Price caps and extraordinary charges will not solve the problem with the European energy market
European policymakers are facing a host of unprecedented shocks to the economy, including stagflation, war in Ukraine and last summer’s record heat waves. Together, these shocks have affected the European energy and electricity markets. Gas produces 20% of electricity in Europe (see graph) and, above all, it is often the marginal producer, so gas prices determine electricity prices. In fact, electricity prices have skyrocketed in Europe, hitting new records and reaching more than 10 times their average for the last decade.
Electricity production in Europe, by source
Sources: European Electricity Review, QNB analysis
In July, members of the European Union (EU) agreed to reduce gas consumption in Europe by 15% until next spring through the European Gas Demand Reduction Plan. However, this plan proved insufficient as Russia continued to reduce and even threatened to continue cutting off the amount of gas supplied to Europe. Political leaders are therefore desperately looking for effective policy responses.
In this week’s article, we take a look at the various policy proposals being considered in the EU to understand their potential impact as well as the likelihood of their implementation in the immediate future.
European politicians have put forward three main proposals, ranging from extraordinary taxes to price caps and support measures.
One concept being considered across Europe is a tax on companies that have made windfall profits from high energy prices. However, there is no agreement within the EU on which companies should be affected by this tax and which sources (ie oil/gas/nuclear/renewable energy) should be included. . While some countries, such as Spain, Greece and Italy, have already introduced such taxes, others, such as Belgium, Germany and Austria, have not yet done so. These taxes leave the consumer redistribution mechanism open, with an unclear effect on the desired intent. In addition, their design and implementation may not be harmonized across EU countries and are therefore subject to potential constitutional challenges at the individual country level. It also limits the idea of reinvesting profits in the energy transition from fossil fuels to cleaner and more sustainable energy sources.
The idea of a price cap is to put a maximum ceiling on the price that European energy companies can charge their customers. This will in principle limit the level of inflation due to high immediate energy prices for consumers, both households and businesses. While price caps can help control the effects of rising energy prices, they neglect the consumer wealth effect. Affluent consumers have less pressure and incentive to reduce their energy consumption compared to consumers with lower income and liquidity. Therefore, the effect is limited because the 20/80 rule applies in most cases, where the largest companies and the richest households have the highest contribution to energy consumption. Moreover, price caps do not act as a brake on the price of energy when it comes to meeting certain basic needs for energy consumption. German politicians pointed out that price caps would reduce excessive profits for energy companies and therefore limit the effect of unexpected taxes.
Finally, relief packages are targeted measures that provide financial support to low-income households, small businesses and essential industries to reduce the economic damage caused by temporary price increases. Aid measures are targeted and are more likely to lead to greater economic benefits than other options considered. Support measures are likely to be more effective because they encourage users to reduce their consumption.
In conclusion, the measures proposed so far to decouple electricity prices from energy prices seem insufficient and ineffective to reduce energy consumption, protect consumers from price increases and avoid energy rationing. High energy prices are expected to last at least until next spring, if not longer. This poses a significant economic risk to Europe, with increased inflation and weak growth, as it will be difficult and time-consuming to find a mutually beneficial consensus between widely dispersed economic regions.