By Oya Celasun, Dora Iakova and Ian Parry

With fossil fuels likely to remain expensive for some time, governments should let retail prices rise to promote energy conservation while protecting poorer households.

Soaring energy prices have sharply increased living costs for Europeans. Since early last year, global oil prices doubled, coal prices nearly quadrupled and European natural gas prices increased almost seven-fold. With energy prices likely to remain above pre-crisis levels for some time, Europe must adapt to higher import bills for fossil fuels.

Governments cannot prevent the loss in real national income arising from the terms-of-trade shock. They should allow the full increase in fuels costs to pass to end-users to encourage energy saving and switching out of fossil fuels. Policy should shift from broad-based support such as price controls to targeted relief such as transfers to lower-income households who suffer the most from higher energy bills.

In a new working paper, we estimate that the average European household will see a rise of about 7 percent in its cost of living this year relative to what we expected in early 2021. This reflects the direct effect of higher energy prices as well as their pass-through to other goods and services. The large differences in impact across countries reflect different regulations, policy responses, market structures, and contracting practices. The spike in the cost of living could get worse in the event of a cutoff in gas supplies from Russia.

In most European countries, higher energy prices impose an even heavier burden on low-income households because they spend a larger share of their budget on electricity and gas. The chart below shows the divergence in the distributional impact of higher prices across countries and income groups.

In Estonia and the United Kingdom, for instance, living costs for the poorest 20 percent of households are set to rise by about twice as much as those for the wealthiest. Putting in place relief measures to support low-income households—who have the least means to cope with spiking energy prices—is therefore a priority. 

So far, Europe’s policymakers have responded to the energy cost surge mostly with broad-based, price-suppressing measures, including subsidies, tax cuts and price controls. But suppressing the pass-through to retail prices simply delays the needed adjustment to the energy shock by reducing incentives for households and businesses to conserve energy and enhance efficiency. It keeps global energy demand and prices higher than they would otherwise be.

Moreover, the increasing cost of these measures is squeezing economies’ limited fiscal space as high prices persist. In many countries the cost will exceed 1.5 percent of economic output this year, mostly on account of broad price-suppressing measures.

Targeted relief

Policymakers should shift decisively away from broad-based measures to targeted relief policies, including income support for the most vulnerable. For example, fully offsetting the increase in the cost of living for the bottom 20 percent of households would cost governments 0.4 percent of GDP on average for the whole of 2022. It would cost 0.9 percent of GDP to fully compensate the bottom 40 percent.

The share of the population that receives compensation would vary across countries depending on societal preferences and fiscal space. But it should ideally be designed in a way that avoids “cliff effects”, with benefits tapering off gradually at higher income levels.

Some governments are also supporting businesses. This is appropriate only if a short-lived price surge would cause otherwise viable firms to fail. There would, for instance, be a strong case for support if Europe faced a complete cutoff of gas flows and countries had to temporarily ration gas to industry. Companies that play a critical role in importing and distributing energy may also need support when prices spike.

In most cases, however, it is difficult to implement a well-targeted support scheme for firms without introducing distortions and blunting the incentives for energy conservation. Since prices are expected to remain high for several years, the case for supporting businesses is generally weak.

—This blog also reflects research contributions by Anil Ari, Nicolas Arregui, Simon Black, Aiko Mineshima, Victor Mylonas, Iulia Teodoru, and Karlygash Zhunussova.


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