Big world economies must rebalance relative price of renewables and fossil fuels

Huge increases in oil prices in 1973, and again in 1979, sent shock waves through the European economy of that time. While the scale of the economic disruption caused was nowhere near what we are now experiencing, the impact was substantial and long-lasting. Higher oil prices caused a surge in inflation, and a brake on economic activity, with significant loss of output here and across Europe.

The last month has again seen a major oil price shock, with the halving of the price in a very short space of time. The proximate cause of the price fall was the dramatic reduction in Chinese demand, consequent on coronavirus.

This fall in oil prices has reduced petrol prices in Ireland by up to 20 cent. Because of the much graver shock to the economy from coronavirus, this drop in oil prices has received little attention, though its effects are much bigger than the much commented-on rise in carbon tax after the last budget.

Lower oil prices will reduce consumer prices by between 0.5 per cent and 1 per cent. Under normal circumstances, such a fall in oil prices would add between 0.5 per cent and 1 per cent to EU and Irish GDP. However, this stimulus will be lost in the massive dislocation which is already occurring across Europe.

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Fall in demand

While the fall in the oil price was triggered by a fall in demand, which will be temporary, it also reflects long-term changes in the world market for oil. In particular, the development of alternative energy sources to fossil fuels has the potential to impose serious losses on the owners of major coal, oil and gas reserves – both companies and countries.

A UN report on the world economy, published in January, looked at the long-term consequences of action to tackle climate change. If we are to have a good chance of keeping the rise in temperature to two degrees, then 80 per cent of the world’s current coal reserves, 50 per cent of the world’s gas and a third of the world’s oil will be unused.

If the world were to keep the temperature rise to 1.5 degrees, the write-off of the value of fossil fuel assets would be much greater.

Thus, the prospect that the world may be taking global warming seriously is a threat to companies and countries that are particularly dependent on fossil fuels. By shifting to renewable energy, the world demand for fossil fuels is likely to fall between 2030 and 2050. Since 1990, Saudi Arabia and other major oil producers, seeing the threat to their long-term future, have tried to slow action at a UN level to tackle global warming.

Financial markets price assets based on their expected future income. While financial markets often have a short time horizon, the prospect that action on global warming and the development of renewable technologies could severely devalue fossil fuel assets over the next 30 years is already having an impact. This is affecting investors’ appetite for shares in companies with major fossil fuel assets, not for ethical reasons, but rather because they are perceived as being less valuable.

Unprofitable

Investors have recently pulled out of developing huge Canadian deposits of incredibly dirty tar sands, not because this would be very bad for the climate, but rather because a probable future fall in demand will make such investment unprofitable.

Similarly, high-cost development of offshore oil is no longer profitable – making legislation to prevent such activity effectively redundant.

The fall in the oil price that Russia and Saudi Arabia have engineered will bankrupt and close a significant part of the US shale oil industr

The objective for countries such as Saudi Arabia and Russia that are heavily dependent on revenue from fossil fuels, much of which will be stranded and devalued by 2050, is to maximise their revenue over the next 30 years. To do this, they need to slow the development of new reserves that could further reduce the long-term price.

To this end, the fall in the oil price that Russia and Saudi Arabia have engineered will bankrupt and close a significant part of the US shale oil industry. Once this is achieved, and once the world economy gets back on track, there is likely to be some bounce back in the oil price.

Longer term, the more successful the world is in developing renewable technologies, the lower will be the demand for oil, and hence the lower its long-term price. In turn, lower fossil-fuel prices will discourage necessary investment in renewables. To ensure that investment in renewables continues to be economically attractive, major world economies will need to rebalance the relative price of renewables and fossil fuels, either through raising the price of carbon or heavily subsidising clean energy.