How rising energy prices can create risk globally

Global energy prices surged in the third quarter of 2021, providing a glimpse of the speed with which market imbalances can feed through to consumers and prompt swift government reactions including subsidies to low-income households. A new report on the ‘The net-zero transition’ by McKinsey Global Institute in collaboration with McKinsey Sustainability and McKinsey’s Global Energy & Materials and Advanced Industries Practices finds that as high emissions assets are ramped down and low-emissions ones ramped up in the net-zero transition, risks include rising energy prices, energy supply volatility, and asset impairment.

Price rise in natural gas, coal and electricity

The McKinsey & Company report says that natural gas price benchmarks in Europe and Asia were 10 times higher in October 2021 than one year prior. International coal prices were also sharply higher, at five times their fall 2020 levels. Rising primary fuel prices sparked large increases in consumer electricity prices in Germany, Spain, and elsewhere in Europe. Deteriorating margins for energy providers and electricity-intensive industries such as fertilizer production forced several companies to curtail operations.

Energy prices are already a highly critical topic given the centrality of energy to consumers and economic activity—even under normal circumstances. For example, according to the European Commission, 31 million Europeans live in energy poverty and are unable to adequately heat their homes.

The reasons for fluctuating energy prices

To help alleviate price rises, India, Japan, South Korea, the United Kingdom, and the United States announced in November 2021 they would be tapping into their respective strategic oil reserves. Some governments also initiated subsidy programmes. Italy and Spain capped home energy bills and redirected utility company profits to subsidize low-income households and small enterprises. A confluence of factors led to the price fluctuations, including a rebound in consumer activity as lockdowns related to the COVID-19 pandemic eased along with persistent labour and supply chain shortages.

In some instances, weather events exacerbated the situation, including low wind speeds in the North Sea, a cold snap in Texas that led to a gas production shut in, drought in Brazil that depleted hydropower reservoir levels to 25% below their five-year average, and flooding of Chinese coal mines that exacerbated shortages driven in part by the recent freeze on coal imports from Australia.

Net-zero transition will expose vulnerabilities

Such events, while not directly attributed to a net-zero transition, nonetheless shine a light on supply chain and grid vulnerabilities. In doing so, they can serve as a cautionary preview of potential future energy market volatility that can be triggered by rapid simultaneous shifts on the supply and demand sides of the global energy and materials landscape.

For example, as reliance on renewables grows and investment in fossil fuel–based power generation declines, tight supply for raw material inputs for technologies like solar panels and batteries may compound energy price volatility given long lead times in the capital-intensive mining sector. As the world acts on net-zero pledges, periods of energy price volatility like those in the last months of 2021, among others, thus serve as a reminder of the importance of careful transition management.

Exposure to these risks would also increase with electrification as a key pillar of the transition. Power outages, whether due to the energy mix, weather or operator error, would have far-reaching consequences where households and businesses are depending on a reliable source of electricity for day-to-day needs such as heating, cooling, appliances, vehicles, and industrial applications.

3 factors influencing cost of electricity

As the mix of the power system shifts to renewables in the net-zero transition McKinsey & Company have analyzed, in their report, various factors could influence the delivered cost of electricity, and also electricity prices for consumers.

First, the delivered cost of electricity would initially rise in the Net Zero 2050 scenario as power generation assets are replaced and transmission, distribution, and storage capacity is built. Increases in these costs could even be higher than calculated here, with implications for prices and with more volatility, for the various reasons discussed previously.

Second, storage and transmission costs, which constitute a substantial portion of the cost of electricity, could feed through to consumers in an uneven way, with some paying more while others experience savings. This will depend in part on a range of localized factors including existing transmission and distribution capacity and the need for long duration storage.

Finally, market design could be an important factor: as the power system changes, power markets may need to change with it. Today, power is sold through the spot market, in which prices are set according to production costs of the marginal power producer, and through bilateral purchase agreements between power producers and consumers. Capacity markets have historically accounted for a relatively small share of power sales, but they may play a larger role in the future to fully compensate flexible producers that help balance the grid.

New market mechanisms may be needed to encourage some marginal fossil fuel power producers to decommission their plants earlier. Key questions remain about how this would be paid for, and also how cost increases, if any, would affect end consumers.