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Drastic action is needed to deal with the energy emergency

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Written by Harry Western

The new government will need to take drastic – and in some ways, ‘un-conservative’, steps to prevent the surge in energy prices leading to a deep recession. Some form of cap on wholesale prices now looks inevitable, alongside other measures to tackle dysfunctional elements of the UK’s energy markets and boost the UK’s domestic energy supply over the medium term. This will be expensive, but there are recent precedents including the response to the global financial crisis and the alternatives are worse and risk generating profound social and political costs.

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The UK economy has so far held up reasonably well in the face of the rise in energy prices that began in mid-2021 and accelerated after the Russian invasion of Ukraine. But the latest data suggest a weakening has begun and the economy faces an enormous potential further shock over the coming months, which without rapid and drastic action will certainly cause a deep and damaging recession.

For households, the latest price cap announcement means a rise in energy bills of around 80% to £3549 per year. With 28 million UK households, this means bill totalling £99 billion, up £44 billion from before. This amount is equivalent to a rise in the standard rate of income tax of 9 pence in the pound. And this is by no means the full extent of the shock, with projections that the price cap might rise much further, to around £6000 per year, at the start of 2023.

Some of this rise in bills will be offset by the indexation of benefits and pensions, plus a rise in average wages of perhaps 6% over the next year. But even with these offsets, it is likely that the real disposable income of UK households will fall by around 5% without further government action. This would be the deepest decline in the post-war period – worse even than in the 1973-74 oil shock.

Businesses, which account for as much energy consumption as households, also face a massive shock which is just now beginning to appear in their revised bills. Obviously, energy-intensive industries like metals and fertilisers have particularly acute problems and there could be serious knock-on effects from those problems to other industries. But many tens of thousands of small businesses, employing millions, in sectors like hospitality are also facing bills that are triple or quadruple the previous levels. For these businesses, many of which have modest turnovers, the ability to recoup this colossal rise in fixed costs via price rises or other adjustments is limited. Without government action there will be a cascade of closures and bankruptcies over the winter. A recent SME insights survey found over half of small businesses were worried high energy bills would lead to them closing.

It is unclear whether the scale of the shock that is starting to hit the economy has fully sunk in, in Whitehall. Many policy measures being proposed are at best half-measures and much effort is being spent on irrelevant debates about fiscal prudence and the need to let price mechanisms work.

The time for such niceties is past. The current situation is an economic emergency and requires emergency measures. The price of energy is now extremely distorted and threatens to crush living standards and render large parts of the economy unviable. Demand for energy is extremely inelastic (even a 30% rise in prices might only cut demand by 1%) so that the scale of demand destruction that would be necessary to rebalance supply and demand is enormous and would imply huge economic and social costs. Prices rises have already been high enough to alter behaviour in favour of energy saving.

Similarly, even today’s sky-high prices are not going to magically bring forth a rush of new domestic energy supply that will drive prices back down. The kind of supply response necessary will take years given lead times for investment and regulatory requirements – even with a friendly government.

What then, is to be done? There are a variety of options that could make a difference. All will be very expensive, but that is now unavoidable.

Tax cuts: One approach would be to try to offset the rise in energy prices with tax cuts. Personal taxes levied in the UK are equivalent to around £650 billion a year. To offset the latest rise in bills, personal taxes would need to fall £44 billion (7%) and to offset a rise in the price cap to £6,000, they would need to fall by £112 billion (17%).

Possible cuts include –

  1. Cutting VAT. A 5% cut in VAT, costing around £40 billion a year, would give the median household about £1,300 per year. The advantages of this are that it could be done quickly and would also cut headline inflation – by as much as 4 percentage points if fully passed on by businesses.
  2. A council tax holiday. The average household spends around £1,500 per year on council tax. Remitting the council tax for one year would cost around £41 billion. The cost could be reduced if the relief were only offered to smaller properties in bands A-D which pay around 70% of the tax and account for 80% of properties.
  3. Cutting business rates. Businesses pay around £24 billion in business rates a year. Halving this would cost £12 billion and provide considerable relief. But it would probably be better to target any cuts at smaller businesses, which would also reduce the cost.
  4. Cutting income tax. As noted above, a 9 pence in the pound cut in income tax would be roughly equivalent to the latest rise in energy bills facing UK households.
  5. Cutting VAT on fuel. This is only levied at 5% on domestic users, so would make only a small contribution to reducing the rise energy prices. The cost would be around £2.5 billion. A bigger impact would come from slashing VAT on business bills, where it is levied at 20%.

While this approach has some attractions, it also has limitations. It is unclear how well targeted such tax cuts would be and bringing them in would doubtless be attended with a lot of objections about their distributional impact.

Nor should we take too seriously claims that tax cuts will spur a dramatic supply side improvement in the economy. Well designed tax changes that improve incentives and remove distortions might add a couple of tenths to annual GDP growth in the long term, and a crisis might be a good time politically to smuggle such changes in. But the case for tax cuts right now is primarily a Keynesian one – concerned with putting money back into people’s pockets and offsetting the massive extra outlays on energy.

Direct rebates: Government could offer households a direct rebate on energy bills. But this is probably even less easy to target than tax cuts are, has a higher administrative cost, and does not impact on headline inflation.

Subsidising energy costs: Given the problems of effectively targeting tax cuts, it may be easier to take a more direct approach and cap energy prices, as has been done in France and perhaps along the lines of a recent proposal by Scottish Power. This proposal suggests that the government fixes the price cap around the level it was before the latest increase (with potentially a freeze for business tariffs too), and that energy suppliers cover the difference between that price level and their increased costs of buying gas and other energy sources by borrowing from a ‘deficit fund’ set up by the government. This could cost around £100 billion over two years, with the cost met over 10-15 years (or longer) either by government borrowing, a levy on future energy bills, or some combination of the two.

The main advantage of this approach would be its relative simplicity and directness. Rather than trying, inevitably imperfectly, to offset energy price rises by cutting other household or business costs, this approach deals with the issue at source. Cutting prices of power procured by suppliers lowers the costs faced by all bill payers downstream.

Removing green levies: The IFS estimates that various ‘green’ levies on household bills will add around £180 to the typical bill over the next year. Removing these would provide some relief for households, but not nearly enough to offset the price cap rises. In addition, some of the cost of the green levies may be offset by renewables producers paying back the difference between the high prices they are currently getting and strike prices in the contracts for difference previously agreed by government. The benefit from scrapping or at least suspending green levies may be stronger for businesses, whose bills are also inflated by various levies including the climate change levy. One estimate suggests increases in these from 2014-2020 added £540 per year to the energy bills of small businesses (using 20,000 kwh per year). The government would have the choice as to whether to discontinue the schemes funded by these levies or fund them through general taxation.

Nationalisation: Nationalisation of energy suppliers will make little difference given that their profits only make up a small fraction of total energy costs – £63 (1.8%) of the new price cap total of £3549 per year. Nationalisation of producers, apart from being time consuming and expensive, would not solve the main problem of highly priced imported energy.

Surveying these alternatives, it is hard to escape the conclusion that some form of temporary price capping must be considered. This a very ‘un-conservative’ measure for a new Conservative government to consider, but the alternatives all have serious drawbacks particularly in terms of the urgent need to prevent the collapse or closure of a huge number of businesses. There are also precedents for the emergency situation the UK is now in. Most recently, the massive intervention during the global financial crisis to bail out banks and direct the Bank of England to buy financial assets whose prices were greatly distorted by illiquidity and uncertainty.

Any policy or set of policies that will have a serious impact will carry a heavy fiscal cost. It is likely that the necessary cost over the next two years might be in the region of £100 billion. This sounds terrifying but more was spent during the pandemic, and it amounts to only 4% of UK GDP of £2.5 trillion. If funded over 20 years via government long-term bond issuance, the additional interest costs per year would be around £3 billion or 0.12% of UK GDP at current rates. Nor will such borrowing ‘fuel inflation’ as is sometimes claimed. That would only be so if it was financed by Bank of England quantitative easing. With the economy on the verge of recession also, such claims are way off-beam.

This is not the stuff of which fiscal meltdown is made, and the cost could be ameliorated by repaying some of the borrowing with a levy on future energy bills or by cutting other government spending. An obvious candidate for the latter would be the incredibly expensive and economically dubious HS2 project, which may well cost above £100 billion, of which only a fraction has been spent or contracted so far.

But it is crucial that if the UK does use drastic government intervention to cap bills for households and businesses, it uses the time gained to radically reform the UK’s energy policy to bring costs down in the medium term and reduce the vulnerability of energy supply to external shocks. This must mean ramping up domestic energy supply of all kinds – including offshore and onshore gas, nuclear and if possible non-intermittent renewables such as tidal power. It means considering changing elements of the current energy market such as marginal pricing where wholesale prices are set based on the costs of the energy which is most expensive to produce. Doing this will require a massive government effort to overcome vested interests and Whitehall inertia.

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About the author

Harry Western