Untargeted bills support will raise risk of stagflation

The failure to provide targeted support for households that helps them meet basic energy needs, without subsidising higher levels of consumption, will worsen the gas shortage for the wider economy and increase the risk of stagflation, academics have warned.

In a new paper from the University of Cambridge’s Energy Policy Research Group written in response to the government’s announcement of an Energy Price Guarantee, they called for a pricing scheme for energy which reflects the current scarcity whilst also limiting the impact on household incomes and inflation.

The paper authored by professors Michael Pollitt, David Reiner and David Newbury said energy demand must be reduced to address the shortage of gas and bring down energy prices.

“We don’t want to demand more, pay more per unit and pay more overall,” the paper explained. “And we don’t want to reduce gas demand simply by inducing a recession. We want to demand less gas, pay less per unit and save on overall energy expenditure.”

It said countries that fail to reduce demand in a way that minimises the economic impact will “suffer larger declines in real income, have more energy price inflation, and be at great risk of stagflation”.

The paper noted that households account for a substantial proportion of both direct gas consumption (37%) and daily peak electricity demand (45%).

It said some of this consumption – for example, heating unused parts of houses, outbuildings and swimming pools – has less social value when compared to both other domestic consumption and industrial and commercial usage, and must be reduced to alleviate the gas shortage for the wider economy and avoid the risk of supply interruptions.

The paper also noted the significant impact of high energy prices on general inflation and said some control is necessary to avoid an inflationary spiral as wages chase prices.

“What we need is a pricing scheme which reflects scarcity and which limits the impact on household incomes and inflation,” it stated. “A rising block tariff, with a high marginal price for final units of consumption is essential to signal to consumers that demand must be reduced to meet supply.”

The paper continued: “We could have a rising block tariff where the first, say, 2000 kWh of electricity and 10,000 kWh of gas per year are at a lower unit price and units above this are at the average expected forward price.

“This would strongly incentivise reductions from the typical consumption levels (2900 kWh of electricity and 12000 kWh of gas). An additional advantage is that it would give bigger percentage bill reductions to those who consume less than average, who tend to be poorer. It also effectively represents a lump-sum subsidy to each household, not a subsidy to every unit of energy consumption.”

The paper drew a comparison with energy policies during the Second World War to highlight the importance of effective demand reduction: “A great success in World War Two was to prioritise the reduction of household consumption of coal (then the major heating fuel) to allow energy to be reallocated to war production.

“A notable failure in World War Two was the failure to do this with electricity, which led to blackouts (as households switched to electric heaters because electricity was unrationed and relatively cheap) and restrictions on post-War industrial output.

“This failure to ration electricity was largely a failure of political messaging. The failure to manage overall fuel demand had disastrous consequences when the UK suffered a fuel crisis in 1947, with an interruption to export-led growth and long-term political damage to for the political party in power (The Labour party).”

The paper said the importance of demand reduction is heightened by the UK’s dependence on imported gas to meet demand: “A policy which increases demand for an expensive import from abroad, by subsidising it, does this twice over. It increases both the quantity of imported gas and its unit price. Where these quantities are materially large in GDP, this will show up as lower exchange rate and the need to increase exports (or attract inward investment) to balance the balance of payments.”

It again drew a historical comparison, this time with the 1970s oil crisis: “Large increases in import bills and depreciation of the current were a significant contributor to the decline in the exchange rate and increase in inflation in the 1970s following the first oil shock. This would have been worsened if UK governments had subsidised oil consumption and promoted oil imports.

“As a historic example of success in reducing its exposure to fossil fuel imports, Sweden went from being the second most oil dependent country in Europe to one of the least due to a range of policies including the promotion of nuclear power and a pioneering carbon taxation system. Other countries similarly promoted successful long-term reductions in fossil fuel dependency, such as France with its nuclear power programme and Denmark with its leadership on wind power, energy efficiency and district heating.”

It additionally emphasised the need for the UK to work with its allies, particularly those in Europe, to address the current gas shortage: “The whole of Europe has a critical gas supply problem that poses a serious security threat… Simply competing with them to secure gas supplies from Norway or on world LNG markets will be costly for everyone.”

“What Russia wants is to divide the UK from our friends and neighbours in Europe: we must actively frustrate this with further energy cooperation, reflecting what has happened in cooperation to help Ukraine in its war effort,” it concluded.

The recommendations of the paper echo those of a recent report by the think tank Policy Exchange, which called for a three-tier relief scheme to help households struggling to pay energy bills, whilst also keeping down costs for the government.

The cost-of-living crisis will be one of the key themes at Utility Week Forum, from 8-9 November in London. Find out more here.