Inflation in the UK has reached its highest level for many years. The latest estimates show the annual rate of growth in the consumer price index (CPI) reaching 3.8% and in the retail price index (RPI) 4.6%. The Government’s official target is just 2%.
Inflation is not the serious problem it was in the 1970s and 1980s, when it sometimes reached 20% per year. Nevertheless, the relatively high and rising inflation is of serious concern to economists and politicians.
The economy is slowing down rapidly and there are fears of a recession. The Bank of England is under great pressure to reduce interest rates further, but is very unlikely to do so, in my opinion, because of its obligation to try to keep inflation close to the official target. Indeed, the bank should actually increase interest rates, but I think that is politically unacceptable in the current climate.
It will come as no surprise that the main reason for the increase in UK inflation is the massive rises in energy prices. The CPI and RPI measures include domestic electricity and gas bills, as well as petrol. World oil prices have more than doubled to more than $120 per barrel over the last year, as we all know well. The petrol price pump, however, has not risen by such a large amount because a big component of the retail price is tax.
That is not the case with domestic electricity and gas bills, which have increased dramatically. Scottish and Southern Energy (SSE), for example, increased its gas bills on April 1 by an average of 15.8% and electricity bills by 14.2%. Other companies’ rises are very similar.
More increases are in the pipeline. Since April, higher oil prices have pushed up the cost of buying gas in the wholesale market.
A substantial proportion of the gas supply in the UK is used to generate electricity, so there are inevitably knock-on implications for domestic electricity prices.
And further down the chain, electricity can be a major cost for businesses that will be forced to increase the prices of their goods and services.
I have seen reports that domestic energy prices could increase by as much as 40% during 2008. There is inevitably a close relationship between wholesale and residential gas prices, although normally with a time lag of about six months.
There is also a close relationship between crude oil and gas prices, which is what I want to comment on this month. I and other energy economists are increasingly coming to the opinion that that relationship needs to be changed.
Many gas contracts in Europe are indexed to oil prices, with the latter accounting for about 70% of the gas price. There are usually time lags in the contracts, sometimes up to nine months.
The implication is that even if world oil prices fall significantly during the second half of 2008, gas prices will continue to rise because they are determined by what happened to oil prices six to nine months ago.
Why should there be such a close link between gas and oil prices in the UK?
Economists expect prices of products that can be substituted for each other to be very similar. If the price of apples, for example, shoots up, the consumer can switch to oranges.
The demand for apples will then fall and the price will also have to fall if the supplier wants to sell apples.
I used to believe that gas and oil were close substitutes, but there is growing evidence that that is less and less the case. Oil is now largely used for transportation and gas for heating and electricity generation, which are very different markets.
Even where there is potential substitutability, it can take a long time for that to happen. The lead time for building a new power station is the obvious example.
The Oxford Institute for Energy Studies published a very interesting paper last year that showed that many European gas prices were not determined by the demand for and supply of gas.
It recommended an end to the traditional contractual indexation of gas prices to oil prices. I agree with most of the institute’s conclusions.
Why should we face higher gas bills because oil prices rose six to nine months ago? The energy suppliers appear reluctant to move away from oil price indexed contracts, but I believe that the energy regulator, Ofgem, should investigate the basic principles of indexation.
Tony Mackay is MD of Mackay Consultants
Recommended for you
