Key points:
- The escalating regional conflict in the Middle East risks contributing to spikes in prices of oil and gas.
- Studies have found that volatility in fossil fuel prices during the 2021-2022 energy crisis was a major driver of inflation in Europe, Asia and the United States, despite the best efforts of governments to keep energy costs down through expensive compensation measures. In the EU, gas prices accounted for 36% of inflation, and around a third of US inflation in June 2022 was from energy prices.
- Countries can reduce their exposure to fossil-fuelled inflation by replacing oil and gas use with electricity based on homegrown renewable energy. Regions with more solar and wind energy were more resilient to price shocks during the energy crisis.
- Solar and wind energy are estimated to have saved European consumers nearly EUR 100 billion during the energy crisis, limiting the economic damage following Russia’s invasion of Ukraine.
Deploying renewable energy as an alternative to fossil fuels reduces exposure to volatility
There are renewed fears that conflict in the Middle East could lead to high oil and gas prices, contributing to ongoing inflation with the potential for severe economic impacts around the world. We know from experience that this is likely to be the case, as sharp fluctuations in the price of fossil fuels have previously driven up inflation.
Oil and gas prices are severely affected by geopolitical risks, but this is only one aspect of their volatility. Another is the constant need to explore and extract for these finite resources – processes which are susceptible to swings in international supply and demand. This can lead to more frequent cost spikes and greater potential for price volatility.
In contrast, renewable energy can be more predictable. While there are significant upfront costs and some volatility in production costs (e.g., construction costs and interest rates), renewable power has zero fuel costs once installed. This removes a key aspect of the price volatility associated with fossil fuels. The absence of fuel costs allows renewable energy producers to enter into long-term fixed-price contracts.
Countries can also reduce their exposure to fossil fuels by switching to electrified alternatives in other sectors, such as electric vehicles. This can be particularly attractive at a time of high oil prices. Delaying the phase out of internal combustion engine (ICE) vehicles increases countries’ reliance on volatile oil markets.
For these reasons, a special report from the International Energy Agency (IEA) concluded: “The transition to a more electrified, efficient, renewables-rich energy system will reduce overall exposure to fossil fuel price volatility.”
Renewables lead to greater resilience
There is a clear link between reducing exposure to fossil fuels and increasing resilience. At the end of 2022, Fabio Panetta, member of the Executive Board of the European Central Bank (ECB), argued in a speech that: “If the green transition had happened earlier […] we would have reduced our exposure to the current energy shock and its inflationary consequences. The European economy would have been more resilient to the ongoing energy crisis.” Civil society organisations have made similar arguments and called on the ECB to invest in the green transition as a way to manage inflation.
A 2023 study by a German research institute also found that “fossil fuels added to the economic and political instability of recent years. Replacing them with renewables can become a pillar of future stability” as it can help avoid price volatility.
The IEA found that solar and wind energy would contribute to European consumers saving nearly EUR 100 billion between 2021 and 2023, helping to contain the economic damage in the wake of Russia’s invasion of Ukraine. Research by IRENA finds that the regions that were more resilient to price shocks were those that had more solar and wind energy. The same report estimates that in 2022 renewable energy added since 2000 helped to bring down the fuel bill in the global electricity sector by USD 520 billion.
The role of electricity markets
The ability of renewable energy to reduce exposure to fossil fuel volatility depends on electricity market design, namely the extent to which the marginal producer, such as a power plant running on coal or gas, sets the final retail electricity price. A recent IMF working paper concludes that a higher amount of renewable energy would not necessarily be reflected in protection from fossil-fuelled inflation in some market structures. This is because: “as long as the marginal producer is a gas fired power plant, it does not matter whether 5% or 75% of electricity production comes from renewables, power prices and gas prices move in sync”.
The same paper notes that during the 2022 energy crisis the European Commission agreed to allow Spain and Portugal, two countries with high shares of renewable energy, to decouple gas from electricity generation by putting a cap on gas. Some studies suggest that this benefited Spanish consumers and has been a factor in the country experiencing lower inflation compared to other countries in the EU during that period.
The question for policymakers, in particular in oil and gas-importing nations, is whether they will learn the lessons from the current crisis and the 1970s oil crises and act to permanently reduce their economies’ vulnerability to fossil fuel price volatility.
We have been here before: Lessons from the 1970s oil crisis and high inflation
In 1973 the Arab-Israeli war prompted producers such as Saudi Arabia to suddenly cut oil supplies to the United States, Europe and Japan. One consequence was significant inflation in these countries.
In 1975 the United States created a mechanism to protect itself from global shocks to oil supply called the Strategic Petroleum Reserve (SPR). During the Biden administration, at times of high oil prices, the government released oil from the SPR with the intention of lowering oil prices, but the precise impact was unclear. Ultimately, this was only a temporary reactive measure.
Another measure taken by oil-importing countries in the 1970s was to increase public research and development into solar, wind, battery and electric vehicle technologies. This was crucial to the ongoing testing, development and wider deployment of these technologies. This highlights the importance of a longer-term response to create viable alternatives to fossil fuels as a means to enhance resilience.
Spiralling fossil fuel prices drive inflation
Oil and gas prices shot up in late 2021 and early 2022 as the global economy bounced back from Covid-19 lockdowns and then Russia invaded Ukraine. Multiple studies tracked the impact of these price increases and found they were a major factor in rising inflation, referred to by some as “fossilflation”. Expensive oil and gas had knock-on impacts on sectors throughout the economy because of growing transport and energy costs.
A particular problem was that electricity prices in many countries were set by the final energy source, which in many cases was gas. In the European Union (EU) gas prices went up by 40.8% in September 2022 compared to a year before, which overall contributed to 36% of inflation. In the United States around a third of the 9.1% inflation rate in June 2022 was from energy prices.
In Europe research showed that: “On average, 50% of year-on-year inflation in 2022, when the inflation wave peaked, was directly due to energy, the vast majority of which was from fossil fuel price rises.” This trend was present in countries across the continent. In various periods of 2022 fossil fuels (mainly fuels for transport and gas for electricity and heating) drove up inflation by nearly 40% in France and Poland, around 30% in Germany and Italy, and by up to 25% in Spain.
Meanwhile, studies in Asia show similar results. Fossil fuels contributed around 20% to India’s rate of inflation and up to 24% in Japan. The Bank of Korea specifically identified oil import costs as a key reason for rising inflation in South Korea. In Bangladesh diesel price volatility is estimated to have increased non-food and food items by around 13% and 17%, respectively.
A common reaction by governments in these countries was to try and lessen the impact on businesses and citizens. These efforts had a significant impact on national finances. Since September 2021 it is estimated European countries had put aside €651 billion in an attempt to shield their populations from rising costs, of which around €158 billion was in Germany and €103 billion in the UK. The Japanese government introduced a stimulus package of more than 25 trillion Yen (USD 170 billion) to compensate for growing electricity and gasoline prices.
Despite these efforts, consumers still ended up spending more on energy. The IEA calculated that: “Consumers around the world spent nearly USD 10 trillion on energy in 2022 – an average of more than USD 1,200 per person – even after considering the subsidies and emergency support mobilised by governments. This is nearly 20% more than the average over the previous five years.”
Reducing exposure to fossil-fuelled shocks
In the long term, countries that produce more renewable energy will have more capacity to contain inflation due to the zero fuel costs of this power and reduced exposure to globally traded fossil fuels. Researchers have argued that given the government’s limited ability to influence inflation through other means a viable option to address energy price volatility is to increase the use of renewable energy.
Modelling by Cambridge Econometrics concludes that “investing in renewables and energy efficiency today will help limit the negative effects of oil and gas price shocks in the short and long run, and make the global economy more resilient to such shocks”. They warn that if business as usual continues and there were to be another shock to oil and gas prices on the scale of the 1970s oil crisis, then by 2040 the cost to the global economy could be 8% of global GDP, or USD 10 trillion.
