Last week, the UK energy regulator Ofgem announced that the typical household energy bill in the country will rise to £3,549 from the start of October. And the UK is far from alone. This week’s Chart Room shares our own current estimates of how high consumer energy bills in the largest European economies could climb over the next two years in the absence of government intervention.

What matters are not so much the specific numbers but the huge scale of these increases. The burden on consumers and the effect on inflation - for example, via demands for higher wages or firms passing on higher costs - are so great that it is reasonable to expect some form of intervention from government.

Policy options

One option is to maintain or lower price caps for energy and directly subsidise utilities. Another, which some energy suppliers are proposing, is for utilities to run tariff deficits, whereby they record in their accounts the theoretical price they would charge customers based on the wholesale market price but then charge a lower end price. The idea here is to spread the higher cost to customers over several years, with utilities carrying the deficit on their balance sheets in the meantime. However, this idea would tie up an enormous amount of working capital and would therefore require some form of government underwriting to make it feasible.

A third potential option involves intervening directly in the mechanism by which electricity prices are set. Typically, the spot price reflects the necessary price to incentivise that last bit of supply to meet demand. For most European countries, this supply is usually gas. However, for a country like Spain, gas makes up only around 15 per cent of its total energy mix. So early this year, Spain and Portugal created a mechanism which caps the natural gas price that electricity suppliers can use, resulting in lower spot power prices than if today’s gas prices were used.

Knock-on effects

The above mechanisms are slightly different routes to the same destination. Consumers are shielded from the full brunt of wholesale energy cost rises because utilities are not allowed to pass them on directly. Utilities incur losses as a result, and these losses are then socialised via one mechanism or another.

That would not be the end of the story. For example, governments seeking to emulate the Iberian mechanism would need to consider what happens to hedges already held by market participants. There are also concerns that expanding fiscal deficits could invite renewed scrutiny of some euro members’ public finances, and so could have implications for European Central Bank policy.

Categorically, what none of these policy options does is change the root cause of spiralling prices. There is less supply of natural gas coming from Russia, and alternative sources of supply are maxed out in the short to medium term. In the longer term, the case for more renewable supply - already well accepted among utilities - has only become stronger.

In the meantime, though, demand destruction will be needed for the market to balance. While a higher price is the standard way to achieve this, it will very probably prove politically and socially necessary to interrupt that process. That in turn would necessitate an alternative mechanism. If you start hearing talk of energy rationing, this will be why.

Alexander Laing

Alexander Laing

Analyst and Portfolio Manager