26 Sep 2022 4 min read

If the cap fits…


We take stock of the new government's plans for support for British households' energy bills this winter – and what they could mean for the markets

If the cap fits.jpg

After the summer’s long contest for leadership of the Conservative party, new British Prime Minister Liz Truss has at last filled the policy vacuum with a major announcement on how her government proposes to tackle the cost of living crisis.


The package

On September 8 Truss announced an Energy Price Guarantee (EPG), intended to cap annual energy bills for the average household at £2,500. Kicking in on October 22, the limit is planned to last for two years, with the government forecasting a saving of £1,000 per annum for the average household in this period.

Meanwhile, businesses and public sector organisations will see ‘equivalent support’ for six months. When this is wound up, the government will then focus its support vulnerable industries such as hospitality.


What are the policy’s implications?

The EPG’s most significant effect will be on inflation.

In a scenario where average annual energy bills reach £6000, we forecast inflation rising as high as 15%.

In contrast, with the EPG in place we now think CPI is close to peaking at just over 10% for a month or two before gradually declining to around 3% by the end of 2023, as we can see below:


UK CPI scenarios.png

Along with stronger growth in the near term, we think this should be enough to keep the Bank of England in hiking mode. We see the Bank’s base rate reaching 4% by early 2023.

At the same time, households’ lower energy costs will allow them to divert their spending to consumption, saving and investment, which should in turn boost GDP.

Our forecast already factored in c. £40 billion of fiscal support; we anticipate the additional package to lift the UK’s GDP from a near-term recession of around 1% to a steady state until the global economic cycle turns.

Why does growth remain weak? Some of the damage from tighter credit conditions and higher interest rates is already done and will continue to feed into the economy. The UK also faces global headwinds: we expect a slowing of the US economy from mid to late this year.


A model for Europe?

There is little getting around the fact that most economies in Europe face a very challenging winter.

We created the below table to illustrate some of the trade-offs facing the continent’s policymakers, representing the likely outcomes in three scenarios: leaving everything to the market, subsidies for consumers and business, and more targeted support.


Energy policy scenarios.png

If Europe adopts a similar policy to the UK (depicted in column two in our  table), we would expect its growth to also improve. However, if many countries adopt this approach, there is increased risk of a bidding war for scarce energy and commodities increases, along with blackouts or rationing becoming more likely.

However, we cannot pretend there were no alternative policy paths that could have had materially different impacts on key macroeconomic variables.

Our modelling suggests allowing market forces to prevail – i.e. no support from the government at all – would have caused higher inflation in the near term, as well as a large negative effect on GDP. Represented in the first column of the above table, this scenario would have posed an acute policy dilemma for the Bank of England.

Alternatively, targeted handouts for the lower-income households most exposed to the energy crisis would also have been inflationary, given these households generally have the highest propensity to consume. Their increased purchasing power would have kept medium-term inflation higher too, thus requiring an even more aggressive tightening of monetary policy.

The middle path chosen by the government tempers both inflation and recession risks in the near term, but it comes with a cost: it’s the most borrowing-intensive choice.  


Paying the bill

The minimum cost of the EPG’s household portion alone will be £50-60bn (amounting to 2½-3% of GDP. If the wholesale gas price moves up, it could cost considerably more.

Overall, the programme is likely to cost more than £100bn. Since the government has stated there will be no further windfall tax on energy companies after then-chancellor Rishi Sunak’s £5bn wedge in May, this means a considerable amount of borrowing.

However, the market reaction to the announcement was muted, with the consensus having for some time been that some form of support package was all but inevitable. Consequently, gilts barely reacted to the news – but UK sovereign debt is now linked wholesale gas prices in ways never before seen.

This has three consequences:

  1. We see this as a transfer of inflation risk from the private to the public sector.
  2. Given the UK is the developed market with the most inflation-linked debt, ‘Inflating away the debt’ is becoming increasingly difficult
  3. The extra borrowing will keep the current account firmly in deficit and add downward pressure on an already weak sterling.


LGIM contributors