Designing policy in straitened economic times

Back home, confronted by the same facts, our governments would have banned everything that moves. Cap prices. Tax windfall profits. Subsidise household spending globally. And when this policy farrago fails, declare every instance of non-compliance “an act of economic sabotage”. Time to pay attention to the conversations around and the lessons from orthodox economics, then?

One of the many undesirable consequences of Russia’s invasion of Ukraine and the subsequent imposition by the West of sanctions on the former has been the upward pressure on oil and gas prices from the resulting supply constraints. After Russia recently shut down its main gas pipeline to Europe, oil prices rose 30% to close last week at the equivalent of almost $400 per barrel of crude oil. Because gas powers businesses and households across most of western Europe, this hike is now the main contributor to the cost of living crises that countries are facing across the continent.

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r homogeneous goods (such as gas), prices are set by the producer with the highest cost structures. Thus, much of Europe prices its energy at the cost of producing an extra unit of gas. With gas costs as high as they have reached of late, energy and electricity prices for businesses and households have ratcheted up through the rafters. Policy makers have therefore been engaged in finding solutions to this problem. In this sense, the energy crisis in Europe provides an unusual opportunity for an experiment in economics. Of the many available options for dealing with the energy crises, a cap on prices is the most immediately appealing. It is the easiest to implement and one that the populace will very easily understand. But it is also the likeliest to remove any incentive on the part of energy users to find more efficient ways of consuming it.

A cap on prices will not, in other words, solve the problem. And because it is far likelier to boost consumption, it may contribute to a warmer world instead. Would a cap on a basic amount of electricity fix this problem? Properly designed, it could reduce the cost to consumers without hurting the incentive which rising prices provide for disciplining consumption. Still, irrespective of particular designs, price control measures suffer most from mission creep, and so it helps that they include sunset clauses.

Would imposing higher taxes on this rent not have the same effect? Reducing generators’ windfall profit, while cushioning the fiscal impact of governments’ interventions to ease the cost of living crises. This option raises the question, though, of how much to charge without disincentivising the global energy transition?

Since the marginal costs of renewable energy providers is as close to zero as possible, pricing energy at the cost of an additional unit of gas has meant that solar and wind power generators have earned large profits since this crisis began. On this basis, a case is being made for redesigning Europe’s electricity markets ― by changing how additional units of electricity is costed. By moving the unit price of electricity closer to the marginal costs of the nuclear and renewable energy industries, reforms could both reduce the costs to businesses and households of energy and electricity. Reducing as well the windfall profits that generators of renewable electricity will earn going forward.

Would imposing higher taxes on this rent not have the same effect? Reducing generators’ windfall profit, while cushioning the fiscal impact of governments’ interventions to ease the cost of living crises. This option raises the question, though, of how much to charge without disincentivising the global energy transition? Government handouts to both businesses and households could square this circle. At a minimum, financial support from governments cushion the damage to electricity consumers from rising prices, without adversely affecting price signals.

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But such handouts do several other things. Of most import is the upward push they lend to governments’ deficits and borrowing. This matters more at a time when monetary conditions are tightening across these economies. Besides pushing up government deficits, handouts are also a major source of price pressures ― driving household spending, often in unintended directions.

Given their effects on the exchequer and inflation, does it make sense to provide such handouts to all citizens, including those whose incomes have only been dented by rising energy costs? Or should interventions go to only those whose very existence are threatened by higher prices? And if the latter, how to target intervention?

Beyond all this, there is a further worry. Is there an optimal structure for these handouts? Given their effects on the exchequer and inflation, does it make sense to provide such handouts to all citizens, including those whose incomes have only been dented by rising energy costs? Or should interventions go to only those whose very existence are threatened by higher prices? And if the latter, how to target intervention? Eventually, each European country will agree to a mix of intervention strategies that works best for it. The challenge in all of these options is to ensure that prices ― as signals of what, where and how much to consume and what, where and how much to produce ― are distorted as little as possible.

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Back home, confronted by the same facts, our governments would have banned everything that moves. Cap prices. Tax windfall profits. Subsidise household spending globally. And when this policy farrago fails, declare every instance of non-compliance “an act of economic sabotage”. Time to pay attention to the conversations around and the lessons from orthodox economics, then?