In a market free of any interference, suppliers would reap the dividends and their customers would absorb the higher costs. In reality, the breakdown of the surplus also hinges on the organisation of the market and taxation – in other words, political choices. The current shock is positive for electricity producers whose costs and production have barely changed (nuclear, hydro and solar). It may also benefit governments receiving additional revenues from the increase in CO2 prices and that can reduce their subsidies to producers of renewables.
With regulated prices, either in the form of caps or a delayed adjustment mechanism, distributors’ margins are squeezed. Hedging strategies have made it possible to spread the risk among many operators. Consumers, both manufacturers and households, are the losers, but shock absorption mechanisms should be taken into account.
Among households, the perception of inflation depends more on changes in prices of certain staple goods or services, such as food or energy. Since the current shock affects gas and electricity, it also poses a political problem for governments. In ancient Rome, there were grain laws to ensure the free distribution of wheat to the population and to avert riots. This is not quite the case in Europe in the area of electricity supply, but several governments have already taken special measures to cushion the blow. The sensitivity of this subject depends on the country and the volatility of prices (right-hand chart, p.2).
In Spain, where wholesale prices feed through swiftly to retail prices, the government has responded by extending electricity bill payment times for low-income families and promising to cap suppliers’ profits. In France, a direct aid (“energy check”) will be paid between now and the end of the year to 5.8m households. In the recent past, French governments have faced social unrest related to taxation and energy prices (the “red caps” episode in 2013 and “yellow vests” episode in 2018). A few months ahead of a presidential election, caution is the watchword.
In the EU as a whole, around one-third of the retail electricity price is explained by the wholesale price, one-quarter by distribution costs and more than 40% by taxes. There is less flexibility on gas prices (taxes represent 25% of the retail cost). As a general rule, the easiest response in the short term is to adjust taxes and subsidies, at the cost of bearing the consequences on public finances. In the longer term, the response to price strains in a market where supply is constrained is not to subsidise demand.
Is it possible to quantify the impact on total inflation? In a worst-case scenario – let’s say a rationing of Russian gas supplies, plus a severe winter, plus lasting distributions to the production of renewables – strains on wholesale prices could go on for months and an additional increase of around 10-20% in retail prices is possible. Since gas and electricity represent 5% of the price index, the direct impact on the HICP would be between 0.5 and one percentage point. This would add to the inflation rate that is already set to rise towards 3.5% year-over-year in Q4 2021. It hardly needs saying that this would cause some concerns, and governments are unlikely to stand idly by. Alternative (less ugly) scenarios would lead to a still positive but far lower contribution to total inflation.
Faced with an inflation spike driven by energy prices, a tightening of monetary policy would clearly not overcome constraints on production or gas and electricity supplies. The ECB made the mistake of raising its policy rates in 2011 amid a surge in oil prices, and we know how this ended. But today’s disruption is still a cause for reflection. It would be good if the ECB, which has made climate issues a component of its new monetary strategy, could clarify if this implies greater tolerance of inflation volatility of if this requires the construction of a price measurement stripping out the effects of the “greening” of the energy mix.
For governments, it is time for them to tell citizens clearly that with the ramp-up of renewables (an objective with broad popular support), it may be difficult to have at every moment energy that is at once cheap, green (decarbonated) and uninterrupted. If nuclear power is excluded in principle and gas is the sole adjustment variable, it will probably be necessary to lower energy independence ambitions unless investment spending is accelerated significantly to bring about the desired transition.