Finance: Research, Policy and Anecdotes

The Russian aggression against Ukraine has further fuelled an already high energy price inflation. There is an intensive debate on how to mitigate the impact on households, especially lower-income households. One politically popular suggestion to mitigate the impact are price caps, which would benefit all consumers; however, this would not entice them to reduce energy consumption and – in the worst case scenario – might result in rationing.  To avoid such rationing, one could impose a more limited use of energy (such as car-free weekends in the 1970s during the first Oil Price Crisis– one of my first memories as child growing up in Hamburg). At my university, we are told to use air conditioning only between 10 and 3; however, this is not being monitored, which raises the general challenge of monitoring caps of energy usages. That’s why economists prefer the power of market pricing.  But what if energy use is price-inelastic for certain ranges of consumption? To off-set rising energy costs for consumer, transfers have been proposed.  However, such transfers would have to be targeted at low-income households and involve an administrative burden (can all low-income households easily be reached, especially if they do not pay income tax?); in addition, there might be a time gap between energy bills and transfer payments, which poses problems for liquidity-constrained consumers.

One intriguing suggestion comes from Isabella Weber and has been picked up by others: a price cap up to a threshold and market prices above. This threshold could be set such that the energy consumption covered by the price cap corresponds to the basic needs of a household. While all households would benefit from this price cap, the administrative burden of proper targeting or transfer payments would not be incurred. And incentives for energy savings would still be in place above the threshold where market prices would rule.  Taxpayers would have to compensate energy companies for what is effectively a social transfer. . And finally, such a price cap has the positive macroeconomic side effect of mitigating pressure on a price-wage inflation spiral. On a broader note, one can see such a quantity-limited price cap also as a tool for the transition towards net zero. 

Overall, an adequate policy for extraordinary times, combining social and market into a policy tool.

Overview