The Price of Power and the Power of Prices

As Europe’s energy crisis intensifies we are seeing calls for price caps, rationing, and command and control.

What’s happening: A range of government-imposed restrictions, akin to the kind of restraints during wartime, here is a sampling.

In Germany:

  • Cologne’s magnificent cathedral — normally lit throughout the night — now goes dark over night. Public buildings, museums and other landmarks — such as the Brandenburg Gate in Berlin — will no longer be illuminated overnight either.
  • In Hanover last month, hot water was cut off at public buildings, as the city seeks to cut consumption by 15%.
  • The southern city of Augsburg decided to turn off traffic lights.

Spain:

  • Congress agreed to temperature limitations — air conditioning no cooler than 27 degrees Celsius, or nearly 81 degrees Fahrenheit.
  • After 10 p.m. shop windows and unoccupied public buildings won’t be lit.

Italy:

  • Air conditioning in schools and public buildings has already been limited in what the government labeled “Operation Thermostat,” starting in May.

France:

  • Shopkeepers will now be fined for keeping doors open and air conditioning running, a common practice.
  • Illuminated signs will be banned between 1 a.m. and 6 a.m.

The Economist, however, reminds us of the power of prices. Namely, price caps can backfire but price increases can be combined with cash transfers can protect vulnerable consumers while maintaining strong incentives to reduce consumption and find substitutes:

How households respond to enormous price shocks has rarely been studied, owing to a lack of real-world data. One exception is that produced by Ukraine, which Anna Alberini of the University of Maryland and co-authors have studied, looking at price rises in 2015 after subsidies were cut. They found that among households that did not invest in better heating or insulation a doubling of prices led to a 16% decline in consumption.

Policies to help households cope with high prices have also been studied—and the results are bad news for politicians capping prices. In California, where a government programme cut the marginal price of gas for poor households by 20%, households raised their consumption by 8.5% over the next year to 18 months. Ukraine has found a better way to help. Households struggling to pay their bills can apply for a cash transfer. Since such a transfer is unrelated to consumption, it preserves the incentive for shorter showers, and thus does not blunt the effect of high prices on gas use. Another option is a halfway house between a price cap and a transfer. An Austrian state recently introduced a discount on the first 80% of a typical household’s consumption, which means people retain an incentive to cut back on anything over that.

…Households are not the only consumers of gas. Early in the war, manufacturers and agricultural producers argued against doing anything that might risk supplies, since production processes took time to alter and output losses could cascade through the economy. But initial evidence from the German dairy and fertiliser industries suggests that even heavy users respond to higher prices. Farmers have switched from gas to oil heating; ammonia, fertiliser’s gas-intensive ingredient, is now imported instead of being made locally.

Over time, households and industry will adapt more to higher prices, meaning that with every passing month demand for gas will fall.

The power of prices reminds us that carbon taxes can be effective at surprising low cost if we give them a chance to operate.

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