Energy supply shocks are expected to accompany the energy transition journey, with significant pass-through effects on economic growth and the cost of living. Effective support mechanisms to protect vulnerable populations and businesses are necessary. Steady energy affordability is essential for economic growth and social justice, and both are key to keep the energy transition momentum going.

The past two years have significantly challenged national economies and energy systems. In 2020, pandemic-related restrictions resulted in a steep drop in the demand for energy¹² worldwide and reduced CO2 emissions, providing a glimpse of the impact demand-side measures could have on climate mitigation.

In contrast, 2021 experienced a fast rebound of demand for products and services and was marked by the global economy’s strong and exceptionally rapid recovery with global GDP estimated at 5.9%.¹³ As economic growth is strongly correlated with energy consumption, the global demand for electricity¹⁴ and oil¹⁵ promptly surpassed pre-pandemic levels, leading to the highest prices experienced in years. Natural gas prices also climbed to their highest in a decade in Europe, the United States, and major Asian markets, owing to a combination of both demand-side and supply-side factors,¹⁶ as well as a succession of extreme weather events.¹⁷

The energy market supply-demand imbalances of 2021 were carried over to 2022 with energy prices sustaining record-high levels even prior to Russia’s invasion of Ukraine. The surge in energy prices emerged as an additional factor, fuelling inflation on top of several other factors, such as strong consumer demand,¹⁸ restricted supply chains,¹⁹ rising wages,²⁰ the increasing cost of housing²¹ and food,²² and low-interest rates.²³ In 15 of the 34 economies that the International Monetary Fund (IMF) classifies as advanced, 12-month inflation through December 2021 measured above 5%.²⁴ A similar trend was observed in emerging markets and developing economies as 78 of 109 countries tackled inflation of above 5%.²⁵

The ability of high oil and gas prices to percolate to other sectors hinges on the relative price inelasticity of its demand. The supply of oil has become more elastic in recent years with the advent of shale oil production in the United States.²⁶ But oil demand remains rather inelastic, especially in the short run. Geopolitical events and severe weather events can disrupt supply.²⁷ Because energy demand is quite unresponsive due to its lack of elasticity, the risks of high energy prices, inflationary pressure and economic headwinds are expected to flank the energy transition process, and increased volatility is likely to be a recurring phenomenon.

Emerging and developing economies are disproportionately affected by spiraling inflation. Although the peak pass-through of high retail energy prices in advanced economies is twice that of developing economies,²⁸ the cumulative impact on consumer price index (CPI) levels in developing economies is higher as prices stay elevated for a longer period of time. Higher energy intensity and lower substitution effects may account for the larger impact on inflation in developing countries.²⁹ In essence, the impact of volatility in energy markets is likely to be more pronounced on developing economies, which adds to the concerns of equity and justice of the energy transition.

With the outlook of potentially recurring periods of supply-demand imbalance of transition fuels such as gas, and rising trends in carbon prices, the contribution of energy prices to CPI could be well above historical norms in the medium term, with potentially far-reaching consequences for households and businesses alike.³⁰ An increasing number of households, including in advanced economies such as the European Union (EU),³¹ United Kingdom^32, and the United States,³³ are unable to meet their basic need for heating and lighting at an affordable cost. The energy crisis has also affected companies producing energy-intensive materials like ammonia, steel, or aluminium, with significant knock-on effects, such as rising costs of fertilizers, which has compounded food security concerns worldwide.³⁴ With the price of consumer goods and services already rising due to constrained global supply chains, a sustained increase in energy costs will likely impact the cost of living and consumer spending while adding an additional cost burden to businesses and governments. Countries have taken various emergency response measures (Figure 4) in response to these concerns.

Figure 4: EU+ countermeasures enacted to combat high energy prices

In the face of economic headwinds along with geopolitical uncertainty, governments have. also been taking measures to address energy affordability challenges from the supply side. As a last resort to counter recent sky-high gas prices, some countries have increased coal-based power generation. In the United States, where coal-based generation has been in decline since its 2007 peak,³⁵ it increased by approximately 22%³⁶ in 2021, with coal production expected to further increase by 4%³⁷ in 2022. Germany is also investigating extending the life of certain of its coal-powered plants³⁸ to maintain competitive energy access. In addition, some countries are reconsidering their nuclear power generation policy.

Moreover, strategic petroleum reserves (SPRs) have been leveraged and have proven once again to be a critical tool for emergency response measures³⁹ to mitigate energy supply shocks. These could be crude reserves, petroleum product reserves or gas caverns. In the face of severe supply disruptions, this countermeasure can help economies mitigate some of the immediate economic impacts of a sudden supply shock. In early March 2022, a coordinated effort was orchestrated by International Energy Agency (IEA) member countries⁴⁰ to address significant supply disruptions. At the time of writing, the United States announced the largest release of oil reserves in history, comprising 1 million additional barrels per day for six months.⁴¹ SPRs can lower oil prices in a high-price environment, thereby having a stabilizing effect on the economy during an oil supply disruption scenario.⁴² Their major impact is by way of price relief or even alleviating the physical shortage of supply to at-risk and strategic consumers.⁴³ The system, however, focuses on handling short-term disturbances and has limited impact on medium- to long-term markets.

No universal definition of energy poverty or basic energy needs exists, because of sensitivities related to regional and income-driven differences.⁴⁴ Addressing these concerns will rest on a robust framework of data transparency to determine the magnitude and prevalence of the challenge at the national and local levels, mechanisms to effectively target vulnerable consumers for financial transfers, and the design of support measures in a manner that does not reduce incentives for efficient consumption.⁴⁵ However, the systemic nature of the challenge calls for long-term measures to safeguard vulnerable consumers and businesses from volatilities resulting from the transition.

Building resilience in transitioning energy systems to mitigate the adverse effects of volatility on small and medium-sized enterprises (SMEs),⁴⁶ consumers and the most vulnerable households is key to help advance energy affordability and a just and socially accepted transition. In this sense, the pivotal events of the past two years advocate for an energy transition that helps ensure energy affordability while pursuing sustainability goals. Developing the necessary support mechanisms to cushion energy supply shocks until the low-carbon energy systems reach the scale and flexibility required to consign the risks of a major fossil energy crisis to history will be essential.

Building resilience will likely come at a price to countries, companies, and consumers, owing to potential inefficiencies, redundancy, extra capacity, or green taxation. However, by minimizing the risks of dropouts and delays for economic reasons, it will be the only viable pathway to achieve close to a net zero⁴⁷ society by mid-century.