Published on 13 November 2022
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Response to energy crunch can and must align with medium-term objectives

The previous blog in this two part series described the current policy responses to the triple challenge of slow growth, the energy price crisis, and the need for energy transition. In this second part, Dimitri Zenghelis asks what should a strategic policy response involve, taking into account changes in technology and the economic environment?

Part one: Energy crunch must not slow moves toward net zero

The global economy is struggling with overlapping challenges, but there is promise amidst the gloom and uncertainty. Clean energy technologies, especially solar, batteries, and EVs (electric vehicles) have continued to advance unexpectedly strongly. Wind and solar accounted for three-quarters of newly installed global capacity in 2021. The International Energy Agency (IEA) estimates that spending on solar, batteries, and EVs is growing at a rate consistent with reaching global net zero emissions by 2050.

Over the past decade, the cost of wind energy has fallen by more than half, while that generated by solar PV (photovoltaics) has declined by more than 90% (Figure below). The cost of lithium-ion batteries, vital for storing power that is generated intermittently, has also fallen by a factor of nine. Today, both solar and wind are cost-competitive relative to thermal power generation, and are often the cheapest form of new generation capacity, even when accounting for the need to cover for variability.

Figure 1: The deployment and cost of key renewables.

Source: Grubb et al. 2021

These cost reductions are particularly welcome in the current energy crunch. By providing a substitute for expensive gas, renewable power generation capacity added in 2021 alone is estimated to have saved around $55 billion in global energy costs in 2022. Record solar generation in the northern-hemisphere summer enabled the EU to avoid spending €29bn on gas imports in 2022. In the longer term, renewable and energy-efficiency investments are likely to yield even more significant gains to capacity, productivity, and resilience. The growth rate of global solar installations in 2022 will hit its highest level in a decade, with over 250 GW (gigawatt) of capacity being installed compared to 182GW in 2021.

The clean transition affords ample medium-term scope for investment to relieve capacity pressures, cut costs and ‘crowd in’ productive investment (whereby it does not displace equally or more productive investment elsewhere). This is why the IMF (International Monetary Fund) claimed that increased public borrowing could boost growth if used to invest in job-rich, highly productive, and greener activities suggesting a $1 investment can generate $2.7 in added output.

Given the rapid change in the energy technology landscape, climate policy should focus on market shaping and market formation rather than fixing market failures. Only private finance can match the scale of climate action needed to deliver the net zero transition. Credible and predictable policy intervention can provide investors and companies with greater clarity and confidence that a low-carbon future will be a profitable one. This can lower the policy risk premium and unlock and steer £3–4 trillion additional global investment a year into clean sectors and away from unsustainable and risky asset accumulation.

Such large-scale and rapid transformation will be disruptive. Workers in fossil fuel-rated sectors will need to be re-tooled and re-skilled if society is to affect a ‘just transition’, whereby all benefit from the opportunities offered by growth in renewables and clean technologies.

Nevertheless, barring further unexpected shocks, the macroeconomic environment will improve, bleak as it looks at the moment. Inflationary pressures have started to ease in many countries. Monetary policy will continue to tighten as policy rates rise, and it may take several years to bring inflation durably back down towards the 2% that previously many central banks had been targeting. But overstretched supply chains are likely to continue to ease progressively, helping to reduce inflation as economies adapt to any permanent changes in the structure of demand.

Workers may return to the labour force, following a temporary withdrawal, as they find that their savings are becoming depleted by recent unexpectedly fast inflation. This may push up unemployment but will help ease inflationary pressures.

Although new clean energy investment will remain vulnerable while central banks are raising nominal interest rates (as they tend to be capital-intensive or, in some cases, are sensitive to valuations based on higher future revenues which are more keenly discounted), real interest rates after adjusting for inflation are likely to stay low. Indeed,  real interest rates have been at historic lows ever since the Global Financial Crisis in 2008.

A long period of weak investment following the financial crash of 2008 coincided with a demographic peak in workers of prime earning and saving age which led to a surplus of desired saving over desired investment.

Moreover, as the IMF has pointed out, saving has tended to be boosted in many countries by the shift in the distribution of income towards those people at the higher end of the income spectrum. They tend to save at a much higher rate than middle- and lower-income households, so that the richest 10% of households account for most aggregate saving. This basic situation – strong desired savings relative to desired investment – seems likely to endure at least in the short run. Such conditions favour a return to low inflation and low real interest rates, but they also indicate ample scope for investment in activities that offer a real return greater than zero.

Indeed, deficient investment remains the key risk and greatest policy challenge. It limits productivity gains, constrains the growth of earnings of those in work, and thereby their ability to meet their needs. It inhibits the supply of infrastructure needed for the clean transition and for investment in future growth. Stagnation thereby breeds stagnation – a bleak spiral policymakers must actively seek to break.

The sustainability of the public debt, a key concern following sharply higher public borrowing to support livelihoods during the Covid-19 pandemic followed soon after by additional borrowing to help people cope with rising energy bills, is in part undermined by the prospect of slow growth resulting from insufficient investment. Outcomes will depend in part on the growth of productive capacity: it is the denominator, rather than the numerator, that largely drives debt/GDP sustainability.

Conclusion – The short-term response must align with medium-term objectives

Policies that are made with an eye to the longer term will help increase energy security, debt sustainability and resilience to future shocks. These are always known unknowns – we do not know what form they will take but there will certainly be some. But a number of trends seem reasonably clear. For example, the digital, low-carbon transition is set to continue, offering new opportunities for profitable investment, lower costs and new market opportunities for early movers. At the same time, there is a growing risk of stranded assets for those sectors which remain greenhouse gas- and resource-intensive.

The macroeconomic environment is challenging now, but it will improve. While governments must take the necessary steps to address immediate needs, they should avoid policies that run counter to their longer-term aims, including locking in fossil fuel supply and discouraging investment in pursuit of short-term fiscal retrenchment. The energy crunch offers an opportunity to support private and public investment in new technologies. This holds the key to a more productive, resilient and sustainable future.

Part one: Energy crunch must not slow moves toward net zero

A more detailed account of these issues can be found in the Background Paper – Foot on the gas? Maintaining momentum for net-zero while responding to the war in Ukraine – by Dimitri Zenghelis and John Llewellyn to support the 43rd meeting of the OECD Round Table on Sustainable Development (RTSD), held on 21 October 2022.


Dimitri Zenghelis

Dimitri Zenghelis

Special Advisor: The Wealth Economy

Dimitri Zenghelis is a Senior Visiting Fellow at the Grantham Research Institute at the LSE where, from 2013-2017, he was Head of Climate Policy. In 2014 he was Acting Chief...

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