Political priorities have been evolving, particularly since 2022.  Due to the sharp increase in geopolitical risks and changing spending priorities, we have observed that many countries have gradually shifted their energy transition priorities. This, in turn, could alter the balance of the energy trilemma's of energy security, affordability, and sustainability priorities. For example, we have seen the U.K. and several EU countries backtrack on proposed environmental regulations regarding heat pump targets and the ban of petrol and diesel cars.

Public sentiment seems to be changing.  European voters are now seemingly more focused on geopolitical risks and cost of living pressures than on climate change. This was reflected in the European Parliament elections this year, with frontrunner parties shifting away from recent years' focus on the climate agenda. This is also reflected in voter surveys on their most important issues and, unsurprisingly, the new European Commission's strategic agenda, which passed in June 2024 and features the green transition significantly less prominently than the previous one.

Europe's dependency on energy imports could accelerate the energy transition.  As Europe's net energy import as a percentage of available energy has increased to about 60% over the past thirty years, Europe's incentive to reduce its reliance on fossil fuel imports continues to grow. Additionally, the terms of trade shock in 2022--marked by a sharp rise in the price of imports relative to the price of exports--impaired European countries' growth and fiscal performance significantly.

At the same time, the fossil fuel price shock may have further strengthened the impetus for renewables expansion also under the energy security aspect, in particular for net energy importers.  What's more, green technologies, especially renewable power, are increasingly cost-competitive with fossil fuel alternatives, thereby strengthening an economic case for climate policies. In many countries, subsidies increase in parallel with investments in the energy transition, including in the EU, the U.S., China, and India (see "Shifting Green Growth Narratives Are Fostering The Energy Transition," published March 20, 2024).

Governments Face Multiple Challenges

Fiscal constraints are becoming more binding.  Following a surge in government debt over 2020-2022 to mitigate the negative economic effect of the COVID-19 pandemic and the spike in energy prices, fiscal space has reduced for many governments globally. Interest rates have increased materially since 2022 and added to fiscal pressures. At the same time, still benign borrowing costs in many advanced economies contribute to persistently elevated deficits, provided funding conditions do not deteriorate sharply.

Regardless of the pace of the energy transition, governments will have to pay a price.  If governments were to slow the energy transition, they would likely have to continue spending on fossil fuel subsidies. The fiscal cost of fossil fuel and other subsidies, as well as foregone VAT and other revenues, is substantial. The most recent example of this is the energy price shock, when governments' subsidies affected the price signal for fossil fuels and reduced incentives to advance the energy transition. On the other hand, if governments were to accelerate the energy transition by cutting fossil fuel subsidies, they might risk voters' discontent. The amount of subsidies varied significantly across regions and was highest in Europe, where the increase in government debt was most pronounced (see charts 1 and 2). Expensive support policies during the energy crisis weighed on sovereigns' fiscal position and ate into other investments, including investments in the energy transition.

Chart 1

Chart 2

Governments have new spending priorities.  For example, defense spending will likely increase substantially, particularly in Europe, given the war in Ukraine. For emerging and frontier markets, on the other hand, economic development is a key challenge. Their energy demand could converge with that of advanced economies, raising the need to expand clean energy supply and avoid increased reliance on fossil fuels. Yet, finance, infrastructure gaps, and lacking access to technology are barriers to speeding up the transition, as is limited fiscal space (see "Development Needs Explain Transition Costs In Emerging Markets," published July 24, 2024).

The increase in energy prices intensified structural pressures in some European industries.  Energy-intensive industries in Europe lost some of their competitiveness due to higher energy prices. Additionally, European electric car and solar panel manufacturers are increasingly struggling with rising competition from China. This adds to political challenges as the European manufacturing industry could face job cuts.

Lingering inflation and higher cost of living affect government approval.  High inflation and energy prices increase affordability challenges, especially for lower-income households. This has contributed to the outcome of several recent elections and could impair the progress of the energy transition, depending on policy design and whether the impact is distributed unequally.

Chart 3

Balancing energy affordability with supply security and sustainability remains challenging.  Depending on the circumstances, some of these aspects get more attention than others. For example, the increase in energy prices that began in late 2021 and was aggravated by the Russia-Ukraine war shifted the focus from energy transition to energy affordability and supply security.

The Political Side Effects Of The Energy Transition Are Multifaceted

Distributional considerations will become increasingly important.  As the energy transition gathers pace, social aspects related to climate policy are becoming more visible. Lower-income households spend a larger share of their disposable income on energy and have been hit harder by the rise in inflation over 2022-2023 than higher-income households (see charts 4 and 5). If the transition increases energy prices, the effects will be felt across the entire social spectrum but affect lower-income households disproportionally due to their limited capacity to deal with rising cost of living. Carbon pricing and regulations, and the design of offsetting subsidies remain key factors in determining the effects of rising energy prices on lower-income households. Discussions about cost allocations--for example whether landlords or tenants have to pay for building renovations and low-carbon heating--already shape political discussions in many European countries. These could intensify if decarbonization efforts extend from the energy sector to the building and transport sectors. To prevent social unrest and voter backlash, we may see governments shying away from additional environmental regulations, which could delay the energy transition further.

Chart 4

Chart 5

The threat of structurally lower competitiveness in Europe, especially in energy-intensive industries, has increased concerns about job losses linked to structurally higher energy prices.  Previous job losses in the manufacturing industry have contributed to rising inequality and political polarization in several advanced economies since the 1980s. This experience, together with the energy price shock, could lead to an increase in protectionism or advanced economies' deacceleration of the energy transition. Developing economies could cite advanced economies' deacceleration of the energy transition to justify the prioritization of economic growth over climate actions. This is especially the case in countries that struggle with low fiscal budgets and a lack of access to basic services.

Countries' approaches to cover high energy transition investments differ.  EU governments mainly opted for carbon taxing, while the U.S. and China took more active industrial policies. Both approaches provide different incentives for companies to enhance green technology industries locally. Additionally, instruments such as the Inflation Reduction Act, which constitutes the largest investment in carbon reduction in U.S. history, affect trade by redirecting capital streams to U.S. companies, while Chinese companies are increasing competitive pressure in global markets. Some governments have attempted to protect their local industries by imposing tariffs on green technology products--for example, electric vehicles and solar panels from China are subject to tariffs in the U.S. and EU.

Energy Security Has Re-Emerged

The spike in energy prices over 2022-2023 has potentially delayed the energy transition over the short term.  The energy price shock cast a light on the importance of stable energy supply at affordable prices and renewed the focus on energy security. This led to governments allocating funds to alleviate the pressure of high energy prices on public and private sectors, thereby potentially reducing transition incentives over the short term.

On the other hand, EU countries' dependence on energy imports and developing countries' rising energy needs could accelerate the energy transition.  High fossil fuel prices incentivized governments to improve energy efficiency and adapt social measures, especially as subsidies might prove fiscally untenable over the longer run. The push for higher renewable investments was most pronounced when energy prices in Europe peaked and policymakers tried to increase energy independence from Russia. Beyond that, energy demand in developing countries is increasing quickly and may potentially catch up with that of developed markets. This indicates larger investment needs to ensure adequate supply.

Related Research

• Development Needs Explain Transition Costs In Emerging Markets, July 24, 2024
• Shifting Green Growth Narratives Are Fostering The Energy Transition, March 20, 2024