Europe struggled with lack of power shortages

 It will take years for European countries to find alternative gas supplies.

We have argued before, and so have many others, that the current economic environment probably has its closest similarity with events during the 1970s and into the early 1980s, what with surging energy prices, roaring inflation, sharp Fed rate hikes and a rising dollar. But there may be another area where the similarities are quite noticeable: price controls. Their success now, particularly in Europe could dictate inflation, central bank tightening and financial market performance.

Last week saw another example of price controls related to energy prices, this time in the UK. Some other European nations have already used such mechanisms. France is the prime one and its 4% cap on regulated energy prices this year is one reason why French inflation is only 6.5% on the harmonised measure compared to a euro zone figure of 9.1%.

In the UK, the new Truss-led government claims that its 2-year freeze on household energy prices can trim five percentage points off inflation. That’s probably a fair estimate and hence inflation may end up staying closer to 10% than shooting to, or even above, 20%. It sounds like a great idea but, as is often the case, there’s disquiet amongst economists about interfering with the sacred laws of supply and demand. Do they have a point?

Energy prices, particularly gas, are high because there is an imbalance between supply and demand, caused primarily by supply reductions through the pipelines that Russia uses to send its gas to Europe. And, as the EU relies on Russia for around 40% of its gas, the reduction in gas supply to a trickle has clearly led to the surge in prices (although it should be noted that prices were already rising notably before Russia started its invasion of Ukraine back in February).

To prevent higher prices for consumers, there either has to be some rebalancing of supply and demand, or price controls. The former appears hard, because it will take years for European countries to find alternative gas supplies. While, on the demand side, the problem now is that it is coming up to winter when demand spikes.

With this in mind, some countries have chosen price controls (some have chosen handouts to consumers instead). The UK is the latest with the announcement last week of a two-year freeze for households and a separate aid package for businesses. But straight away we can see a potential problem here because if prices had been allowed to surge, it would have reduced energy demand, perhaps bringing about better balance in the market and quite possibly ruling out the need for power cuts during the winter.

Many European governments have recognised the possibility of power shortages and have taken – very modest – measures to ration energy. But in the UK, there seems to be little more than a plea to consumers to watch what they use. This might prove sufficient, if only because household energy bills had already been increased by more than 50% back in April, although Mr. Steve Barrow, Head of Standard Bank G10 Strategy has his doubts.

Some sort of rationing would seem appropriate but we are sceptical that the government will do so. Hence there’s a greater risk of power shortages in the winter; something that would hit GDP and make the country’s debt burden arising from this scheme look even worse. Another issue is that price controls often start off as temporary but are then continued or re-introduced. The UK government has to gamble that the forward gas price curve is correct and prices start to come down so that, in two years’ time, a freeing of prices does not cause a new surge in household bills. It is a gamble, but most probably agree it is a gamble worth taking even if they have some reservations about price controls.

Mr. Steve Barrow thinks that price controls are necessary in the present situation but, for financial markets and investors that have not really seen such significant controls since the 1970s, there might be more trepidation. And, if that’s the case, it is likely to play out negatively for UK asset prices so, here at least, we suspect that some degree of underperformance is likely through the rest of this year at least”, said Mr. Steve Barrow.