6 September 2022

Freezing energy bills could be cold comfort for the economy


The first big policy announcement from Liz Truss is likely to be a freeze on energy bills. This is an extraordinary turnaround from the early campaign promises of no more ‘handouts’. I dislike the idea too, but we are where we are. So can we say anything constructive about it?

Based on media reports, the plan is to cap the unit cost of energy by subsidising suppliers so that they do not have to pass on higher wholesale prices in full, either to households or to businesses.

The appeal is obvious. This would lift the huge cloud of uncertainty which is now hanging over the UK economy. The peak in inflation would also be much lower. With this plan in place, the new Government can claim a big ‘win’ and move on to other priorities, including tackling the underlying problems in energy supply.

However, this is another massive state intervention which will distort markets even further, mainly benefit higher users of energy, and could be very expensive. Consumers will still have some incentive to reduce bills by using less energy, but much less than if prices were free to adjust.

A freeze on energy bills would also be a blanket subsidy for everybody, and potentially unlimited. In contrast, the furlough scheme was at least targeted (the government only paid towards the wages of those who were unable to work), and capped (at 80% of average earnings).

The balance of arguments on the energy freeze depends on many factors which are still unknown, notably the level at which the price cap would be set, how long it would last, how much this would cost (which would also depend on what happens to wholesale prices over the life of the cap), and how this would all be paid for.

My own crude calculations suggest that fixing prices at the current level of the Ofgem cap (£1,971), for two years, might cost around £100 billion – just for households. This is based on the latest prices in the wholesale market, which are unlikely to remain this high, but of course we cannot bank on that.

There might be some offsetting savings to reduce the net cost. If bills were not frozen, the Government would presumably have had to provide more targeted support anyway, probably in the tens of billions of pounds. Lower inflation could also reduce the debt interest and social security bills.

For what it is worth my advice would still be to freeze prices at a higher level – not least because lots of households are already getting extra support in anticipation of a rise in October.

Fixing instead at the new October level (£3,549) might roughly halve the cost – say to £50 billion. This might require some extra top ups for the most vulnerable households. Repeating Rishi Sunak’s package for those on benefits might cost another £10 billion.

Or we could land somewhere between the two. Low-income households receiving means-tested benefits are already getting an extra £650 in cost-of-living support. People on non-means-tested disability benefits are receiving another £150 and pensioner households who receive the Winter Fuel Payment are getting an extra £300. Based on these numbers, fixing at a new figure of around £2,500 would seem a reasonable compromise.

The other big issue is how to pay for this. Energy suppliers originally proposed a surcharge on customer bills, spread over ten to twenty years, funded by government-guaranteed loans from commercial banks.

However, there is a strong case for covering these one-off ‘wartime’ costs with additional public borrowing. This would increase the stock of debt, but the burden can be eroded over time by stronger economic growth, without the need for additional tax increases.

This does expose the Government to a huge potential liability, with the final bill unknown. But if prices do remain high, or rise further, it would be better for this liability to land on the broader shoulders of the Government, rather than individual households and businesses.

Obviously, the bond markets won’t like this. But other countries are also likely to have to do similar things, and a deep recession would be even more damaging for the public finances in the long run. Indeed, the initial market reaction has been fairly sanguine: 10-year gilt yields have settled at around 3%, and the pound has stabilised against the dollar.

In short, a freeze on energy prices could therefore still be the worst solution to an intractable problem – apart from all the others.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.