Economics & StrategyEmail
Simon French, Chief Economist
Published: The Times 29/12/2021
Economic crises have a nasty habit of upending UK governments. The Winter of Discontent in 1978/79, the Exchange Rate Mechanism (ERM) Crisis in 1992 and the Global Financial Crisis in 2008 were all followed by General Elections where the incumbent government was thrown out by the British electorate. Fears are rising within the Conservative Party that the spiralling cost of heating and electricity may trigger a similar political nadir. The race is on to find an economic solution before the energy price cap is reviewed in April. Left unchecked the average UK household looks set to spend an additional £800 on heating and powering their home in 2022. This would amount to 80% annual inflation on domestic fuel bills, at a time when overall inflation is already running in excess of 5%. This is not the backdrop for a healthy economy, or a happy electorate.
In many ways this looming economic crisis has snuck up on a government still grappling with the challenges of the COVID-19 pandemic. The UK economy rebounded strongly during 2021 – with growth expected at close to 7%. This led to hopes that 2022 could be the year that the economic agenda focused on levelling up and addressing the UK’s poor productivity performance. The energy market clearly has other ideas. Current wholesale energy prices are around five times higher than usual at this time of the year. This is the market from which energy companies buy capacity that they sell on to you and I. Should these higher prices be passed on in full in April when the regulator, OFGEM, reviews the energy price cap this would lead to considerable economic distress. For millions of households with limited savings, on fixed incomes or in low-paid employment the ability to absorb this scale of price increase is limited. Fuel poverty – involving deeply uncomfortable choices on food, heating and day-to-day essentials – could quickly overwhelm the COVID-19 pandemic as the salient political issue at the next General Election.
Uncomfortably for the Business Secretary, Kwasi Kwarteng, and the Chancellor, Rishi Sunak, there are no quick fixes to this issue. And whilst there are temporary sticking plasters the government can apply, none are cheap. My own analysis suggests it would cost the Treasury upwards of £10bn next year to subsidise UK energy companies sufficiently to limit household tariff increases to just 10%. To put that cost in context that is equivalent to around 2p on the basic rate of income tax, or a considerable new windfall tax on recent corporate profits. It would be a considerable blow to the Chancellor’s hopes of being seen as a tax-cutter ahead of the next General Election or Conservative Party leadership contest.
Such direct intervention in the energy market would also require intensive cooperation between the Government and the energy companies. A climate of candid honesty, trust and full financial disclosure would be needed to avoid long-term damage to the UK energy market.
The alternative to working with the energy companies is a more targeted, yet operationally more complex approach of compensating households directly. The Winter Fuel Payment, State Pension and Universal Credit could all be increased to provide additional support to the hardest-hit households. The risk however is that many of these schemes overlap, whilst some of the poorest families sit outside these schemes altogether and will not benefit. I am in little doubt that the Government will be forced to act, but lets not pretend that it will be easy or without considerable risk.
The longer term solutions to the energy crisis are well-understood but, alas, will make little short term impact. More intensive exploration of North Sea oil and gas, including approval of the controversial Cambo oil field, looks increasingly likely. The political cycle suggests it will be worth the environmental criticism that will inevitably come the Government’s way. In a similar vein, fracking licences – to help secure greater domestic gas supplies – are likely to be looked upon more favourably. More environmentally sustainable battery and hydrogen storage solutions to smooth out the UK’s growing – but erratic – wind and solar output is also likely to get a more sympathetic hearing in Westminster, and from private investors. The lead-in time for new nuclear capacity make current events only relevant for strengthening the strategic case for nuclear.
It is important to note at this point that this is not a uniquely British energy crisis. Most of mainland Europe is facing a similar unprecedented increase in energy costs. Some European governments have already responded by cutting VAT on domestic fuel – a policy the UK Labour Party are now advocating. Across the continent reliance on Russia for gas supplies – a situation always vulnerable to geopolitical manipulation as well as historically low storage volumes going into the European winter have left the supply side vulnerable. Accelerating demand from the electrification of transport and heating are a pan-European challenge that is not going away anytime soon.
Of course households are not the only ones facing a squeeze. Businesses, schools, hospitals and charities across the country also face higher energy prices this Spring. For many businesses who have recently passed on higher staffing, shipping and raw material costs it will be a delicate calculation on how much more their customers can absorb. With furlough, the temporary Universal Credit uplift and interest-free loans available during the pandemic consumers have generally been able to pay higher prices. However with the backdrop rather less supportive in 2022 consumers may baulk at having to pay a second wave of higher, energy-led prices.
I have been a long-standing critic of the UK’s energy price cap as it disrupts important price signals to users and suppliers on the merits of energy efficiency, hedging out risk and expanding spare capacity. But perhaps paradoxically recent events are on such a scale that a renewed energy price cap is exactly the correct response for the UK economy. But such crisis measures should not be allowed to become the status quo. Otherwise they simply accelerate the timetable for the next crisis, and the political fallout that comes with it.
Original article from The Times found here.