This energy shock demands a green industrial strategy

The US-Israeli war on Iran has destabilized the entire Middle East, inflicted a massive human and environmental toll and caused one of the biggest oil price swings ever recorded. With the fallout reverberating through global stock markets and pushing up government borrowing, policymakers must recognize that this type of energy shock is not an isolated, short-term crisis. It represents our new reality.

In an era of geopolitical turmoil, economic resilience requires changing not only the kinds of energy we consume, but also how, where and by whom things are produced. Through a mission-oriented green industrial strategy and a macroeconomic framework that supports strategic public investment, governments can help secure living standards and build economic resilience simultaneously.

Immediate measures to protect households and businesses from the squeeze should be designed to advance larger economic goals. If a policy serves merely to prop up fossil fuel profits, it should be considered a failure.

Immediate measures to protect households and businesses should be designed to advance larger economic goals

Mariana Mazzucato

This is the moment for a new approach. Inflationary energy shocks driven by geopolitical conflict are becoming more common. Iran threatened to close the Strait of Hormuz during the 12-day war last June and it has now followed through with this threat, sending crude oil prices above $100 per barrel for the first time since Russia invaded Ukraine in 2022.

The UK, which was hit harder than any other country in Western Europe four years ago owing to its heavy reliance on natural gas and woeful lack of storage, is a cautionary tale for any country that is still willing to risk high exposure to sudden supply shocks. Despite the progress UK Energy Secretary Ed Miliband has made in advancing his “clean power” mission to decarbonize the power grid, the link between gas and electricity prices has not been severed. UK wholesale energy prices have shot up by about 50 percent since the start of the Iran war.

It would be a mistake for developed economies to follow US President Donald Trump’s example and double down on the fossil fuels that are driving energy price volatility and serving as military bargaining chips. The UK — and all other economies — will be more secure if the supply of electricity comes from clean, homegrown sources and, beyond the grid, transforms how we move, build and live.

The role of government is to ensure that crises do not benefit a small group of shareholders at the expense of everyone else

Mariana Mazzucato

But achieving this objective requires coordinated action across the government departments that oversee housing, transport, science and technology, and finance. Government missions should set a clear “moonshot” goal for all relevant ministries to pursue, because that is how the necessary cross-sectoral investments are mobilized.

The prospect of a renewed cost-of-living crisis looms large as a result of the current shock. In the UK, for example, the Office for Budget Responsibility’s projected decline in inflation from 3.4 percent to 2.3 percent this year has already been derailed and Chancellor of the Exchequer Rachel Reeves is under growing pressure to protect households from further pain. Food and energy accounted for about half of the 9 percent increase in UK consumer prices in 2022. A similar, even more potent dynamic may well now take hold as geopolitical threats and climate change intensify and disrupt agricultural yields and transport routes around the world.

Moreover, there is ample evidence to show that corporate profits were a major source of the 2022-23 inflation. The energy shock allowed firms to extract rents — excess profits — simply because they owned scarce assets, not because they had suddenly generated productive gains. The proper role of government is to ensure that crises do not benefit a small group of shareholders at the expense of everyone else. With the right response, crises become opportunities to drive real economic activity and broader economic transformations.

UK Prime Minister Keir Starmer and Reeves have, for example, proclaimed a “zero-tolerance” policy toward price gouging, much to the chagrin of leading gasoline retailers. But the details of such a policy matter immensely. The UK’s 2022-23 Energy Price Guarantee capped how much households paid by effectively subsidizing suppliers and then trying to tax windfall profits. Spain and Portugal found a better way to contain inflation by capping the cost of the gas used in electricity generation, thus reducing windfall margins at their source.

This second approach, combined with an ambitious renewable energy buildout, proved superior. Spanish electricity prices were 57 percent lower than the European average in the second half of 2022. Expensive gas now sets the electricity price only 15 percent of the time in Spain, compared to 89 percent in Italy. If the goal is to promote sustainable growth, it is better to establish equitable economic relationships from the start than to allow monopolistic profits to accrue and then attempt to tax them back.

Energy shocks reverberate through the entire economy because oil and petroleum products remain key inputs in manufacturing, transport and agriculture. Complicating matters further, higher central bank interest rates — currently the main tool used to tackle inflation — would only exacerbate the problem. Rate hikes make investment — including financing for renewables, which entail high up-front costs — more expensive, without doing anything to tackle supply-side sources of inflation.

Worse, sovereign borrowing rates will be pushed higher as investors price in these trends, further choking off much-needed public investment in schools, healthcare systems and infrastructure. To prevent this downward spiral, governments must stop relying so heavily on central banks and start addressing inflation at source.

Fortunately, green investment is a win-win. In addition to mitigating climate change, its spillover effects lead to higher productivity, good jobs and higher living standards. Once these are counted, it pays for itself. Just last week, the UK’s independent climate watchdog confirmed that every £1 ($1.34) spent on getting closer to net-zero emissions generates about £2.20 to £4.10 of value, along with wider benefits such as cleaner air, warmer homes and healthier diets.

This energy crisis is a moment for entrepreneurial states to develop the capacities, tools and institutions needed to secure affordable essentials, prevent opportunistic profiteering and catalyze an industrial transformation. As John Maynard Keynes pointed out nearly a century ago, the state must provide direction and investment when private sector and consumer confidence stalls. Governments must not let this latest shock paralyze them. It should spur decisive action to minimize human suffering and invest in long-term economic resilience.

• Mariana Mazzucato is Professor in the Economics of Innovation and Public Value at University College London and the author, most recently, of “The Big Con: How the Consulting Industry Weakens Our Businesses, Infantilizes Our Governments and Warps Our Economies” (Penguin Press, 2023).

©Project Syndicate