Energy Affordability - Subsidies Deep Dive

Saviour Of The Energy Sector Or Hyped-Up Pocket Money?

Contents

1. Introduction

2. Financing and Interest Rates

3. Strategies To Clean Up Our World

4. Subsidy Dependence

5. Types of Subsidies

6. Concluding Remarks

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Bitesize Edition

• We’re currently experiencing a period of higher interest rates when compared to the previous years of ultra-low rates. This has come on the back of inflation returning. As we pursue a cleaner energy sector, how will interest rates and inflation play into this? Will the inflationary pressures remain?

• If we do remain in a period with higher interest rates and inflationary pressures, what strategies can we adopt in our pursuit of a cleaner world?

• Finally, if subsidies are how governments are seeking to expand their energy sectors, when can subsidies become a bad thing? If projects and companies become dependent on subsidies, is the government keeping afloat companies that are potentially unproductive, inefficient, and unprofitable? To me, this isn’t a company that we want subsidies to be propping up. Let’s dive in.

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Introduction

Last week, I set a basic introduction to tariffs and subsidies. This week, I’m going to dive more into specific concepts. How do higher interest rates affect the financing of energy projects? Can projects become too dependent on subsidies, and what subsidies can be utilized in different scenarios?

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Financing and Interest Rates

The world is entering into a period of potential fracturing. We have the Russia-Ukraine War in Europe, the Israel-Hamas conflict and the Israel-Lebanon clashes in the Middle East. We also have Civil war in Sudan, Syria, and Myanmar. Venezuela is in political turmoil and raising tensions with Guyana, Mexico has a gang crisis, and Haiti has descended into chaos. The list goes on.

The conflict is occurring due to shifts in power. Power vacuums are forming and moves are made to take advantage of this. The shape of the geopolitical world is changing, and Middle Powers are rising and gaining influence; Powers such as Turkey, Indonesia, Vietnam, Poland, and India. All this is happening in conjunction with the United States-China superpower conflict which is unfolding through different “hard to see” methods, but not through a hot war. One such way this is unfolding is through the tariff war, which I’ll discuss later on.

I bring up the general geopolitical landscape because the breakdown of some geopolitical relations, the emergence of power vacuums, and the rise of middle powers have the potential to spark further geopolitical tension. Trade and resource wars are already a method that has been seen in this new geopolitical world. Be it Indonesia restricting nickel exports, or China limiting the export of Gallium and Germanium, supply chains have been weaponised, and they will be again.

In a period where countries are trying to clean up their energy sectors, they often need access to scarce resources. If a country with a large market share of a scarce commodity chooses to hoard its supply, this can incite inflationary pressures. If this resource is one that is vital for the energy transition in developed countries, their options are limited. They pay higher prices elsewhere, establish their own domestic supply chain, or explore other technologies. None of these strategies come without disruption.

There are inflationary undertones to our clean energy transitions. There is the potential for fiscal inflation with high spending to fund these projects. There is also supply chain inflation as we saw with energy in 2022 after the decoupling of Russia and Europe.

Photo by Mahsha Ziapour on Unsplash

One such strategy central banks have taken recently to attack inflation is to raise interest rates. Higher interest rates ensure that borrowing costs more since you have to pay greater interest payments on any debt you take out. Hence borrowing occurs less, and spending falls. The aim of reducing spending is to reduce demand for goods and services. As a result, supply remains fairly constant, while demand falls. The aim from here is that inflation, which is the percentage rate at which prices are increasing, falls with reduced spending and reduced demand. Note, this doesn’t mean prices in the grocery store start to fall. Deflation is needed for this, which is negative inflation. The rate at which prices are rising is what declines.

The aim here is to balance supply and demand so inflation reaches the levels of central bank targets, which are currently around 2%. When supply chains are weaponised, especially by those with possession of a high market share of key materials, reduced supply can lead to an imbalance that is reflected in rising prices. Again, this is inflationary.

Where we find ourselves in a tough situation, is how we navigate an environment with higher inflation, higher interest rates, and slower economic growth, when we are trying to undergo clean energy transitions that will cost a large amount of capital.

Private investment will also fall during this period of higher interest rates, so let’s assume the burden comes from government spending. In developing countries in recent years, high government debts have been in the spotlight. With more debt issuance in an environment of higher interest rates comes larger interest payments on debt. Over the long term, this isn’t sustainable.

Have we got ourselves into an impossible-to-manage situation with inflationary pressures and high government debts? In developed countries, this is the reality of the situation. Countries with lower levels of government debt have manoeuvrability. They have options. If they can innovate and build infrastructure during this period, they will establish themselves as a rising geopolitical power.

For the United States, possessing the dollar as the global reserve currency is a great advantage. This means if countries hold debt, or purchase anything on international markets, it is usually the dollar that facilitates this. Countries are diversifying away from dollar debt, but the dollar still reigns supreme and will for decades to come. It is the deepest bond market in the world and the most liquid currency by quite a distance. The fact that no other currency today can rival it is why the dollar will continue to reign supreme. A further issue arises when we consider a country without this privilege. Take a country like the UK and the situation grows more difficult. Take a country that can’t freely print its own currency, and the situation grows darker still.

Photo by Kenny Eliason on Unsplash

In a sentence or two, inflation pressures remain, and geopolitical competition will further exaggerate these inflationary pressures through the potential for supply chain disruptions. Couple this with the inflationary pressures of high government spending on infrastructure projects, while interest rates are higher to combat inflation, and we find ourselves stuck between a rock and a hard place.

The choice in this situation is between the loss of purchasing power through high inflation, or economic slowdown through high interest rates. Neither is particularly great, but do we have options? Are there any strategies that can pull us out of this mess and incentivize cleaner energy, all while navigating tough economic environments? If we want to clean up our energy sectors, we have to incentivize countries to pursue cleaner energy sources. After all, if costs for some energy sources are high, underdeveloped countries will take energy that is readily available and cheap. That continues to be fossil fuels. How can we improve the affordability of cleaner energy sources so they can’t be denied as the cheapest and easiest to access?