Price caps are precisely how Putin’s government wants Western states to respond

Alex Hughes

September 8, 2022

The centrepiece of the plan of action announced today by the government involves erecting a ceiling on average household energy bills at roughly £2500. The plan is said to have been internally costed at £150bn, with the spending directed at household and business bills at a 60:40 ratio.

The eventual cost will depend, of course, on the trajectory that market prices take, which in turn depends on other countries’ energy policies, on how quickly extra sources of supply are brought online, and on the strategy Moscow chooses to pursue.

Truss’s allies have publicly disputed that £150bn figure, pointing to the fact that the lower inflation number that follows a suppression of energy prices will mean lower interest payments on the quarter of public debt whose interest payments are linked to inflation. The direction of this effect is ambiguous, however, given that higher inflation simultaneously erodes the real value of the portion of the debt that isn’t linked to inflation.

In any case, as a weapon to deal with an energy crisis of this magnitude, the size of the package is easy to defend. Its target, however, is less so.

When supplies of a resource are withheld and its price rises, the quantity demanded will only fall if that price is the one customers are actually confronted by. If the price is capped, the effective demand curve relating price to quantity is vertical rather than downward sloping, because buyers don’t have to contend with higher prices and then have no incentive to shift their spending to other areas.

Price caps are also precisely how Putin’s government wants Western states to respond. Faced with an inelastic demand curve, Russia’s overall revenue can sharply rise, because the increased price-per-unit is not offset by a fall in the quantity demanded.

Although Russian gas only accounts for a small proportion of Britain’s fuel imports, in a global market greater British demand for Norwegian gas exerts upward pressure on the price Moscow receives for its product. If demand fell, Norway’s supplies could be used by other European countries to reduce their reliance on Russia.

Of course, the government has a responsibility to protect households, especially those least able to absorb or adapt to the price shock, as well as otherwise-solvent firms, but a better strategy would employ large-scale cash transfers. These should be financed by borrowing, preferably via long-maturity debt.

The proceeds should be allocated according to each recipient’s energy consumption and, to avoid incentivising more of it, the relevant figure should be last year’s consumption.

This kind of transfer scheme would incentivise households and firms to find ways of saving energy, because they could spend elsewhere whatever they’re able to save.

Meanwhile, those who can’t cut down would have to demonstrate that preference by paying a price that reflects the underlying scarcity of energy. Alongside that, the negative effect on their incomes can be largely – or if the new government chooses, entirely – offset.


Written by Alex Hughes

Alex Hughes is Research Associate at the Adam Smith Institute


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