John FitzGerald: Energy price rises set to topple economies into recession

While the European economy has, until this year, been humming along, it will soon grind to a halt. The increased cost of our imports of energy this year, for both the EU and for Ireland, will almost certainly exceed 3 per cent of national income. About two-thirds of this increase in cost will arise from the exceptional price of gas, consequent on the shutting off of supplies from Russia.

Without any further increase in gas prices, the impact next year would cost a further 2 per cent of national income. This is of a similar order of magnitude to the oil price shock of 1974, which cost Ireland 4 per cent of national income.

Taken together, these price increases will probably drive the Irish economy, as well as the EU’s, into recession. The Department of Finance in 2019 estimated that a 1 per cent fall in world output would cut Irish output by 1 per cent. We are looking at a possible 5 per cent loss of income and output, which could be enough to cause the rapidly growing Irish economy to reverse engines, with a serious negative impact on employment.

How are businesses coping with rising costs across the board?

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While the effects are particularly severe for Europe because of its dependence on Russian gas, the consequences will be felt by other major energy importers such as India, China and Japan. They import much of their oil and their gas imports will also be much more expensive as Europe competes against them on Asian markets. This will mean that the reduction in demand will affect national income across the world, magnifying the effects of the shock.

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Effectively the rest of the world is transferring wealth to energy-supplying countries such as Saudi Arabia, Norway and indeed Russia. On past experience, while US beneficiaries may spend the extra income this year, countries like Saudi Arabia are likely to save their unexpected windfall gain, at least initially. The net impact will be a big fall in world demand for goods and services.

The oil price shock is less severe than what is happening to gas, though it affects consumers of oil throughout the world in a rather similar manner

Some firms in Europe will seek to recoup the hike in costs by raising their prices. However, if this reaction gets out of hand, the end result, as in the 1970s, would be rampant inflation. It is clear that central banks, following their mandate, will raise interest rates to minimise the surge in inflation. In turn, this will further hit output and incomes in Europe and beyond.

The oil price shock is less severe than what is happening to gas, though it affects consumers of oil throughout the world in a rather similar manner. Attracted by the higher price, oil supply will tend to rise and there will also be some fall in demand. Increased supply and reduced demand could result in a partial reversal of the oil price rise over the coming two years.

For gas things are different. Increasing supply to Europe to replace Russian gas needs the construction of new liquefied natural gas terminals, both at source and in destination countries in Europe. Even without planning delays, this will take three to five years.

Until new capacity comes on stream to replace the Russian supply, exceptional prices will continue to haunt European households and companies dependent on gas.

This is a crisis which will probably last a number of years … It’s vital to target funds at helping those in most need

Some European businesses or plants that are gas-dependent will shut down, as the goods they produce can be manufactured more efficiently elsewhere where gas is cheaper. It would be a mistake for governments to try to keep those plants going, as the priority will be to use scarce gas supplies to keep the heating and the lights on in Europe over coming winters.

This is a crisis which will probably last a number of years. Governments, including ours, need to guard their resources — what may look like sustainable solutions today may not be possible in subsequent years. It’s vital to target funds at helping those in most need.

This means supporting households that face the most dramatic loss of disposable income as a result of the price rise. It’s notable that, on average, urban households that largely depend on gas for heating are likely to be worse affected than average rural households, which may heat their homes through oil or solid fuels. Also, the oil price rise is likely to unwind earlier than that for gas.

The sharp rise in energy prices is equivalent to a carbon tax of about €700 a tonne. One result is that the balance of economic advantage for households has strongly tilted in favour of retrofitting. Most of us would be better off (and warmer!) if we were to invest in the energy efficiency of our homes.