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World How to smooth over the energy price shock

01:45  15 january  2022
01:45  15 january  2022 Source:   bbc.com

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The government has a trilemma over energy prices : how to solve the cost-of-living crisis, while being focussed on net zero, and unwilling to increase taxation or borrowing. There may be no ideal solution, but a number of questions need clarification. It is not really designed for a situation where several million people might need support to fund a £20bn energy price shock . The "core" element of the scheme distributes payments automatically to low income elderly using pension credit data. But there are now more people in the broader part of the scheme for working age recipients of the discount.

In other words, how have the “observed” energy price shocks between 1971 and 2005 affected output growth in these thirty-five years? To answer this question, we generate a total impulse response function, that is, not with one single shock but with the thirty-five energy price shocks εp,t one after 11. Specifically, Kim and Loungani (1992) show that energy price shocks do not produce a sizable frac-tion of business cycle fluctuations. Dhawan and Jeske (2006) show that modeling durable goods on the household side even softens the impact of energy price shocks because households have more

Prime Minister Boris Johnson is under pressure to act on soaring energy prices and household costs as a jump in capped bills looms in April.

  How to smooth over the energy price shock © Getty Images

The government has a trilemma over energy prices: how to solve the cost-of-living crisis, while being focussed on net zero, and unwilling to increase taxation or borrowing.

There may be no ideal solution, but a number of questions need clarification.

Who should be shielded from a 50% rise in energy prices and for how long?

Who should bear the burden - bill payers or tax payers? Are we willing to take a hit on government debt?

And do we want to smooth this over 25 years or two or three years?

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An energy price shock will raise the rates of inflation and unemployment, and reduce investment levels. This will cause a further change in real national income. and may well magnify the direct reduction discussed above. The parameters of the model were estimated using aggregate data for the U.S. manufacturing sector, treating energy and materials as flexible inputs, but capital and labor as quasi-fixed (adjust-ment costs on labor were found to be very small). This model can be used to show how factor inputs change over time in response to various kinds of anticipated and unanticipated

Thus, energy markets, rather than levels of economic development, appear to be a key determinant of the effects of energy price shocks on the economy. Naturally, given that the economy’s increasing dependence on oil has been relatively recent (i.e., after the Second World War), this study considers The third section outlines the data used for this analysis. The fourth section explains the methodology used, based on Kilian (2008), and identifies the sources and size of the energy shocks over the last three hundred years. The subsequent section presents the evidence on how the impact of these

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Imminent rises

The energy price rises that are coming in April and again in the autumn will reach well beyond the "hard-up" or "fuel poor", possibly sending inflation towards an incredible 7%.

This is something not seen in three decades, since well before the independence of the Bank of England.

Such is the scale of the increases in the pipeline - with typical bills heading to £165 a month - that the pressure will affect millions of lower middle-income households as well as poorer ones.

Average households, which currently spend 4% of their disposable income on energy, will see that almost double.

A recent poll suggested that half of Britons would not be able to afford a rise in their monthly bills of £50 a month. That's the increase which is coming in a few week's time.

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Surging energy prices are imposing a fresh squeeze on European consumers, already strained by the coronavirus, lockdowns and job worries. The financial pain is taking a toll on households, who are more worried about prices than at any time this century, and feel less inclined to splurge, according to a Wholesale gas prices are up almost 300% in the past year because of unusually low storage levels, increased demand from economies emerging from the pandemic and capped flows from Russia. That has driven inflation higher, and analysts at Bank of America estimate that household energy costs will

Remember that price shocks involve more risk than most trading days, so be sure to start small. Most moves will be small, but it will be good practice and your experience can save a great deal of future grief. Put your price series into a spreadsheet, calculation the “true range” for each day, and the 20-day average true range. Then find the ratio of today’s true range divided by yesterday’s average true range. When that value is over 4 you should have a price shock . Look to see how prices moved after the shock .

All of this means there are some fundamental flaws with the three main solutions currently being floated.

Discount expansion

An expansion of the £140 Warm Home Discount scheme is the current most talked-about plan.

The current budget of this scheme is less than £500m a year.

It is not really designed for a situation where several million people might need support to fund a £20bn energy price shock.

The "core" element of the scheme distributes payments automatically to low income elderly using pension credit data.

But there are now more people in the broader part of the scheme for working age recipients of the discount.

This part of the scheme is run on a first-come first-served basis, where recipients have to apply for the discount from a fixed pot of funds at each energy company, and hope that the fund isn't exhausted.

There are some different criteria applicable at each energy company so claimants may not be eligible if they have switched.

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Historical Energy Price Shocks and their Effects on the Economy. Dirk-Jan van de Ven and Roger Fouquet12. London School of Economics. The purpose of this paper is to identify the changes in the impact of energy shocks on economic activity at different phases of economic development – with an interest in assessing if the economy’s vulnerability and resilience to shocks improved. Using data on the United Kingdom over the last three hundred years, the paper replicates a method introduced by Kilian (2008) to disentangle supply, demand and speculative shocks .

Oil price shocks are known to affect the financial sector of the economy, due to the inflationary We illustrate this approach by solving the long-standing problem of how to recover the market Our results suggest that, on average over the period of study, OPEC's behavior is best described as Why has this new energy price shock not caused a recession so far? Have the effects of energy price

The most significant factor, though, is that no funds come from the taxpayer.

It is all funded by the energy companies, or rather, funded from energy bills.

Redistributing half a billion for the fuel poor on to wealthier people's bills is one thing.

Adding several times that, on top of the record increases, starts to assume the character of a new tax.

Cuts to VAT and green levies

A cut in VAT saves 5% or £95 off a £1900 predicted bill. This might prove a helpful addition, but will not fundamentally alter the picture.

It also gives more cash back to those with the biggest bills, or the largest, least well-insulated mansions. And it also loses revenue to the Exchequer.

And then there is getting rid of the "green levies". These are a range of policies that add about £170 to bills.

They reflect the funding for historical investments in green energy, and a range of social obligations.

They would be required instead to be funded by the taxpayer.

A version of this idea was floated four years ago in Professor Dieter Helm's "Cost of energy" report to the government. He said that report had been "shelved".

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Putting off costs

There is another solution that the government is looking at: what is being termed a "cost deferral mechanism".

Essentially some big banks, possibly backed by Treasury guarantee, lend billions to energy companies, who then spread a £600 immediate hike, into, say an additional £120 premium every year for five years, or less over a decade.

It is possible to do this without Treasury backing, but some sort of adaptation of rules governing existing deferral arrangements such as the last resort supplier schemes would be needed.

Another version of this scheme being pushed in Whitehall could utilise the pandemic rescue architecture at the Bank of England by providing up-front funding.

This could prove rather controversial, but some argue that the scheme could help prevent inflation getting to 7%.

Some version of the scheme, or "smoothing mechanism", has been gaining traction in the energy sector, in some government departments, and among MPs keen for a plan.

But it doesn't have universal backing in the energy industry.

In an interview with the BBC earlier this week Centrica chief executive Chris O 'Shea referred to it as a "bailout" for energy companies.

That in turn has led to some scepticism at the Treasury about how it can work.

But I understand that plans along these lines are being worked up, with some observers seeing this scheme as the cornerstone of a Prime Ministerial relaunch in the coming weeks.

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Short or long-term hike?

The judgement on whether this is a one-off shock, or whether, as Mr O'Shea suggested, it will last two years or more, is critical here.

There are reasons to believe it is the consequence of an exceptional set of circumstances.

Firstly, the post-pandemic bounce-back leading to unprecedented demand, including for gas.

Secondly, the fact that due to a late, cold and long winter last year, crucial stores of gas in Europe never got full in the first place going into this winter.

And lastly there is the Nordstream 2 pipeline from Russia which is finished, but which has not been certified by Germany.

The prediction that wholesale gas prices stay high for a year or two is a reflection of what futures markets are saying.

All of that could change rather rapidly with a speech from Russian President Vladimir Putin, or when the global economy normalises.

But we cannot be certain either way.

If a smoothing mechanism is put into operation, and wholesale prices remain high, then households might get prolonged chronic pain, and a never-ending scheme.

Does the political cycle lend itself to such a spread of the burden with a general election expected in 2024?

All of this points to the traditional moment where Number 10's First Lord of the Treasury - one of the Prime Minister's official titles - overrules a fiscally cautious Chancellor.

But the political backdrop of "partygate" adds some uncertainty to what actually happens here.

The fundamentals are this though: Is this a one-off price shock? And for how long does the government want to spread the energy price pain?

For ordinary households, there couldn't be a more important consequence to the nation's currently delicate political balance.

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The left in the Bundestag wants to make the burdens resulting from rising energy prices for low-income earners to a central theme in political confrontation. "Life must be affordable for everyone," said faction leader Amira Mohamed Ali to the resolution of the annual opener of the left faction on Friday in Berlin. People with small and medium income suffered more and more among the increased energy costs.

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This is interesting!