EU there is a push to make electricity pricing less linked to the marginal cost of generation, which at the moment means the cost of using gas in thermal power plants. Another example is to strengthen incentives for buyers and sellers of energy to enter into long-term contracts with more stable prices.

What most distinguishes these approaches is whether they work with or against the market, and as a consequence align with or frustrate the longer-term interests of the governments that adopt them.

The first two, by trying to push prices below their true marginal costs, encourage consumers to use more of the energy sources whose relative scarcity is responsible for driving prices so high: gas for heating and electricity, oil for non-electrified transport. Price caps on energy prices, such as the UK’s one on what households pay, and reduction in taxes such as fuel duty, are guilty of this flaw.

Trying to blunt fundamental relative price signals in order to lower average price inflation is bound to store up problems for the future. It increases demand for fossil energy — and by extension for energy sold by Russia — and reduces the incentive to invest in renewables.

The third and fourth approaches are therefore preferable. By allowing marginal prices for the energy source getting us into trouble to rise as high as necessary, they protect the incentive to economise or shift into substitutes. Direct financial support is easy to design and can be targeted at those in greatest need. Structural reform of energy markets is harder and may have to include elements of implicit rationing.

But most importantly, compensating measures must be matched with plans to change how we generate and consume energy: big and rapid rollout of low-marginal cost renewables and much greater capacity in storage to allow people to shift away from spiking costs.

How does the UK’s current set of policies measure up? The good: new direct support announced this week. The bad: retaining ill-designed price controls. And the ugly: far too little in the way of investment in a smarter energy system. As a sticking plaster, it does the job. It fails badly as a sustainable solution to our problems.

martin.sandbu@ft.com