High gas prices: Europe must avoid a subsidy race

Created: 10/19/2022, 8:27 p.m

Clemens Fuest is President of the Munich Ifo Institute and Professor of Economics at the University of Munich.

© © Imago/Bruckmann/Litzka (montage)

In the fight against the high gas prices, the head of the Munich Ifo Institute, Prof. Clemens Fuest, sees the EU as having a duty.

Without coordination of the national crisis plans, there is a risk of a dangerous subsidy race in Europe - with far-reaching consequences, Fuest warns in the guest article.

Munich – The energy crisis – in particular the gas bottleneck due to a lack of supplies from Russia – plunges Europe into a recession and leads to social tensions and distribution conflicts.

European governments are intensively searching for ways to defuse the situation, but success will only come through close cooperation.

The cross-border energy market must remain open and the European Union must use its market power to buy gas in third countries.

But without coordinating national crisis management strategies, the European response could become a self-defeating subsidy race.

High gas prices are at the heart of the crisis

Soaring energy prices have squeezed production and consumption alike, with households responding to rising costs by cutting other spending.

Some people are already drawing on their savings, while others don't want to touch their savings just yet for fear of needing them later.

Still others have no reserves at all.

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The high price of gas is at the heart of this crisis, as it affects not only heating costs, but also industrial and electricity production.

When demand for electricity is high, renewable energies, coal and nuclear power are not enough.

And since the most expensive active power plant determines the price of electricity, the higher gas price has also caused the price of electricity to rise sharply – both increased roughly tenfold between January 2021 and September 2022.

The extent of the economic and social turmoil will depend to a large extent on government responses.

Two approaches are possible.

The first is to intervene directly in energy markets and try to make electricity, gas and oil cheaper through tax cuts or subsidies.

The subsidization of gas for electricity generation in Spain is an example of this option.

Gas crisis: Subsidies can boost demand

The other approach is to refrain from price interventions and instead focus on supporting low-income households or hard-hit firms with lump-sum transfers.

At first glance, the first approach seems more effective - and obviously attractive to politicians who want to appear to be tackling the problem head-on.

However, there are two disadvantages associated with this.

First, lower gas, electricity, or oil prices benefit those who consume the most energy, and these are typically higher-income households, larger homes, and larger cars.

Not only can this population group bear the higher prices now without help, they will ultimately pay for this subsidy with the taxes that the state has to collect in order to service the additional debt incurred for these subsidies.

The second and more important problem is that subsidies or tax cuts stimulate demand because they weaken the incentive to reduce energy consumption.

However, since energy has become scarce in real terms, this increased demand will meet unchanged supply and prices will have to rise before supply and demand are balanced again.

As a result, a significant portion of the subsidies or tax cuts will go to utilities rather than consumers.

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This misalignment is particularly problematic in the gas market, all the more so when subsidies are designed and implemented at national level.

After all, Europe's gas supply is not particularly flexible when liquid gas terminals are working to capacity.

If a single Member State lowers the price of gas through subsidies and other countries do nothing, the Europe-wide gas price will rise a little, but significantly more gas will flow into the country with the subsidies, which means that the rest of Europe will be deprived of this volume.

In addition, if all states acted in this way, they would get caught up in a subsidy race that worsened the situation for all countries.

If the amount of gas available in Europe this winter cannot be increased by higher price offers (because there is simply no more supply), the gas price will increase by exactly the amount of the subsidy.

That would be like governments giving the money off their balance sheets directly to gas producers.

Ultimately, there would be no relief for consumers at all.

Effective energy crisis management requires coordination at European level

A policy that limits itself to subsidizing only poorer households and hard-hit companies would avoid both problems, because only those who actually need the help would be helped.

Unfortunately, due to the shock of rising energy prices, national governments are under increasing domestic pressure to intervene directly to lower prices.

Most domestic debates do not take into account the wider implications of such measures.

To make matters worse, the cross-border effects of the subsidies affect other, much-needed measures.

An effective means of stabilizing the gas and electricity markets is, for example, the reactivation of decommissioned coal and oil-fired power plants and the extension of the lifespan of nuclear power plants.

This would reduce the amount of gas needed to generate electricity, benefiting not just the country but all of Europe.

Effective energy crisis management requires coordination at European level.

If each country only has its own interests in mind, Europe will be far worse off - and needlessly so.

About the author: Clemens Fuest is President of the Munich Ifo Institute and Professor of Economics at the University of Munich.

Copyright: Project Syndicate, 2022. www.project-syndicate.org