Cyprus inflation surge exposes energy dependence, council says

The Cyprus Fiscal Council on Friday called for a shift away from broad tax cuts as a response to inflation, arguing in a presentation covering developments through August 2026 that support should instead be temporary and targeted at vulnerable households.

The presentation, titled “Inflation in Cyprus 2025-2026: From the energy shock to a fiscally prudent response”, examines the evolution of inflation, the contribution of energy, food and services, and the fiscal options available for supporting vulnerable groups.

The council described a sharp reversal in Cyprus’ inflation position, with the country moving from the lowest inflation rate in the European Union in 2025 to the third-highest in August 2026.

Cyprus recorded average inflation of 0.8 per cent in 2025, the lowest rate in the EU, with inflation close to zero between July and December.

The increase began in March 2026, when inflation reached 1.5 per cent, amid the crisis in Iran and disruption around the Strait of Hormuz.

By August, inflation had reached 5.2 per cent, according to the council.

The council said the speed of the increase demonstrated “the unusually high sensitivity of Cyprus to an external energy shock”.

Cyprus’ inflation rate was by then two percentage points above the euro area average, compared with being two percentage points below it a year earlier.

For 2026 as a whole, inflation forecasts stand at 3.3 per cent according to the Central Bank of Cyprus (CBC) and 3.6 per cent according to the European Commission.

The CBC expects inflation to ease to around 2.4 per cent in 2027.

Energy drives inflation higher

The council said energy was the initial trigger for the rise in inflation, with price pressures subsequently spreading to services.

Energy inflation rose from minus 8.8 per cent in February to 15.5 per cent in August 2026. Services inflation increased from 4.2 per cent to 7.4 per cent over the same period.

Restaurants and accommodation recorded inflation of 13.3 per cent, while transport prices rose by 9.8 per cent.

Food inflation increased from 2.4 per cent to 3.2 per cent. Industrial goods, by contrast, remained in deflation at minus 2.3 per cent.

The council said fuel prices were affected directly by the energy shock, while electricity prices followed with a lag of about two months.

It nevertheless noted that petrol in Cyprus remained among the cheapest in the EU-27, weakening the case for further tax reductions.

Electricity costs present a different problem for businesses. While household electricity charges are close to the EU average, businesses in Cyprus pay the second-highest electricity prices in the EU.

“For businesses, the high price is a competitiveness issue, not just an inflation issue,” the council said.

The council argued that the underlying problem was structural, pointing to Cyprus’ heavy dependence on imported energy.

“The root of the problem is structural,” it said.

Cyprus imported 88 per cent of its energy in 2024, compared with 57 per cent across the EU, with almost all of the imported energy consisting of petroleum products.

Petroleum products accounted for 86 per cent of available energy in Cyprus, compared with 38 per cent in the EU, while they represented 96 per cent of energy imports.

The electricity system is also isolated, with 76 per cent of electricity generation coming from oil.

The council said this dependence increased Cyprus’ exposure to international disruptions.

Every rise in the Brent crude oil price feeds through into the cost of fuel, electricity generation and transport, with the impact particularly significant for lower-income households and energy-intensive sectors such as hotels and transport.

The council added that without interconnection, storage and natural gas, the economy could not quickly switch to alternative energy sources.

Renewable energy production has increased, but Cyprus remains among the EU countries with the lowest share of electricity generated from renewables.

The share reached 21.5 per cent in 2025, up from 9.9 per cent in 2015, but remained below the EU average of 26.2 per cent.

The share of renewables in electricity consumption stood at 27.5 per cent in 2025, the fifth-lowest figure in the EU, compared with 49.9 per cent across the bloc.

However, the council said the main obstacle was not renewable generation itself but the ability of the electricity system to absorb it.

The system is forced to reject cheap solar power because of insufficient storage capacity and a lack of electricity interconnections, according to the council.

On energy storage, the council referred to batteries announced by the Transmission System Operator Cyprus and the Electricity Authority of Cyprus.

It said their installation was running about one year behind schedule.

The Great Sea Interconnector, known as GSI, was also facing delays, with no new official timetable available.

“The system remains isolated, without a reserve from the market,” the council added.

The arrival of natural gas through the Vasilikos project has also been delayed, with the original contract terminated and no official date given for the arrival of the first gas.

Fiscal response should be targeted

The council warned that broad tax cuts are costly and poorly targeted, while potentially concealing inflation temporarily rather than addressing its underlying causes.

It argued that energy costs could not be permanently addressed through tax measures.

“More domestic energy is needed, which can be stored,” the council said.

“Priority should be given to storage, networks and the energy upgrading of households, which permanently reduce exposure to oil and the cost of the emissions trading system,” it added.

The council stated that Cyprus had repeated what it described as “the 2022 recipe” during 2026, with successive extensions to reductions in consumption tax, electricity VAT and VAT on certain products.

The existing measures had a combined cost of more than €200 million, according to the council.

“Tax cuts ‘hide’ inflation today and return it when they expire,” the council warned.

It said that if tax reductions were used in response to an exceptional shock, they should be temporary, clearly limited and reversible.

The council also proposed establishing a “normal” inflation reference level capable of distinguishing an extreme shock from normal price fluctuations.

Its preferred benchmark would be the average inflation rate over the previous 36 months, expressed in current prices and adjusted using the underlying Harmonised Index of Consumer Prices, with a tolerance band of plus or minus 15 per cent.

Alternative benchmarks could include the cost of importing fuel, based on Brent prices in euros plus the average margin and applicable taxes, or the EU average before taxes.

“The deviation from the normal price can determine when, how much and for how long support is provided,” the council proposed.

Under its example framework, a deviation of up to 15 per cent would require no intervention.

A deviation of more than 15 per cent lasting less than 12 months would be treated as a temporary shock, with support restricted to vulnerable households.

If the deviation remained above 15 per cent for more than 12 months, it could instead be treated as a potential new price level, with support withdrawn gradually over six months.

Using this methodology, the council said only the period from 2022 to 2023 would have qualified as a “new level”, while all the deviations recorded in 2026 would be classified as a temporary shock.

The council warned that permanently suppressing prices could delay the economic adjustment needed to respond to higher energy costs.

It could also create the wrong incentives by encouraging greater consumption of imported energy while slowing the shift towards renewable energy and energy efficiency.

Such measures could further increase the fiscal cost without a predetermined limit and turn temporary interventions into permanent obligations, the council said.

Instead, it recommended phasing out support gradually and announcing the timetable in advance, while limiting price smoothing to vulnerable groups and for a defined period.

The fiscal space released as support is withdrawn should be redirected towards energy storage, electricity networks and upgrading homes to improve energy efficiency, according to the council.

The council concluded that fiscal policy should not seek to permanently contain prices through broad tax measures.

Instead, it should distinguish temporary shocks from permanent changes in relative prices and allow the economy to make the necessary adjustments.

Where support is required, the council said, it should be targeted and temporary, focusing on vulnerable groups rather than applying broad measures across the economy.