2. Overall methodological approach

Our approach has been to start by mapping relevant compensation measures in the Nordic countries. This analysis covers the Nordic countries for the implementation period 2021–2023. Subsequently, a selection of measures to analyse was made in consultation with the project's steering group. The selection has been made so as to illustrate different types of measures, within the given project budget. For some countries, similar types of measures are analysed to further compare different measures designs in terms of their environmental impact and distributional effects. Iceland was excluded after an initial screening, concluding that there were no relevant measures implemented in Iceland during the time period of interest. This was also confirmed with a contact at the Ministry of the Environment, Energy and Climate in Iceland.

Alongside the selection of measures, we developed a theoretical and analytical framework for the analysis. We also surveyed economic literature, reports, and other documents to identify experiences and evaluations of past compensation measures (some of which were referenced in Chapter 1 above). The theoretical framework focuses on the economic theory of introducing political measures on energy and climate under existing policy regimes, including perspectives such as first- and second-best policy theory and the incentivisation of energy efficiency. The analytical framework introduced a set of criteria to evaluate distributional effects and impacts on existing climate and environmental policies and targets. These criteria were later used to assess the selected policy measures in each country.

The preliminary results of the analysis were presented and discussed at a digital workshop on September 7^th, 2023. The workshop gathered relevant stakeholders and experts in policy development and environmental policy, and included participants from Denmark, Finland, Norway, and Sweden. In the workshop the preliminary results, as well as ideas on alternative policy-designs, were discussed, with special emphasis on distributional impacts and coherence with existing policies. The outcome of the workshop has been integrated into the results and conclusions presented in this report.

The questions addressed in this project and the corresponding analytical approach taken comes with limitations. The most important limitation is the fact that we are still within the implementation regime of the compensation measures. This means that the final effect of the measures is yet to be revealed, and that the project has little to no data to base the analysis on.

2.1 Theoretical framework

The theoretical framework used in this project is built around market imperfections: compensation measures distort the market forces, and there is presence of environmental externalities. Hence, the interesting element is the relationship between these factors. The framework considers compensation measures, distributional effects, climate policies, and policy implementation in real-world situations, as presented below. The framework is based on standard textbook (environmental) economic theory, the theory of ‘second-best’ (Lipsey & Lancaster, 1956), and is also influenced by theories of innovation systems (Löfgren & Rootzén, 2021).

2.1.1 Compensation measures

Compensation measures aim to alleviate the burden of high energy and transport costs by offering targeted assistance to those in need. For households, this may involve direct financial support, subsidies for energy-efficient upgrades, or reduced rates for essential services. For companies, compensation measures may include direct transfers, tax incentives, grants for energy-saving technologies, or assistance programs to improve energy efficiency. By specifically targeting vulnerable populations or companies, these policies can help ensure that those who are most affected receive the necessary support to cope with high energy costs.

If the goal of a policy is to alleviate the burdens for those most in need, the accuracy of the policy is vital in determining its effectiveness. Policymakers should then design policies to accurately identify and assist the population in greatest need of support. Accurate targeting helps to prevent misallocation or exclusion, ensuring that the resources are effectively used to alleviate the challenges faced by households and companies burdened by high energy costs. Targeted support may in some cases come with relatively high administrative costs (e.g., administrative considerations of who should and should not qualify for a given scheme) and sometimes there is a trade-off between targeted support with high transaction costs, and more general support with lower transaction costs. Politically, it may be easier to implement general schemes since (almost) everybody will benefit, even if the scheme can be considered unfair in some ways (e.g., if it benefits higher income groups more than lower income groups, i.e., a regressive scheme).

In an otherwise perfectly functioning market, compensation measures can hinder effective functioning of the market by disturbing the price mechanism. Energy prices serve the important role of signalling scarcity, which in turn, provides incentives to economise on energy use and to invest in increased supply. Compensation measures that are directly aimed towards consumption will increase the consumer’s consumption level, all other things equal. They may thereby inflate demand and subsequently price levels. Even minor changes in consumption are found to potentially have a significant impact on energy prices (Energiforsk, 2022).

2.1.1.1 Types of compensation measures

Compensation measures aimed at addressing high energy and transport prices encompass a range of strategies and interventions designed to mitigate the adverse economic, social, and environmental impacts of rising energy costs. These measures are typically implemented to alleviate the burden on households, industries, and vulnerable groups. Several types of compensation measures can be employed:

Direct financial support or lump-sum payments: Governments may provide direct financial assistance, such as cash transfers or subsidies, to households and businesses to help offset the increased energy expenses and to provide immediate relief. The support can be targeted towards low-income individuals or specific sectors that are particularly sensitive to energy price fluctuations.
Energy Tax Reductions or Exemptions: Temporarily reducing or exempting energy-related taxes, such as value-added taxes (VAT) or excise taxes, can lead to lower energy prices for consumers. This approach aims to decrease the overall cost burden on energy consumers and potentially stimulate demand.
Price caps or controls: Implementing temporary price caps on energy commodities, such as electricity or fuel, can prevent prices from exceeding a certain threshold. This measure seeks to shield consumers from price spikes during periods of volatility.
Energy efficiency incentives: Promoting energy-efficient practices and technologies through incentives, such as subsidies for energy-efficient appliances or home improvements, can help reduce overall energy consumption and costs. This type of measure is a more long-term investment, and the economic benefits may be seen after some time.
Targeted non-financial assistance programs: Designing programs specifically targeted at vulnerable or marginalized populations, such as low-income households, elderly individuals, or people with disabilities, can ensure that those most affected by high energy prices receive adequate support. In contrast to the direct financial support, these programs provide only non-financial support to the beneficiaries. One example may be advisory support for financially vulnerable individuals.
Flexible payment plans or deferral schemes: Energy providers may offer flexible payment plans to consumers, allowing them to spread out their energy costs over a longer period and avoid sudden spikes in monthly bills.
Rationing or quota systems: In extreme cases, governments may implement rationing or quota systems to limit energy consumption, ensuring that energy resources are allocated fairly and efficiently.

Expansion of social safety nets: Strengthening social safety net programs, such as unemployment benefits, housing assistance, or food assistance, can indirectly help individuals and families cope with the financial strains of higher energy prices.

It is worth noting that these various measures can be combined, for example providing some of support conditional on investing in certain energy efficiency measures. The selection and design of compensation measures depend on a variety of factors, including the specific energy source affected, the socio-economic context of the region, the policy goals of the government, and the available budget. It's important to note that compensation measures are often temporary and designed to address short-term challenges while maintaining alignment with broader policy objectives, such as sustainability and economic stability.

2.1.2 Distributional effects

The recent increase in energy and transport costs have posed significant challenges for both households and companies (European Scientific Advisory Board on Climate Change, 2023). For households, increased energy expenses can strain budgets, particularly for low-income families, the elderly, and those living in energy-inefficient homes. Rising energy prices can lead to difficulties in meeting basic needs, such as heating, cooling, and lighting. Similarly, for companies, high energy costs can impact profitability, especially for small businesses with limited financial resources. To the degree that increased expenses are local, it may, for energy-intensive industries, also hinder competitiveness in the global market.

Energy inequality has a different effect to that of general inequality, despite being correlated. For example, it is more closely related to connectivity (energy grid, transport distance), and therefore often involves a spatial aspect. Furthermore, it is strongly linked to the ownership of properties, as energy saving investments are made by owners, but the energy use costs paid by renters. Hence, it is common to study measures directed towards alleviating energy poverty (e.g. Lowans et al., 2021; Charlier & Legendre, 2021 for reviews and further description). Energy poverty can be defined with an expenditure approach, i.e. based on the proportion of income spent on energy, or with a consensual approach, e.g. whether a household can keep the home warm and free of rot, damp, etc. (e.g., Halkos & Gkampoura, 2021). Looking across Europe, Scandinavia includes the countries with the lowest energy poverty levels (Halkos & Gkampoura, 2021). While a large share of households own their home in Norway (78%), this is somewhat lower in Sweden (65%), Denmark (59%) and Finland (70%), and in EU as a whole (70%) (EUROSTAT, 2021). This difference in ownership rate can be of importance for compensating measures and their effect on investment incentives in energy renovation, and therefore long-term climate goals.

2.1.3 Climate and environmental policies

Climate impacts from human activities presents a classic case of market failure due to negative externalities and common good characteristics. Emissions of greenhouse gases impose costs on society, but these costs are not reflected in the market price of goods and services causing these emissions. Hence, market actors will generally not factor these costs into their decisions, resulting in higher emissions than what is optimal for society. To address this problem, economic policies can align incentives with what is desirable for society. Carbon pricing mechanisms, such as carbon taxes or emissions trading systems, internalize some or all of the external costs of greenhouse gas (GHG) emissions by assigning a monetary value to them. This creates an economic incentive for businesses and individuals to reduce their emissions and transition towards low-carbon technologies (Perman, 2003). The European Emission Trading Scheme (EU ETS) for CO₂ is one such example.

While carbon pricing provides an incentive for innovation and implementation of new technologies to some degree, other economic policies can provide direct incentives for innovation and development of low carbon energy technologies. Dedicated subsidies, grants, and tax incentives are examples of economic instruments that can directly promote the development of clean energy technologies.

Further, direct research and development (R&D) incentives are often prioritized where the potential benefits are far into the future, very uncertain, of public good nature, and where patents are not easily applicable. However, R&D incentives also come with trade-offs – they are in general less cost-effective than incentivising implementation by carbon pricing and may further distort the effect of the carbon pricing market. From a national perspective, policies incentivising R&D can create jobs, improve national competitiveness, and potentially create first-mover advantages. One such example is the recent American Inflation Reduction Act which, among other things, has incentives for green energy innovation and investments.

Another group of instruments are command and control measures, such as targeted regulations and standards, which can be used to ensure a desired change. This group of instruments can require implementation of a specific technology, or prohibition of certain pollutants (Kolstad, 2011). One example is energy efficiency requirements for appliances and buildings. Command and control measures are in general less cost-effective than economic incentives since they often leave little room for corporate-specific solutions to be used. But on the other hand, they can, in some instances be easier to implement. They are typically preferred where damages are severe for even small emissions (e.g., very poisonous chemicals), where implementation barriers depend on collective implementation practices, or where implementation barriers are judged as structural more than economic.

Finally, information policies try to influence behaviour by changing people’s attitudes and perceptions, with the hope that such changes will lead to change in behaviour. Well-known examples are water-saving campaigns and turn-off-the-light campaigns. Although popular, the effectiveness of stand-alone information policies has been discussed (e.g. Haug, 2004; Owens & Driffill, 2008) and for climate risk communication it has been questioned whether the effectiveness of information is hampered by psychological biases such as confirmation biases (Nickerson, 1998; Hulme, 2009)

2.1.4 Policy implementation in real-world situations

The real-world environment, in which real-world economic decisions are made, differs from the description of environment and rational decisions in standard economic textbooks. In the textbooks, much of the economic theory is developed upon the framework of the Market under perfect competition, a market rarely found in reality (Samuelson, 2010). Consequently, any discussion on the effects of policy instruments and compensation measures needs to expand from the standard economic textbooks. A prominent expansion is the theory of first- and second best (Lipsey & Lancaster, 1956). First- and second-best theory refers to outcomes that are optimal or close to optimal in a market or policy context (Lipsey & Lancaster, 1956). The first-best represents an ideal scenario where all market conditions are perfect and there are no market failures or distortions, such as the environmental impacts or externalities mentioned above. In this scenario, the allocation of resources is said to be efficient and achieves the maximum possible total welfare or utility for society. The first-best outcome is achieved when competitive markets are fully functional, and there are no externalities, public goods, information asymmetries, or any other sources of market failure. If there is one market failure, it can be addressed by a first-best policy, essentially internalising the problem in the market. Putting a price on carbon emissions corresponding to the social cost of carbon into a perfectly competitive market, is one such example.

The second-best theory acknowledges that many real-world markets suffer from several market failures and imperfections, making the first-best outcome unattainable in practice. When attempting to correct for a distortion, other distortions may be created or worsened, not necessarily providing a welfare-maximizing solution. Whether the aggregated effect is an overall welfare improvement therefore depends on these other effects. For example, if a market has a natural monopoly due to high entry barriers, a straightforward solution might be to introduce competition by lowering the entry barriers. However, in the presence of other distortions such as externalities, enhancing competition may not lead to an optimal outcome. In such cases, policymakers need to consider a combination of interventions to achieve the best possible outcome under the existing constraints.

The European Union Emission Trading System (EU ETS) is a strong market-based policy instrument to adjust for the externalities of greenhouse gas emissions within the EU. At its outset, it is a first-best policy, which accounts for all or some of the external costs by internalizing them into prices. However, there are a number of other sources of industry market failures, such as potential transition barriers. These can be categorised as technical-, regulatory-, market-, and coordination barriers, and will lead to markets not functioning efficiently (Löfgren & Rootzén, 2021).

Furthermore, perspectives such as energy security, equity, and technical innovation are important to consider in the transition towards a low carbon economy. Therefore, several EU-policies are focused on ensuring a just and equitable transition, long term security of energy supply, and stimulating technical innovation (European Commission, n.d.a; European Parliament, 2020; European Commission, n.d.b). The ETS is also subject to several adjustments, such as the market stability reserve and the carbon border adjustment mechanism (yet to be implemented). These are adjustments made to ensure investment stability and therefore incentives, and to consider the global aspect.

It is also important to notice that there can be public and political opposition to efficient environmental regulation, for example as a result of undesirable distributional impacts. Hence, in the pragmatic world of policymaking, it is often better to implement an economically sub-optimal policy to deal with an environmental problem, than no policy at all.

2.1.4.1 Introducing measures within existing policy regimes

If the EU ETS was implemented as a pure first best policy, any subsequent intervention in the market would be without effect in the short run; emissions from energy production are subject to trading and constraints within the EU ETS. Hence any incentives (or removed incentives) for reduced emissions from energy production and consumption will, in the short run, be offset by adjustments in the market for emission allowances. The total amount of allowed annual emissions has already been established, and additional incentives can only influence the distribution of emissions among different sources. Consequently, compensation measures that remove incentives for energy conservation would not impact emissions levels, although they could affect the costs associated with emission reductions.

However, the EU ETS is, with its many revisions and adjustments, like the market-stability-reserve, a complex system of regulations. Neither the EU ETS market or the primary market for products and services in which the EU ETS market operates are “Markets under perfect competition”. For example, Silbye & Sørensen (2019) show that subsidising green energy within the ETS will first be neutralized by the end of the century. As climate policy does distinguish between emissions now and later, this is crucial. The analysis by Silbye & Sørensen was made before the latest revision of the ETS system, yet their conclusions still have relevance. In another study, Kruse-Andersen & Sørensen (2022) analysed optimal national policies within the ETS system if countries want to be frontrunners in dealing with leakage. Both of these studies are examples on how important it is to look at the detail of regulations, as they are normally taking place in a second-best world.

Finally, it is important to note the endogeneity of policy target setting: Ambitious targets depend on political support, and this is more likely to be received if it is not too costly for the industry and households. Correspondingly, the long-term effects of an incentive might be different from the short-term effects. For example, the Swedish government proposed an annulment mechanism for surplus emission allowances within the EU-ETS. This proposal was based on the fact a significant number of emission allowances were being left unused, which gave political room to manoeuvre and propose changes in the legislation. This proposal has been accepted and has become a part of the 4^th trading period within the EU ETS (Swedish Environmental Protection Agency, 2023a).

2.1.4.2 Interplay between climate policies and compensation measures

When compensation measures effectively alleviate the financial burden of high energy costs, they can inadvertently reduce the urgency for individuals and companies to actively engage in efforts to reduce climate impacts, such as energy conservation. If the costs of energy consumption are offset or mitigated through compensation measures, the incentive to adopt energy-efficient practices and technologies is reduced.

The introduction of compensation measures to alleviate the immediate financial burden of high energy costs may also create an expectation of sustained support. Hence, when individuals and companies anticipate future compensation, they may delay or forgo proactive investments in energy-saving technologies or practices today. This reliance on compensation measures can therefore hinder the development of a long-term culture of energy efficiency. If the compensation measure is certain to be a one-time event, it is crucial to effectively communicate that. This is even more important in the context of climate change, since climate policies are long-term policies. Hence, clear and transparent communication is necessary to manage expectations and avoid creating a sense of reliance on repeated compensation for price shocks.

2.2 Analytical framework

Based on the theoretical framework presented above, we designed an analytical framework aimed at evaluating the compensation measures assisting households and companies facing high energy and fuel costs. In our analytical framework we chose to focus on criteria that best address the project objectives. Hence, we focused on elements that address distributional impacts and disincentives for climate positive behaviour and investments, with a secondary focus on policy coherence and on other environmental aspects. This framework follows evaluation criteria inspired by the literature (e.g., Sterner & Coria, 2013, Goulder & Parry, 2008). However, the potential to evaluate a compensation measure across all criteria is dependent on available data and supporting literature, which varies between countries and measures.

By assessing several evaluation criteria, we sought to provide an understanding of the impact of the compensation measures in addressing energy cost challenges while aligning with climate goals and ensuring proper distributional effects. The evaluation criteria assessed were:

Distributional impacts
Climate and environmental impacts
Coherence with existing climate policies

The distributional impacts criterion focuses on how funding was distributed among different socio-economic groups, and whether the support was targeted to alleviate the burden for the individuals most affected by the high energy prices. To the extent feasible, we also analysed regional differences. The climate impact criterion focuses on 1) short-term market effects, 2) short-term emissions, 3) altered incentives for climate-friendly behaviour, 4) altered incentives for climate positive investments, 5) other environmental effects. The coherence criterion comments on factors such as efficiency, transparency, and transaction costs.

2.2.1 Distributional impacts

The distribution criterion evaluates the extent to which policies specifically target and support vulnerable households and companies. It is important to assess whether the policies effectively address energy cost challenges for those who are disproportionately burdened and financially strained. By analysing the policy's design, implementation, and impact, it is possible to determine whether it provides sufficient support and resources to vulnerable groups. An often-discussed aspect of environmental and other policies is whether the impacts are relatively more positive (or less negative) for people with lower incomes (i.e. progressive policy) or if the policy has the opposite effect (i.e., regressive policy). Furthermore, other factors for distributional impacts that may be relevant include geography (e.g., rural vs urban), gender, age, and ethnicity (e.g., if immigrant groups are more vulnerable). In our assessment we will primarily focus on income and vulnerability towards energy price increases.

Compensation measures that effectively target any of these factors include income-based eligibility criteria, subsidies tailored to low-income households, or support programs for energy-intensive industries facing financial difficulties. Ensuring equitable access to monetary assistance and consideration of the unique needs and challenges of vulnerable populations are key considerations in assessing the policy's ability to reduce energy cost disparities and promote equity in energy access and affordability.

2.2.2 Climate impacts

The provision of monetary support for high energy costs may affect incentives for climate-positive behaviours. Depending on the policy design, disincentives for reductions in energy consumption may be created if energy price signals are blunted, reducing the urgency of behaviours to reduce energy usage. Disincentives arise if monetary support is aligned with current energy consumption, as it keeps the cost of energy relatively low. If monetary support is instead based on past consumption or provided as a lump-sum to all consumers regardless of their energy use, incentives for reductions in energy consumption remain effective. By avoiding disincentives for energy reduction, consumers internalise the high costs into their household budgets, which generally should encourage adoption of energy-efficient behaviours like adjusting indoor temperatures or minimizing hot water usage during showers (European Scientific Advisory Board on Climate Change, 2023). Monetary support for high energy costs may also affect investments in climate-positive initiatives such as energy efficient technology and retrofitting.

A critical consideration, for both behaviour and investment, is the influence on beliefs (expectations) regarding future policies and supports, as beliefs significantly impact current behaviour and investment incentives. If compensation policies are believed to be repeated in the future, the urgency to change behaviour or invest in energy-efficient technologies or retrofitting may be diminished in the short term

Given the importance of whether support is given for past or current energy use, and of beliefs, it is also highly important that the design of the measure and its potential re-occurrence is communicated effectively. Correct communication helps prevent the perceptions of being ‘bailed out’ and the formation of expectations for repeated support.

2.2.3 Coherence with existing climate policies

The coherence criterion relates to how well the compensation measure aligns with other existing climate policies on energy and transport on both national and transnational level. The assessment analyses whether the measure complements, distort or conflicts with other environmental policies in terms of reaching specific reduction targets, interest conflicts and cost efficiency. Emphasis is placed on the measure’s overall objectives in relation to other policy objectives on climate, relating to energy and transport.