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Ed Birkett is the Head of Energy & Environment at Policy Exchange.

Every day this month the papers have carried dire warnings about coming increases in household energy bills. The current crisis is a symptom of rapidly increasing European and international gas prices, primarily caused by rising demand as economies have recovered from the worst of the coronavirus pandemic.

The current crisis raises long-term questions about UK energy policy. However, the immediate challenge is what happens to the Energy Price Cap, which is expected to go up by 50% in April next year. The increase could cost the average household £700 per year.

Rising energy prices aren’t caused by the Energy Price Cap, but the cap still puts the Government under pressure on both sides: some in the Labour Party can argue that the Energy Price Cap was insufficient, and that only full nationalisation will suffice, whereas free marketeers can argue that trying to cap prices was economically naïve and bound to fail.

The price cap has undoubtedly contributed to the failure of energy suppliers (26 have failed since August). These failures raise bills still further because their cost is recovered through a levy on everyone’s energy bills. This could be over £100 per household next year.

There is a way out of this crisis, but it requires the Government to tread a very narrow path, starting with targeted support for households that can’t afford a 50 per cent increase in their energy bills, followed by reform of the Energy Price Cap.

The Energy Price Cap was introduced to stop loyal customers paying more for their energy.

The Energy Price Cap, introduced in 2019, sets an absolute limit on the price that energy suppliers can charge their domestic customers. This means that customers won’t pay significantly more if they don’t opt for the best tariff. The cap is set by the regulator Ofgem and is updated every six months. The cap does not apply to business users.

Before the current crisis approximately half of households opted-in to a fixed-price energy tariff. Fixed-price tariffs are typically better value, although not under current market conditions. Customers opting for them are known as “engaged customers”. The other half of households, known as “disengaged customers”, end up on worse-value variable tariffs.

You could argue that it’s not the job of government to bail out customers who are unwilling to switch tariff. However, this ignores the barriers that some customers – especially the elderly and the disabled – face when engaging with the energy market. Either way, by the 2017 General Election, both the main parties agreed that something had to be done to tackle the “loyalty penalty” paid by disengaged customers.

The current crisis is a symptom of higher international gas prices.

The primary cause of energy shortages is a stronger-than-expected increase in demand for gas and other commodities post-Covid. In simple terms, demand has recovered more quickly than supply.

The crisis raises questions over UK and European energy policy, and over the role of Russia and the Nord Stream 2 pipeline. All of these factors need to be reviewed to ensure that the UK is better prepared for future energy shocks.

In most markets, when companies’ costs increase, they respond by increasing prices. However, in the energy market, there were two factors that stopped suppliers passing through price rises quickly:

Firstly, many customers have one or two-year fixed-price deals. Such deals are not a problem for suppliers, so long as they have bought energy in advance (known as “hedging”).

Secondly, the Energy Price Cap limits how quickly suppliers can increase prices for households on variable tariffs. Specifically, the Energy Price Cap lags changes in underlying energy prices by six to eight months. Suppliers know this rule applies, and it is generally not a problem for them, so long as they have bought energy in advance.

Many energy suppliers were unprepared for an energy price shock.

Unfortunately, many energy suppliers had not bought much energy in advance and had low cash reserves, so they went bust when energy prices spiked.

Some of the blame lies with suppliers that took too much risk. And some lies with the regulator, Ofgem, which should have had stricter oversight of energy suppliers’ finances. Ofgem recently proposed “stress tests” for energy suppliers – standard practice in the banking industry since 2014.

However, MPs and the Government must take their share of the blame for how the price cap was implemented. Because the Energy Price Cap lags underlying energy costs by six to eight months, it increases the financial risks faced by energy suppliers.

There were warnings about the design of the current Energy Price Cap.

One of my predecessors at Policy Exchange, Richard Howard, argued against an absolute price cap in 2017, warning that it “would represent a significant leap towards re-regulation of the energy market. It could severely impact competition, innovation and investor confidence”.

Instead, Howard called for a “relative price cap”, which would “set a cap on the differential between the highest and lowest price charged by each supplier”. The idea was backed by John Penrose MP, who argued for it on this site. Howard maintained that a relative price cap “would likely achieve much of the same benefit for consumers, with far less Government involvement in the market.”

In the short term, the Government must cushion the blow of rising energy prices for those who can’t afford it.

Energy companies and others have put forward a range of proposals to cut the impact of higher bills from April next year. These include cutting VAT on energy bills or government rather than customers paying the cost of green levies. These proposals all amount to basically the same thing – government temporarily subsidising the energy bills of some or all households.

When Policy Exchange looked at this in September, we recommended a temporary increase in the Warm Home Discount, an existing bill subsidy for low-income households. To reduce the fiscal impact of this measure, the money could be provided by the Treasury as a loan, recovered through a levy on all energy bills when prices fall.

In the medium term, the Government must reform the Energy Price Cap.

Assuming that the public and politicians want to retain some form of price protection for disengaged energy customers, there are two main options to reform the Energy Price Cap.

The Government could either implement a relative price cap, as described above, or a “social tariff”, which would cap prices only for those on low incomes. These options are explored in more detail in a recent Policy Exchange report.

However, in the short term, the current price cap must be maintained. Energy suppliers are already buying energy ahead of the next price cap period, which starts in April. Any sudden changes to the cap could negatively impact on suppliers have done the right thing by hedging in line with it.

When the Energy Price Cap was debated in the Commons in 2018, John Penrose MP argued that:

“Free market Tories are pretty concerned that we are choosing the most anti-competitive, complicated, bureaucratic and inflexible cap on offer.”

Unfortunately, these concerns have proven correct.

Once we have weathered the current storm of higher energy bills, the Government must look again at the price cap. Their aim should be to make the cap more competitive, less complicated, less bureaucratic and more flexible.

The relative price cap looks like the right answer – ensuring that all households pay fair energy prices without putting the financial stability of energy suppliers at risk.