The Price Is Right: Can Price Incentives Help Make Energy Price Support Affordable?

UK Policy Net Zero Prosperity

The Price Is Right: Can Price Incentives Help Make Energy Price Support Affordable?

Commentary
Posted on: 21st October 2022
By Multiple Authors
Daniel Newport
Head of Net Zero - UK Policy
James Browne
Head of Work, Income and Inequality Analysis

On Monday the Chancellor announced a review of the Energy Price Guarantee (EPG) by April, with the aim of bringing down the cost of the policy for the exchequer. Earlier this week we published a blog exploring why the options for making major savings through better targeting alone are limited.

With ongoing pressure to get the government's finances under control, it is time the Chancellor also took a look at how support can be designed to ensure households are fully incentivised to help cut the cost of support.

The government’s Energy Price Guarantee for households and companies shields them from the full price incentive to reduce consumption. To an extent, this is intentional; intervention is intended to keep households warm and businesses open, after all.

But a freeze in unit prices inevitably dampens incentives to reduce demand. High prices in wholesale markets have a purpose. Nobody sets them, they are simply the result of matching demand and supply. If there is more demand than supply, then prices will rise until they are equal and the market clears. If, as is now the case in European energy markets, there is no scope to further increase supply, then the high price will act to clear the market through reducing demand – provided it’s allowed to.

It was therefore always a risky move to slash the price of energy to below the market rate without another mechanism for reducing demand in place. Such a move increases the chances of physical shortages of energy which could trigger winter blackouts. And in the context of the ongoing fiscal crisis facing the government, it also increases the fiscal costs of support – especially if prices stay high for some time.

Our report, Staying Power, sets out an alternative package of cash rebates to support households1To minimise the “rough justice” of flat rate rebates, we also propose adjusting rebates wherever practicable to account for EPC and number of children per household.. The size of rebate would respond to changes in the prices and the typical household energy use over time2Under our rebates proposal, the level of rebate would be adjusted (say, on a quarterly basis), to reflect the latest evidence on actual typical consumption. This means the savings from reduced consumption would, on average, pass back to HMT.. This means that if energy demand falls over time, fiscal costs will fall by the full amount of financial savings3Households who are slower than average to reduce consumption may end up paying more. But such a dynamic would encourage a sort of race between households to cut back wherever they reasonably could. It would also incentivise government to throw everything it had at reducing demand and thereby its own bill. Something it has not shown huge appetite for to date. – unlike under a price freeze.

How much difference could these stronger incentives make to reducing bills and therefore the chancellor’s fiscal exposure? These prices are new territory, so we can’t be sure. But we take a look at what the evidence from the literature suggests might happen. We have quantified the likely energy and fiscal savings if market prices were to remain around £4,500 for a typical bill (see notes below on the method).

We find that rebates could lead to a considerably larger demand response and fiscal savings than a price freeze:

  • In the short-term the estimated home energy demand reduction would be 12% (compared to 8% under the EPG) - a modest improvement, but enough to significantly reduce the risk of energy shortages and blackouts.
  • The annual fiscal savings would be around £15 billion, much larger than the impact under the EPG (around £4 billion). This is because rebates offer the government a way of reducing subsidy in response to outturn changes in demand.
  • Over the medium-term the evidence suggests savings could be much higher still as households adjust both their behaviours and homes. Our analysis of two-year elasticities suggests a sustained high price signal could see a 30%4This economic estimate of 30% reductions would almost certainly require behaviour changes and some loss of comfort e.g. lower thermostats. Not all households will want to do this. The key point is that choices should ultimately be up to householders themselves. Give them the cash and they can decide whether to spend it all on highly priced energy.reduction in energy demand, reducing the annual fiscal cost of support by £38 billion if energy prices remain high.

Medium-term savings on this scale may be ambitious given supply-side constraints to insulation and the fact many householders will consider high prices temporary. But it’s nonetheless likely that over time, the resulting demand reduction would substantially cut the government’s fiscal exposure – and supportive government action, including the introduction of information campaigns, investment in skills and green finance could maximise these effects.

Figure 1 – Comparing the impact of switching to rebates based on different price caps

 

Immediate short-run

Over two years

Price cap (£)

4500

4500

Total Expenditure with no demand response (£bn)

126

126

Fiscal Expenditure with no demand response (£bn)

56

56

Demand Response relative to pre-crisis

Estimated demand response if no support

-13%

-31%

Estimated demand response under price freeze

-8%

-19%

Estimated demand response under equivalent rebates

-12%

-30%

Fiscal savings

Fiscal savings of demand reduction under price freeze (£bn)

4

11

Fiscal savings of demand reduction under price freeze (£bn)

15

38

Importantly, the higher prices go, and hence the larger the fiscal burden of support, the more these incentives will act to reduce both demand and fiscal costs.

So, where does this leave the government’s goal of reducing the fiscal burden of energy bill support? It depends on the price level of course, but this analysis demonstrates both that price incentives can play an important role, and that government is likely to need a combination approach to reducing the costs to make energy bill support fiscally sustainable.

With no demand reduction, and assuming true prices average a £4500 typical bill next year, annual fiscal support costs of the EPG would be around £56bn. Restoring the full price signal might save  £11bn next year (on top of the £4bn that might be saved through price reduction under the EPG). The 25% reduction in support for those not on benefits suggested in our previous blog could save another £10bn. Together these might bring the total annual cost of support down from around £56 billion to £31 billion.

Figure 2 – Fiscal savings of moving from price freeze to TBI rebate proposals

This would be a significant saving in these fiscally precarious times but would still leave a challenging £31bn funding gap. Further demand reduction over time would help. But it is perhaps little wonder then that a Treasury keen to avoid increasing personal taxation is looking harder and harder at energy companies’ windfall profits to help plug the rest of the hole.

They will have to tread carefully given the need to avoid penalising generators who have sold their output ahead, or to discourage investment we desperately need. The open-endedness of the Energy Prices Bill suggests this is very much a work in progress – something they will need to remedy fast.

Notes on methodology

We have used research findings5Saving energy in residential buildings: the role of energy pricing - PMC (nih.gov) and Annex_D_Gas_price_elasticities.pdf (publishing.service.gov.uk)into the elasticities of demand for energy to make our estimates. We calculate the typical short-run reduction in energy consumption which would be expected from a given change in price or household income. We then apply the estimated changes in prices and income of the typical household under a price freeze versus a cash rebate.

  • Step 1: We use the short-run price elasticity of -0.1 estimated in studies of UK and European energy-price elasticities (a measure of the responsiveness of demand to a change in price). This means that at this margin, a 10 per cent rise in prices would lead to a 1 per cent fall in consumption. However, in the calculations we use log points rather than percentages as this reflects the log-linear models that underlie these estimates (although for small price changes these are approximately the same, this approximation breaks down when price changes are large, as is the case here).
  • Step 2: We are also interested in the longer-term elasticity because, over time, higher prices lead to more structural changes (for example, insulation, more efficient appliances or sustained behavioural changes). Ewald et al. (2021) estimate that the long-run price elasticity is -0.48 and that 23 per cent of the remaining difference to the long-run elasticity closes each year. Thus, after one year, the elasticity is -0.11 – 0.23(-0.11 – -0.48) = -0.19 and after two years it is -0.19 – 0.23(-0.19 – -0.48) = -0.26. This means that after two years of high prices, each 10 per cent increase in prices could lead to a 2.6 per cent reduction in consumption.
  • Step 3: We also need to consider the income elasticity of demand because rebates do not affect the price of energy but would give households more money to pay for it. Here we use the direct income elasticity of 0.2. This means that each ten per cent increase in household income would result in a two per cent increase in energy demand. We apply this to the UK’s median disposable-household income of £31,400.
  • Step 4: Using these elasticities, we calculate the potential demand response of different price levels under three scenarios: a) no financial support; b) Energy Price Guarantee; c) Rebates that are designed to target the same level of average bill as the EPG.

Data taken from: Saving energy in residential buildings: the role of energy pricing - PMC (nih.gov) Ewald J, Sterner T, Ó Broin E, Mata É. Saving energy in residential buildings: the role of energy pricing. Clim Change. 2021;167(1-2):18. doi: 10.1007/s10584-021-03164-3. Epub 2021 Jul 21. PMID: 34305213; PMCID: PMC8294229

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