Ukraine invasion: from oil sanctions to accelerating the energy transition

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Rabah Arezki and
Per Magnus Nysveen
April 19, 2022

The sanctions placed on Russian oil may give new impetus to the energy transition by encouraging developed economies to find new sources of energy. Current policy has focused largely on supply-side responses to manage this development. This VoxEU column says that demand-side policies may also play a critical role. The authors argue for policies that increase the price elasticity of oil demand, such as incentives for individuals to switch to electric vehicles through subsidies. Nonetheless, they emphasise that the distributional effects of policies, including carbon pricing, are politically important and cannot be ignored.

In a nutshell

Most efforts to achieve the energy transition rely on supply-side policies such as bans on investments in fossil fuels and promotion of investments in renewable energies; these measures could be derailed without stimulating demand for cleaner energies.

Subsidies for the purchase of electric cars will be necessary as well as bold infrastructure investment to support the decarbonisation of transport; subsidies should also support the purchase of energy saving devices such as heat pumps.

For advanced economies, financing demand-side interventions in a progressive manner would surely lead to higher taxes; for households in developing countries including Africa, these interventions will require solidarity at the international level.

The war in Ukraine has triggered a debate in Europe and the United States over the moral imperative to extend oil sanctions against Russia to help stop the invasion (van Bergeijk, 2022; James et al, 2022). Estimates of the economic cost of oil sanctions on Europe are significant but appear manageable (Bachmann et al, 2022; Berner et al, 2022).

Beyond their intended purpose to stop Putin’s war of choice, oil sanctions provide a stepping-stone to accelerate the energy transition. But for that, the focus should not just be on the supply side but also on the demand side of the energy transition.

In the short run, finding an alternative to Russia’s oil and gas supplies is paramount for Europe. Prior to the start of the invasion, Russia, which controlled about 10% of global oil production, played an important role in the oil market, including through its alignment with the Organization of Petroleum Exporting Countries (OPEC). Following the invasion, the heightened geopolitical tensions from the war and talks about imposing sanctions on Russia’s oil have sent prices to new highs. In turn, higher oil prices are having a negative impact on the global economy.

To limit the increase in oil prices and fill the void that an interruption in energy supply from Russia could create, there have been insistent calls, including by the G7, for OPEC and non-OPEC members to ramp up oil production. Specifically for natural gas, countries like Algeria, Qatar and Norway have been called to the rescue. While tapping into global supply of liquefied natural gas will help to alleviate the dependence of Europe on Russia’s pipelined natural gas, issues related to the limited capacity to re-gasify natural gas have emerged.

Besides supply-side considerations, the best way to respond to what are likely to be lasting sanctions is to reduce demand for oil and natural gas. That could be achieved by public campaigns to reduce consumption akin to the ones seen in Europe and the United States during the energy crisis of the 1970s. To achieve a structural reduction in the demand for fossil fuels, Europe and the United States must use the current crisis as an opportunity to accelerate the energy transition.

To date, however, most of the efforts towards the energy transition have relied on supply-side policies such as bans on investments in fossil fuels and promotion of investments in renewable energies. These efforts towards the energy transition, as with the potential oil sanctions on Russia, could be derailed if not accompanied by commensurate efforts to stimulate demand for cleaner energies.

A one-sided approach relying on supply-side policies and ignoring the demand-side lever is problematic. To see this, consider oil, which constitutes about a third of the global energy mix. The differential of price elasticity between supply and demand determines the relative effectiveness of policies targeting supply and demand. The supply of oil has become much more elastic. Indeed, the advent of shale oil production in the United States has rendered the supply curve effectively flat.

In contrast, demand for oil is rather inelastic at least in the short run. The long-run elasticity of oil supply could remain much greater than the elasticity of global demand, even when accounting for the advent of substitutes for oil in the transport sector. Without accompanying measure on the demand side, sanctioning Russia will result in higher prices, which will stimulate oil production in other parts of the world much more than it will reduce oil consumption.

In this context, the most potent policies to achieve an accelerated but orderly energy transition will consist of policies to increase the elasticity of the demand side to accompany the shift in supply. Governments should thus pro-actively incentivise the switching of fuels including by subsidising the purchase of electric cars and supportive infrastructure such as charging stations.

Protests and social tensions often flare up in the face of higher oil prices. The perceived political cost associated with higher energy prices has led politicians to often reverse their efforts, in turn favouring dirty fuels (Arezki et al, 2020).

Without structurally enacting the demand-side lever, the energy transition will go through ebbs and flows, while the climate clock is ticking. Indeed, even as car manufacturers are producing more electric cars, they risk facing an abrupt demand slump on account of lack of available charging stations. What’s more, the absence of subsidies for modest households to acquire electric vehicles will limit the shift in demand and cultivate the perception that the transition is reserved for richer individuals.

Norway has incentivised the purchase of electric cars by removing high taxes and fees that applies to conventional cars and has provided free and green charging infrastructure. The Norwegian experience has been successful. In 2021, nine out of ten cars sold in Norway were electric ones. Norway remains a notable exception even so there are encouraging trends in China where two in ten cars sold were electric ones (Rystad Energy, 2021).

Adjusting prices is necessary but it likely to be insufficient to affect demand sustainably. The economists’ solution to climate change is carbon pricing to account for the negative externality associated with the use of fossil fuels (van der Bremer and van der Ploeg, 2021). But navigating the transition is complex and attention has shifted towards distributional issues (Klenert et al, 2020).

While surveys point to a majority of citizens, especially in advanced economies, supporting the struggle against climate change, there seems to be a sort of cognitive dissonance. Evidence also suggests that citizens are not ready to pay more for energy during the transition – at least in the short run (Bell et al, 2021).

Revenues derived from carbon pricing could be redistributed to address distributional issues associated with carbon pricing. But it remains to be seen whether carbon pricing with redistribution will suffice to shape the demand side sustainably.

Subsidies for the purchase of electric cars will certainly be necessary as well as bold infrastructure investment to support the decarbonisation of transport. Even if advances in technologies make the initial investment by households or firms profitable, that saving will not be felt immediately. That can create reluctance to purchase electric vehicles especially among more modest households.

Beyond electric vehicles, subsidies should support the purchase of energy saving devices such as heat pumps. These subsidies on the demand side would echo the effort on the supply side to promote decentralised power generation where users also become producers and more accepting of market-oriented solutions to the energy transition.

For advanced economies, financing demand-side interventions in a progressive manner would surely lead to higher taxes. For households in developing countries including Africa, these interventions will require solidarity at the international level. Yet if Europe and the United States impose oil sanctions, accompanying measures on the demand side of the transition, not just on the supply side, must become central to any efforts to accelerate the energy transition.

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