The cost of living crisis and net zero

An interview with Professor Karen Turner, Director, Centre for Energy Policy

With the prices of everyday goods going up, including spiralling energy bills, and inflation rising to 5.4% (its highest level in 30 years) and with Bank of England projections suggesting it will reach 6% by the spring, CEP Director Professor Karen Turner reflects on what this means for the longer-term UK economic picture and the country’s ambitions to realise net zero.

1. What are the main drivers of the current cost of living crisis?

The current cost of living crisis is partly driven by global factors linked to the COVID recovery. Full re-opening and recovery of economies isn’t just about restoring demand, which itself is subject to a mix of pent-up demand offset by confidence and real income challenges. No, complex supply chains need to restart, with many still affected by COVID conditions and other shocks, such as incidents like the blockage of the Panama Canal.

How do such constraints impact? Well, taking the example of our energy supply, we’ve already seen prices rise, particularly in nations like the UK where residential heating is heavily dependent on gas and where the shift from coal in thermal power generation means that electricity prices are also subject to rising gas costs.

Moreover, the situation in the UK has become acute with our gas coming from a range of overseas sources where our Governments have little control over production, and with limited domestic storage resource to mitigate price spikes. Geopolitical issues, as we are currently seeing in Ukraine, could bring further pressures to supply and with gas still being required as global economies transition to net zero, it could be that global demand and prices remain high for some time to come.

Other crucial circumstances are currently at play in the UK, such as what Brexit and numerous sector specific factors mean for our labour supply. As has been reported, we have seen labour shortages in important sectors, such as HGV drivers. Here, constraints can raise real wages, but, particularly in the context of core sectors such as transport, where cost rises ripple out across multiple supply chains, this is a benefit delivered at the cost of triggering wider inflationary pressures and processes impacting the broader cost of living.

2. How might increasing energy prices affect the economy?

Energy, like (and perhaps even more so than) transport, is used by all sectors of the economy and is, thus, deeply embedded in all our supply chains. So not only are consumers impacted by rising energy bills, but there will be upward pressure on the prices of all goods and services.

That’s why the current gas price increases are already impacting the CPI so heavily (The Consumer Prices Index including owner occupiers’ housing costs (CPIH) rose by 4.8% in the 12 months to December 2021), with the full effects of raising the energy price cap still to come in the spring of 2022.

All of this at the same time as the proposed national insurance increase kicks in reduces the real take-home pay of many households and further reduces their purchasing power in the face of higher consumer prices.

3. Are there sectors and groups that are and could be particularly impacted?

If we focus on energy price impacts specifically, the greatest impacts will be felt by those sectors/groups that are the most directly (and indirectly) reliant on energy and those who cannot easily reduce their energy use. For those goods and services most reliant on energy (and/or the goods and services that embody energy use and/or the other drivers of the current cost of living crisis) their consequent ‘inelastic demand’ (restricted ability to reduce energy use) will mean that price rises will be particularly impactful.

For households, this will be those lower income consumers whose energy use is largely concentrated in essentials like heating and lighting, with this accounting for a higher share of their take home pay and/or benefits. Among industries, it will be the more energy intensive ones – and many of these produce things that are essentials in our everyday supply chains, whether we’re aware of it or not, such as plastics and metals. However, given that rising costs are ultimately passed onto the price of consumer products, this is one of the main drivers of the heavy CPI impacts.

And it’s not just the cost of gas itself – as I’ve said, the knock-on impacts on electricity prices will also feed through to the costs of low carbon transportation, while the higher oil prices we are experiencing at present will impact the costs of filling up at the pumps. Combined, the wider global supply chain conditions and labour supply conditions here in the UK, are increasing the costs of transportation and prices of all goods and services. It’s hard to change consumption patterns across society quickly, so ultimately, everyone will be impacted, but with the consequences felt very differently by different income groups and sectors.

Importantly for the net zero transition, supply chain issues are also being reported to be driving up costs for some renewable energy project developers, who expect to be ‘heavily impacted by cost inflation in 2022’.

4. What lessons can we learn from the current economic situation for the net zero transition?

From the last point above, we need to think more about how complex whole economy challenges are. Alongside the benefits, and avoiding the catastrophic costs of inaction, we need to recognise that decarbonisation will bring costs that ultimately need to be passed onto consumers. Here, even where there are opportunities for a shift to ‘green growth’, like any form of economic growth, where economic expansion happens in a supply-constrained economic system, it will result in price pressures.

People often don’t consider labour market conditions when thinking about decarbonisation, but what’s happening now should highlight just how important they, and other fundamental market conditions, will be in allowing us to make the transition and what it will cost.

We also need to consider what the impacts of rising energy prices - and how these ripple out to the costs of all goods and services - may mean for how carbon pricing could impact our economy and costs of living. As policymakers are well aware, the implementation of any carbon pricing mechanism in the UK will need to be carefully designed if a broader challenge of ‘carbon poverty’ is to be avoided.

5. What could be done to improve the current economic situation now and in the future?

Given how we’re seeing just how interdependent things are in economic systems, clearly we need more innovative and coordinated public policy going forward.

Many of the drivers of today’s crisis have been argued to be outwith the control of public policy makers – this may be true, but lessons can be learned for the future. For example, if we had more energy storage and had more energy efficient buildings, we could reduce our exposure to global energy price spikes and reduce the risk of wider inflation.

However, reducing carbon emissions to the extent we need to for net zero means that the cost of carbon has to be better reflected in goods and services that involve fossil fuels and/or other polluting activities in their production. However, with this, we risk triggering further inflationary processes, particularly where low carbon alternatives are still coming on line. Thus, to avoid and/or mitigate price pressures from effectively reflecting carbon costs, we need to increase productivity in the supply of what we consume, and to increase efficiency in how we consume.

Investment and action to deliver productivity and efficiency gains are more controllable from within the UK and arguably must become a primary focus of public policy for net zero – something we described in a recent discussion paper on ‘Green growth, price pressures and productivity’. The cautionary lesson here is that had we stepped up the process of increasing productivity in and the availability of non-fossil fuel substitutes earlier, and of enabling UK households and business to be more efficient in their energy use earlier, we would not be as exposed to the energy price element of the current cost of living crisis as we currently are. This is a point raised in recent analysis from Carbon Brief, which argues that ‘Cutting the ‘green crap’ has added £2.5bn’ to UK energy bills.

However, these are implicitly longer term solutions. It is very challenging to find nearer term solutions to the current cost of living crisis. Importantly, it is largely driven by supply factors, not over-heated consumer demand. Thus, the effectiveness of a response from a central bank like the Bank of England to inflation – such as raising interest rates – will be limited and could be damaging if rates rise to a level that deters the investment and consumer spending that is essential to the COVID recovery.

In the near term, the best policymakers can do is to consider how the most serious impacts of the cost-of-living crisis on vulnerable households and businesses can be mitigated. Generally, this is likely to involve a reallocation of resources supported by those better able to ‘ride’ the crisis. However, just what this may involve and just how/whether specific actions can be delivered in the current political context is the real pressing public policy challenge that will inevitably dominate and play a central role in decision making around net zero actions in the coming months.