Sir Dieter Helm, Professor of Economic Policy at the University of Oxford, and Arima Jun, Professor at the Tokyo University Graduate School of Tokyo and Consulting Fellow at RIETI, shared their views on the current geopolitical landscape, state of energy and commodity markets, the strategies taken by European countries to diversify energy sources, and the ongoing impact on climate change.
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Sir Dieter HELM:
It is very important to distinguish the difference between crisis and crisis management and medium-term and long-term energy policy. At the end of the 1970s, a short-term energy crisis led to decisions that then four or five years later turned out to be very ill-considered. When oil and gas prices go up, people start assuming that they'll go on up forever, and can never come down. In the 1980s, the oil price collapsed from its peak in 1979, and we inherited a whole set of policies on the assumption that oil prices would go up right through the 80s, the 90s, and beyond, and they virtually never went back to those same levels.
The commodity cycle and the rise of commodity prices across the board started well before Russia started its invasion of Ukraine. Commodities were rising at the end of last year, and this wasn't confined to oil and gas. It included agricultural markets where commodities were already going up, as well as nickel, aluminum, steel, and many other commodity products.
That commodity price inflation is the product of two things: first, the recovery from the pandemic in which supply chains have been seriously damaged and where all sorts of cost-saving measures were implemented during the pandemic for companies to survive, including the just-in-time production philosophy of keeping their inventory, stocks, ships, etc., at a minimum, and suddenly demand burst back and supply couldn't respond, resulting in prices going up. The drive to disinvest from fossil fuels by environmentalists also meant that oil and gas companies were not investing as much capital for the last few years.
Second included the extraordinary monetary and fiscal policies and quantitative easing, all of which are still going on. In a country like the UK, the interest rate is half a percent, and it might rise to 0.75% later this week. However, the inflation rate is around 8%, which means the real interest rate is currently -7%. That's an extraordinary monetary stimulus, and much of the bond buying, etc., has not come to an end across the developed world. Stimulus like this has never been seen before and it would be surprising to find if this did not produce a lot of inflation, particularly commodity price inflation.
On top of this, Russia also invaded a sovereign country. As the invasion started in February, it was a bit late in the winter to have the maximum effect on oil and gas markets in the northern hemisphere, and has not been the optimal time for Russia to exploit the position in the West. Russia does have a stranglehold over Germany in particular, but within some limits. We have to ask what's going to happen in one to five years after this. The resistance could last for a decade, it could be over by Christmas, Putin might be deposed, there might be a revolution inside Russia and then we'll all want to be friends with Russia, and suddenly we'll all be buying Russian oil and gas again. So, we do not know what those options look like.
What we do know is that Russia is overwhelmingly dependent on oil and gas exports. The economy is relatively small and it has oil and gas, and a large military. As oil and gas prices go up, there is a windfall for Russia, which helps finance its aggression. But that may not last going forward. The consequence of the dependence on oil and gas is that Russia needs to sell it. Russia does not have the luxury of keeping its supply and turning off exports. The impact on the Russian economy would be dire.
That said, Russia does have one outlet: China. If Putin remains in power, Russia could possibly become a vassal state of China. China needs a lot of natural resources and Russia has them, such as timber. Russia will figure out what economic dependency in geopolitical terms really means, and that probably won’t be in the interests of either the Russian people, the Russian elite, or what's left of it at the end of this episode.
In Europe, Germany has the biggest dependence on Russian raw materials, and oil and gas. The relationship between Germany and Russia is at least 100 to 150 years old. Russia essentially sells natural resources to Germany, and Germany provides machine tools, manufactured products, etc. This dates right back through the 20th century, most notoriously during the Hitler-Stalin pact, when Germany, without its own domestic oil production in order to support its military, needed a reliable source of supply. It was a deep integration between Germany and Russia at the time. The biggest immediate geopolitical consequence of the invasion of Ukraine – apart from the Ukrainian people – is that Germany has changed its foreign and energy policy probably more than any time since about 1948.
Germany has delayed the closure of nuclear power stations, with some speculation of trying to reopen some of the recently closed nuclear power stations, and they have gone from a fairly pacifistic position to one aspiring to a defense spending of 2% of GDP. With German GDP being quite large, with a lot of money in defense, and in the supply of arms to the Ukrainian people in their valiant defense of their country, they will try to prune themselves off Russian gas. They're building new LNG plants that are hydrogen ready. So, a long-term geopolitical effect in Europe is that hydrogen has been given a huge boost, especially in Germany. But if the Putin regime was to collapse, the dependent relationship would revert back to how it was.
In terms of climate change, effects in the short term are very bad. There has been a switch from gas to coal, with a big increase in coal burn in China as well. The world is a very long way from any aspiration to seriously address climate change. 80% of the world's economy is provided by oil, gas, and coal. Most of our economies are fueled by fossil fuels, with the rest being a bit of nuclear and hydro. And only around 1.5% are from renewables, wind and solar, etc.
The push to expand nuclear and wind, etc., will be spurred on by what's happened. But in the bigger scheme of things, if we carry on adding two parts per million per annum to the concentration of carbon in the atmosphere, as we have done for the last 30 years, and as we did in 2020 and 2021 despite the lockdowns and the emissions reductions, that concentration of emissions in the atmosphere keeps going up. Even after 26 COPs, we're no closer to fixing climate change that way.
The outlook in the medium-term, however, has been the big reappraisal in nuclear, hydrogen coming a long way up the scale, and CCS carbon storage also getting a big lift. Although it is just a sketch of some of the issues at stake, do not mistake crisis management for energy policy.
It would be inevitable that we would see a delay in the clean energy transition. Over the last 10 to 15 years, an excessive priority was placed on climate change, while taking supply security for granted. However, the situation in Ukraine will bring supply security back as a top agenda for many countries.
The EU has put forward a very laudable policy for energy independence while pursuing clean energy transition simultaneously. The supply shortage of Russian oil and natural gas will call for additional supply from the U.S. and Qatar. However, as that may not be sufficient, so high gas and electricity prices could lead to strong incentives to use coal for the sake of supply security and more affordable energy prices, particularly in countries like Germany or Poland and other eastern European countries.
The impact will be even more acute in Asian countries where they are still heavily dependent on coal, and high natural gas prices in the international market will discourage the move of switching from coal to natural gas. This will have a big impact on global mitigation efforts, since the shift to natural gas was regarded as a low hanging fruit for energy transitions in Asian countries.
The willingness to pay the higher energy costs will dwindle not only in developing countries, but also in developed countries, and the government should be honest about anticipated energy price hikes caused by green policies, which will not be welcome during difficult economic times.
While environmental activists may strongly argue for an accelerated phase-out of fossil fuels and nuclear power, it would be self-destructive for many countries. For Japan, reoperating its nuclear power plants will be the most feasible option for energy security and greenhouse gas emission reduction. Japan will certainly promote renewable energy as well, but it needs to be careful about its dependence on Chinese renewable energy products and strategic minerals in which China has a strong direct or indirect influence. With the increase in cheap gas and oil from Russia that China is likely to benefit from, China is likely to increase production and export of batteries and EV to developed countries, and coal-fired power plants to developing countries, which will both be suffering from the higher energy prices. Overly hasty introduction of intermediate renewables will just be a boon for China’s exports. The situation in Ukraine is likely to lead to a more confrontational cold war between autocratic states like China and Russia, and democratic states in the future, which would not be conducive to the climate change agenda, which demands true international collaboration.
While it is necessary to sustain our efforts for long-term decarbonization and accelerate research on innovative technologies, especially CCUS and hydrogen, we should recognize that the 45% reduction in global emissions by 2030 called for at the COP26 is a pipedream.
What’s your perspective on the energy market in this inflationary environment?
Sir Dieter HELM:
No energy policy should ever be designed on the assumption that you know what future energy prices will be. As an example, the secretary of state in the UK said that it was a good idea to build new nuclear power stations to avoid high and volatile gas prices. If you take a moment to think about what that means, he is saying that he knows that oil and gas prices will be particularly volatile at the earliest date when nuclear power stations would come online, which would be 2035.
Crisis management for high prices must be implemented for today, and you must manage security today, particularly where there are real tight constraints. But if you look out over the decade to come, and this is one of the reasons why addressing climate change is so difficult, we have a world that is awash with potential gas supplies, potential oil supplies, and has for all practical purposes, infinite coal supplies.
What we know is the cost of production even for shale gas in the United States has come tumbling down. We know the Middle East has a marginal cost of oil of about $2-5 a barrel, and we know Russia's marginal cost of production is probably about $20. It takes time for supply to respond to demand. All sorts of countries are now going to develop oil resources. Uganda, Mozambique, and Angola are examples of other countries in the developing world pushing forward with development. We have plenty of potential sources.
The one twist that's slightly different is that shale technologies are very fast. You can literally design the capital expenditure in shale on the future price of oil. It could take 4-5 years, but for the price itself, markets work. Price is destroying demand everywhere. Substitutions are happening, such as with coal, but these were happening long before Russia invaded Ukraine.
Then you have people saying renewables are the cheapest source of electricity generation. They’re generally not, once you take into account their intermittency. It's true that the marginal cost is zero, but nothing follows from that, and the components for products such as electric cars, wind turbines, solar panels, etc., many are dependent on China and are rising in price extremely fast. So, we're going to have an inflation, but the real price of the fossil fuels will in due course return to the path that it's had for 100 years, which is a gradual, slow fall in its real price, which is attached to a gradual, slow fall in the real costs of production. So, I expect over time the oil and gas prices will do what they always do, which is fall back to some normal balance of supply and demand.
Were Russia to go through an internal revolution where Putin was disposed, having gone through all of these efforts now, and then have Russia come back into the market on top of all of that, it's not inconceivable we could see in a few years’ time a price collapse of oil and gas. I don't know whether that's going to happen, and I wouldn't design energy policy on it, but I certainly would not design energy policy on an assumption of oil and gas prices remaining high and volatile forever, and right through to 2035 to be the framework for deciding whether to build nuclear power stations or whatever.
Do you think the current crisis in Ukraine will accelerate or derail the transition to a clean energy future?
Sir Dieter HELM:
It's complicated. There are some technologies that are in the green camp and they enhance security. The case should always be that any decarbonization policy follows a path that meets security and because most renewable technologies are low density, disaggregated, and intermittent their operation is necessarily backed up by a lot of gas And one of the ironies of what's happened in this price cycle is that the UK, which imports virtually no gas from Russia, has been hit very hard. Part of that is because the UK got out of coal, and also, it needs gas as its main source of producing electricity to back up the renewables, but the intermittent renewables make the gas intermittent too, and therefore raise the cost of that gas.
For some parts of the decarbonization path, this seems to be “good news for nuclear,” and Germany’s change of heart, perhaps as well as Japan, has been dramatic. It's also a turn to small modular reactors and new nuclear. The UK looks to the experience of France, where 70-80% of its electricity is produced from nuclear. Much of the rest is hydro. Therefore, the French government can limit price increases to customers to 4%, because prices haven't gone up in France. Of course, the Électricité de France (EDF) could have sold its electricity at the marginal cost of gas, but that would have been a windfall profit to the French government because the French government owns most of EDF. So, it does give you an example of what kind of insurance is bought by having baseload low carbon energy.
And the other component of this is that if we look at the technologies coming to the market going forward, a lot of them are zero marginal cost. That requires a rethink of electricity in particular markets to see it more as capacity and less as energy because the energy itself is free, and that's been true of nuclear. But as Germany discovered in one fell swoop, restarting existing nuclear power stations has big potential for addressing a portion of climate change. There are sensitivities and arguments around nuclear power, but purely from a climate change point of view, why wouldn't you do that?
A big change in Germany is deeply a political psychology. As long as German industry is quietly going on importing all that gas from Russia and on long-term contracts, it is not paying the current spot price of that gas, and German industry might be complicit or compliant with closing those existing nuclear power stations, but that might change if the political pressure keeps moving in the current direction, allowing them to renew their interest in nuclear, given that the green party, which is part of the government, is now pro-nuclear.
As a fan of carbon border adjustment measures (CBAMs) for combating consumption-based CO2 emissions, and as it seems very difficult to have a transatlantic alliance over CBAMs due to Congressional situation in the US, how do you see the future of CBAMs under the current geopolitical situation?
Sir Dieter HELM:
There are two parts to the answer to that question. First, CBAMs are the right answer. If you want to stop causing climate change, it's absolute nonsense to address climate change domestically, to have all the costs that go with it, and to damage your existing domestic industry compared to imports.
In the UK, where 80% of industry are in services now, (we import our fertilizer, aluminum, steel, petrochemicals, etc.), and anybody in the UK who wants to produce steel has to pay a carbon price, but if it's imported from China, they don't, it's basically a subsidy to your competitors. Territorial carbon production targets in net-zero terms don't achieve the claimed objective of stopping causes of climate change and in fact they can make things worse.
If you look at where carbon-intensive trading is coming from, it is actually coming from countries like China and Russia. That's why they are so vehemently opposed to these, because it gives them a competitive advantage. You can see this in other areas as well. In rare metals, nickel, etc., mining them in China, using coal energy to do this, and then exporting them for so-called renewables in other countries is a great game. It's actually very damaging to the climate, and one of the reasons why we haven't diversified to produce these minerals elsewhere and not rely on China is precisely because we've effectively given them a carbon subsidy to do it there.
The second question is whether it will actually happen. There you come up against deep vested interests and lobbying, which is part of political life. In the end, the U.S. will end up with a carbon price, just like Europe and elsewhere already have, because they need the money and they have run out of a tax base. Also, there are many carbon prices out there already, so, the current oil price is largely an OPEC carbon tax, with the production cost at $5 a barrel and the price at $110 a barrel, making that a $105 carbon tax, and that's why I think the carbon price should be inverse of the oil price.
The other bit of politics is it depends on who the losers are. If the losers turn out to be China and Russia, instead of putting import tariffs on China's imports, you could have them put on the pollution content of those imports, which is much better. But the longer things go on without choosing this option, the worse climate change will be, and the more we may pursue an unsustainable set of policies, (that's what we're doing in respect to climate change), but you can't escape the consequences of that, which is that it will not be sustained, and then we will be on the path to 3 degrees warming or more, which looks more likely than ever now, with COP26 achieving very little.
Focusing on the dependency on the Chinese market could be complicated, due to its market being so large, particularly for countries such as Germany. What is your view on the possible strong opposition to that, even from developed countries?
Sir Dieter HELM:
In the case of Germany, one of the little-known features of the German government is that the Greens are very keen on human rights. Therefore, their foreign policy has always been much tougher on China and on Russia. The Uyghur issues, the concentration camps in Northwest China, etc., are matters of deep concern to the Green Party and that shapes the nature of that government.
This dependency of countries like Germany on exports to China, just like the dependency of German industry on Russian gas, both of those have had a nasty shock, and globalization may continue on its retreat, which has been going on for the last 5 to 10 years. This will most likely be reinforced.
This notion of energy independence is too far-fetched, just like economic independence. Shortening of supply chains and re-shoring, especially in a world where labor costs don't matter so much because it's all digital, location is a lot less important. Europe may have the potential to become a serious manufacturing base again, and the current misunderstanding over this is because we have not understood the basic underlying technology changes that are taking place with big data, AI and machine learning, robot production etc., and this old idea of cheap labor, which led to the historic transformation of China, is over. Chinese economic growth may be over as well. In the 1980s, we thought the future was entirely Japanese. We imported any idea from Japan to learn how to do it, and those miracles came to an end and the Chinese miracle is coming to an end. That may also be reinforced in Europe.