Quasi-fiscal scoundrels 3: Energy tariffs in the UK

Gutless politicians prefer paying subsidies to favoured special interest groups by tinkering with the price mechanism to doing it through explicit budgetary transfers. The reasons are obvious. Explicit budgetary transfers can be observed and measured objectively. The transfer of resources is transparent. Explicit budgetary transfer payments have to be financed, either by increases in current taxes or current cuts in public spending, or by government borrowing, that is, by increases in future taxes or cuts in future public spending. Explicit budgetary transfers are on-budget. They can cramp the government’s room for fiscal maneuver through budget rules (the UK government’s golden rule, the budget deficit norms of the EU’s Stability and Growth Pact etc.). Explicit budgetary transfers imply a measure of accountability. For all these reasons, governments prefer to engage in quasi-fiscal operations that are off-budget and off-balance sheet, and that achieve the government’s distributional objectives mainly by mucking about with prices, rules and regulations under the control of the government.

The quasi-fiscal energy subsidy

The UK government is about to announce a quasi-fiscal subsidy to poorer energy consumers (those using pre-payment meters) financed through a quasi-fiscal tax on the energy suppliers. Only the words ‘subsidy’, ‘tax’ and ‘quasi-fiscal’ will not appear. Instead words like ‘fair tariffs’ are likely to be used. As much as £400m per year may be taken from the suppliers and given to the consumers.

It may or may not be true that (part of) the gas and electricity industry is ripping off (some of) its customers. If the industry is misbehaving, it can do so because at least one of the two following conditions applies. First, the customers using pre-payment meters (generally the poorer customers) don’t have the information/ability to switch suppliers. Second, there are not enough alternative suppliers offering more competitive terms.

There is a role for the public sector in the provision of information to households, because information is a public good – non-rival in use. There may also be a role for the public sector in further assisting consumers in the perhaps daunting business of switching suppliers. Both these functions should be performed by the regulator, not by the Treasury.

If there is not enough competition, it is again the regulator’s job to encourage competition by ensuring that there are no artificial, man-made (especially incumbent supplier-made) obstacles to entry into the industry. It is unlikely that lack of competition is a major issue in the UK energy sector. Both British Gas and EDF already offer terms for customers with pre-payment meters that are in line with their lowest prices. If there were to be insufficient competition to prevent the generation of routine above-normal profits, and if entry is not an option, say because the industry is a natural monopoly, the regulator should restructure the tariffs of the industry. I don’t believe this is the case in the UK energy sector, but even if it were the case, it should be the regulator’s call, not the Treasury’s.

Last time I checked, the UK had a regulator for the gas and electricity industry – Ofgem. According to its website “It’s role is to protect and look after consumers interests by promoting competition where possible” (yes, the illiterate spelling error, It’s instead of Its, is on its homepage; perhaps it’s not surprising the chancellor ignores Ofgem …).

Tariffs in the industry should be set to cover the long-run marginal cost (including the cost of capital and of environmental externalities) of the industry. If, because of increasing returns to scale/declining long-run average cost, long-run social marginal cost pricing is not commercially viable (long-run social marginal cost is below long-run private average cost), there should be a (lump-sum) subsidy to the industry to stay in business, not a tariff subsidy to the consumer, which would induce excessive consumption and, in the case of energy, environmental damage. Except for the bits of the energy supply infrastructure that are (up to the point where capacity constraints bite) subject to network externalities (the electricity grid and the gas pipeline network), economies of scale in the power industry are not so massive that they preclude effective competition, provided consumers are well-informed and sufficiently motivated to switch suppliers. The government, through the regulator, can help with the ‘well-informed’ pre-condition for an efficient market. Getting even a well-informed consumer to act is not a trivial task; if it is cost-effective, it should again be done by the regulator.

It is possible that energy prices that cover long-run social marginal cost (especially where these include the cost of environmental damage limitation and abatement) impose undue hardship on the poorest segments of society. The solution is straightforward. Don not address the poverty problem by aggravating the environmental problem. Make the poor pay the full social long-run marginal cost of gas and electricity, but provide them with cash payments (unrelated to their individual energy consumption) to prevent hardship.

This requires the government to know who the poor are. In the Kyrgyz Republic this may be a problem, but not in the UK. Cash payments to prevent poverty are feasible and efficient. They are, of course, on budget, so the Chancellor does not like them.

Even if the government cannot desist from acting like quasi-fiscal scoundrels, they could at least be efficient quasi-fiscal scoundrels. If they cannot stop themselves from tinkering with the price mechanism, they should adopt a two-part tariff for customers using pre-payment meters. The subsistence consumption levels of gas and electricity would be subject to a low or even a zero tariff (the ‘lifeline tariff’). Beyond the minimum socially necessary level of household gas and electricity consumption, the full long-run social marginal cost tariff would apply, to provide even the poorer consumers with the right incentives for energy conservation; with a bit of luck, the subsidy would become inframarginal and therefore non-distortionary for most of those benefiting from it. If the industry receives no government subsidy to pay for the lifeline tariff, the full tariff would have to include a margin to cover the cost of the subsidy to the poorest consumers.

But no. The populist instincts of this government and of this chancellor, and its fiscal cowardice (unwillingness to pay the bill of meeting its social objectives through higher taxes or cuts in other public spending), have driven it once again to mess about with the price mechanism for distributional purposes. The results are distortionary and inefficient.

The quasi-fiscal energy tax

From the point of view of the energy producers, the chancellor’s decision to cut tariffs for customers with pre-payment mechanisms amounts to a quasi-fiscal tax. No doubt the government would refer to it as a windfall profits tax if had imposed the tax explicitly.

This government has a nasty habit of imposing so-called excessive profit or windfall profit taxes/levies, mainly on the energy sector and the financial sector. It’s bad economics even if it is great populist politics. To tax profits at a higher rate simply because profits are high, is massively distortionary and a disincentive to investment and risk-taking.

These public grabs of above-normal profits – you seldom get a windfall loss subsidy from the government to an industry making below-normal profits, unless it is the banking industry (Northern Rock) – is not just distortionary because it increases the uncertainty and unpredictability of the tax regime. It isn’t even always true that a more predictable tax regime is better than a less predictable one. A highly predictable but extremely inefficient and unfair tax regime is not necessary better than a less predictable but less inefficient or less unfair tax regime. But clearly, creating additional uncertainty about future tax rates is silly if it serves no clear efficiency or distributional objective. The chancellor’s energy profits grab may serve a distributional objective, but the same objective could be served much more effectively using less distortionary methods.

The energy profits grab would be distortionary even if it were completely predictable and did not create any uncertainty about future tax rates. The temptation to engage in ex-post expropriation of profits is always there, because once the investment producing the profits has been made and the profits have materialised, a profit levy appears ‘lump-sum’. Politically it’s like shooting fish in a barrel. The detrimental effects will be felt only in the long, through the announcement effects of the windfall taxes, explicit or quasi-fiscal, on future investment. The ability to resist the temptation to engage in rational but socially destructive behaviour of this kind – to solve what economists call the time-inconsistency problem – is rare. Credible commitment of the kind that allows you not to use your powers of expropriation when they stare at you seductively and mouth ‘use me, use me’, did not come naturally even to Ulysses. Who will tie Alistair Darling to the mast when he hears the siren song of populist (quasi-)fiscal politics?

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website