Over the last year, a sharp rise in energy prices – including natural gas, coal, and oil – has contributed to renewed fears that higher input costs could constrain industrial production, reduce household real incomes, and slow economic activity. Relative to pre-pandemic levels, global crude oil prices are now up roughly 50%.

In a historical context, this is not uncommon: Since the 1990s, the year-over-year increase in oil prices has exceeded 50% roughly once every three years. In the U.S., while fears that higher energy prices will act as a regressive tax on consumers are warranted, the overall burden from higher oil prices is still considerably below past peaks.

However, the long-term transition away from carbon and toward green energy is likely to be marked by a period of generally higher and more volatile energy prices. Underlying the geopolitical risks that have escalated recently, uncomfortable vulnerabilities that have arisen from these green initiatives are reflected in today’s price moves.

Shifting away from carbon

Recent events concerning Russia and Ukraine have contributed to heightened energy market volatility and generally higher prices. However, the volatility started before these tensions escalated, suggesting that the price drivers have deeper roots than the currently heightened geopolitical risks. Indeed, the recent price escalation has happened amid structural changes in energy capital markets given the pressure to reduce global economic reliance on fossil fuels. Poor returns have also led many energy companies to prioritize balance sheet repair and returning capital to investors, which has further inhibited the normal investment and production response to higher prices.

What’s more, the need for a more dramatic reallocation of resources to meet Paris Agreement climate goals implies that fossil fuel prices are not only likely to remain elevated, but may even need to rise further: Higher prices for carbon-based energy are needed to provide the economic incentives to spur the necessary investments in green energy that should eventually bring overall prices back down.

Government actions to facilitate the transition are further complicating the situation. Policies aimed at restricting hydrocarbon production growth and reducing coal and nuclear power usage have gutted many of the energy sources economies rely on, leaving energy supply more susceptible to increasingly volatile weather patterns. Germany’s recent announcement to halt the certification review of the Nord Stream 2 pipeline, which would have transported additional natural gas supplies from Russia to Europe, has only exacerbated these issues.

Without sufficient backup storage, many economies are likely to face greater levels of energy insecurity, and as a result, higher vulnerability to even moderate energy shocks. This increased vulnerability could spill over into political and monetary policy spheres, contributing to more volatile and uncertain policy regimes. And all of these factors are likely to create a more uncertain environment for downstream businesses.

In other words, as we discussed in our latest Secular Outlook, the brown to green transformation is one reason we believe that the pre-pandemic New Normal decade of subpar but stable growth, below-target inflation, and subdued volatility is largely behind us, while elevated preferences to save (to create more resiliency amid uncertainty) could offset upward pressure on interest rates from greater investment (for a greener future), and ultimately help keep interest rates low.

Higher energy prices are key to the green transition

Many economists agree that to reach the Paris climate goals, we need a global price on carbon. The main purpose of carbon pricing is to reduce the emissions that contribute to global warming. Carbon dioxide is a negative externality of producing energy-intensive goods, and raising the costs of these goods turns away both consumers and producers. Higher energy costs also provide a strong incentive to invest in alternative, less carbon-intensive sources.

But just how high do energy prices need to go? According to a recent Reuters poll, climate economists estimate the price of carbon would need to average $100/ton to reach net zero emissions by 2050. However, only 22% of the world’s emissions are currently covered by a carbon tax and/or trading scheme, and most carbon prices are a fraction of the $100/ton estimate. Only in a few places are those taxes or carbon prices steep enough to change people’s behavior. Energy prices likely need to rise further to provide the needed incentives to bring emissions down.

Approaches differ across developed markets

Despite the majority of economists’ beliefs that setting an explicit price on carbon is the most efficient way to bring down emissions, jurisdictions with some of the most aggressive carbon pricing schemes, namely Europe, have been at the epicenter of the recent energy price spikes. In the EU, carbon prices are set under the Emissions Trading System, and have recently reached as high as €97/ton (roughly $110/ton). Although these prices are a strong incentive for investment in renewable energy sources, those investments will take time to yield additional energy capacity. In the meantime, higher carbon prices have discouraged substitution between natural gas and coal in response to the gas shortage, leading to much higher natural gas prices in Europe than would have been expected without a carbon price. These higher prices are, in turn, rippling through the supply chain, increasing the cost of production and lowering household real incomes.

Meanwhile, in the U.S., although a dozen states have established carbon trading markets, the federal government’s focus has been on placing an implicit cost on emissions via stricter regulation of fossil fuel development. This, plus the higher capital costs in global markets, have weighed on the U.S. oil and gas industry, and resulted in a much slower ramp-up of U.S. shale oil production in response to higher global oil prices (and less U.S. production, in turn, has contributed to higher prices). Nevertheless, in contrast to Europe, the U.S. has benefited from a relative abundance of natural gas. U.S. natural gas prices are largely disconnected from the rest of the world, blunting the economic toll on domestic industry, consumers, and households.

More investment in the energy transition is needed

Higher fossil fuel prices and government green energy initiatives have spurred renewable energy investment and growth in electric vehicles. However, much more investment is needed to meet energy demand and provide stable supply, and the progress to date has left energy security across the globe vulnerable to weather fluctuations. Furthermore, as fossil fuel and nuclear plants are shuttered, investment in energy storage (large-scale batteries) has lagged, increasing the need for excess capacity buffers to blunt any weather-related swings in renewable energy production. While there are hopes for technology breakthroughs on storage, and investment has picked up, we expect the system will increasingly become dominated by intermittent energy sources over our secular horizon.

Energy prices affect nearly every industry

Higher energy prices have broader implications than winter heating bills and retail gasoline prices. They also drive higher production costs for most commodities. For example, higher energy prices tend to increase the price of ammonia fertilizers (which are produced using natural gas), in turn lifting the cost of most agriculture production. In the U.S., food prices are already up 6.7% in the 12 months through January 2022 – the fastest single-year acceleration since the 1990s (source: U.S. Bureau of Labor Statistics). Food price inflation in Europe has also accelerated, with more price hikes likely to come.

Higher energy prices also affect the movement, fabrication, and mining of virtually every product. Across developed markets, we estimate that a 10% increase in oil prices has historically raised consumer prices by 0.2–0.3 percentage points. While the historical pass-through rate may sound small, the prospect for sustained higher prices could push producers to pass through a greater portion of the additional costs in the future.

Key takeaways: inflation, policy, investment

Higher and more volatile energy prices have meaningful implications for inflation and economic activity. As we look to the secular horizon, carbon may be a major component in inflation, particularly as regions with carbon prices – such as the EU – look to impose border adjustment mechanisms to effectively export their carbon policies abroad.

This in turn will have implications for the political sphere, and for monetary policy. Public backlash to lower real incomes seems inevitable, in our view, without government energy subsidies to cushion the blow. Meanwhile, a more prolonged period of energy inflation could raise longer-term inflation expectations and result in tighter monetary policy despite the supply-side nature of the shock. Indeed, energy prices may already be influencing the policy outlooks of developed market central banks, such as the European Central Bank.

Finally, higher expected input price volatility and a generally more uncertain operating environment will likely have important implications for downstream businesses. Many companies have already shifted their operating focus toward building resiliency instead of efficiency. This argues for higher reserves of cash, capacity, and inventory to weather potentially more frequent shocks. This trend toward resilience (for saving over investing) may help offset the interest rate pressures inherent in the higher investment requirements of the green transition.