Firm-Level Responses to Energy Price Increases: Strategic Adaptations and Policy Insights

The World Bank's report examines the varied firm-level impacts of energy price increases, highlighting mechanisms like cost pass-through, cost absorption, input substitution, and innovation. It emphasizes the importance of policy design in mitigating negative effects and promoting efficient responses.

A recent study by the World Bank explores how firms are impacted by and respond to energy price hikes. Authored by Juergen Amann, Defne Gencer, and Dirk Heine, the report is part of the "Energy Subsidy Reform in Action" series by the Energy Sector Management Assistance Program (ESMAP). ESMAP aims to aid low- and middle-income countries in reducing poverty and boosting growth through sustainable energy solutions, integrated within the World Bank's policy dialogue and financing strategies.

Reforming Energy Subsidies: A Path to Efficiency

Energy subsidies, while providing temporary relief to firms and households, distort economic efficiency by encouraging excessive and inefficient energy use. By lowering the price of energy, these subsidies disrupt firms' decisions regarding the optimal mix of input factors, resulting in economic inefficiencies and excessive energy consumption. Reforming energy subsidies can help address these distortions, leading to a more efficient allocation of production inputs by firms. Recent research reviewed in the report reveals that firms' responses to energy price increases vary based on multiple factors, including the firm's energy dependence, the magnitude of the price change, and the availability of alternatives to adapt and reduce energy consumption. The four main response mechanisms identified are: passing the cost increase to customers, absorbing the cost, substituting inputs, and enhancing innovation and productivity.

Passing the Buck: Cost Pass-Through

Cost pass-through, where firms increase the sales price of their outputs proportionally to the energy price hike, is a common response. This mechanism depends on the firm's market power and the competitiveness of the market. Studies show that firms in energy-intensive industries often pass on a significant portion of energy price increases to consumers, which can have welfare implications. Empirical evidence from various sectors and regions, including the EU Emissions Trading System (ETS), supports the existence of this mechanism. Absorption of costs, another response mechanism, is more feasible for solvent firms and in the short term. This approach does not require changes in production processes but can lead to reduced profitability and potential shifts in employment within specific sectors. Research indicates that while there is no conclusive evidence of firm exit or significant aggregate employment loss due to energy price increases, there are potential shifts within sectors that require careful policy consideration.

Adaptation Strategies: Substituting Inputs

Substitution of inputs, particularly between different energy types and broader production factors like labor and capital, is another significant response. The availability of alternatives and the financial capacity to invest in new technologies are crucial for this mechanism. Studies show strong evidence of interfuel substitution, especially between fossil fuels and electricity, although the extent varies by country and sector. Innovation and productivity improvements driven by investment in new technologies are also notable responses. The weak form of the Porter hypothesis, which suggests that government intervention can spur innovation, is supported by empirical evidence. However, the strong form, which posits that such interventions lead to increased competitiveness and productivity, is less conclusively supported. Firm size and managerial quality play important roles in how effectively firms can innovate in response to energy price increases.

Innovation and Productivity: The Long-Term Solution

Overall, the report highlights that while energy price increases pose challenges, firms have multiple mechanisms to navigate these changes. Policy design and accompanying measures, such as reducing corporate taxes or providing support for innovation, can mitigate the impact on firms and promote more desirable responses. The report calls for further research to gather additional evidence and document novel approaches to understand better and support firms' responses to energy price increases. The complex topic of how firms are affected by and respond to policy-induced energy price increases had not been extensively explored in research and the academic literature until recently. In the past few years, more evidence and studies exploring this subject have become available. To better understand emerging knowledge and evidence in this field, this report reviews a selection of the academic and empirical literature on the firm-level impacts of energy price increases published from 2010 onward.

Firm-Level Responses: A Closer Look

The empirical literature identifies substantial cost pass-through by firms in response to energy price increases. Research consistently demonstrates that increased costs stemming from energy price reforms are often passed on to consumers. This dynamic interplay underscores the potential ramifications for overall consumer welfare. Cost pass-through is identified across various levels of analysis, including sectoral, firm-specific, and commodity-based assessments, revealing intricate links within production networks. Furthermore, data constraints at the firm level complicate the understanding of capacity-related response patterns, particularly within the context of developing economies. Firms' tendency to absorb policy-induced energy price increases varies depending on their characteristics and sectoral attributes. Not surprisingly, businesses in sectors that use substantial amounts of energy tend to react the most when prices go up. Although there is no conclusive evidence for firm exit or significant aggregate employment loss in response to energy price increases, the evidence does suggest potential shifts in the workforce within specific sectors, highlighting the need for careful policy responses. The literature presents compelling evidence of substantial substitution among various production inputs, notably between energy and labor inputs and among different energy sources. The necessary data for analyzing interfuel substitution requires comprehensive information on diverse energy inputs used by firms, which is not commonly available in standard firm-level data sets. Consequently, empirical insights into interfuel substitution mechanisms remain relatively scarce. Nevertheless, the overall picture emerging from the literature highlights widespread substitution. Particularly noteworthy are discernible disparities in the ability of firms to substitute between different fossil fuels, in particular between coal and gas, but also between fuels and electricity.

Finally, recent research offers insights into the relationship between government intervention energy price intervention in particular and innovation. The empirical field finds broad support for the weak form of the Porter hypothesis, in which policy interventions trigger innovation. In turn, the research does not appear to offer conclusive support for the strong Porter hypothesis, according to which environmental policy innovations spur firm competitiveness, productivity growth, and profitability. Overall, research does offer evidence that firms' responses to rising energy prices vary depending on their characteristics, with firm size being a particularly important factor. Another highly relevant aspect is managerial quality, given that well-managed and environmentally conscious firms are typically more responsive and adjust to changes in energy prices more successfully. Finally, firm-level responses to energy price increases vary by energy source or carrier: although firms have been observed to use Porter-type adjustment mechanisms in response to fossil fuel price increases, electricity price increases are typically found to have much more significant firm-level impacts, with relatively limited options for adjustment.