“WORST MACRO-ECONOMIC POLICIES OF ANY MAJOR COUNTRY IN A LONG TIME”

Pretty poor on the energy policy front too. And levelling up is no longer even on the agenda.

 

Today’s mini-budget deserves a quick comment in this blog, not least because of the close connections with energy issues. 

 

Let’s begin with a few quotes

 

Paul Johnson, Director of the Institute for Fiscal Studies, said: 

“Today, the Chancellor announced the biggest package of tax cuts in 50 years without even a semblance of an effort to make the public finance numbers add up. Instead, the plan seems to be to borrow large sums at increasingly expensive rates, put government debt on an unsustainable rising path, and hope that we get better growth.”

FT Robert Shrimsley described it as “…  a stunning repudiation of the economic strategy of the last two Tory premiers …” and  its “dismissal of the central importance of sound public finances” as a rejection of core Conservative principles.

 

The UK is "pursuing the worst macroeconomic policies of any major country in a long time" says former US Treasury chief Larry Summers.

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Why it is likely to fail in its own objectives

Governments cannot mandate growth; if they could we would not be worrying about it now. GDP growth would already be with us.

 

·      Under the right conditions a fiscal stimulus can boost GDP, but tax giveaways to the wealthy are among the least effective polices as wealthy people have a higher propensity to save rather than spend. They also have a higher propensity to spend on imports and to spend on foreign holidays.

·      Purely in macro-economic terms, a fiscal stimulus that benefits lower incomes is more likely to stimulate spending.

·      The economy already has severe supply side constraints, especially evident in labour shortages. But the apparent pursuit of a trade war with Europe will simply make things worse, and reduce our economic potential further.

·      Unfunded tax cuts will simply increase the risks of further currency devaluation (with sterling already 2% lower today), and inflation.

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Energy matters too

The crisis in gas prices, and possibly in supply adequacy, matters for two immediate reasons:

 

·      affordability of energy, particularly for the poor and vulnerable.

·      sufficient gas to meet demand and “keep the lights on”.

 

A blanket subsidy for energy prices is an inefficient means of protecting the vulnerable, with a high cost for only very limited protection. The sensible strategy would have been much more targeted support, either through social security, or, better still, through so-called “rising block” tariffs which allow initial tranches of supply at a much lower price, but with a higher price for higher levels of consumption, which provides a bigger incentive to avoid waste. This would also be more consistent with net-zero objectives for the sector.

 

The practicalities of this are not helped by the many dysfunctional features of a “quasi-competitive” energy market. 

 

Finally passing up the opportunity for at least some level of windfall taxation in the sector has merely added to the already extreme macro-economic risks that we face.

MEETING THE ENERGY PRICE CHALLENGE WITHOUT BANKRUPTING THE UK ECONOMY

Readers will have to excuse my long lay-off from posting comments on energy and climate. This has been only partly due to diversions –  storage issues in the context of a forthcoming Royal Society report, reading up on “solar refinery” technology, and collaboration with an Oxford colleague in reviewing the failure of the neo-liberal consensus on electricity markets.

But it’s also partly due to the fact that much of what I write has been about alerts to the dangers of climate change and the importance of action. The last year has seen much more emphasis on these issues in the mainstream media. But with a new government stuffed with climate science denial, I fear there will be more to write about.

 

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MEETING THE ENERGY PRICE CHALLENGE WITHOUT BANKRUPTING THE UK ECONOMY

 

The UK now faces multiple, closely linked, economic and energy challenges:

·   poor economic performance, manifested in low growth and falls in real incomes

·   the highest inflation since the 1980s (when Mrs Thatcher was PM) 

·   escalating prices for gas, which dominates the cost of both heating and power generation in the UK

·   managing the UK role in transition to a global low carbon economy 

 

Poor economic performance and inflation are among the worst in the G20[1]. While many factors contribute to this, it is at least partly driven by the trade and cost issues resulting from Brexit. The OECD says the UK is unique in simultaneously grappling with high inflation, rising interest rates and increasing taxes.

 

But today’s immediate issue is managing the massive escalation in gas prices. There is a real risk that, in politics as elsewhere, the urgent drives out the important. In this case the crisis of fuel affordability, undeniably important, risks diverting us, at least temporarily, from what is in the long run a much more serious challenge, the existential crisis of climate change.

 

Gas prices are obviously driven, in the short term at least, by events in Russia and Ukraine. But there were already reasons to suppose that the previous disconnect, between low prices in Europe and much higher prices in the Far East, would not be sustained indefinitely. It would be a mistake therefore to imagine that gas prices will eventually revert to the low levels to which we had become accustomed. This immediately casts a shadow over what appear to be the new PM’s policy choices to deal with the crisis – a blanket freeze on prices, paid for by borrowing which will be paid back by future consumers through higher bills over (perhaps) the next twenty years. If fuel prices are not going to drop any time soon, this seems foolish.

 

First we need to dismiss the fallacy that today’s global energy crisis is a clean energy crisis.

This is an absurd claim. To quote Fatih Birol, Executive Director of the International Energy Agency:

“I talk to energy policymakers all the time and none of them complains of relying too much on clean energy. On the contrary, they wish they had more. They regret not moving faster to build solar and wind plants, to improve the energy efficiency of buildings and vehicles or to extend the lifetime of nuclear plants.”[2]

 

The government’s renewed interest in fracking is therefore an irrelevant diversion, an observation I made in a post in 2019, quoting the views of professionals in the gas sector.[3] Its near term impact would be trivial.

 

So what would a good strategy look like.

 

Trying to insulate all consumers from any impact of the rising price of gas is both impossibly expensive and potentially encourages wasteful use of an increasingly scarce resource. Among other objections it would involve a cross-subsidy from taxpayers as a whole to some of the wealthiest citizens who are also high users of energy. Targeting those most in need of help ought to be one of the objectives

A good practical strategy that avoids excessive expenditure might involve a multi-faceted solution which includes measures along the following lines:

 

·   capping fuel prices at current levels for households, but only for a limited level of consumption per household. For electricity this might be the first 1000 or 1500 kWh in a year.

·   high levels of usage would pay something much closer to full cost (this could of course be done in steps)

·   paying for that support partly through windfall taxes, to reduce the impact on public expenditure. 

·   simultaneously encouraging reduced energy usage, particular examples being reduced levels of heating in public buildings, and unnecessary illumination of office buildings at night.

·   some additional targeted support for vulnerable households through the social security system.

·   some additional targeted support for sectors of business most at risk, although it will be hard to separate small business problems from the impact of the expected recession..

 

No solution is likely to be perfect. There will be plenty of special cases, for example in households locked into electric heating. Some poor households will be high consumers, and some wealthy people low consumers.

 

But at least this is an approach that stands a chance of being affordable, given the other strains on the public purse. 

 

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[1] GDP – International Comparisons: Key Economic Indicators. House of Commons library

[2] Writing this week  in FT of 5 September

[3] http://co2economics.blogspot.com/2019/11/fracking-was-never-sensible-choice-for.html

ELECTRICITY TARIFF REFORM. SHIFTING THE BURDEN FROM ELECTRICITY TO GAS IS A START

 

Plans to shift green surcharges from household electricity bills to gas bills are an overdue and welcome reform. With the necessity to shift consumption away from gas to low carbon power, taxing electricity but not gas has been perverse. In particular it conflicts with policies to shift residential heating to electricity-based systems, especially heat pumps. It was one of several key recommendation of the 2019 report, on network tariffs for a low carbon future, that I prepared for Energy Systems Catapult. So it’s satisfying to see the proposed change.

However this shift is probably not enough on its own to provide a clear incentive for consumers to switch from gas to electric systems, including heat pumps, even if the present surge in gas prices is sustained. A more fundamental recasting of the structure of electricity tariffs will be essential, notably a significant change towards recovering far less of the fixed costs of network infrastructure through the kWh charge. This is a profound change, and may require additional measures to prevent the regressive effects of a larger burden on lower income households. But it can be done in ways that are consistent with equality or levelling up agendas.

The flaw in current tariffs

The incremental costs of supplying energy are the right basis for any price and tariff comparisons that consumers make when choosing a heating system. Costs should ideally include all environmental costs and these may be expressed for example as a carbon price. Energy costs are however only a part of the story for the tariffs faced by consumers. For residential consumers, up to 50% of total costs reside in the fixed costs of the networks, concentrated in the local distribution networks. The marginal cost of accommodating extra throughput is, at least in uncongested networks, very low. But the fixed cost still needs to be recovered. How best to do it poses some difficult questions in terms of reconciling considerations of equity and income distribution, on the one hand, and the efficient allocation of economic resources on the other.

Current UK practice for smaller retail consumers is simply to average most fixed costs over all units of energy sold. This seems fair, and prima facie results in those who consume most (and might broadly also be those with higher incomes) paying the most towards the fixed costs. However it distorts the economic message, that the actual marginal or incremental cost is much lower. This leads to at least two major problems.

1.       It exaggerates the incentive for individual consumers to instal their own forms of power generation, even if these incur high resource or environmental costs, simply in order to avoid network charges. There is no saving in overall fixed cost and, while individual consumers with own generation may benefit, a larger share of fixed public network costs is then picked up by others. Total societal costs increase. Incidentally, this also tends to benefit the wealthier households who are more likely to instal their own generation.

 2.       Policies for a low carbon economy rest on persuading consumers to use large amounts of extra electricity for heating (eg with heat pumps). The high unit kWh rates that result from the current practice of spreading the fixed costs over all kWh then become a very serious obstacle, particularly when the consumer choice is between electricity and gas. This is reinforced by the matter of high per household capital costs for retrofitting heat pumps.

 

For household consumer, a higher fixed charge in the tariff, and a lower unit energy charge, transforms the choice between using the low carbon solution (electric heat pumps) and traditional fossil fuels (gas or oil).  I examined this in my 2019 report, but it is worth recalculating in the light of recent price trends. Assuming 10,000 kWh per annum consumption, a coefficient of performance (COP) of 3 for heat pumps, and 90% efficiency for modern condensing boilers (both slightly optimistic), the message is clear.

 

Economics of Heat Pump vs Gas [Energy Cost Only]	elec tariff p/kwh	Elec useful heat p/kWh	Gas tariff p/kWh	Gas useful heat p/kWh	Heat pump saving £ pa
Current tariffs[1]	14.50	4.83	3.86	4.29	-54
Current tariffs and + 1p/kwh CO2 tax on gas[2]	14.50	4.83	4.86	5.40	57
Reform tariffs + CO2 tax.[3]	7.50	2.50	4.86	5.40	290
Reform tariffs + CO2 tax + permanent high gas price[4]	7.50	2.50	8.00	8.89	638

 

With current tariffs, heat pumps struggle to be competitive with gas even on running costs. A 1p per kWh carbon tax on gas, or its equivalent, helps to shift the balance (to a small advantage for heat pumps). Tariff reform has a much larger impact (2.5 times), and this is of course hugely reinforced if we assume permanently higher gas prices. This takes us at least part of the way to compensating households for the higher capital costs of heat pumps.

Disadvantages to poorer consumers

We noted above that some wealthier consumers benefit from current tariffs through the arguably excessive implicit subsidies to own generation. Other beneficiaries include second home owners with very low annual consumptions. However the regressive impact of a necessary tariff reform cannot be ignored. But there are many different options available.

One is to change the basis for applying standing charges to consumers. One proposal put forward has been to collect contribution to fixed costs through tariffs based on property values, akin to traditional approaches in water based on rateable value, or property tax band.

Another is to limit the application of the lower tariff rate to consumption for heating, but not for other purposes. Modern technology makes separate metering, as well as the detection of any metering fraud, a very plausible option.

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The conclusion must be that tariff reform will be an essential component of any national strategy for the decarbonisation of the heat sector.

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[1] Average kWh rate for UK, and recent variable rate British Gas tariff for gas.

[2] Set at 1.0 p/kWh as first approximation to likely impact of transferring environmental cost burden to gas. I used a higher number in the original report

[3] Assumed future average wholesale power cost of 7.5p/kWh

[4] Assumed winter gas price of 170 to 210 p/therm, deduced from recent reports

ENERGY CRISIS? MARKET FAILURE, INCOMPETENT GOVERNMENT, COVID, OR JUST ANOTHER MANIFESTATION OF BREXIT.

 

Nothing better illustrates the complex interdependencies in modern economies better than the cluster of interrelated threats now hitting the UK with high gas prices, gas company failures, HGV driver shortages and supply chain problems, and shortages of CO₂ – all interacting and impacting on food supplies, supermarket and fuel deliveries, and retail price inflation. So looking for the OBE – One Big Explanation – is a mistake.  But the explanations, excuses and blame shifting currently in evidence are interesting and various. As usual they will include personal prejudices and ideologies as well as informed analysis. Here are a few from the last few days, and an attempt to give a considered, but still personal, verdict on each. The perspective is examination of UK response to both global trends and UK circumstances.

In energy at least it’s just the global gas market and supply shortage. There are multiple causes, and all we can do is try to mitigate the impacts. This contains an essential truth, with a well-established willingness to pay much higher prices (for LNG) in Far East markets, together with more immediate and temporary factors such as weather or low renewables output triggering dramatic spikes in gas prices. But in spite of meeting up to 50% of demand from domestic production, UK prices remain highly exposed to international markets and possibly have surged more than elsewhere in Europe. Decisions to leave the EU's single market for energy, and to make Britain more “independent”, plus reduced reliance on storage, are additional factors that may be exacerbating the UK crisis. Verdict. Global and more regional, European, factors and trends are real and substantial; but the obvious criterion for judging UK government and institutions is UK performance in comparison with other EU countries, most of which are significantly more import dependent.

Covid? It is hard to see why the fading impacts of the covid pandemic should be very different in the UK from the impacts in other countries which have suffered very similar levels of infection. Verdict. Covid will have affected everything in the last 18 months, but as an all-purpose excuse, this is starting to sound rather tired.

It’s all down to our obsession with climate change, and trying to go green, at the expense of energy security. So, if we had doubled down on our dependence on gas, we would be better placed to manage a global tightening of gas supplies? Prima facie, earlier moves to low carbon sources, renewables or nuclear, would have reduced gas import dependency and mitigated the current crisis. One might also more justifiably argue, in relation to the related CO₂ shortage, that Osborne’s highly controversial 2015 cancellation of carbon capture projects (essential components of global low carbon climate strategies) deprived us of an obvious alternative source of CO₂. This would at least have reduced the risk to food production that was an indirect consequence of the gas price spike, and avoided the need for a government subsidy to CO₂ production. These potential supplies might well have been in the wrong place or lacked delivery infrastructure, but this is at least a logical response to a silly argument. Verdict: blaming Green policies to reduce fossil dependency is both counter-intuitive and, in this instance, simply wrong.

Turning to the transport sector, other long term trends, including demographics and an ageing HGV workforce, are to blame. Other countries face the same HGV problems. These are exactly the trends markets are supposed to anticipate, manage and remedy, eg via higher wages and industry training initiatives? The UK has been particularly badly hit, largely due to the post-Brexit exodus of EU drivers. Verdict. These are trends that should have been anticipated, so this is a partial explanation or excuse at best. Comparison with other European countries, which do not have empty shelves or petrol queues, is instructive.

Failures in the design and regulation of UK energy markets. UK electricity trading arrangements do not deal adequately with reliability. Consequently, in the power sector, government has already assumed de facto responsibility for capacity planning. But the current crisis is primarily in gas and responsibilities for security are less clear than in other parts of the energy sector. Traditionally, public utilities supplying essential services like gas were regulated monopolies for a reason. Competition, the Tory and Thatcher mantra for decades, should have been fine provided there was a means of enforcing an obligation to supply on all market participants. Absent that, together with a weak regulatory framework and no clear responsibility for delivering reliability, and problems begin. There is every incentive for aggressively competitive suppliers to undercut more prudent suppliers who have covered their commitments to consumers by contracting for firm future supplies, sometimes at a higher but guaranteed price. This can lead to gambling on permanent excess capacity and the assumption that spot prices will always be low. Failure to anticipate price spike risk puts some companies in trouble and leads to systemic risk for the sector and government bailouts. Verdict. This is a regulatory and policy failure by the UK government, over decades, but it is also a major factor in the current crisis.

It’s Brexit, stupid! Brexit adversely affects both transport and the energy sector.  Undoubtedly the loss of EU drivers is a major factor, probably the biggest, in reducing HGV capacity. But Brexit has also made haulage less efficient. It limits the cabotage rights which made UK (and EU) haulage more efficient. A truck from Spain dropping fruit in Glasgow could pick up dairy in Glasgow for delivery in Hull, then fish in Hull for delivery in Madrid. Ending cabotage is equivalent to reducing effective HGV capacity.  

Trade with Europe in both gas and power remains important for our security. Brexit inevitably puts more friction into that trade, though this may have so far had at most only a limited impact on exchanges of power or on energy security. But it could become a significant factor in a more serious energy crisis, just as in other supply chains. Verdict. Brexit consequences, positive or negative, inevitably impact on almost every aspect of the economy and this includes energy, transport and trade.  

It is the downside that is currently in evidence, summed up in the following quote. “Energy price hikes, empty shelves, chronic labour shortages, tax rises, rampant inflation and that’s before we start talking about farming, fish or the motor industry. Where is the Brexit Wonderland we were promised?”