Alex Simakov is a Senior Research Fellow at Policy Exchange. Conor MacDonald is Head of Economics and Social Policy at Policy Exchange.
The UK is facing an extremely difficult winter. No challenge looms larger than the energy crisis, the handling of which could very well define the tenure of our new Prime Minister. Unfortunately, she will be constrained by international economic factors well outside of her control.
Had Vladimir Putin elected to launch his brutal assault on Ukraine and weaponise energy exports just three years ago, the Exchequer would have had a richer policy tool kit at their disposal to meet the domestic economic fallout. Absent inflation, a universal benefit scheme of £1,000 per household could have helped families withstand the price shock. Cutting interest rates could have helped cushion the blow for businesses, perhaps even helping pep up a languid economy. Even the more drastic measure of a price freeze could have been imposed at a manageable cost.
Unfortunately, the autumn of 2022 is an economic lifetime away from the halcyon days of the late 2010’s. Britain’s inflation rate has surged past 10 per cent, the highest since the 1980s, and may peak at 13 per cent by year’s end.
The pound has collapsed to under $1.15 against the dollar and risks falling below the all-time-low of $1.05. In turn, the Bank of England has been forced to raise interest rates by fifty basis points to 1.75 per cent, with City analysts forecasting further hikes to 3 per cent or beyond. Underlying these conditions is the £320 billion in new debt incurred during Covid-19.
These economic realities leave the next Chancellor against the wall with little room for manoeuvre or mistakes. Another universal cash handout would further stoke inflation. A total energy price freeze promises an even steeper price tag, while incurring the greater threat of silencing price signals and undermining the imperative to conserve energy. There is the additional hurdle of identifying and reaching the households in most dire straits; as utilities do not know their customers’ income.
The situation therefore requires an approach that is both fair, by providing a level of support for basic energy usage to every household, while targeting consumption levels as an imperfect but effective proxy for household wealth (see Figure 1 above). A strategy that appreciates the crippling consequences of allowing entrenched inflation, and prioritises support for working families while maintaining clear incentives for demand reduction by preserving market mechanisms. Policy Exchange proposes the introduction of a Tiered Energy Relief Scheme (TERS).
Our plan calls for restructuring household energy bills for a six-month period, saving the average household up to £936 at a nationwide cost ceiling of £26.6 billion. This program would be delivered through a dedicated Government funding envelope and settled through general taxation over 10 to 20 years, a less regressive method than relying on future billpayers.
The envelope would absorb Value Added Taxes and Green Levies off all residential bills, reducing household costs by £2.3 and £3.6 billion, respectively. The outstanding wholesale component, which now represents three quarters of energy bills, would be recovered through a set of new price ceilings based on escalating Tiers of Consumption per month:
This approach would ensure the majority of the median energy bill for the lowest decile households would be heavily subsidised, while leaving households with higher energy usage with greater exposure to higher energy prices. As per Figure 2 below, the median household in the lowest income decile would see 100 per cent of their median kWh monthly consumption subsidised, while the top income decile would typically only receive support for under half their usage.
Similarly for gas in Figure 3, the median bill in the lowest decile would receive support for over half of their gas consumption, while the wealthiest would benefit on just a fifth.
A tiered consumption structure offers two major advantages. First, it leaves the most energy intensive homes exposed to market prices, encouraging those with the most potential to reduce their usage and lower system-wide costs. Second, a tiered price intervention aligns with the criteria outlined by the Office for National Statistics to yield a deflationary benefit, thereby reducing the cost of servicing index-linked government debt. Additionally, the projected £26.6 billion cost of restructuring would be lowered by every household that can reduce their consumption below the subsidised monthly ceiling of 175 kWh of electricity or 450 kWh of gas.
However, there are limits to the correlation between energy consumption and income, and we recognize the need for enhanced support for vulnerable families. This could be achieved through a complementary targeted support package worth £10.9 billion, which we recommend consist of:
The Tiered Energy Relief Scheme (TERS) outlined above is far from perfect, but there is no path to perfect in the economic circumstances of 2022. But what the TERS can do is steer British households through the hard winter ahead, and leave us on stronger footing to address the deeper economic challenges we face come the spring.