Fabio Panetta: Greener and cheaper: could the transition away from fossil fuels generate a divine coincidence?

Speech by Fabio Panetta, Member of the Executive Board of the ECB, at the Italian Banking Association

Rome, 16 November 2022

The EU economy^[1] is highly dependent on fossil fuels^[2], which represent close to three-quarters of its total energy consumption. Most of this fossil fuel energy is imported: while the EU accounts for 8 per cent of global fossil fuel demand, it accounts for only 0.5 per cent of global oil production and 1 per cent of global gas production.

A major cost of this dependence - which we are reminded of daily - is that energy-producing countries can use their fossil fuel exports to pressure or even threaten energy importers, creating geopolitical tension in the process. Historically, the price of crude oil has often spiked in the context of war, as is the case today. This underlines the need to reduce our dependence on fossil fuels.

Another huge cost of our reliance on fossil fuels is climate change. The earth is warming rapidly, with massive risks to ecosystems and humans, and urgent action is needed to reduce our consumption of fossil fuels and shift to green sources of energy.^[3]

At the global level, energy generated from oil, coal and natural gas makes up more than 80 per cent of primary energy consumption. According to the Network for Greening the Financial System (NGFS), this share will have to be reduced to around 30 per cent to reach net-zero emissions by 2050. For the EU, the reduction will have to be even greater.^[4] This will require wide-ranging structural changes in energy production, but we still have a long way to go (Chart 1).^[5]

These changes will have profound implications for our daily lives and economic system.

The price of energy affects the cost of virtually everything we consume and produce. As a result, the cost-push shock from an increase in energy prices is felt throughout the economy. Given that the ECB's primary mandate is to preserve price stability, understanding the relationship between the transition to a greener economy and the price of energy is crucial.

To start with, let me be clear: we cannot blame today's high oil and gas prices on the green transition. The culprit is clearly Russia's manipulation of the energy supply^[6], which has resulted in higher and more volatile energy prices in an already tight market.^[7] Reduced supply has exacerbated the effects of the strong post-pandemic recovery in fossil fuel demand, resulting in the high energy prices we are seeing today.^[8]

But the massive shift required by the green transition may matter for energy prices in the future. In this respect, the argument is often made that the green transition will cause a persistent rise in energy commodity prices and inflation.^[9]

However, the price effects of the green transition are not straightforward. In fact, the green transition will influence several dimensions which will in turn affect energy prices. For example, it will modify both the demand and supply of fossil fuels through multiple channels, with ambiguous effects on market prices along the transition path. It will also affect the cost and availability of renewable energies, which also influence the substitution away from fossil fuels and therefore their cost.

Today I will examine the possible implications of the green transition for energy prices. I will argue that the pathway to a greener economy does not necessarily imply persistently higher inflation. Much will depend on the policies we adopt to transit away from the most polluting sources of energy. I would even argue that we can reach a "divine coincidence" between price stability and decarbonisation.

The effects of changes in the supply anddemand for fossil fuels and renewables

The green transition will affect the price of fossil fuels and other sources of energy, particularly renewables. Together, these dynamics will determine how overall energy prices evolve in the future.

Taxation will play an important role. Lower taxation (or subsidisation) of green energy and higher taxation (or penalisation) of fossil fuels will have an impact on relative prices and demand. The net effect on consumer energy prices will depend on the balance between the two and how the proceeds from carbon taxation are used (whether, for instance, they are used to subsidise green energy and invest in green technologies).

Ultimately, the impact on energy inflation will depend on how energy supply and demand react to these price signals.

The effects of the green transition on fossil fuel prices

Let me start by outlining the channels through which the green transition might affect energy commodities.

A wide range of interacting channels will determine how the transition risks will affect energy commodity markets (Chart 2).^[10]

On the supply side, a transmission channel that is often referred to is the "policy uncertainty channel": lower expected demand makes future payoffs highly uncertain and compresses investment in fossil fuels.^[11] As investment declines, fossil fuel prices rise.

Yet there are other supply forces at work that might lower prices. Supply may increase if fossil fuel producers extract their reserves now due to the "frontloading channel".^[12] Also, innovations in fossil fuel technologies, such as carbon capture and storage solutions, might support investment through the "brown innovation channel".^[13] This would cause fossil fuel prices to fall.

Demand channels also matter.

First, preferences can shift towards greener forms of energy via the "preference channel". For example, sales of electric cars in Europe now account for 14 per cent of the market, after an increase of 160 per cent in only two years.^[14]

Second, policy measures can further discourage demand for fossil fuels by making these costlier than their green counterparts through the "relative cost channel". Carbon pricing is a case in point.^[15] By increasing the after-tax cost of fossil fuel and electricity produced by burning fossil fuel, carbon taxation (or equivalent measures, such as the Emissions Trading System) reduces fossil fuel demand and increases the recourse to renewables. The price effect is unclear a priori: the price before tax of fossil energy might decline, but the after-tax price might be higher.

Third, innovation in green technologies could make cleaner sources of energy more available and affordable, thereby lowering demand for more polluting sources via the "green innovation channel".^[16] The massive increase in the installation of heat pumps in Europe in the last two years to replace gas boilers is a clear example of how new technologies can rapidly decrease fossil fuel demand.^[17]

The bottom line is that the effect of the green transition on fossil fuel prices is ambiguous. It will depend on which channels prevail, which is largely determined by technological developments and the policies implemented by governments globally. Different channels might have opposite effects and dominate at different points in time.

Renewables and the effects of the green transition on overall energy prices

The effect of the green transition on overall energy prices will also crucially depend on the availability and price of renewable energy.

The costs associated with renewables have been decreasing. They are now lower than those of fossil fuels. In 2020, new utility scale photovoltaic and onshore wind power plants were cheaper than new fossil fuel plants. In 2021, onshore wind costs fell by 15 per cent compared with 2020, while offshore wind and solar photovoltaic costs fell by 13 per cent. As of 2022, the marginal cost of new solar energy production was estimated to be a quarter of the marginal cost of existing gas plants in Europe.^[18] And in the current energy crisis, wholesale electricity prices have been lower when EU power generation relied more on renewable energy than on gas.^[19]

Not only, therefore, is a reallocation of production and consumption from fossil fuel energy to renewable energy necessary to reach the net-zero emission target. But the lower cost of renewable energy can also put downward pressure on overall energy prices. In fact, the EU has decided to cushion the impact of the electricity price spike on households and businesses by imposing a temporary revenue cap on producers with lower marginal costs^[20], which mainly comprise renewable and nuclear energy producers.

Expanding renewable energy production would increase the European economy's resilience to fossil fuel price spikes and supply disruptions. While renewable energies also have some drawbacks, such as the intermittence of their supply and the commodity inputs required during the plant construction phase^[21], they do not use any more commodities during the lifetime of an installation.^[22]

What should we expect amid all the uncertainty?

To assess the effects of the green transition on energy prices in the future, international bodies such as the NGFS and the International Energy Agency (IEA) have turned to scenario analysis. I will refer to two contrasting scenarios.

The first is an orderly scenario which assumes ambitious climate policies are introduced immediately. This scenario limits global warming to 1.5 °C through stringent climate policies and innovation, reaching global net-zero emissions by 2050 in line with the Paris Agreement.^[23] It nevertheless requires ambitious policy action and technological change across all sectors of the economy.^[24] The NGFS does not provide detailed and granular information on the overall cost of energy production (including from renewable energy sources), which would give a more complete picture. But it does provide estimates for the price of oil, gas and coal, which would only increase moderately over the next decade under the net-zero scenario (Chart 3).^[25] In particular, oil prices are predicted to increase by around 6 per cent cumulatively from 2020 to 2030, reflecting increasing costs of extraction.^[26] Gas prices, in turn, are expected to increase faster as gas demand is expected to remain relatively strong, although in annual terms the magnitudes are also contained.^[27] In a similar scenario constructed by the IEA, prices for fossil fuel (except gas) would even decline, as channels that reduce demand dominate price dynamics.^[28]

By contrast, the second NGFS scenario, referred to as "nationally determined contributions" (NDCs), assumes that only currently pledged climate change policies are implemented. This means that global efforts would be insufficient to halt significant global warming. Emissions would decline but lead nonetheless to at least 2.6 °C of warming associated with severe physical risks, setting the world on a "hothouse" path and failing to meet the climate goals of the Paris Agreement.^[29] In this case, the NGFS foresees moderate increases in fossil fuel prices, while the IEA projects energy prices to increase more strongly in a similar scenario. This is because the demand for gas and oil is set to rise over the short run, and investment in renewables will fall short.

These results should be taken with a pinch of salt. In fact, the NGFS scenarios do not yet fully incorporate the current gas market turbulence. Consequently, the actual change in prices may differ from the projected paths, at least in the short term.^[30] Moreover, the range of possible outcomes is extremely wide, reflecting different assumptions regarding policies, consumer preferences, technological innovation, market developments and other aspects.

The International Monetary Fund (IMF) emphasises that the inflationary effects of the green transition depend crucially on the policies adopted during the transition. Although there are scenarios in which the transition can generate mild inflationary pressures, the IMF foresees that a transition aimed at cutting emissions by 25 per cent between now and 2030^[31] and where one-third of the revenue generated from higher carbon prices would go towards green subsidies would not lead to any material increase in inflation in the euro area compared with the baseline.^[32] Its analysis concludes that the transition to clean energy need not be inflationary and that delaying the transition would only cause costs to rise.

Overall, these analyses confirm that the effects of the green transition on energy prices are not one-sided. The transition should not necessarily lead to skyrocketing energy costs in the future - it may well have the opposite effect. The consequences crucially depend on the interaction between the different channels driving the green transition and on policy action.

For instance, significant investment in research and innovation is required in the short term to develop technological solutions and ensure that decarbonisation objectives can actually be met. If the transition happens at the required pace and is supported by the right policies, upward price pressures are likely to be contained. And when comparing the present value of the benefits from lower emissions with the present value of the costs of reducing our reliance on fossil fuels and replacing them with renewable energy, there are actually considerable net benefits.^[33]

Limited role for green factors in the current energy price shock

Let me now turn to the current energy shock.

After months of continual increases, the price of oil and gas reached multi-year highs in the summer. This raised the question of whether the green transition had played a role in these increases. To answer it, I will rely on empirical studies^[34], building on the vast range of literature available on the drivers of oil prices.^[35]

Recent analyses suggest that the green transition has affected fossil fuel investment to a limited extent. Expectations about the transition may have led to lower investment in the oil sector over the last few years, probably because it has made it more expensive to attract capital.^[36] The estimated impact of a shock similar in size to the Paris Agreement on oil investment is nevertheless negligible - between one and two per cent - and increases only moderately over a longer period (Chart 4, panel A).^[37]

Transition risk has not left a noticeable mark on oil prices so far (Chart 4, panel B). This is consistent with what I said earlier. Different transmission channels are at play: fossil fuel investment may have been reduced due to policy uncertainty and lower demand for these types of fuels, but these supply and demand channels have opposite effects on prices. The net impact on prices may therefore have been contained or even cancelled out.

The results suggest that more "conventional" shocks to oil demand and supply have probably been the dominant drivers of oil prices up until now (Chart 4, panel C). This is also true for the high oil prices we see today: these are a result of the post-pandemic recovery in oil demand and shortages on the supply side driven by reasons other than climate change, such as managed oil production.^[38]

For gas prices in Europe, supply disruptions are even greater. There are signs that even before invading Ukraine, Russia manipulated the gas supply to the European market, cutting gas flows and creating scarcity and uncertainty about future supplies. There was already less Russian gas flowing to Europe in 2021 despite higher gas prices and robust demand (Chart 5). The reduction in supply depleted European storage facilities even though there was the potential to export more. After the invasion of Ukraine, Russian gas flows through major pipelines such as Nord Stream 1 were further reduced and eventually halted altogether, causing European gas prices to surge even higher.

The economic, inflationary and political tensions caused by this supply strategy probably had twin aims: break Europe's unity and weaken its support for sanctions in view of Russia's (planned) invasion of Ukraine, which began in February 2022. These aims were not achieved.

Instead, large shocks like this one should reinforce the EU's determination to speed up the green transition - rather than slow it down - and to rapidly eliminate its dependence on Russian fossil fuels.^[39] The considerable progress made on energy intensity after the oil shocks in the early 1970s gives us cause to be optimistic that similar progress can be achieved in response to the current shock.^[40]

Policy implications: seeking a divine coincidence

To achieve a "divine coincidence" whereby reducing the dependence on fossil fuels does not come at the expense of higher energy prices, public policies will need to succeed in reducing energy intensity, protecting energy security and financing the transition.

First, policies will need to provide incentives to lower fossil fuel demand for a given after-tax price.^[41] This would limit upward pressures on energy prices during the green transition, and - importantly - would help reduce greenhouse gas emissions. In the EU, the Fit for 55 package and the REPowerEU plan have raised targets for energy efficiency and include concrete measures to achieve them. In the short term, EU ministers have agreed on voluntary and mandatory reductions in electricity demand in response to the current crisis. Initial results are encouraging.^[42]

Second, policies need to protect energy security to contain the likelihood of significant shocks to inflation linked to spikes in the price of fossil fuels. This is best coordinated or delivered at European level as national measures to secure energy supplies and shelter businesses from the impact of price increases could turn into beggar-thy-neighbour policies.

Recent EU initiatives are moving in the right direction. For example, the EU Council has agreed to collect solidarity payments from fossil fuel companies to support households and businesses. The European Commission has proposed joint gas purchases to strengthen the EU's bargaining power when securing supplies for all Member States. It has also proposed solidarity rules in the event of gas shortages and is working on a revision of its State aid framework. Lastly, ministers have agreed that fiscal support to cushion the impact of higher energy prices should be targeted at the most vulnerable households and firms while preserving price signals and incentives to reduce fossil fuel consumption.

Third, policies need to support the necessary investments in the green transition. According to the IEA, investment in renewable energy needs to triple by the end of the decade to effectively tackle climate change and contain energy prices.^[43] For the EU, reducing dependence on Russian fossil fuels and achieving climate targets will require investing an estimated €500 billion per year between 2021 and 2030.^[44]

Bridging the gap in green investment will require the contribution of the private sector. Incentives can be offered through regulatory efforts. For example, streamlining administrative approval processes can help accelerate renewable energy projects. In the area of sustainable finance, progress in adopting climate disclosures can significantly contribute towards lowering the cost of capital for green investments.^[45],[46]

The private sector will nevertheless need time to adjust. It may also not invest enough in green projects that have the characteristic of public goods. We thus need to accelerate, sustain and provide a backstop for the green transition through public investments. As I have previously argued, these investments would be financed more effectively and efficiently at European level than by individual Member States.^[47] They could, for example, take the form of an EU climate and energy security fund aimed at supporting the green transition in future years.

Conclusion

The green transition is often presented as a threat to fundamental aspects of our daily lives, including growth opportunities or purchasing power.

This negative narrative is unjustified. The divine coincidence is not a pipe dream: greener can mean cheaper. This depends crucially on the policies we adopt.

If properly managed, the global response to the climate crisis can increase productivity and growth through several channels: by improving the allocation of resources, enhancing health conditions and stimulating technological progress.^[48] Under these conditions, we can place "…climate action at the heart of a new growth story, powered by investment, technology, policy and finance".^[49]

Similarly, the green transition need not lead to higher inflation. In fact, appropriate public policies that compress the demand for fossil fuels and stimulate the production of cheaper renewable energy sources can help to contain inflationary pressures and may even help to reduce inflation compared with a counterfactual situation that does not contain these policies. In reality, we are already using the lower cost of renewable energy to cushion the impact of the fossil fuel shock on electricity prices.

The high levels of energy inflation currently being observed cannot be blamed on the green transition. They are mainly the result of fossil fuel supply manipulation by Russia. If the green transition had happened earlier, it would have been easier to progress towards our climate goals and 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.

In order to act on climate change, policymakers need to take swift, bold and ambitious measures that garner the support of citizens. This result can only be obtained by establishing a realistic and positive narrative on the green transition.^[50] In particular, we need to reassure citizens that, under well-designed policies, the green transition would increase - not decrease - their job opportunities, the quality of their lives and their purchasing power. The counterfactual situation would be worse, with the likely repetition of the kind of crisis we are currently living through.

In shaping this narrative and taking policy action, a European approach is in our collective interest. Common policies are more likely to deliver the necessary reduction in energy intensity, protect our energy security and finance the investments required. Unity makes us stronger when facing shocks and gives us greater influence in determining our climate and energy future.

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