Weekly Roundup, 12th September 2022

We begin today’s Weekly Roundup with the energy markets.

Energy markets

Before Liz Truss’s energy price freeze was announced, The Economist looked at the UK government’s plans to reform power markets.

• As everyone knows by now, the regulatory cap on electricity and gas prices has already shot up well beyond the inflation rate.

By October it was expected to be triple the rate from the previous year, and pessimistic projections show it doubling again by April 2024.

• The cap does not apply to businesses, which face even higher prices (and in some cases, the prospect of closure).

Gas is hard to store and transport and the war in Ukraine has obvious implications for European gas prices.

• But the problem with electricity prices stems from the decision to pay all producers the price needed by the marginal supplier to meet overall demand (ie. the most expensive).

This means big profits for plans with low running costs (notably renewables).

One idea is to pay all generators the average bid. Another is to pay each what it bids. A third is localised pricing, which would mean lower bills for people living near wind farms, say.

But many generators would be loss-making at the average price, and using an auction would likely lead to inflated bids.

• Localised pricing would have long-term impacts on where capacity is built, but also unacceptable short-term political costs.

Another option is to split prices according to the average per source, or perhaps just between renewable and fossil.

• But most renewables built since 2017 are already on long-term fixed-price contracts, and a split won’t help with those (rather, the variability of future prices would deter investment).

So price freezes and subsidies (to be repaid long into the future) were more likely (and indeed, have come to pass).

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Scottish Power and E.On had suggested a two-year freeze, which might cost £100 bn up front but which would be repaid by consumers over perhaps ten years.

• Keir Starmer’s Labour has proposed something similar but funded through a windfall tax on energy companies – with the Treasury (ie. taxpayers) presumably swallowing the excess above the initial estimate.

These plans would help with inflation and would prevent some firms from going bust, as well as helping poorer households with their energy bills.

• But the chances of the bill being repaid by the same people that it benefits is remote.

And keeping costs artificially low will not fully curb demand (or motivate investment to increase supply, a drawback shared with the windfall tax).

• But it’s probably a reasonable short-term fix.

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A second Economist article suggested that there are better solutions than meddling with prices.

The cheapest protection is to trade natural gas across national borders. Within domestic markets, price signals have a vital role to play in curbing demand. Hearteningly, there are signs that people and businesses can and do respond to high prices by conserving energy.

The article is also in favour of regulation, such as shop lights going out at 10 and air-con set to 27C (both in Spain).

And support should be targeted:

Some European governments are on course to spend 1.5% of gdp on energy policies by the end of the year. Measures that protect the poorest fifth of the population would cost only 0.4% of gdp; the poorest two-fifths, 0.9%.

But where to draw the line is as much a political decision as an economic one.

A letter in response to this article suggested a price ceiling that only applies to a standard (average?) amount of electricity.

• Above this, households would pay the market price.

This preserves the market signal to conserve energy but also helps the poorest.

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A third article looked at the economic literature to work out how to avoid energy rationing.

Until recently, research had found that consumers were largely unresponsive to higher petrol prices: they need to drive to work, and will do so even if expensive.

If this were the case, price caps would not have much impact (since high prices would not have curbed demand).

• But new studies suggest that prices really do matter.

The earlier generation of studies analysed aggregate data, such as weekly sales and prices in a region, not demand from individual consumers or even driving patterns.

Aggregating data loses detail, which can lead to the wrong interpretation.

One recent study used credit card data.

For a 10% rise in petrol prices, consumption fell by about 3%. If they had used aggregate data, they would have concluded there had been a much smaller drop.

Another study looked at Oregon gas supply by two firms with overlapping footprints but different price-adjustment mechanisms.

A 10% rise in gas prices led to an average 2% drop in consumption. During summer months, there was hardly any response to prices; in winter, households cut use by 4%.

But these are studies of small price changes, not the big shocks Europe is facing.

Another study looked at the withdrawal of subsidies in Ukraine:

Among households that did not invest in better heating or insulation a doubling of prices led to a 16% decline in consumption.

And the reverse:

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.

Flat cash transfers to poorer households (a fixed dollar amount) and/or a price cap on the first tranche of usage are therefore better mechanisms.

There are also some industrial studies:

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.

The bottom line is:

Without high prices to encourage households and industry to cut back on their energy consumption, governments will have to find ways other than the price mechanism to allocate scarce resources. Who wants to be the politician to have introduced rationing?

Debt forgiveness

The Economist looked at Biden’s decision to forgive hundreds of billions in student debt.

• Loan repayments have been suspended since March 2020 – at a cost of $60 bn a year (twice as much as the mortgage interest tax deduction) – and will remain suspended until just after the November mid-term elections.

And now they are being cancelled for a lot of people.

• Penalty-free debt forgiveness is rarely a good idea, and this example is no exception.

The plan will take $1LK off the balances of anyone earning less than $125K and $20K if you had a Pell grant (given to those from poor families).

• Around half of the student debt accounts are expected to be cancelled entirely.

This will cost around $500 bn up front, compared to the ironically-named Inflation Reduction Bill, which aims to save $300 bn over a decade.

• The newspaper suggests that we call the new measure the Inflation Acceleration Action.

It’s also regressive since graduates earn more than non-graduates.

The wage premium for a worker with some college education relative to one with just a highschool diploma is 11%; for a completed bachelor’s degree it is 65%; for a professional degree it is 138%.

And there’s the issue that without caps on fees, these will simply increase to restore the aggregate debt load within a few years.

Tax-Efficient Gilts

In the FT, Mary MacDougall said that UK gilts are becoming a tax-efficient option for high earners.

• The idea (which originates from Brewin Dolphin) is that there is no tax on the capital gain on the bond (though the coupon is taxable).

Short-dated bonds with a low coupon have the biggest discounts and so the most attractive tax break.

• Inflation-linked bonds and those with a higher coupon will trade closer to their issue price (or even above it), shrinking (or negating) the tax advantage.

On August 24, for example, a UK gilt with an expiry date of January 31 2024 paid a coupon of 0.125 per cent and traded at £96.22 — providing an annual equivalent yield, with no tax paid, of 2.84 per cent.

There are fixed-term savings accounts with higher rates, but not after tax is taken into account.

• The bond mentioned above has a yield after tax of 2.79% for higher-rate taxpayers and a “gross equivalent yield” of 4.65% (the yield needed to match the post-tax return if tax had to be deducted).

Which sound pretty good, if you can ignore the 10%+ pa “shrinkage” on your cash from inflation.

Green Bonds

NS&I have doubled the returns on its Green Saving Bonds GSBs).

• GSBs started at 0.65% last October, then version 2 raised the rates to 1.5%.

Now we’re at 3% pa, still short of the market-leading rates for a three-year lock-in (now closer to 3.5%).

• The latest hike shows the risks of tying up your money in a rising rates environment.

Not to mention locking into a rate which is 6%+ below inflation.

• Three years is also a tricky period since markets are forecasting short-term rate rises and then a decline after that.

You can invest a minimum of £100 and a maximum of £100K, but there are better homes for your money.

Quick Links

I have six for you this week, the first two from The Economist:

1. The Economist explained why businesses are furiously hiring even as a downturn looms
2. And said that the digital yuan offers China a way to dodge the dollar.
3. Mauldin Economics looked at some Labor Mysteries
4. Alpha Architect examined Brand Values and Long-Term Stock Returns
5. Klement on Investing looked at what makes a good meme stock?
6. And UK Dividend Stocks published its quarterly review of the UK Top 40 High-Yield Blue-Chip Stocks.

Until next time.