What is going on with the energy crisis?

Everyone in the United Kingdom is under pressure to act on soaring energy prices and high household costs.

The government has a trilemma over energy prices: how to solve the cost-of-living crisis while being focussed on not being drowned in loans, and unwilling to increase taxation or borrowing. The last is the reason for high inflation happening right now. There is no ideal solution, but several questions need clarification.

Who should be shielded from a 50% rise in energy prices and for how long? Who should bear the burden – bill payers or taxpayers? Are we willing to take a hit on government debt? And is the crisis ending smoothly in 25 years or acutely in two or three years?

Imminent rises

Well, the energy price rises that are coming in April and again in the autumn will reach well beyond the normative, possibly sending inflation towards an incredible 7%. This is something not seen in three decades, since well before the independence of the Bank of England. Such is the scale of the increases in the pipeline – with typical bills heading to £165 a month! The pressure will mostly affect millions of lower-middle-income households. 

Average households, which currently spend 4% of their disposable income on energy, will see that almost double. A recent poll suggested that half of Britons would not be able to afford a rise in their monthly bills of £50 a month. That’s the increase which is coming in a few weeks. All of this means there is a necessity for a quick and sustainable solution. There can’t be solutions with fundamental flaws. So, let’s talk about the possible solutions.

Discount expansion

An expansion of the £140 Warm Home Discount scheme is the current most-talked-about plan. The current budget of this scheme is less than £500m a year. It is not designed for a situation where several million people might need support to fund a £20bn energy price shock. The “core” element of the scheme distributes payments automatically to low-income elderly using pension credit data. But there are now more people in the broader part of the scheme for working-age recipients of the discount. This part of the scheme is run on a first-come-first-served basis, where recipients have to apply for the discount from a fixed pot of funds at each energy company and hope that the fund isn’t exhausted. There are some different criteria applicable at each energy company so claimants may not be eligible if they have switched.

The most significant factor, though, is that no funds come directly from the taxpayer. It is all funded by the energy companies, or rather, funded from energy bills. The problem with this plan is simple. When the quantity of people in need of assistance paying the bills gets larger, the smell of a new tax arises. 

Cuts to VAT and green levies

A cut in VAT saves 5% or £95 off a £1900 predicted bill. This might prove a helpful addition, but will not fundamentally alter the picture. It also gives more cashback to those with the biggest bills, or the largest, least well-insulated mansions. And it also loses revenue to the Exchequer. And then there is getting rid of the “green levies”. These are a range of policies that add about £170 to bills. They reflect the funding for historical investments in green energy and a range of social obligations. They would be required instead to be funded by the taxpayer. A version of this idea was floated four years ago in Professor Dieter Helm’s “Cost of energy” report to the government. He said that report had been “shelved”. This plan features a redistributing the energy bill into different taxes.

Putting off costs

There is another solution that the government is looking at: what is being termed a “cost deferral mechanism”. Essentially some big banks, possibly backed by a Treasury guarantee, lend billions to energy companies, who then spread a £600 immediate hike, into, say an additional £120 premium every year for five years, or less over a decade.

It is possible to do this without Treasury backing, but some sort of adaptation of rules governing existing deferral arrangements such as the last resort supplier schemes would be needed. Another version of this scheme being pushed in Whitehall could utilise the pandemic rescue architecture at the Bank of England by providing up-front funding. This could prove rather controversial, but some argue that the scheme could help prevent inflation from getting to 7%.

Some version of the scheme, or “smoothing mechanism”, has been gaining traction in the energy sector, in some government departments, and among MPs keen for a plan. But it doesn’t have universal backing in the energy industry. In an interview with the BBC, earlier this week Centrica chief executive Chris O ‘Shea referred to it as a “bailout” for energy companies. That in turn has led to some scepticism at the Treasury about how it can work.

Short or long-term hike?

The judgement on whether this is a one-off shock, or whether, as Mr O’Shea suggested, it will last two years or more, is critical here. There are reasons to believe it is the consequence of exceptionally set circumstances.

Firstly, the post-pandemic bounce-back led to unprecedented demand for energy, including gas. Secondly, the fact that due to a late, cold and long winter last year, crucial stores of gas in Europe were never completely filled going into this winter. And lastly, there is the Nordstream 2 pipeline from Russia which is finished but has not been certified by Germany yet. The prediction that wholesale gas prices stay high for a year or two is a reflection of what futures markets are saying. All of that could change rather rapidly with a speech from Russian President Vladimir Putin, or when the global economy normalises. One is as unlikely as the other, unfortunately. 

But we cannot be certain either way.

If a smoothing mechanism is put into operation, and wholesale prices remain high, then households might get prolonged chronic pain and a never-ending scheme. Definitely does not sound sustainable. Does the political cycle lend itself to such a spread of the burden with a general election expected in 2024?

All of this points to the traditional moment where Number 10’s First Lord of the Treasury – one of the Prime Minister’s official titles – overrules a fiscally cautious Chancellor. But the political backdrop of “party gate” adds some uncertainty to what happens here. Is this a one-off price shock? And for how long does the government want to spread the energy price pain? For ordinary households, there couldn’t be a more important consequence to the nation’s currently delicate political balance.

What were the fundamentals to understand? 

Expect the worst. It does not sound comfortable, but the situation will not resolve itself and the options listed by the leading powers are not sustainable. The energy crisis is a start to something bigger and getting ready for it is essential. Try to save and invest the savings in something certain. This being not an advertisement for gold, but rather an emphatic suggestion – let’s get through together. 

The article was cited and modified from https://www.bbc.com/news/business-60001695.