The Good, the Bad, and the Ugly of Government Energy Policies

Last Thursday, the UK government unveiled a package of policies worth more than 15 billion pounds to tackle energy prices, large enough to redistribute nearly one per cent of national output. That Conservative Party chancellor Rishi Sunak presided over massive redistribution and market intervention illustrates the scale of the challenge facing most European governments today.

Addressing the cost of living crisis is the most urgent political imperative. It is tempting to do so with short-term solutions. But this risks exacerbating larger challenges in the medium term: the carbon shift and the need to resist Russian President Vladimir Putin’s plans for the balance of power in Europe. Both require a major overhaul of our power systems, not lingering financial plasters.

Adhesive plasters are also needed, of course. The rise in energy prices in Europe has been staggering. Natural gas prices are five to ten times higher than normal since last fall, when Putin began cutting supplies. Electricity followed suit, as gas-fired power plants often provide a balance between the fluctuating energy demand in European energy markets. Global oil prices doubled their levels in 2019.

These price movements are politically effective because they entail two important economic redistributions. One international, from energy importers to exporters; The other is within countries – even within energy exporters like Norway – from consumers to energy producers. As energy takes a larger share of the budgets of low-income people, that’s downward — and it gets worse because energy costs raise the price of everything else.

Together, this leads to a terrible predicament. Most countries face a hit in their real income only when it becomes necessary to help their citizens who cannot withstand greater hardships. So what principles should guide their policies?

Governments have, roughly, four ways to mitigate rising energy costs. First, they can set prices directly. Second, they can reduce or eliminate any taxes on energy purchases. Third, they may leave prices unchanged, but directly compensate groups of people for higher costs.

Fourth, they can leave prices the same, but change the market structures by which they are determined – in particular so that consumers can take advantage of the lower marginal cost of generation for renewable electricity. For example, in the European Union there is a push to make electricity pricing less tied to the marginal cost of generation, which currently means the cost of using gas in thermal power plants. Another example is strengthening incentives for buyers and sellers of energy to enter into long-term contracts at more stable prices.

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

The first two factors, by trying to drive prices below their true marginal costs, encourage consumers to use more of the energy sources whose relative scarcity is responsible for raising prices so much: gas for heating and electricity, and oil for non-electric transport. Energy price caps, such as those the UK imposes on what households pay, and tax cuts such as fuel surcharges, are to blame for this imbalance.

Attempting to dampen basic relative price signals in order to reduce average price inflation is bound to buffer problems for the future. It increases demand for fossil energy – and therefore energy sold by Russia – and reduces the incentive to invest in renewables.

Therefore, the third and fourth approaches are preferred. By allowing the marginal prices of an energy source to get us in trouble to rise when necessary, they protect the incentive to economize or switch to alternatives. Direct financial support is easy to design and can target those most in need. Structural reform of energy markets is more difficult and may have to include elements of implicit rationing.

But most importantly, offsetting measures must match plans to change how energy is generated and consumed: a large and rapid rollout of low-marginal-cost renewables and much greater storage capacity to allow people to move away from rising costs.

How is the UK’s current set of policies measured? The Good: New Live Support announced this week. The Bad: Maintaining poorly designed price controls. And the ugly: Too little investment in a smarter power system. As an adhesive plaster, it does the job. It has failed miserably as a sustainable solution to our problems.

martin.sandbu@ft.com