Are energy crises the new normal?

Good morning from New Economy Brief.

The US–Israel war on Iran has already been termed “the biggest energy supply/logistics crisis… in modern history”, with warnings that stagflation could “bring down the economies of the world”.

The scale of impacts remains highly uncertain – one key dependency is how long oil supply chains in the Strait of Hormuz remain disrupted and the extent of damage to regional energy infrastructure. But even if the war ends now, recovery will take “weeks to months”. 

This week’s New Economy Brief assesses the implications of the crisis for the UK economy, and looks at what can be learned from the last energy shock after Russia’s invasion of Ukraine.

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Energy price shocks and their effects

Oil has risen from $60 to around $100 per barrel, with Iranian officials threatening to drive prices to $200 to pressure Western governments into encouraging the US and Israel to stop the war. Geopolitical analysts see a 70% chance of prolonged disruption. Goldman Sachs warns the impacts could be 17 times worse than the last shock and oil prices could reach ~$150 per barrel. Meanwhile Oxford Economics warns that oil reaching $140 per barrel could trigger global recession.

Energy costs increase the price of other goods. The Resolution Foundation warns sustained disruption could raise bills by £500 this year. Ofgem’s price cap will cushion most households until at least the end of June, but bills will probably rise from there. However, firms renewing energy contracts will face immediate increases. Fuel prices are already rising and companies are passing increased costs on to consumers: the trade body Make UK says orders are falling, input costs are rising and confidence is weakening across manufacturers, while firms are raising prices at the fastest pace since 2023. 

Price spikes in other imports. Energy costs drive up to 50% of food price inflation, so we are likely to see increased food prices. The war has also disrupted trade of other goods, such as fertilisers – which UK farmers are wholly depending on importing. The Strait of Hormuz is a critical chokepoint for food (in)security; Chatham House experts warn that any disruption risks shortages and price spikes. 

Overall, stagflation risks are rising. Are we going to see another period of low growth and high inflation – stagflation? The OBR has estimated elevated energy prices could increase inflation by 1%, and markets now think the Bank of England will increase interest rates, rather than the gradual cuts over the year they previously expected. Recession was already a risk, but higher interest rates are likely to slow growth even further, eating into the government’s fiscal space - and that is before considering the costs of any crisis response.

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Learning from the last energy price shock

Inflation reached over 10% in late 2022, under the last government. And while rising inflation was a global trend, the UK fared worst in the G7 for much of this period. 

The Bank of England found that companies protecting their margins by passing on higher costs to their customers accounted for around 75% of UK inflation at its peak. IPPR and Common Wealth research argued that this is because energy, food and commodities giants have the monopoly power to set higher prices: “some stock market-listed firms not only protected their margins but also increased them, not only passing inflation on but further amplifying it.”

The last energy crisis undid many governments. The impact on lower income states was particularly acute, as they were priced out of energy markets as richer states outbid them for scarce supplies. Higher global interest rates also deepened the international sovereign debt crisis by increasing indebted countries’ borrowing costs. 

In the UK, it has been argued - for example by IPPR and NEF - that interest rates remained too high for too long. This dragged growth down, and led to increased borrowing costs that are still constraining the government’s fiscal options even now. How can stagflation be avoided this time?

The economic case for ‘unconventional fiscal policy’ to limit inflation. The Bank of England is bound by its current mandate to focus on targeting 2% inflation, and setting interest rates is its main tool to do this. Yet Monetary Policy Committee member Swati Dhingra has warned of monetary policy’s limitations in countering supply-side inflation: "even outside of extreme scenarios, monetary policy action alone… is not well-suited to address systemic price shocks in key sectors such as energy and food. It may even be counterproductive, as it could constrain investment that would enhance supply resilience and exacerbate future vulnerabilities."

Countering profiteering. The previous government allowed inflation to rise beyond 10%, in part because it was too slow to prevent rising energy prices from spreading into other parts of the economy via “pass the parcel inflation”. Other governments singled-out firms that they judged to be exploiting the crisis. Examples include the Australian government's targeting of supermarkets over rising food prices and Spain's windfall tax on banks to subsidise public transport and use of rent controls to protect renters. It's worth noting that both governments are rare political survivors of the last energy price crisis, suggesting that there are political as well as economic benefits to such policies.

Windfall and excess profit taxes? In 2022, IPPR proposed the Competition and Markets Authority should launch “pre-emptive investigations into the potential for excess profits in the most concentrated sectors of the economy” and tax excess profits in sectors beyond oil and gas. For example, Positive Money calculated that replicating Spain’s windfall tax on banks to recoup unearned profits from higher interest rates could have raised £12.5bn last year. Excess profit taxes don’t just deter companies in many sectors from passing inflation on to consumers; they also raise funds to provide the most vulnerable with extra support.

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UK government’s short-term response (so far)

Chancellor Rachel Reeves said “nothing is off the table” to help households and businesses cope with energy bills. Energy Secretary Ed Miliband also warned “this government will not tolerate price gouging”, while the Prime Minister Keir Starmer has announced a ‘legal direction’ for energy firms to pass on £150 in savings from the 2025 Budget and pledged to protect “working people” from rising energy costs.

Early signals suggest more targeted support than the universal price caps used last time. The Financial Times’ Stephen Bush suggests cash transfers for vulnerable households could both be cheaper and include incentives to switch to lower-carbon options. Proposals like NEF’s National Energy Guarantee aim to focus support where it’s needed most and encourage home decarbonisation.

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Building long-term resilience

Three lessons emerge.

First, the crisis reinforces the government’s case for clean energy to reduce exposure to volatile fossil fuels. While the UK is already moving at pace towards a largely renewables-based electricity system, further efforts are needed to electrify the wider economy - especially to accelerate the process of getting homes off gas heating. 

Second, greater resilience is needed to cope with price shocks in an increasingly volatile global economy. The International Energy Agency has now agreed to the biggest release from its strategic oil reserves in history to stabilise prices in the short term. The government could also consider building up stocks of fertiliser like Finland and Switzerland do, or buffer stocks of other essentials to control inflation when trade shocks inevitably arise.  

Third, the UK’s monetary policy framework was built for a different economic context. The government could consider using dual mandates or green credit guidance to reduce the cost of capital for investments that enhance resilience, and ‘adaptive inflation targeting’ and other forms of monetary and fiscal coordination against supply-side inflation. Last reviewed in 2013, the framework predates Brexit, Covid, Ukraine, and Iran. In an economy that is ever-more prone to crisis, a reassessment seems well overdue.