Professor Isabel Schnabel of the ECB spoke about the inflationary effects of the global push to cease using fossil fuels.[1] She told a US audience that the energy transition might continue to add to prices, and persistent inflation could result in a reduction in ECB bond buying and, partly as a consequence, higher interest rates.

Press coverage of this important speech has sometimes suggested that Schnabel was saying that the cost of renewables was tending to push energy prices up. This mirrors an assertion made elsewhere by the UK government adviser, Sir Dieter Helm.[2] The Financial Times headline was ‘ECB executive warns green energy push will drive inflation higher’.

It seems to be me that this is not what Professor Schnabel is saying. Nowhere does she assert that an energy system based on renewables is more costly.

Her argument is very different. Instead, she says that

· Renewables growth is far too slow to meet Europe’s ambitions for emissions reductions.

· At the same time, investors - and capital markets more generally - are demanding that fossil fuel exploration and production bear an increased cost of capital. This raises the costs of producing oil, gas and coal. It also reduces the incentives to explore for, and then develop, new sources of fossil energy. This is a necessary part of the transition.

· And carbon taxes are becoming more prevalent around the world, while the levels of penalty imposed are rising sharply. In addition, the taxes are being applied across a wider range of emissions-producing activities. These taxes increase the cost of buying fossil fuels.

The impact of not having enough renewable electricity at the same time as crunching down on the cheap availability of fossil fuel is to inflate the price of energy. She comments that the effects are particularly acute in the case of natural gas, which is increasingly used in Asia and elsewhere to avoid burning coal in power stations. It is not that Europe has pushed too fast towards an energy system dominated by renewables, it is that it has not been able to move rapidly enough. ‘At present, renewable energy has not yet proven sufficiently scalable to meet rapidly rising demand’.

In the past, sharp rises in energy costs rapidly corrected themselves. Exploration activity increased and more oil and gas duly appeared in response to the incentive of higher prices. This time is different. Schnabel writes ‘last year’s strong economic expansion, for example, was characterised by an atypically slow response of US shale oil production to rising oil prices, as such investments may no longer prove profitable to investors over the medium term − at least not to the same extent as they have done in the past..’

As a result, it may be that price inflation continues at a high level. Energy price rises were responsible for over a third of overall European inflation in 2021 and this pattern might continue during this year.

She summarises the position as follows:

‘As the shift in the energy mix towards cheaper and less carbon-intensive fuels will take time, a rising carbon price, higher tax rates across a range of fossil fuels, and relatively inelastic energy demand may lead to continuous upward pressure on consumer prices in the transition period’

Schnabel suggests that increased rates of inflation in other parts of the economy do not appear likely. Wages pressures remain subdued (though some would strongly argue with this conclusion) and this energy price shock, unlike those in the past, was not driven by an overheating world economy that might produce high levels of general inflation. Unless oil and gas prices continue to rise, inflation rates will therefore fall back before the end of 2022. Using future (‘forward’) prices for oil and gas, she shows that the markets expect fossil fuel prices to fall considerable from the end of this year (though they will still be far higher than in 2020).

The overall tone of the piece is strikingly optimistic in many respects. Although the world is not decarbonising fast enough, Professor Schnabel of the ECB stresses that ‘In our baseline scenario, the current energy shock is expected to fade over the projection horizon’. There are risks of continued inflation of prices, but they do not dominate the Bank’s thinking.

She asserts that the policies causing the price inflation are helping the decarbonisation drive and need to be continued.

‘In other words, even in the absence of a global carbon price, which remains essential, there are growing signs that the green transition is accelerating around the globe’.

And that carbon taxes are probably effective at increasing economic activity.

‘An emerging strand of empirical evidence finds no robust negative effects of carbon taxes on GDP growth and employment. If anything, the evidence is consistent with a modest positive impact’.

There is no reason, she says, to change energy policies. Although the pain of higher prices is substantial, particularly for the less well off, slowing the pace of the energy transition is not a good response to the current crisis.

So what should governments do to ease the position of those people spending a large fraction of their income on energy? Schnabel supports either direct lump-sum payments to households or a reduction in taxes on employment. A lump-sum transfer in European countries, funded by the higher carbon tax revenue, could ‘largely cushion’ the cost of more expensive fuels.

There is no reasonable case for reducing VAT on energy, a policy currently being advocated in several European countries. This would simply increase the demand for oil and gas, prolonging the period of an inflationary mismatch between demand and supply. And we won’t solve the global warming problem by making fossil fuels cheaper.

To conclude, nothing in Professor Schnabel’s remarks suggests any ambiguity about the need to continue pushing forward with the energy transition.

In fact, she argues the reverse. It is only by increasing the speed of decarbonisation, partly by the use of a global carbon tax, that long-run price stability will be encouraged. And the eventual result, in her words, wil be cheaper energy. However this goal must be accompanied by a commitment that temporary rises in oil and gas prices will not affect the living standards of the less well-off.

[1] https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220108~0425a24eb7.en.html

[2] http://www.dieterhelm.co.uk/energy/energy/luck-is-not-an-energy-policy-the-cost-of-energy-the-price-cap-and-what-to-do-about-it-2/