Why energy costs could remain high for up to five years

At the core of the current inflationary surge is energy. It’s by far the biggest component of price growth here, accounting for almost half of the 5.5 per cent inflation rate we’re currently experiencing. And the chief villain in the energy camp is natural gas. Wholesale gas prices rocketed by an unprecedented 470 per cent last year. The full impact of this has yet to be felt by consumers. That’s because companies have been hedging or forward-buying supplies, effectively shielding themselves and their customers from the full hit. But these hedging contracts are now exhausted and a painful pass-through to consumers is on the way.

Firmus Energy, formerly Bord Gáis's Northern Irish operation, announced last week that it planned to increase prices by 33.57 per cent from the end of this month. One insider said the Firmus increase or ones of a similar magnitude would be played out across the industry in the coming months.

Central banks and others have sought to assure us, however, that while things will get worse in the short term, the energy price surge is predicated on temporary factors such as depleted gas stocks; a faster-than-expected rebound from Covid, poor wind energy, geopolitical stresses, all of which will unwind or correct within the next 12-18 months.

Some, however, think this is a misdiagnosis and that there’s something more fundamental, something more long-lasting at play in energy markets.

Record wind power generated in Ireland over stormy weekend

---

Electricity charges: what are other countries doing to ease the pain?

---

Ireland to get nine new power plants by 2024 to prevent shortages

---

Scottish auction shows Irish policy on floating offshore wind is out of date

---

"In a world that's heading towards a net zero objective, the consumption of natural gas has to go down, everybody knows that," the head of climate solutions at Legal & General Investment Management (LGIM), Nick Stansbury, said.

“And that uncertainty about how quickly it goes down has led people to back off investing in gas projects.”

Mismatch

This mismatch between the reduction in supply because of our long-term climate objectives and the short-term challenge of not transitioning the demand side fast enough is behind the explosion in gas prices, he says.

Natural gas has historically been significantly cheaper than oil but currently it’s trading at about $150 a barrel in oil equivalent terms, compared to oil, which is trading at roughly $90 a barrel.

“The region [Europe] has underinvested for a long time and demonised domestic gas supply, while doing little to address demand,” Stansbury says. “That has only heightened its dependence on foreign gas supplies. We expect that dependence to continue to grow, and quite rapidly, to at least 2030,” he adds.

While the Government is planning ameliorating measures in the form of energy credits, they're likely to land at the same time as further price hikes

What Stansbury is describing is a time horizon mismatch between the exit from fossil fuels and the wholesale adoption of renewables. This is backed up by data from the International Energy Agency (IEA), which shows that while the oil and gas industry is – broadly speaking – investing at a level that is consistent with keeping global warming to a 1.5 degree increase, the investment in renewables or low-carbon alternatives is nowhere near high enough to keep us within this zone.

“What we’re saying is that this energy price environment could stay tight for a long time, which means that the squeeze on household bills could remain for a quite some period of time,” he says.

But for how long? Three to five years, according to Stansbury.

Squeeze

Inflation is merely a derivative of higher energy costs. If energy prices double then for a period of time we get higher inflation. But if energy prices stop going up but remain high, inflation could moderate because inflation is the rate of change in prices not the level of prices. In other words, households could remain in the grip of a cost-of-living squeeze even if headline inflation moderates.

And higher energy costs are perhaps more corrosive to household disposable income than increases in the cost of other items or even broad-based inflation itself as they’re unavoidable and can heap misery on poorer households. Similarly, if energy costs remain elevated, firms may try to insulate themselves through raising prices, potentially entrenching price growth in the economy. Central banks have been telling us that the current price surge is merely a temporary manifestation of the post-Covid unwind but energy market dynamics cast serious doubt on this narrative.

Running hotter

European Central Bank chief Christine Lagarde acknowledged recently that euro-zone inflation was running hotter than expected, while adding that raising interest rates this year was "very unlikely". However, the mood had changed from last year and markets viewed her comments as a clear signal that the process around preparing for a rate rise, an implicit admission that inflation was no longer viewed as transitory, had begun. "Compared with our expectations in December, risks to the inflation outlook are tilted to the upside, particularly in the near term," Lagarde said. She had previously argued that inflation would soon abate without intervention. And while the Government is planning ameliorating measures in the form of energy credits they're likely to land at the same time as further price hikes, leaving households no better off, and potentially aggravating the politics around it.