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VoxEU Column EU policies Energy Politics and economics Welfare state and social Europe

Targeted income support is the most social and climate-friendly measure for mitigating the impact of high energy prices

Targeted income support is the most social and climate-friendly measure for mitigating the impact of high energy prices

Energy prices have been on the rise since 2021, with additional volatility since Russia invaded Ukraine. Oil and gas futures point to only gradually falling prices in the coming quarters. This price surge is set to heavily increase the costs European households face to cover their energy needs, in particular for heating and transport (see Afunts et al. 2022 and Seiler 2022 on the impact of the war on inflation expectations). The impact will differ considerably from country to country, depending on the mix of energy sources and tariff regulation.1

Low-income households suffer disproportionately from energy price inflation (see also Claeys and Guetta-Jeanrenaud 2022), as they spend proportionally more on energy products for residential purposes. In 2020, the median households in EU member states paid around 2½% of their income for residential energy (ranging from 1½% to almost 4% across countries), while for the lowest income quintile, the share was 4¾% (with a range from 2½% to over 6%). The direct impact of the energy price increase, assuming full pass-through, an inelastic energy demand and the absence of any regulatory or mitigating policy measures would bring the share to 3¾% for median households, and 6½% for the lowest quintile (Figure 1 and related notes). 

Figure 1 Energy expenditure for residential purposes as a percentage of household income by income quintile, assuming full pass-through from wholesale prices

 

Note: Energy expenditure data are taken from Eurostat (Structure of consumption expenditure by income quintile and COICOP consumption purpose). Data for 2020 and 2022 have been imputed according to energy price growth rates, and assuming the same energy source expenditure composition for all quintiles. Prices for 2022 are projections based on futures prices as of 15 March 2022. Income data has been taken from EU-SILC and ECHP surveys and imputed for 2022 according to the AMECO household income growth rate. The data cover 18 EU Member States for which data are available (AT, BE, BG, CY, DE, FI, HR, IT, MT missing). Note that 2022 displays the maximum impact of wholesale prices, if they were fully passed through to consumers and with no price regulation in place.
Source: Eurostat, Commission Service calculations.

Governments in EU member states have taken a variety of measures to alleviate the impact of high energy prices on consumers (Sgaravatti et al. 2022). Key policy objectives are to protect low-income households and shield firms in energy intensive industries from the sudden price volatility. At the EU level, efforts to reduce the dependence on imports of fossil fuels from Russia are fully integrated into the strategy to reduce greenhouse gas emissions (the European Green Deal). 

In this column, we review the measures so far taken by EU member states. We then use the Commission’s E-QUEST model to simulate the impact of stylised policy measures on greenhouse gas emissions from the use of fossil energy as well as their distributional effects. 

EU member states’ mitigating policy measures 

Measures to mitigate the short-term economic and social impact of high energy prices can be broadly categorised into price and income policies. Price policies directly target the final energy price paid by households and firms. They include lowering indirect taxation (including excise duties on energy) or levies, subsidies, direct interventions in price setting, and social tariffs. Income policies entail some form of monetary compensation paid to energy consumers, i.e. transfers in cash or in kind (e.g. through ‘energy vouchers’). Other measures include support to firms, in particular to energy intensive industries and revenue raising measures (including in particular taxes on windfall profits). 

Income polices targeted to most vulnerable households have several advantages over price policies, although they may be more difficult to implement. Price policies reduce the signalling effect of higher energy prices on demand and may thereby reduce incentives to increase energy efficiency or to shift to alternative energy sources. Price caps or freezes in particular can also have a detrimental effect on economic efficiency by hampering competition in the retail market and restricting new players from entering the market, especially when kept in place for a longer period. The costs of these policies can become very high, and they may be difficult to reverse should energy prices remain elevated for a longer period of time. Income policies, on the other hand, maintain the incentive of the high energy prices to reduce energy demand. They can also be more easily targeted to vulnerable groups, and thereby provide more relief for a given amount than price policies (though depending on design features). Targeting income policies requires some form of means-testing. This additional administrative effort can be reduced if the measure can be linked to other means-tested benefits. Income policies may also be easier to remove when energy prices stabilise to avoid that those policies outlive their motivation. 

Figure 2 Budgetary cost of discretionary measures to counteract the impact of energy price increases in 2022 (% GDP) 

 

Note: In the case of EL, 0.6% of GDP of the budgetary costs is covered by windfall revenues from emission allowances, which for the purpose of this estimate has not been recorded as an energy related measure.
Source: own calculations.

The Commission’s Spring 2022 European Economic Forecast estimates the cost of new discretionary measures to mitigate the short-term economic and social impact of high energy prices at 0.6% of GDP in the EU (European Commission 2022; see also Verwey et al. 2022). This estimate includes those measures that specifically target energy prices, consumption and production. It does not include the impact of broader measures in response to the increase in overall inflation or support to firms suffering from a general slowdown in economic activity. The overall budgetary cost of the surge in energy prices will also exceed these estimates because of (semi-)automatic adjustments of social benefits to the general price level (not counted as a discretionary measure) or the impact of the deceleration in economic activity on tax collection. To some extent, this may also explain relatively large differences in the impact of energy-related measures across member states reported in Figure 3, as some may rely more on automatic adjustment mechanisms than others, or opt for policies that are less strictly tied to energy prices. Most measures entered into force in early 2022 (some already towards the end of 2021) and have generally been announced as temporary. However, their budgetary costs will ultimately hinge upon future developments in energy prices, and for how long those measures will apply. 

Price policy measures represent the majority of measures announced thus far, predominantly in the form of cuts in indirect taxation. Less than one third of the impact can be attributed to income policies. On the whole, measures taken so far are often not very targeted and may often prove difficult to reverse in the future. 

A stylised assessment of policy impacts 

An additional aspect is to what extent these measures contribute to reducing the EU’s overreliance on (imported) fossil fuels and advance the decarbonisation of the energy system. We employ E-QUEST, a sector-disaggregated version of the Commission's QUEST model with an energy block, to analyse price and income policies with respect to their social and environmental impact.  The model distinguishes between energy from fossil fuels, leading to greenhouse gas emissions, and clean energy, which does not cause emissions. It is populated by two types of households. The first group is liquidity constrained without the possibility to save, borrow, or invest in capital and financial markets. These households consume their entire income each period. By contrast, Ricardian households do save and invest, and thus smoothen their consumption over time.3

For the ease of comparison, all policy measures are assumed to be permanent and of the same size, i.e. 0.1% of GDP. Our first illustrative scenario is a reduction of ad valorem fuel taxes (or subsidy); the second is income support (lump-sum transfer) to all households while in the third scenario the transfer is targeted to liquidity-constrained households only. 

Table 1 Welfare and emission effects of fuel tax cut and income support measures

 

           

Source: E-QUEST simulations, percent deviations from baseline

Table 1 shows the impact of these stylised measures on the main macroeconomic variables of interest. Each of these policies can help the most vulnerable households to cope with the burden of higher energy prices, in particular targeted transfers. Liquidity constrained consumers can increase their consumption by about 0.2–0.3% relative to baseline in the first two scenarios and up to 0.5% under the targeted income support measure.4 Targeted transfers also lead to the strongest stabilisation of consumption and output in the short term, as liquidity constrained households spend all their additional income. 

While all three policies can lessen the economic costs of higher fuel prices, income policy measures – not proportional to current energy consumption – are preferred for their significantly lower impact on greenhouse gas emissions compared to fuel tax cuts. Tax reductions on fossil energy induce higher emissions from burning fossil fuels. With the fuel tax subsidy, greenhouse gas emissions increase by 0.8% in the short-run and by up to 1.5% in the long-run relative to the baseline, while they stay relatively stable in the other two scenarios. The tax reductions also increase the reliance on imported fossil fuels and encourage the consumption of fossil fuel-intensive durable goods. Consequently, they would make the required switch from dirty to clean technologies even costlier in the long run.5 In short, energy tax subsidies not only enforce the EU’s reliance on fossil fuel imports but also work against achieving the ambitious climate targets of the European Green Deal. 

References 

Afunts, G, M Cato, S Helmschrott and T Schmidt (2022), “Russia’s invasion of Ukraine has led to higher inflation expectations of individuals in Germany”, VoxEU.org, 20 April.

Claeys, G and L Guetta-Jeanrenaud (2022), “Who is suffering most from rising inflation?”, Bruegel blog post, 1 February.

European Commission (2022), “European Economic Forecast, Spring 2022”, DG Economic and Financial Affairs Institutional Paper 149. 

International Energy Agency (2022), Gas Market Report Q2-2022, Paris.

Seiler, P (2022), “The Ukraine war has raised long-term inflation expectations”, VoxEU.org, 12 March.

Sgaravatti, G., S. Tagliapietra and G. Zachmann (2022), "National policies to shield consumers from rising energy prices", Bruegel dataset.

Varga, J, W Roeger and J in ’t Veld (2022), “E-QUEST: A multisector dynamic general equilibrium model with energy and a model-based assessment to reach the EU climate targets”, Economic Modelling, forthcoming.

Verwey, M, L Bardone and K Orsini (2022), “Russian invasion tests EU economic resilience”, VoxEU.org, 20 May.

Endnotes

1 For example, Dutch, Luxembourgish, Italian, Belgian, and German families rely heavily on gas for heating, and are most exposed to the gas prices surge, while households in Greece, Ireland, and Cyprus have a high dependence on heating oil.

2 E-QUEST belongs to the family of dynamic stochastic general equilibrium (DSGE) models. In these simulations, the model is set up for two regions: the EU and the rest of the world. For detailed model description and applications, see Varga et al. (2022).

3 There is no distinction in terms of expenditure shares by products between the households, i.e. each household spends the same share of its consumption expenditure on energy.

4 At the aggregate consumption level, tax subsidies are slightly more favourable than non-targeted lump-sum transfers because the wealthy (Ricardian) consumers also benefit from the higher profit in the fossil fuel-intensive sectors of the economy.

5 Returning to the baseline emission path may not only increase the burden of the green transition in the form of higher carbon prices or stricter regulatory measures, but it would also require paying the adjustment cost of switching back from dirty to clean technologies.