In all markets, prices perform an essential role in signalling to us whether it is sensible to consume a good or service. Of course, just because the price is “right” doesn’t guarantee that consumers will choose the cheapest option – there is ample evidence that individuals’ decision-making is much more complex than simple economic theorems would suggest. However, if prices do not reflect true costs, we are pretty certain to make unwise decisions.

In the old Soviet Union the price of energy was massively subsidised. Consumers paid a fraction of the true price of energy. This had a number of consequences. Firstly, the USSR lost a lot of revenue as a result of selling the energy domestically at a much lower price than they could get for it abroad. The second consequence was that households and companies were massively inefficient in how they used their energy.

One lesson from this “experiment” was that consumers, whether households or companies, should be faced with the true cost of energy. Subsidies to energy users results in major inefficiency.

When the Berlin Wall fell, energy prices outside Russia rose towards the full-market price as countries such as Poland had to buy their energy on the open market. Without the previous “support” from the Soviet Union, the new independent governments could not afford the subsidies needed to keep the cost of energy at its previous level. The rapid rise in prices proved exceptionally painful for many households, especially given the low temperatures they experience in winter.

Households were not ready for this: in Poland, for example, much of the housing stock was very poorly insulated. Also, many apartment blocks had communal heating systems and individual apartments had no control over their own energy use. When the communal heating system was on it operated at full blast and opening the window was the only way to control the temperature. However, when the price of energy rose to the market level, the cost of operating the heating systems proved unsupportable. Even if home owners insulated their apartments properly, it did not result in any significant saving if no one else followed suit.

The solution was to introduce metering of the use of hot water by each apartment. When this was done, the owners of individual apartments insulated their homes. Due to the hot water being metered, households were able to capture the major saving in energy costs from proper insulation and they were also much more comfortable in winter.

A key lesson from this experience is that individuals should know and control their own energy costs: if households and companies face the true cost of energy, this can produce major gains in efficiency, as well as happier, richer and warmer households.

More difficult questions

Finding the economically sensible answer on energy pricing in eastern Europe after the fall of the Berlin Wall was reasonably easy, even if implementation was often very painful. Within the EU today, we are facing more difficult questions on who should pay for some of the policies used to tackle global warming.

In Germany, the huge cost of their renewables programme is all charged to households; industry does not have to pay. Effectively, there are two prices of energy. On the face of it this would appear to be “state aid” – favouring German industry and potentially giving it an advantage over industry in Ireland and the rest of the EU that has to pay the full cost of energy.

It is also not economically efficient. The high electricity price means German households take exceptional measures to reduce consumption. However, much of German industry could achieve a similar reduction at a much lower price than households have to pay. It means that the reduction in emissions as a result of the investment in renewables is being achieved at a higher price than is necessary, especially for households.

Tax on households

In footnote 2 on page 50 of the Department of Finance’s Stability Programme, it is disclosed that the Public Service Obligation (PSO), which appears on all our electricity bills to fund, among other things, renewable energy, is now defined by European statistical authorities as a tax – not part of the cost of energy. (As in last week’s article, this shows that reading footnotes is important!)

This means the higher electricity payment paid by German consumers to fund renewables is a tax on households – quite acceptable legally – and the high payment made for solar power is a subsidy. Thus the exemption of German industry from paying the cost of renewables is quite legal.

This has significant implications for other EU countries. In Ireland, the approach taken to date seems to be correct – the cost of renewables is treated as part of the cost of electricity and, as a result, everyone should pay, including industry. However, governments everywhere are now likely to come under pressure to adopt the German approach to protect the competitiveness of their industries – placing all the burden of the PSO on households.

This could result in a substantial rise in household electricity prices if it was adopted in Ireland.

This difference in approach across the EU to how the cost of tackling global warming is paid for makes it very difficult to develop a single EU market in electricity, something that could benefit all EU citizens (and the environment). While the mantra of less EU regulation is popular in some quarters, this is a case where greater EU harmonisation could prove beneficial. It also highlights the problems resulting from the EU setting national targets for emissions or renewables – it can lead to very different costs across member states.