The New Energy Risk

By Karen Karniol-Tambour

Karen Karniol-Tambour is Co-Chief Investment Officer for Sustainability at Bridgewater Associates.

NEW YORK – We have entered a new period of energy insecurity, in which acute shortages of the kind seen this summer will remain a persistent risk. The economic, political, and social consequences of this shift are already apparent. Energy shortages mean rationing, and if rationing is left to market forces, the outcome will be deeply regressive, with poorer people spending disproportionately larger shares of their incomes on basic needs such as heating and transportation.

Energy inflation, in turn, will increase the risks of social upheaval, as incumbent leaders in rich and poor countries alike are quickly learning. Though energy shortages naturally will lead to greater investments in additional capacity, new projects will take time to come online. And unless most are carbon neutral, investments to address a near-term need will exacerbate a much larger long-term problem.

Today’s energy insecurity has been long in the making. Most energy investments take years to complete, and their associated infrastructure tends to be used for decades. The world’s current energy footprint was thus “baked into the cake” years ago, which is why fossil fuels still account for over 80% of global energy consumption.

Even before Russia invaded Ukraine, years of underinvestment meant that global oil demand reliably outstripped supply. What the war has done is rapidly amplify the imbalance, by removing Russian supply from the market through a mix of official government sanctions and self-sanctioning by merchants and consumers. Since Russia was still supplying some buyers, the war had reduced global supply by perhaps 1.5% as of May.

That might not sound like much, but even a small reduction can have serious price ramifications when supply is already tight. When Muammar el-Qaddafi’s regime fell during a similarly vulnerable period, in 2011, the loss of Libyan oil reduced global supply by 1% and sent oil prices 50% higher. Moreover, Russia’s lower output is likely to become entrenched as sanctions on technology, equipment, and Western expertise erode its ability to export oil and gas even to willing buyers.

Owing to the significant lag between new investment and production, today’s oil shortages cannot be rapidly alleviated. US shale companies are uniquely equipped to increase production relatively quickly, but past losses have made them reluctant to move aggressively, and even they need at least nine months’ lead time. The traditional OPEC+ oil producers have little real ability to expand production further than their agreed-upon path of higher quotas; and after years of underinvestment, many producers are struggling to meet even those increases. Finally, while a revived US nuclear deal with Iran could bring new Iranian oil into the market, that is a best-case scenario, and it is unlikely before late 2022.

New nuclear, solar, and wind facilities take even longer to develop and bring online. And even if energy supply could be boosted, there would still be logistical constraints in shipping, ports, and refining capacity. For example, Europe’s existing gas pipelines cannot transport liquefied natural gas if there is no LNG import terminal connected to them, as is the case in Germany today.

With most energy sources being expandable only on a multi-year time horizon, and with inventories at historic lows, the market has been left with only one way to achieve a near-term equilibrium: a sharp increase in prices, resulting in lower aggregate demand. The new world of persistent energy shortages is thus stagflationary as well as regressive. While inflation rises, economic activity declines, because there is inadequate energy to fuel it. Without subsidies, lower-income people could be priced out of the energy market entirely, introducing a dangerous form of inequality.

Europe experienced a “rehearsal” for these circumstances in 2021 when Russia cut back on its natural gas shipments. Governments stepped in to offset rising energy costs for the most vulnerable households, but energy-intensive industries became unprofitable and were forced to stop or slow production. This was an “efficient” way of rationing energy, but it still led to slower growth. As shortages have worsened in 2022, the same circumstances have appeared worldwide, and most governments have yet to devise a coordinated response.

The challenge is not only to produce more energy in the short term but also to introduce energy infrastructure that will help in the fight against climate change. Locking in fossil fuels would merely bake more global warming into the cake. There are two ways to avoid this outcome.

The first strategy is to create regulatory certainty that carbon will be taxed in the future. This is already happening to some degree, with many oil producers thinking twice before making new investments in oil fields that have decades-long operational lifespans. But there is still significant uncertainty about how new policies will lead to a decline in fossil-fuel consumption in the coming decades. Moreover, a large swath of producers – especially state-owned oil giants that are less reliant on private funding – will have incentives to expand production capacity in response to today’s shortages.

With inflation already at its highest level in 40 years, there will be little political appetite for measures that increase energy prices further. One possibility, then, is to legislate carbon pricing far into the future, so that it takes effect only after today’s inflationary pressures have eased. Given that many fossil-fuel producers adhere to long budget timelines, even carbon pricing with a decade-long countdown would be sufficient to discourage long-term investments in capacity.

The second strategy is to ensure that more green investments are made today. This could take the form of fiscal spending on research and development and market-making (advance purchase orders) for potential breakthrough technologies, especially those that currently are too risky or underdeveloped for the private sector. Moreover, governments can subsidize the adoption of renewables, electric vehicles (EVs), heat pumps, and retrofitting of buildings through tax credits and public-procurement policies.

While government spending could add to inflationary pressures (depending on how it’s carried out and offset), it also would reduce prices and costs for the businesses and households that take advantage of the new subsidies and incentives. Compared to carbon pricing or supply constraints, this approach therefore seems more promising in today’s stagflationary environment.

Whatever governments do about today’s energy shortages, their decisions will have major implications for global growth, inflation, and asset prices. Massive quantities of iron, copper, nickel, and other commodities will be needed to build the renewables power grid and to scale up production of EVs. But securing an adequate supply of these metals will take years. The irony is that to address climate change, policymakers will need to adopt the decades-long time horizons of the oil producers they hope to push aside.