The drop in oil prices in recent months has brought welcome relief for consumers (while shrinking producers’ profits). But a new paper co-authored by SEI Senior Project Manager Per Klevnäs and Lord Nicholas Stern finds that oil prices are impossible to predict, and protecting economies from oil price volatility should be a priority for policy-makers.
Oil price volatility can seriously hurt the economy. The market value of oil is 5% of world GDP, its price can move by 50% within months. It is hard to reduce consumption quickly when prices rise, and this has widespread knock-on effects across other sectors. Oil price volatility can thus delay business investment, require costly reallocation of resources, reduce consumer spending, and slow job growth.
Conversely, reducing exposure to oil price volatility has economic value. Countries can do so by discouraging wasteful consumption, increasing energy efficiency, and expanding renewables.
“Governments must peg their policies to long-term energy trends rather than betting on oil prices staying low,” says Stern, co-chair of the Global Commission on the Economy and Climate, which published the paper. “These prices have never been stable, and price shocks are becoming more drastic and frequent than ever before.”
Instead, Stern adds, “governments should boost investment in renewable energy sources that are increasingly competitive, moving away once and for all from the current outdated carbon-intensive and unsustainable economic model. Missing this chance would be devastating for the future health of our economy and our planet.”
An opportunity for reform
Low oil prices do offer a valuable opportunity, the paper notes: countries can seize the day to improve energy pricing and reform. Energy prices are now “distorted”, the authors note, failing to reflect their environmental costs and often heavily subsidized. Subsidies for fossil fuel consumption alone reached an astonishing 550 billion USD in 2013, encouraging waste, straining public finances, and weakening growth by depressing investment in the energy sector.
Klevnäs, Stern and co-author Jana Frejova recommend that governments “seize the day” to undertake reforms with long-term benefits, including establishing carbon pricing and reforming fossil fuel subsidies. Low oil prices will dampen the impact on consumers and businesses, and the reforms will reduce inefficiencies and help insulate countries against future oil price volatility.
“Reducing our fossil fuel dependency is easier now than ever before,” says Klevnäs. “Just a year or two ago, consumers were paying double the price for gasoline as they are now, meaning they are less likely to notice a few extra cents on each gallon of gas due to a carbon price or reduced energy subsidies. The increased revenues could be used to offset impacts on low-income households and to finance reductions in other, distortionary taxes.”
Why renewables are still the best bet
Another key message of the paper is that even with low oil prices now, expanded investment in renewable energy — particularly for electricity — is still important, not just to reduce greenhouse gas emissions, but to help lower and stabilize energy prices in the longer term.
Cheaper oil does not compete directly with renewable energy for electricity production, but it can bring lower natural gas and coal prices, with wider impacts. Lower natural gas prices may strengthen the near-term case for switching from coal to gas, while making renewable energy less cost-competitive. In the long term, however, a shift to gas cannot depend on the indirect impact of lower oil prices, and achieving GHG benefits in such a scenario requires getting several policy measures right, from steps to reduce methane leakage, to continued support for fully CO2-free energy.
At the same time, the costs of renewable energy are falling and have low volatility, making them an attractive option regardless of short-term oil price movements. The costs of solar and wind power continue to fall fast, and there are steps countries can take now to reduce the cost of renewable energy solutions further, notably by enabling lower-cost finance. These energy sources have very low operating costs, so they can effectively lock in the cost of energy production for 20 years or more.
The best wind and solar projects can already compete even with cheaper natural gas, and renewables can also mitigate pressing problems that do not show in the market price for energy: energy security concerns, air pollution, as well as exposure to future fossil fuel price volatility. Still, using modern renewables is not without challenges. To benefit, countries need to start the process of “learning by doing”, putting in place local supply chains, new financing models, stable policy to attract investment, and the know-how for grid integration.
The paper also notes that the current low prices present an opportunity to avoid future “stranding” of assets. Producers are already cutting back on investment in the development of high-cost oil resources that are no longer viable under lower oil prices. Because a low-carbon future will require a sharp reduction in fossil fuel use, avoiding these investments now can protect against future stranding.