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

On Thursday, the UK government unveiled a more than £15bn policy package to tackle energy prices, large enough to redistribute close to 1% of national output. The fact that Conservative Prime Minister Rishi Sunak should preside over such massive redistribution and market intervention speaks to the scale of the challenge facing most European governments today.

solve cost of living crisis is their most pressing political demand. This is easy to do with a short-term solution. But it risks exacerbating larger medium-term challenges: the carbon transition and the need to resist Russian President Vladimir Putin’s plans for a European balance of power. Both require a fundamental overhaul of our energy system, not fiscal tape.

Of course, plaster is also required. The rise in energy prices in Europe has been breathtaking.Since Putin last fall start to tighten supplyElectricity is not far behind, as gas-fired power plants often balance the fluctuating energy demands of the European electricity market. Global oil prices are double their 2019 levels.

Such price movements have political implications because they require two major economic redistributions. One international, from energy importers to exporters; from consumers to energy producers, another within countries – even within energy exporters like Norway.With energy accounting for a large portion of low-income people’s budgets, it’s a step backwards — and with vitality Cost drives up the price of everything else.

Together, this creates a dire dilemma. Real incomes are taking a hit in most countries at a time when it is imperative to help those citizens least able to withstand greater hardship. So what principles should be followed to guide their policies?

There are roughly four ways that governments can reduce energy costs. First, they can directly cap prices. Second, they can reduce or eliminate any tax on energy purchases. Third, they may keep prices the same, but directly compensate the crowd for higher costs.

Fourth, they can change the market structure that sets prices without affecting prices themselves—in particular, allowing consumers to benefit from the low marginal generation costs of renewable electricity. For example, the EU is pushing to lower the link between electricity prices and marginal power generation costs, which currently means the cost of using natural gas in thermal power plants. Another example is strengthening incentives for energy buyers and sellers to enter into longer-term contracts with more stable prices.

The biggest difference between these approaches is whether they work with the market and therefore serve or hinder the long-term interests of the governments that adopt them.

The first two, by trying to drive prices down below their true marginal cost, encourage consumers to use more of the energy sources that are relatively scarce that drive prices so high: natural gas for heating and electricity, oil for non-electrified transportation . Price caps on energy prices, such as those paid to households in the UK, and reductions in taxes such as fuel taxes are to blame for this shortcoming.

Attempts to dampen underlying relative price signals to lower average price inflation are bound to build up problems for the future. It has increased demand for fossil fuels — which in turn expanded demand for energy sold in Russia — and reduced the incentive to invest in renewable energy.

Therefore, the third and fourth methods are preferable. By allowing the marginal price of energy, which has trapped us, to rise as high as possible, they protect the incentive to save energy or switch to alternatives. Direct financial support is easy to design and can be targeted to those who need it most. Structural reform of energy markets is more difficult and may have to include elements of implicit rationing.

But most importantly, the compensation must be matched with plans to change the way we produce and consume energy: the rapid rollout of low-marginal-cost renewables and greater storage capacity on a massive scale to free people from soaring costs.

How does the current set of UK policies measure up? OK: new direct support announced this week. The bad: Retain poorly designed price controls. And the ugly: too little investment in a smarter energy system. As a sticky plaster, it gets the job done. It fails badly as a sustainable solution to our problem.