Published on 11 November 2022
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Energy crunch must not slow moves toward net zero

Russia’s invasion of Ukraine is affecting progress toward tackling global warming and causing tensions at the global UN Climate Conference in Sharm el-Sheikh. A key impediment is the triple policy challenge faced by developed economies: delivering affordable energy in Europe this winter; accelerating the transformations required to tackle climate change; and sustainably growing the economy, incomes and employment. In this first of a two part blog, Dimitri Zenghelis looks at the policy responses to the current crisis.

As global leaders gather in Egypt this week, the mood at this year’s major United Nations Climate Change Conference, COP 27, remains muted. Following Russia’s invasion of Ukraine, rich world governments have faced significant domestic budgetary pressures. This is limiting their propensity to cooperate on the more difficult questions, such as transferring clean finance to developing countries or compensation for the loss and damages they disproportionately inflicted on poorer countries from climate change. Yet in the longer term, the crisis has provided an impetus to accelerate the phase-out of fossil fuels and bring forward the energy transition. Indeed, considerable advances being made by the private sector are prompting governments from the United States (US) to India to push ahead with decarbonisation plans themselves.

Climate change, energy and economy challenges before the war in Ukraine

The economic recovery post Covid-19 was already fragile. Only in around half of the world’s economies has GDP (Gross Domestic Product) reached or surpassed pre-pandemic levels.[i] Moreover, governments recognise the need to enhance resilience to unexpected shocks, such as Covid-19. Governments across Europe are struggling to help people cope with huge increases in their energy bills because of the conflict, causing growing public indebtedness and limits on future fiscal policy.

Prior to the Russia-Ukraine war, there was already a significant gap between ambition to reach ‘net-zero’ emissions by around mid-century, under the Paris Agreement, even though severe climate impacts are already being experienced around the world.

On the economic front, some progress was being made with reducing a backlog of pandemic-disrupted global supply chains and mounting inflation. In the US, for example, survey-based measures were suggesting that ‘upstream,’ price pressures might be starting to diminish. Manufacturers’ order backlogs and lead-times for production material had apparently turned down from their peaks and inventories were starting to be rebuilt. Yet disruptions persisted, especially in China, with new Covid lock-down restrictions based on the country’s continuing ‘zero covid’ policies. More fundamentally, there remained growing concern over the prolonged stagnation in underlying productivity growth.

Challenges post-Ukraine

Since Russia’s invasion in February 2022, economic conditions deteriorated further. There have been sudden and sharp increases in food and energy prices. Global food prices surged by nearly 20% in the months following Russia’s invasion and have eased only somewhat since. European gas prices have recently been around 10 times above their average of the past five years.

Partly as a result, inflation is at rates not seen since the two great oil shocks of the 1970s and the inflation spike in 1988: for the OECD (The Organization for Economic Cooperation and Development) as a whole annual consumer price inflation topped 10½ % in September, its highest for 40 years. The reductions in real income are undermining aggregate demand, particularly in Europe. Leading indicators are now pointing to a contraction in world GDP.

Meanwhile, the impacts of higher costs of living are unequally distributed, impacting people on low incomes disproportionately, and leading to significant pockets of poverty in many OECD countries, as well as grave poverty in parts of the non-OECD world.

Policy response to the Ukraine war

In response, almost all central banks are raising official interest rates to prevent the initial inflationary impulse of higher energy and food prices from igniting a longer-term price/wage spiral. They are also responding to a renewed injection of demand from fiscal policy. The European Union (EU) and the UK are implementing policies to offset a significant part of the effect of higher energy prices on users, both for households and, in many cases, for industry as well. At latest count, the magnitude of the European package is around 2.2% of EU GDP; the UK’s package will probably turn out to be of a similar size relative to its GDP. European public sector indebtedness, already high, is increasing again.

The international political environment has also soured. Tensions have grown between the West and China[ii], and the West and other non-OECD countries, including India and Indonesia. All this is affecting the ability to collaborate on clean energy.

Impact on energy policies

Despite the challenges, most countries have not backtracked on their overall climate goals. In fact, the crisis has provided an impetus to accelerate plans to phase out fossil fuels and bring forward the transition to clean energy. Even before the Ukraine war, renewable deployment was growing rapidly on the back of sharp cost declines.  Now, the longer-term viability of gas as a transition fuel or ‘gas as a bridge’ has been called into question.

The EU, for example, has recently announced plans to nearly double domestic green hydrogen production to 10 million tonnes, and to import an additional 10 million tonnes of renewable hydrogen from third countries by 2030.

Action has also been taken around energy supply policies in speeding up enabling regulation, pricing, planning, and investment. The EU and the UK have recently announced plans to simplify their permission policies on rooftop solar panels. And the German government has pledged to make additional sites available for renewable energy projects, while removing bureaucratic barriers that can slow the planning and approval processes. Meanwhile, in the US, the Inflation Reduction Act aims to invest US$391 billion over the coming decade for energy security and tackling climate change, while the EU plans to spend about €200bn on renewable energy infrastructure as part of its REPowerEU programme.

On the energy demand side, there are efforts to scale-up energy efficiency programmes in residential and commercial buildings, through grants, insulation support, and tighter standards and regulations for new-builds. Denmark, for instance, has announced a ban on the installation of new gas boilers, and the EU and the UK have pledged to expand significantly the installation of heat pumps.

More generally, higher resource prices are likely to promote efficiency in industry and encourage greater recycling and reuse of materials. Industry will look to electrification or hydrogen and synthetic fuels where possible. ICT (information, communications and technology) products will play a key role in optimising resource use through network infrastructure and data and responsive digital demand management.  

Policy trade-offs

On the other hand, there are policy initiatives, responding to perceived short-term imperatives, that are not aligned, and may even conflict, with longer-term climate change objectives.

To keep the lights on, the ‘phase-down’ of coal has—understandably—been reversed, at least temporarily.[iii] Coal consumption in Europe and the US is likely to accelerate this year. There is also renewed investment in LNG (liquified natural gas) terminals in Germany, the Netherlands, Italy, and Greece, which could double Europe’s LNG import capacity. Such infrastructure is extremely costly and typically lasts for decades, risking a prolonged reliance on high-carbon energy supplies.

Likewise, many European countries have entered long-term contracts with alternative fossil fuel suppliers to replace Russian gas, thereby potentially locking in new dependencies in the longer term. The EU, for example, has signed new LNG deals this year with the US, Qatar, Azerbaijan, Egypt, and Israel.

A further risk of locking into high carbon production comes from granting new exploration rights or permits and initiating and accelerating new domestic oil and gas production infrastructure. The US has overturned the Biden Administration’s 2021 pledge to suspend new leases for oil and gas companies, by allowing oil and gas drilling to resume on federal lands as part of the Inflation Reduction Act.

The crisis also provides potential cover for ‘rent seeking’ behaviour by the fossil fuel sector, which may seek to turn short-term contributions to alleviating energy supply problems into a longer-term dependency on fossil fuel systems.

The design of electricity systems has not caught up with the revolution in renewable energy. In this context, marginal cost pricing systems that determine the cost of energy generated by renewables or nuclear by the price point for gas, need to be reformed.  The President of the EU Commission has recently promised a “deep and comprehensive reform” that would, “decouple the dominant influence of gas on the price of electricity.” The absence of longer term energy market reform has prompted demands for a windfall tax on the profits of all companies involved in fossil fuel production and use.

The policies being put in place to shield consumers from some of the impacts of high energy costs in the near term (e.g. price caps, non-targeted reductions of tax and fuel duties, or the reintroduction of fossil fuel subsidies) risk encouraging longer term fossil fuel energy use.[iv] Targeted income support would be preferable. Additionally, opposition to green levies on soaring energy bills risks curtailing funds for the development and deployment of low carbon technologies and systems.  The UK, for example, has temporarily scrapped the ‘green levy’ that typically accounted for around 8% of household energy bills. 

Finally, some elements of macroeconomic policies are not aligned with desired medium-term outcomes. For example, the perceived lack of fiscal space is prompting governments to bear down on public deficits and debt, which is likely to limit public resources available to promote and deploy clean infrastructure. The public sectoralso faces a direct loss of energy tax revenues because of the shift away from fossil fuels and emissions. On the other hand, government finances would benefit from taxing carbon more heavily, although the revenue potential of such policies will be limited in the long term as people change their behaviour and switch to renewables.

In these circumstances of sluggish growth, conflicting priorities and perceived budget constraints, how can momentum toward climate change targets be maintained, while ensuring an equitable energy transition and managing disruption to employment and livelihoods?

Part two: Response to energy crunch can and must align with medium-term objectives

[i] Specifically, at the time of writing (7 August 2022) 38 countries of 54 for which seasonally adjusted GDP estimates are available had surpassed their pre-pandemic GDP peaks.

[ii] The recently announced controls on US exports of advanced semiconductors and associated technologies to China has potential to seriously damage China’s medium term growth prospects.

[iii] Germany is delaying the closure of some coal- and oil-fired power plants, while Austria is reviving a retired coal power station. The Netherlands is lifting the limit on power from coal, while France is preparing a coal plant as a reserve for the winter.

[iv] While wholesale natural gas prices in the EU were around 10 times their average in the early months of 2022, demand had fallen by just 7%, with consumers shielded from these price rises by existing national price-regulation systems and new government intervention and contract designs.

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.

The views and opinions expressed in this post are those of the author(s).

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