How Europe can protect the poor from soaring energy prices

(MENAFN-Caribbean News Global)

By Oya Celasun, Dora Iakova and Ian Parry

Since fossil fuels are likely to remain expensive for some time, governments should let retail prices rise to promote energy conservation while protecting poorer households.

Soaring energy prices have sharply increased the cost of living for Europeans. Since the beginning of last year, world oil prices have doubled, coal prices have almost quadrupled and European natural gas prices have increased almost sevenfold. With energy prices likely to remain above pre-crisis levels for some time, Europe must adjust to higher import bills for fossil fuels.

Governments cannot prevent the loss of real national income resulting from the terms-of-trade shock. They should allow 100% of increased fuel costs to be passed on to end users to encourage energy savings and the shift away from fossil fuels. Policy should shift from generalized support such as price controls to targeted relief such as transfers to low-income households who suffer the most from rising energy bills.

In a new working paper, we estimate that the average European household will see its cost of living increase by around 7% this year compared to what we expected at the start of 2021. This reflects the direct effect of rising energy prices and their transmission to other goods and services. The large differences in impact between countries reflect different regulations, policy responses, market structures and contractual practices. The spike in the cost of living could get worse if gas supplies from Russia are cut off.

In most European countries, rising energy prices place an even heavier burden on low-income households as they spend a larger share of their budget on electricity and gas. The graph below shows the divergence in the distributional impact of higher prices across countries and income groups.

In Estonia and the United Kingdom, for example, the cost of living of the poorest 20% of households is expected to increase about twice as much as that of the richest households. Putting in place relief measures to support low-income households that have the least means to cope with soaring energy prices is therefore a priority.

So far, European policymakers have responded to soaring energy prices mainly with general price suppression measures, including subsidies, tax cuts and price controls. But removing the pass-through to retail prices only delays the necessary adjustment to the energy shock by reducing the incentives for households and businesses to save energy and improve efficiency. It keeps global energy demand and prices higher than they otherwise would be.

Moreover, the rising cost of these measures is compressing the limited fiscal space of economies as high prices persist. In many countries, the cost will exceed 1.5% of economic output this year, mainly due to extensive price suppression measures.

Targeted relief

Policy makers should move decisively away from blanket measures towards targeted support policies, including income support for the most vulnerable. For example, fully offsetting the increased cost of living for the poorest 20% of households would cost governments 0.4% of GDP on average for all of 2022. It would cost 0.9% of GDP to fully compensate the poorest 40%.

The share of the population that receives compensation would vary from country to country depending on societal preferences and fiscal space. But it should ideally be designed in such a way as to avoid ‘cliff-edge effects’, with benefits gradually decreasing at higher income levels.

Some governments also support businesses. This is only appropriate if a short-lived price spike would drive otherwise viable businesses out of business. There would, for example, be a strong case for support if Europe faced a complete cut in gas flows and countries had to temporarily ration gas to industry. Companies that play a critical role in importing and distributing energy may also need help when prices rise.

In most cases, however, it is difficult to implement a well-targeted support scheme for businesses without introducing distortions and blunting the incentives for energy conservation. Given that prices are expected to remain high for several years, the case for business support is generally weak.

—This blog also reflects research contributions from Anil Ari, Nicolas Arregui, Simon Black, Aiko Mineshima, Victor Mylonas, Iulia Teodoru, and Karlygash Zhunussova.

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Mary I. Bruner