How (not) to intervene in energy prices


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Every European country is concerned about high energy prices, and as far as I know every country has put public money on the table to support those who have to pay them. (Readers, please let me know of any exceptions!)

But how best to design such support is a thorny question, and a highly topical one. Just two examples: Germany is setting aside up to 200 billion euros, but now has to decide how that war chest will be used. The UK did it the other way around and adopted an overall price cap, then looked at the price tag and decided – after some ministerial turnover – that the system needed to be made more targeted.

A useful starting point is to think in two extremes. On the one hand are universal price caps, where a maximum or guaranteed price is offered to all users, and the government intervenes to pay the difference between that price and what it costs to get the energy delivered (for example, the wholesale price).

The other extreme is not to regulate prices at all and just let the market do its job of matching supply and demand. Instead, consumers receive cash support so that people, even though they have to pay higher prices, receive financial assistance to pay them.

Price caps have the advantage of simplicity and generosity. Generosity is also one of their drawbacks: they help everyone, including those who don’t need it (because they are rich enough to expend more energy to begin with) more than those who do.

Cash compensation, on the other hand, is complicated. It must be decided how much to give, whether and how it should be tested, what criteria should be applied for eligibility. It can be difficult to get enough compensation for the right people to avoid serious hardship. It also leaves the sticker shock in place, and with it the stress that rising prices cause.

But again, the disadvantages are also advantages. Because cash compensation can be targeted, you can provide more effective assistance for fewer taxpayers. And sticker shock is what gives an incentive to save on energy.

For me, the last bit is the decisive difference. Price caps provide the wrong incentive – to consume even more of something whose scarcity is the root of the problem. Cash offset market prices will reduce consumption – leaving more money to reduce overall energy costs.

If this sounds like Economics 101, that’s a danger sign – because Economics 101 tends to start and end with prices doing the work. This week I discussed with the German economist Sebastian Dullien (do follow him if you’re on Twitter), which pointed to the energy crisis analogy with famines. Referring to the work of economists Amartya Sen and Jean Drèze, Dullien emphasized that you don’t solve famines with the price mechanism – otherwise people will die. There must always be a redistributive policy. He encourages us not to be tempted by the standard economic premise of using price mechanisms to allocate scarce goods in the event of the energy crisis.

I had some squabbles with the analogy. One of Sen’s key points is that famines are generally not caused by shortages in food production, but rather by the inability to secure everyone’s food. straight to enough food. It is clear that the current energy crisis is the result of a shortage of energy in the form of the deliberate turning off of gas taps to Europe by Russian President Vladimir Putin. There is simply not as much gas available as before.

But Dullien’s bigger point about the price mechanism remains – on it’s own, it does not bring us close to an acceptable result. That is precisely why Putin is destroying energy prices and European governments are rightly looking for policies to remedy the consequences. Yet the price mechanism plays an indispensable role in that remedy. Because price incentives work. They really do. Have a look at the latest quarterly reports in energy markets. Gas consumption in the EU was 16 percent lower in the second quarter than a year earlier. That is unthinkable without the large price increases that took place.

Between the extremes are designs that combine the two approaches. One is offsetting some of the energy costs above a certain price level, creating a kind of soft price ceiling. Norway does this — households get 90 percent of electricity costs above about €70/MWh covered by a government-paid discount on their bills. That dampens a large part of the incentive to save, but in any case the discount only applies to an allocated amount of energy used, so above that the price incentive applies in full.

Another design with a similar effect is a tiered tariff, where a price cap applies to a certain reasonable but modest allocation of energy, and the market clearance price for the rest. This is the Norwegian discount model with a compensation percentage of 100 percent. Of course, that also maintains the incentive to cut spending to the amount allocated below the cheaper price. The size of this subsidized allocation can be income-related and tailored to circumstances, making it more cost-effective than a price ceiling. (Social fares, where eligible consumers are offered a lower price up to a certain amount, are an income-dependent version of tiered fares.)

Germany, after a committee of experts, appears to be taking such an approach recommended (Dullien has a nice Twitter thread Overview in English). It seems that a quantity of gas – generally 80 percent of consumption – will be subsidized to cost no more than 120 €/MWh. A particularly nice feature of the German proposal is that you keep the entire discount that guarantees the guaranteed price, even if you manage to reduce consumption to less than 80 percent (the full allocation). In theory, you could make a profit if you reduced your energy consumption enough, as explained here. The market incentive to cut spending never disappears.

There are, of course, important decisions and trade-offs to make, but they must fall within this general type of design. A crucial decision is how large the subsidized allocation should be. For example, the German reference to past consumption is far from ideal, as it favors those who can afford to be licentious with their energy consumption – a flat fee based on family characteristics rather than past behavior would be better. It’s even harder to come up with a reasonable fee for businesses, where past use may be best.

This brings us to the last point. We often hear warnings that if we fail to reduce energy consumption sufficiently in winter, we risk ‘rationing’. But when you set the allocation of energy to be delivered below the market clearing price, you are already rationing. Any policy intervention that separates specific quantities from the price mechanism amounts to rationing. You can only avoid it by choosing one of the two extreme options we started with (or don’t help at all, and let the energy starvation rage). So we should not let the debate turn to ‘pros and cons of rationing’, but focus entirely on the type of rationing that is best.

different readability

  • The Ukrainian economy may be grow again.

  • The Federal Reserve is ask discreetly financial institutions or also the US could face hidden instabilities, such as the collapse of the UK pension fund.

  • Brussels is increasing the pressure on Poland because of the rule of law.

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