Understanding Energy Inflation
The global economy is going through a tumultuous phase at the moment with a looming energy crisis, food insecurity, and anticipated recession risks. The Russia-Ukraine War has had far-reaching impacts on the world economy. It has caused massive energy supply disruptions across the globe, causing energy prices to skyrocket.
The recent COP27 summit highlighted the need to quickly transition from non-renewable energy sources to renewable energy sources. While the main reason for this argument is climate and environment based, there is another reason behind it. The price differences between these sources.
This clarifying concept introduces the concept of energy inflation, the impact it has on households and businesses, and explores the price differences between renewable and non-renewable sources of energy.
What is Energy Inflation?
Inflation refers to a general rise in the prices of goods and services in an economy over a period of time. Therefore, Energy Inflation is the rise in energy prices over a period of time.
As a commodity, energy is vital for the functioning of every sector. For businesses, this means higher input costs, since energy is required in every step of the production process, right from procuring raw materials to exporting finished products. To prevent losses, businesses increase prices of their products. These increased prices then have to be borne by the consumers, implying consumers have to pay more to buy the same quantity of goods.
A direct effect of energy inflation for consumers is increasing electricity bills and thus extra out-of-pocket expenses. The rate at which inflation rises, not necessarily corresponds to the rate of increase in income of individuals, many times income has no change. Inflation becomes a burden on households when income remains constant and every month’s expenditure keeps on increasing. To prevent this, households reduce consumption and this eventually leads to a fall in demand. If this cycle continues for a long period of time, the economy risks sliding into recession.
What are the causes of energy inflation?
- Supply and Demand: Like other commodities, energy prices are dictated by basic supply and demand. As business and leisure travel have resumed and manufacturing has returned, demand has increased, but energy supplies remain constrained due to a variety of factors.
- Uncertainty: The exploration and production of oil and natural gas is extremely capital intensive and requires significant investment and planning. Investors pay close attention to these kinds of signals, and fear of regulatory hurdles impacting returns have held investment back. In part to balance this headwind, companies are now returning a higher percentage of the profits back to investors and investing less into new exploration and production.
- Supply chain and labour: Energy companies are still recovering from the pandemic-related lockdowns and are struggling to source the materials and workers necessary to expand production. Global shortages and transportation bottlenecks have pushed inputs like tubular steel and sand to historically high prices, and often aren’t available at all. This is limiting new exploration globally and preventing supply from keeping up with demand.
- Global Markets: Oil is a global commodity traded in a global market. Different types of oil products are produced in different places, depending on refinery configurations, and shipped across the globe. The price that consumers pay at the pump is reflective of the cost of crude oil, refining, transportation, distribution, and taxes.
How are energy prices determined?
Demand and supply determine energy prices. For example, the price on electricity exchanges depends on the “merit order” of power plants. Demand and supply are matched at the exchange and the price varies depending on how much power is available from different kinds of sources and at what cost. According to the merit order, the most expensive power station sets the price. In pre-pandemic times, the most expensive plants were either gas-fired or coal plants. At times of high input from (cheap) renewables, this more expensive generation is pushed out of the market. This means that all electricity is expensive when the price is set by a natural gas plant or a hard coal-fired power plant. This happened more often in 2021 because of lower renewables generation and because it was even more expensive to operate gas-fired plants.
Renewable and Non-Renewable Sources of Energy
In terms of prices, energy generated from non-renewable sources is more expensive, as compared to renewable energy. Offshore wind, onshore wind and solar photovoltaic (PV) are examples of renewable energy sources, while nuclear energy and coal are examples of non-renewable energy sources.
The following chart shows the differences in prices per megawatt hour of electricity (PME) generated by renewable and non-renewable sources of energy, for the years 2010 and 2019. The following calculations have been done by the authors with data compiled from various sources.
Under renewable energy sources, PME for Offshore Wind declined from $162 in 2010 to $115 in 2019, registering a decline of 29.01%. The trend is similar for Onshore Wind. In 2010, PME was $86, which fell to $53 in 2019, a 38.37% fall. For Solar PV, PME in 2010 was $378. In 2019, it fell to $68, a whopping 82.01% decline.
Under non-renewable sources of energy, the PME for nuclear energy in 2010 was $96, which increased to $115 in 2019, registering an increase of 19.79%. PME for Coal, however, declined by 1.80% from $111 in 2010 to $109 in 2019.
In general, it can be observed from the above chart that the prices of renewable sources have declined much faster as opposed to non-renewable sources. The above price changes are said to have occurred as cumulative installed capacity increased between 2010 and 2019. This implies that any technological changes in the installed capacity causes price reductions, specifically for renewable energy sources. There are stark differences in the way energy is generated from renewable and non-renewable sources which is primarily the reason for high prices of electricity generated using non-renewable sources.
Additionally, renewable sources are available everywhere, however, non-renewable sources are unevenly distributed across the globe. Some powerful countries like Russia, the USA, Saudi Arabia are abundantly blessed with non-renewable sources. These countries are the major producers and exporters in the energy market. Therefore, changing geo-political status-quo has a great influence on prices of energy generated by non-renewables.
Transitioning to green and clean energy requires major investments. While the process has begun, it is likely to take several years before most of our energy needs are met by energy generated by renewable sources. Until then, energy prices will continue to be dictated by the market forces of demand and supply and changing geo-political landscape. Due to uncertainty, the risk of inflationary pressures, in the energy market, will always prevail.