A month ago, our assumption about the wholesale gas price was that it would stay around £2.50 per therm on average through the next financial year, with the price rising during the year as the world and especially the European economies recovered from the second half of 2023 onwards.
However, prices have tumbled in recent weeks reaching £1.80 on Thursday, which means that the current wholesale price is now below its pre Ukraine invasion level. We therefore need to reassess both the inflationary and the fiscal consequences for the UK economy.
Our gas price model takes account of basic relationships between energy usage and demand on a regional basis around the world. Pipelines cause prices within regions covered by them (such as Western Europe) to be fairly similar. There are more limited linkages between prices in different regions around the world.
Two trends have made the 2023 price lower than had been expected. The first is the exceptionally warm winter experienced in Western Europe so far. While the US winter has been colder than expected the disconnect between the two markets means that there has not been much impact from this on European energy prices. The second is that the weakness of the currently Covid-ravaged Chinese economy has had a positive knock-on impact on the availability of LNG in Europe. This has reduced the LNG price and helped bring down the total wholesale price.
Meanwhile, most European countries have succeeded (and not unexpectedly) in economising in energy. We estimate that demand for gas is about 20% lower than it might have been after adjusting for climate and GDP. This is not inconsistent with the price elasticities in our model.
Additionally, global growth momentum is weakening as consumers feel the hit to their pockets from higher inflation and this has also held back prices.
On the earlier forecasts for gas prices, the plan in the UK to raise the Energy Price Guarantee from £2,500 to £3,000 for the average household implied a 1.7 percentage point boost to inflation on the Consumer Price Index (CPI) from April onwards and to cost the Treasury £13 billion during the financial year 2023/24.
If the wholesale price over the next year reflects the price in the current forward market (falling to £1.53 per therm in January 2024) there will be a significant macroeconomic impact. First the CPI, far from being boosted, should be pulled down by lower gas prices. We estimate that this should reduce CPI inflation by nearly 1.2 percentage points, meaning the total impact is equivalent to a nearly three percentage point reduction in inflation compared to the baseline forecasts. This would help the Bank of England a great deal in reducing inflationary pressures and could lead to a lower peak in interest rates and less collateral damage in the economy.
Second, there will be no need for the energy price cap to cost the government any money at all. This should reduce borrowing by at least £13 billion (probably more because of the increased spending on other items subject to full VAT). The additional fiscal headroom could be used to address the crises the UK currently faces, including an imploding health system. A prudent approach would be to retain at least some of the windfall which would help to further restore confidence in the UK’s fiscal policies and also serve as a buffer for potential future shocks, given that lower energy prices are by no means guaranteed.
These macroeconomic effects are significant. Even if they start to impact prices too late to prevent a technical recession, they should help boost the expected economic recovery in the second half of the year.
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