Should energy or commodity prices be capped?
Price caps are en vogue. But they come with risks.
Energy prices have risen around the world. For example, energy prices could increase by more than 25% this winter in the US and by as much as 50% in Australia. Amidst concerns that household energy prices could increase by $2 trillion, European countries have brought in a range of energy price caps. Australia’s treasurer has flagged possible energy price caps.
The whole situation raises the question of whether there should there by energy price caps. And, whether there could there be unintended consequences. And, it turns out that unless there is a clear and credible plan to both make the caps short term, and to not rely on caps whenever there are price increases, the caps could backfire. It is worth discussing those risks.
Caps on commodity prices and windfall taxes
One approach is to cap commodity prices. For example, Australia is considering gas price caps. However, it is unclear whether this would cap the price of the commodity or the amount charged to consumers via energy retailers. However, capping commodity prices has significant unintended consequences.
The main problem with capping commodity prices is that it would deter supply. Companies evaluate all investments based on whether they will be profitable. Commodity price caps reduce projects’ profitability. This is especially a concern as the cap would impact prices now, potentially forcing the company to rely more on long dated cash flows to recoup investment. But, these are uncertain, especially given the move away from fossil fuels. They are also more subject to the impact of discounting. This means that more projects will be more uneconomic under a price cap. This would deter supply at precisely the time more supply is needed.
The caps also create issues raising financing. The cap reduces projects’ revenue, as indicated. However, this makes the project riskier to lenders. This is especially since it raises the specter of additional future caps, which the lender must also factor into their assessment. This would increase companies’ cost of capital. In turn, this exacerbates the aforementioned issues creating more supply.
Windfall taxes have similar issues. They are implicitly a price cap by another name. But, they also deter broader investment: they send a signal that government will impose additional taxes on organizations in ‘good times’. This reduces the potential upside from a project. In turn, this renders any project incrementally less attractive due to the risk of government intervention.
This price caps and windfall taxes send a bad signal to business. They indicate that government will penalize companies in good times, which are necessary to off-set bad times. This is especially the case in commodities. Ironically, they would deter new supply precisely when it is needed.
Super-normal caps on energy prices
Energy prices are often regulated. However, this is not always the case. And, when there is regulation, the regulated prices is usually set by reference to input costs. However, several jurisdictions have looked at supernormal caps. In some cases, the government caps what an energy producer can charge, and makes up the difference. In other cases, the energy producer must bear the loss. This was the case in France. In this latter case there are significant issues.
Maintenance problems: A major concern is about grid maintenance, safety, and modernization. Basic corporate finance tells us that firms make capital expenditures out of cash flows and that such capital expenditures are necessary for the firm to both operate as a going concern and to grow. However, if revenue falls due to price caps, the firm will simply have less money to spend on maintenance increasing the risk of blackouts, outages and substandard service.
Growth and renewables: Energy companies face pressure to invest in renewables. They must also grow energy production if only due to population increases. But, if government caps revenues and/or harms productivity, access to capital will worsen. For example, lenders will charge higher interest rates to reflect regulatory uncertainty and lower profits. Similarly, shareholders will be less willing to invest as much in the company. This harms energy generation growth, reinvestment, and renewal.
Negative spillovers to other industries: The hit to revenues and profitability deters investment in any industry that might be subject to such regulations. For example, France effectively bankrupted an energy producer by forcing it to wear the loss of government price caps. This sends a negative signal to any industry that could be subject to any such intervention.
What then should government do?
Government has a difficult decision. Governments face pressure from voters over energy prices. This partly reflects a chronic underinvestment in energy supply. Ideally, the government would have encouraged supply over the long term. However, in the current situation, the UK approach of temporarily subsidizing energy prices might be the least bad option if government really is to intervene. This avoids the unintended consequence of deterring investment. But, comes with significant costs to tax payers. If governments take such steps, they should have a clear plan to move away from them that is credible, well formulated, and stated in advance. However, permanent tax payer subsidies, or continual caps on profits, are not sustainable and will not stimulate growth.