An economic narrative for better managing the european energy crisis

Supply disruptions, most importantly the reduced supply of gas following the Russian invasion of Ukraine, has triggered a major energy crisis across all of Europe. It appears clear that prices for gas and electricity will be elevated, remaining perhaps three times pre-crisis levels or higher for two years or more. This threatens to trigger the most severe economic downturn in half a century with substantially reduced real incomes, a big increase in industrial unrest, widespread business closures and – especially in the UK with its heavy reliance on natural gas as a domestic fuel – many households pushed into ‘fuel poverty’ in which they must choose between adequate nutrition and adequate heating for their homes.

This note presents a narrative for understanding the economic mechanisms driving this crisis and the policy tools that can be used to address it. The principal message is that in a crisis such as this it is a damaging mistake to rely solely on market prices for the allocation of scarce energy resources and only intervene ex-post with government transfers to offset their impact. A comprehensive program of managed demand reduction is needed, promoting voluntary reductions and where appropriate rationing of energy consumption. This can reduce the market prices of gas and electricity below what they would otherwise be, ensure adequate availability to priority users and limit what would otherwise be an extreme financial redistribution from energy consumers to energy producers with damaging economic and social consequences.

The UK has left the Single Market, but it is still part of a single European energy market. A much larger reduction in energy prices will be achieved if policies of direct demand reduction are pursued by all the major countries of Europe, along with the UK. A strong case for such European solidarity can be made as part of the necessary political response to the efforts of Russia to employ energy supply as weapon of war and undermine European opposition to the invasion of Ukraine.

This narrative can be contrasted with the dominant view of many governments and politicians in Europe of higher energy prices as a market outcome, therefore something beyond their control that can only be dealt with through large-scale government expenditure. Au contraire, while the looming energy crisis cannot be entirely avoided, demand management can substantially limit the price rises for European energy and, along with fiscal measures to protect the most vulnerable households, deal with its economic and social consequences.