The true cost of Liz Truss’ energy price cap plan

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This article was originally published on September 12, 2022. On October 1, 2022, the new Ofgem energy price cap came into effect. This article has been republished in light of the latest news.

In October 2008, a financial analyst from JP Morgan wrote an article in the new statesman entitled: “And again the Chancellor borrows”. In it he lamented the “madness” of an increasingly unpopular party trying to hold on to government by rejecting “fiscal responsibility” by dramatically increasing government borrowing, only to turn it over to an amoral industry. “We are happy to believe in markets in good times. When times are bad, we run to the state,” he wrote.

The writer was of course Kwasi Kwarteng, who himself is now chancellor and does exactly the same thing in the same post. Last week, Liz Truss announced the Government would cap consumer energy bills at £2,500 a year for a typical household for two years, and apply a similar discount for businesses for six months.

This plan provides for a vital and very significant reduction in the cost of energy and in doing so, the government expects it to reduce inflation by four to five percentage points. But this is a short-term effect that has an immense long-term cost. It commits the UK to borrow an unknown and unlimited amount in the financial markets, at a high rate, so as to produce higher inflation and higher interest rates for years to come.

The effect of this can already be seen in financial markets, where inflation-linked securities change in price depending on how much the people buying and selling them expect inflation to increases or decreases.

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“Longer-term inflation expectations haven’t come down much,” said Janet Mui, head of market analysis at Brewin Dolphin. “The market estimates that one year later, inflation [in the UK] will go down, but in five to ten years inflation should remain high. So the decline in inflation from the previous forecast is a very short-term thing the market is expecting due to artificial price suppression, and in fact the market is worried about the longer-term implications. inflation term.

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This concern stems in part from the fact that, as the energy price cap is funded by new government borrowing, rather than new taxes (such as a windfall tax), it commits the UK to borrowing as much it is necessary. The cost of the plan has been estimated at £100bn by the government and £250bn by others, but the truth is the UK will have to pay whatever the difference between the wholesale cost of energy and the new price cap. Since wholesale prices can, as we have seen, increase exponentially, UK borrowing is effectively unlimited.

The situation is getting worse, however, because public debt – when contracted in financial markets – is not created in the same way. Committing to borrow an effectively unlimited amount in the financial markets means committing to sell an effectively unlimited number of government bonds, or gilts. This makes these gilts cheaper. As bonds become cheaper, their “yield” (the return the lender receives) increases. The UK’s new borrowing to fund the energy cap will be issued at current market levels, which Mui said will make the country’s new borrowing costs “very high”.

But this is not the only financial market in which Britain will have to pay more. Bloating debt and a large trade deficit are affecting the value of the pound – now at its lowest level in 37 years – making imports more expensive and driving up prices across the economy. It’s an effect we’ve seen before: researchers at the London School of Economics found that the collapse of the pound after the Brexit vote pushed UK inflation up by 1.7 points. percentage.

Even more costs are added by the fact that the Truss plan not only undermines market confidence in the UK, but does not solve the demand problem.

Stephen Millard, deputy director of macroeconomic modeling and forecasting at the National Institute for Economic and Social Research, explained that “someone, at some point, has to pay energy companies to cover their costs.” When the government creates new debt to pay the bill, there will be, he continued, “more money will flow into the economy…there will be more demand for goods and services across the country. economy…and this increase in demand means that inflation will be higher”.

Millard said that would leave the Bank of England little choice but to counter the demand created by the government. “The government is spending a lot more money, which creates additional demand…which drives up inflation. At the same time, we have the Bank of England saying, “We still want to bring inflation back to our target. We will therefore have to react more strongly, by repressing this demand in order to bring down inflation.

The use of a blunt instrument – the same benefit for everyone in the country – also fails to meet the demand for energy from businesses and consumers. During a global supply crisis, as France discusses energy rationing and German banks turn off their heating, the UK fails to encourage its wealthy citizens and businesses to reduce their energy consumption .

“If anything, the incentive is actually to use too much gas,” Millard said, “because you’re paying way below the odds for that. And the concern then is that it actually creates a shortage.

New energy from hydraulic fracturing and new nuclear power plants will arrive – if ever – in a decade. The only short term measure the UK has to deal with the wholesale cost of energy is to reduce demand by insulating people’s homes, making businesses more energy efficient and encouraging those who can allow it to consume less. With such an incentive, many could invest in energy saving measures; otherwise, they will wait and see.

Essentially, the Truss Plan is the equivalent of a quarter of a trillion pounds spent pretending that the last decade of energy policy was not some short-sighted, wasteful disaster, and that the recession we all know is coming will happen to someone else. ‘other. That may make the economy healthier for a while — just long enough to get through an early election, maybe — but the cheaper price of energy for everyone this winter will be a weaker economy for a decade.

[See also: Vague policy is leaving businesses in the dark on their energy bills]

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