Energy plan’s dampening effect on prices may not last

The government’s energy plan is likely to put some downward pressure on inflation in the short to medium term, but its long-term impact on prices is less clear.

The Energy Price Relief Plan, passed in Federal Parliament last week, aims to curb soaring power costs for households and businesses, after the October budget forecast prices to jump by 30 per cent in 2023-24.

The policy is a two-pronged approach which puts a 12-month cap on domestic gas and coal prices, while providing targeted support to eligible low-and-middle-income households and small businesses.

The measures will reduce the cost of energy across the economy and, all else equal, will have a dampening effect on the consumer price index. The government expects the price caps to shave 0.5 percentage points off inflation over 2023-24, with a further 0.25 point reduction from the targeted support.

However, cheaper energy prices will mean that people have more cash to spend, adding to demand in the economy at a time when the RBA is looking to put the brakes on with a series of interest rate hikes.

Energy prices will still be rising, just not as fast, so the propensity to spend the savings will likely be lower, particularly among wealthy households.

Even so, the total value of the package is substantial, and any fiscal stimulus in this form is likely to be inflationary because it adds to demand. This is especially the case when the economy is already seeing capacity constraints and the labour market is at its tightest in a generation.

Gas producers have argued that the policy may also add to inflation in the long-term by disincentivising investment in new domestic resources, resulting in lower supply and ultimately, higher prices.

The price caps for both coal and gas have been set at a level that allows for “reasonable profits” - in other words, there should still be enough incentive for producers to invest in local supply. However, if global market prices remain well above the cap, there is a risk that suppliers focus their attention on more profitable projects overseas.

The clean energy transition means coal and gas will become less important to our energy mix, and if the price caps do reduce investment in new supply, it would be consistent with the move to more sustainable energy sources.

But the key question is whether the transition can progress rapidly enough to reduce demand for fossil fuel before any shortfall in coal and gas supply emerges from lower investment.

Despite having implications for demand and inflationary pressures, the plan is unlikely to have much impact on the RBA’s monetary policy in the short term.

But there is the potential for demand to be stoked further by the government’s promise to deliver a “significant package” of measures to support the electrification of homes and businesses. We await further details in the May budget.