July 04, 2022
Stagflation and Net Zero
Professor Brian Sturgess, Chris Hill and Oliver Ontiveros

Summary

 

• The cost of electricity, gas, and oil will continue to rise globally in the coming years.


• The UK government is hiding behind the short-term consequences. It is not honestly communicating the economic cost of moving to net-zero by 2050 and meeting the planned carbon reductions by 2030.

• While the most vulnerable households will receive at least £1,200 this year, the energy bill discount starting in October will be doubled to £400 with no requirement to pay it back.

• The cost of purchasing wholesale energy can account for up to 40% of a customer’s overall bill.

• The rise in gas prices has been phenomenal. The UK uses gas to generate just under 40% of electricity.


• The UK’s excellent record in meeting carbon emissions targets has been partly due to the growth in renewables. Renewables provide electricity at a low marginal cost, but supply can be unreliable.

 
• Nuclear power is to be rejuvenated but given the amount of time it takes to commission nuclear stations, offshore wind will have to play a much greater role in the transformation.

 

• Over 80% of homes use gas for heating compared to 7% using electricity.• Until lower carbon gas is phased out and nuclear is expanded or hydrogen technology advances, lithium-ion storage batteries will be needed to prevent frequent power failures by assisting grid operators to balance electricity supply and demand.

 

• The total pipeline of battery projects has increased to 32.1GW, but the planning system is not processing these fast enough.

 

• Coal still accounts for over 40% of world electricity generation. Chinese economic growth since 1990 and the electrification of the Indian economy, were mainly based on coal.

 

• The current pain felt by consumers in terms of general inflation and rising energy prices is only the start of a long-term trend as the world invests to combat climate change.

 

It is popular to blame the invasion of Ukraine on rising energy inflation, particularly oil and gas prices, but there are sound structural reasons why the cost of generating electricity from these sources will continue to rise globally in the coming years. Russia’s militarism is a humanitarian disaster and will place inflationary pressures on food prices, but despite these problems, the UK government is hiding behind the short-term consequences and is not honestly communicating the real economic cost of moving to net-zero by 2050 and meeting the planned carbon reductions by 2030. In addition, the policy measures such as raising interest rates that are being promoted by many economists to meet the problem of stagflation (rising prices and falling output) will only exacerbate the pathology, while making the transition to a low-carbon future more painful.

 

Meanwhile, the headlines are dominated by quick policy fixes, which only kick the can down the road. The Chancellor of the Exchequer, Rishi Sunak, has finally responded to the rising cost of household energy bills by announcing a £15 billion package of targeted help for 8 million beleaguered UK households and while the most vulnerable households will receive at least £1,200 this year, the energy bills discount which was due to start in October will be doubled to £400 with no requirement to pay it back anymore. The measures are in response to the decision by energy regulator Ofgem to raise the Price Cap by 54% because of the rising wholesale prices faced by energy distributors. The cost of purchasing wholesale energy can account for up to 40% of a customer’s overall bill and Ofgem considers wholesale prices when setting the level of the Price Cap twice a year in February and August.  


When the Facts Change

The problem with blaming rising energy inflation on the talented or not Mr. Putin is that it does not fit the facts. Gas prices had been rising well before the threats of an invasion of the Ukraine and the military action on the security of Europe’s gas supply. Rising gas prices from the end of 2020 was not due to supply issues, but to a rising demand for gas to generate electricity particularly in the United Kingdom, which imports a very small proportion of gas consumed from Russia compared to some other major European countries.

The rise in gas prices has been phenomenal. From February 1, 2021, to December 20 the same year according to Ofgem data, the wholesale price of gas in the UK had risen by 459% from 48.3p to 270.1p per therm. Given that the UK uses gas to generate just under 40% of electricity this has had an inflationary impact on wholesale electricity prices which rose as illustrated in Chart 1 353% from £53.1 to £240.6 per MWh.

 

Chart 1: Wholesale Gas and Electricity Prices in the UK



 

Source: Ofgem

 

 

Britain has become increasingly reliant on gas which generated 139.1 TWh of electricity in 2019, up from [1] only 0.4 TWh in 1990. During that period, nuclear supplied a stable amount of electricity from 19.7% to 17.4% by 2019, while electricity generated from oil and other fuels [2] fell from 6.4% to 2.8%. The staggering structural change over this period has been the end of the coal era in Britain with the electricity generated from this source falling from 229.9 TWh in 1990, 71.9% of all electricity generated to 7 TWh by 2019. The UK’s excellent record on meeting carbon emissions targets has been partly due to the growth in variable renewables with wind and solar generating 28.4% of all electricity by 2020 from nothing three decades earlier, but the main green contribution has been the rapid decline in the use of highly polluting coal.

 

Renewables provide electricity at a low marginal cost, but their unreliability when the wind does not blow, or the sun does not shine has meant that any disequilibrium between electricity demand and supply has been met by increased use of gas, which although it is more costly on a per-unit basis, at least this fossil fuel emits only half the carbon emissions of coal. A dramatic fall in the use of coal and an increased use of renewables balanced by gas has given the UK the ability to reduce total carbon emissions relatively smoothly without any real economic pain being felt by consumers. The much-maligned impact of the £160 green levy on energy bills is trivial beyond these positive winds. The reduction in the use of oil to generate electricity has also meant that this century’s instability in crude oil prices rising sharply with spikes from 2000 to 2009, in 2012 and this year have been mainly felt by the transport sector and less so by domestic consumers of electricity in the UK.

 

Perhaps the most important factors easing the transition to a lower-carbon economy in the UK in the last decade have been the absence of inflationary pressures and a regime of lower interest rates, as these were the Bank of England’s primary policy response to the financial crisis of 2007 and to the Covid pandemic in 2020. These favourable influences will no longer hold to help the UK transform its economy in the count-down to net-zero whatever the outcome of Russia’s war and its impact on global energy security. Meanwhile, the government is not communicating what the coming energy transformation will really involve apart from promising a low carbon, low energy cost final future destination. The success in reducing carbon emissions over the three decades to 2019, removing the pandemic outlier year of 2020, took place by mainly switching gas for coal, as variable renewable generation capacity rose, but there was also a more efficient use of electricity in supporting economic activities. Aggregate electricity generation rose by only 1.3% from 319.7 TWh in 1990 to 323.8 TWh in 2019 while GDP at constant prices increased by 77% over the same period.

 

The government has recently announced an impressive, albeit expensive, wish list of new investments to meet both the climate crisis and the reliance on imported energy by accelerating past trends in its Energy Security Strategy published in April of this year.[3] Nuclear power is to be rejuvenated with the capacity tripling from 6.9 GW to 24 GW by 2050, but given the amount of time it takes to commission nuclear power stations, offshore wind will have to play a much greater role in the transformation. The target for wind farms is set at 50 GW by 2030 compared with 11 GW currently and planning regulations to approve a wind farm are expected to be expedited from 4 years to 1 year. Solar capacity, grid-scale, commercial and domestic, will be encouraged to expand from a current capacity of 14 GW by five times. Hydrogen capacity is planned to increase to 10 GW by 2030, according to government documents.

 

Whether or not this planned electricity generating capacity will meet the additional demand pressures caused by the electrification of transport remains to be seen more likely in the years after 2030. In the next decade the need for gas in the UK and globally, will not go away. At present, in addition to the gas needed for electricity generation, British homes are heavily dependent on gas boilers for heating and consumed 299.3 TWh in 2019, 8% more than required for the former use. Over 80% of homes use gas for heating compared to 7% using electricity, [4] but in a short-term reaction to the current energy crisis, rightly or wrongly, the government plans to place the climate levy onto gas bills to encourage households to move to heat pumps have been shelved. [5]

 

The British Energy Security Strategy pragmatically recognises the importance of gas by admitting that in meeting net-zero by 2050, the UK will still use a quarter of the gas that is now consumed. Less probably the government expects a 40% reduction in gas consumption by 2030, but in the face of the invasion of Ukraine and the high carbon cost of imported LNG, wants to stimulate further production in the North Sea. The strategy confirms a new licensing round for offshore oil and gas projects and there will be a review of the evidence on fracking. Furthermore, despite the Chancellor’s recent announcement of a new temporary Energy Profits Levy on oil and gas firms expected to raise around £5 billion, there will be a new 80% investment allowance to encourage firms to invest in oil and gas extraction.

 

 

It’s a Gas

 

The British Energy Security Strategy outlines the continuing importance of gas but does not stress that there has been a failure to invest sufficiently in large-scale battery storage as the capacity of renewables increased while phasing out coal. A new industrial revolution scale expansion of wind and solar will provide a future of low-cost electricity for consumers and businesses, but this nirvana is balanced by the unreliability of these sources. Until lower carbon gas is phased out and nuclear is expanded or hydrogen technology advances, lithium-ion, currently the most popular, storage batteries will be needed to prevent frequent power failures by assisting grid operators to balance electricity supply and demand. Batteries also provide an extra resource when needed, for maintaining stability within the electricity system. Unfortunately, operational battery storage capacity is currently 1.4GW. The total pipeline of battery projects has increased to 32.1GW, but the planning system is not processing these fast enough. [6]

 

Even if Britain manages to successfully build up renewables while relying on domestically produced gas, the problem is global. Britain may have almost phased out coal as a source of electricity generation, but as Chart 2 shows coal still accounts for over 40% of world electricity generation. Chinese economic growth since 1990 and the electrification of the Indian economy, were mainly based on coal. In 2020, coal-generated 63% of electricity in China and 72% in India. In consequence, the world has doubled its coal-fired capacity since 2000 to over 2000 GW. However, to meet the agreed COP 26 carbon reduction targets by increasing wind and solar capacity while maintaining each country’s grid integrity, the demand for gas will soar with only a modest reduction in coal consumption across the world pushing up its long-term price, a fact that strategists in major gas-producing countries such as Russia cannot be unaware of.

 

 

Chart 2: Global Electricity Production Energy Source 1985 to 2021

 

Source: Our World in Data

 

 

That Dirty Nasty Oozy Stuff

 

The end of the Cold War and the expansion of world GDP resulting from the entry of China onto the world stage, has meant that the structural transformation of the energy sector has taken place during decades of relatively low inflation. The irredentism of a military aggressive Russia, the frictions between the USA and China and the worsening global supply chain issues as the global economy recovers from the pandemic, means that these low inflationary conditions will no longer hold. The current pain felt by consumers in terms of general inflation and rising energy prices is only the start of a long-term trend as the world invests to combat climate change. In the next few years, this pain will be exacerbated by the inappropriate monetary policies adopted by the Bank of England and the Federal Reserve.

 

Faced by the spectre of 1970s style stagflation, the main monetary authorities are employing an out-of-date tool kit which by raising interest rates prematurely will provoke a recession and will not address the structural causes of inflation particularly in the price of energy. John Maynard Keynes once wrote: “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” In this case the scribbler is Milton Friedman whose main thesis was that inflation is ‘always and everywhere a monetary phenomenon’. Since then whenever there are inflationary pressures in an economy, someone will resurrect Friedman’s ghost and blame central banks or governments for printing too much money.

 

There are many types of inflation and very few of them meet Friedman’s simplified form of a general rise in all prices as specified by the theoretically naïve Quantity Theory of Money. Inflationary and deflationary periods also see large changes in relative prices and have structural causes and consequences.[7] Monetarism always treats inflation as a uniform rise in prices and sees the cure in terms of reducing the supply of money by raising interest rates. However, not only does this cause recessions reducing output and worsening stagflation in the short run, but by raising the cost of capital it discourages the investment made necessary to adapt to the structural forces that sparked the inflation.

 

Inflation is not always a general rise in prices. To take an example from the energy market, while the price of gas rises by 50%, the price of electricity for businesses and homes might rise by 100% with effects on consumer spending and supply chains, while the cost of generating electricity by wind, falls by 5%.

 

The problem the world faces can be illustrated by Chart 2 and Chart 3. In 1973, according to World Bank data, oil was used to generate 21.3% of the world’s electricity. The oil price shocks of 1974 and 1979 produced not only inflation, but sharp falls in GDP which in the latter case was worsened by the interest rate rises employed to combat price rises. Structural change, not because of a need to reduce carbon emissions, but in reaction to price substitution and a drive for energy security reduced the importance of oil. The global use of oil in electricity generation had fallen to 10% by 1991 and had reached 3.3% by 2015 mainly because of changes in the developed world. Later oil prices rises, such as the increase from $12 per barrel in 1999 to $93 by 2009, had inflationary effects on global food prices, but the downturn in real GDP in the UK of 4.2% in that year were more a consequence of the global financial crisis. The sharp upturn in oil prices in 2021 has been due to a post-pandemic recovery of demand in the global economy which has affected coal and gas prices pushing up the cost of electricity generation whatever the source of energy.

 

 

Chart 3: Oil Prices and GDP in the UK 1971 to 2021

 

 

 

Source: World Bank

 

 

A Perfect Storm

 

The global economy is facing a perfect storm with energy costs rising because of structural causes and because of the pledges made to reduce carbon emissions paradoxically by the EU, the UK, and the USA. Whatever the outcome of the Russian-Ukraine crisis, the long-term need for gas will grow as these countries invest in variable renewables pushing up energy prices, but raising interest rates will not control this inflation, which is structural.

 

This prescription for monetary inflation, a la Freidman, will only hasten and deepen an approaching world recession. Unfortunately, while the Federal Reserve is committed to raising rates as is the Bank of England, the European Central Bank will have to follow to prevent currency depreciation from causing imported inflation. This is reminiscent of the currency depreciations carried out by the leading economies during the beggar-thy-neighbour policies of the 1930s. In that case, the objective was to prevent the importation of deflation, but the result was a breakdown of international cooperation and a slide to global war. Governments in the West have made major commitments to accelerate investment in solar and wind, but only shifting generation to oil and gas in the short-term will push emissions down to 2010 levels so that developed countries can meet their 2030 emission targets. This is not good news for consumers of energy prices in countries without natural gas and oil reserves.

 

[1] https://assets.publishing.service.gov.uk/government/uploads/
system/uploads/attachment_data/file/1032260/UK_Energy_in_Brief_2021.pdf


[2] Including Electricity from pumped storage

 

[3] https://www.gov.uk/government/publications/british-energy-security-strategy

 

[4] https://www.energy-uk.org.uk/publication.html?task=file.download&id=5714

 

[5] https://www.thetimes.co.uk/article/cost-of-living-crisis-puts-160-green-levy-on-the-backburner-n7rlhftrb

 

[6] https://www.renewableuk.com/page/EnergyPulse

 

[7] https://mpra.ub.uni-muenchen.de/5624/8/MPRA_paper_5624.pdf

 

BACK TO NEWS
Copyright 2021 ENVIROTECH.
We use cookies to provide the services and features offered on our websites, to monitor their use and to improve user experience.
Learn more about our approach to your privacy by reading our Privacy Policy. There's more information about cookies available at www.aboutcookies.org.uk