Europe is facing a growing energy crisis as Russia cuts off natural gas supplies, leaving nations with no good policy choices to contain the fallout.
A series of timely, targeted and temporary price caps is, for now, the best of a set of bad choices.
The United Kingdom on Thursday announced a price cap that will freeze the average household’s energy bill at 2,500 pounds for two years. This scheme will likely cost around 75 billion pounds a year (or 3% of gross domestic product) for two years.
That amounts to 150 billion pounds in total—twice the cost of the furlough scheme implemented during the pandemic. Even with the price cap, the impact of higher energy costs still means real household disposable incomes will probably now fall by roughly 2.5% this year and by about 1.0% next year. This will most likely result in a 1% decline in UK GDP.
From our vantage point, the move will dampen inflation and provide relief to UK households in the near term, with a peak of 11%, in contrast to the 13% we estimated before the announcement.
The UK’s plan stands in contrast with the European Union, which proposed a windfall profits tax on energy companies to finance fiscal support for households and businesses. These taxes are not going to be imposed in the UK.
The suppression of the price signal will also most likely cause further economic distortions that will lead to a deterioration in the UK fiscal position, further devaluation of the British pound and higher inflation over the medium to long term.
Attempts to fully offset losses in real income would be counterproductive and create longer-term distortions in the economy.
That leaves short-term price caps as the best way—or, put more accurately, the least bad way—to mitigate the price shocks and to prevent wider declines in aggregate demand.
A series of timely, targeted and temporary price caps as opposed to price controls is, for now, the best of a set of bad choices.
The fiscal authority
Under current conditions, the fiscal authority will need to provide the primary financial backstop while the Bank of England and European Central Bank focus on restoring price stability.
It is critical that fiscal authorities not lose their nerve and leave the central banks to address both rising inflation and an energy crisis simultaneously.
Authorities in Europe are about to put in place a series of price caps and other policies. If those caps are not designed and implemented properly, they could further distort price signals and result in a longer, more expensive adjustment to what may be permanently higher energy prices.
We expect a series of timely, temporary and targeted measures that provide direct relief to households as well as to small and medium-size firms to get though what will almost certainly be the most difficult winter in decades.
As the International Monetary Fund has said, it is possible to adopt a temporary approach that can simultaneously preserve price signals and support households and firms, all while retaining incentives for the longer-term transition away from fossil fuels.
The cost of doing so is within the reach of the UK and European states. To provide support for the lower quintile of households, or those in the bottom 20% of income, will cost on average roughly 0.4% of gross domestic product across the European economies.
For the UK, the cost will be closer to 0.5% of GDP and France a little less than 0.2% To provide support up to the 60th percentile of households will cost a little less than 1% of GDP.
But once prices return to their near long-term equilibrium. it will be necessary to end such support if economies are to de-link from Russian natural gas and energy while at the same time transitioning to renewable energy resources.
State of play
Fiscal backstops over the past week have been put into place in Finland (10 billion euros), Germany (65 billion euros) and Sweden (25 billion euros) to support key energy-producing companies facing liquidity constraints.
Given that the EU and UK economies are either in or will soon be in recessions, the possibilities of a knock-on financial crisis cannot be discounted.
At this time, there is no evidence of any risk to the banking system, nor is there evidence of dollar-funding stress. Market talk of a spillover into the financial sector should be taken as just that—talk.
In the case of spillover into the financial sector, we expect that the European Central Bank would quickly construct a liquidity-enhancing facility to dampen further capital outflows and put forward further stabilization policies to address any exigent crisis.
Through the end of the first quarter, crude oil prices in Europe had doubled, coal prices had tripled and natural gas prices had increased more than five-fold compared to early last year, according to the IMF. Since then, all have deteriorated further, and futures prices suggest that these increases have a significant permanent component.
In response, governments in Europe have taken a multifaceted approach:
- Adopt measures that impede price pass-through of higher prices,
- Support households through cash transfers and vouchers,
- Support businesses through subsidies, energy efficiency grants and temporary unemployment benefits,
- Offer grants to local governments.
Whatever policy frameworks are adopted, it is critical that they be temporary. While geopolitical tensions are not likely to abate soon, any policy framework should be organized around provisional price caps.
Should the war continue into 2024, governing authorities will have to adjust their policy approach accordingly.
But for now the focus of policies should be twofold:
- First, provide fiscal support for households up to the 60th percentile of the income distribution during the first winter of the war. Rebates and direct cash transfers can provide timely relief. This support can be in addition to the targeting of low-income households facing liquidity constraints to provide education, food and health care.
- Second, provide relief to small and midsize enterprises. These firms do not have the financial depth nor are they able to tap liquidity through traditional lending. This kind of financial support can avoid second-round effects like rising unemployment, permanent balance sheet damage, declining productivity and bankruptcies.
Such small and middle market firms are the backbone of the UK and EU economies. Any policy framework that intends to prevent significant and long-term disruption to the regional economy demands such support.
Windfall profits taxes
Given that windfall profits taxes are going to play a large role, they need to be designed with the goal of preserving investment incentives and be imposed only on excess profits. It is essential that critical energy firms be allowed to pass along costs to consumers to preserve price signals and minimize distortions.
Such policies will always be controversial. The idea that firms paying excess profit taxes need to be able to obtain a reasonable rate of return on investment is going to be politically explosive.
Still, the longer-run goal of constructing an energy infrastructure that supports a move away from Russian supplies and creates the conditions for the reduction of an over-reliance on fossil fuels will require exactly such incentives and a reasonable return on investment.
In addition, any entities that play a role in critical energy production and national security will almost certainly need to be included in any prospective fiscal and monetary support.
Given that the course and duration of the war on the edge of Europe are uncertain, we are well aware that a timely, temporary and targeted policy may present the appearance of a half-measure in light of the tremendous challenge.
Yet it is the least bad option that retains the price signal from energy markets and keeps incentives to invest during what is going to be a transition away from Russian supplied natural gas toward a more sustainable energy future.