On Friday afternoon, the Australian government announced its much-anticipated solution to the energy crisis – subsidies and price caps. According to Prime Minister Anthony Albanese:

“I’m pleased to announce that there was agreement at the national cabinet on a way forward to provide the energy price relief for households and for businesses.

We are determined to provide some relief and to take what are extraordinary measures to deal with these extraordinary times.

The commonwealth will provide up to $1.5 billion to provide support for households and also small businesses.

This will be paid through state governments by reducing people’s bills.”

Albanese also claimed the payments would have “a deflationary impact on the economy”, which is technically correct but only for the period during which the subsidies are delivered and only if the price caps don’t choke off supply.

When the WA, QLD and ACT governments handed out cash in the September quarter, national energy prices increased by just 3.2% instead of 15.6%. But the effect was temporary; the rise, which has already happened and was simply hidden by the one-off payments, will show up in its entirety in future quarters, on top of any additional price increases.

The second part of the energy plan involves capping coal prices at $125 per tonne and gas prices at $12 per gigajoule. Assuming coal and gas suppliers don’t find a way to export additional supply into global markets at 4x the price – forcing the grid to fall back on more expensive generators – this will probably reduce prices and therefore inflation, at least in the short run. Treasury would have ensured the price cap was set above variable costs to ensure firms will keep producing, even if it’s at an economic loss, which the government doesn’t care about anyway because “coal fired power stations are going to close”.

But there are important long run considerations: will changing the rules discourage future investment? I’m not just talking coal and gas here; the disincentive also applies to renewables and other capital-intensive projects, which could result in costly under-investment. How can investors be sure that the Australian government won’t extract rents from those when the next crisis inevitably rolls around?

Perhaps most notably, no additional energy will be produced under this plan. It’s essentially $1.5 billion [update 11/12/22: $3 billion because the states are matching it] worth of debt-financed fiscal stimulus into an overheating economy (Australia’s GDP deflator increased by 6.9% in September 2022, suggesting broad-based price pressures). Reducing the price consumers pay for energy without increasing supply means they will demand more of it, increasing the risk of shortages. The number of dollars chasing a finite number of goods also hasn’t changed; whatever households save on energy they can now spend on something else, which will change the composition of inflation but not the overall rate.

There are too many unknowns and too much uncertainty to draw any concrete conclusions about this plan, but at first glance it’s quite far off what one might consider optimal. The government had better tread very carefully!