Economic crises have a nasty habit of upending 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. 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 energy bills in 2022. This would amount to 80 per cent annual inflation on domestic fuel bills, at a time when overall inflation is running in excess of 5 per cent. 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 pandemic. The economy rebounded strongly in 2021, with growth expected at close to 7 per cent. 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. The energy market clearly has other ideas. Wholesale energy prices are about five times higher than usual at this time of year. This is the market from which energy companies buy capacity that they sell on to you and me. Should these higher prices be passed on in full in April when the regulator, Ofgem, reviews the 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 rise is limited. Fuel poverty, involving deeply uncomfortable choices on food, heating and day-to-day essentials, could quickly overwhelm the pandemic as the salient political issue at the next general election.
Uncomfortably for Kwasi Kwarteng, the business secretary, and Rishi Sunak, the chancellor, there are no quick fixes. And while there are temporary sticking plasters the government can apply, none are cheap. My own analysis suggests it would cost the Treasury upwards of £10 billion next year to subsidise energy companies sufficiently to limit household tariff increases to only 10 per cent. To put that cost in context that is equivalent to about 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 election or Tory leadership contest.
Such direct intervention in the energy market would also require intensive co-operation 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 a more complex approach of compensating households directly. The winter fuel payment, state pension and universal credit could be increased to provide additional support to the hardest-hit households. The risk however is that many of these schemes overlap, while 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 let’s 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 oilfield, 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 to 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 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, has left the supply side vulnerable. Accelerating demand from the electrification of transport and heating are a pan-European challenge that is not going away any time 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 which 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 balk at having to pay a second wave of higher, energy-led prices.
I have been a longstanding critic of the 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. Perhaps paradoxically recent events are on such a scale that a renewed energy price cap is exactly the correct response for the UK economy. However, 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.
Simon French is chief economist at Panmure Gordon