Managing energy transition risks in a shifting political landscape

The evolving political landscape, particularly since 2022, is reshaping energy transition priorities, according to S&P Global analyst Ludwig Heinz. With geopolitical risks increasing and changes in government spending, several countries, including the UK and some EU members, have altered their stance on environmental regulations, such as those concerning heat pump targets and the phase-out of petrol and diesel cars.

Heinz said that public sentiment in Europe has shifted, with voters now more focused on geopolitical risks and cost of living issues than on climate change. This change in priorities was reflected in the European Parliament elections, where leading parties moved away from the recent focus on climate agendas.

The new strategic agenda of the European Commission, passed in June 2024, also reflects this shift, with less emphasis on the green transition compared to previous agendas.

Heinz suggested that Europe’s dependency on energy imports, which now account for approximately 60% of available energy, could accelerate the energy transition. The 2022 terms of trade shock, marked by a sharp rise in the price of imports relative to exports, significantly impacted European countries’ growth and fiscal stability. The fossil fuel price shock has further emphasized the need for renewable energy expansion, particularly for net energy importers.

Governments are now facing multiple challenges as fiscal constraints become more binding, according to Heinz. The surge in government debt from 2020 to 2022, driven by efforts to mitigate the economic effects of the COVID-19 pandemic and rising energy prices, has reduced fiscal space for many governments.

While borrowing costs in advanced economies remain relatively low, the increase in interest rates since 2022 has added to fiscal pressures, making it more difficult for governments to manage deficits without sharp deteriorations in funding conditions.

Significant costs regardless of the energy transition pace

Heinz pointed out that regardless of the pace of the energy transition, governments will face significant costs. If they slow the transition, continued spending on fossil fuel subsidies will likely be necessary. These subsidies, along with the loss of VAT and other revenues, represent substantial fiscal costs.

The recent energy price shock, where government subsidies lowered fossil fuel prices and reduced the incentive to advance the energy transition, serves as a recent example. However, accelerating the transition by cutting fossil fuel subsidies could risk voter discontent, especially given the significant variation in subsidies across regions, with Europe seeing the highest increase in government debt.

The changing priorities of governments are also evident in increased defence spending, particularly in Europe, in response to the war in Ukraine, Heinz said. For emerging and frontier markets, economic development remains a key challenge. As their energy demand begins to converge with that of advanced economies, the need to expand clean energy supply grows.

However, barriers such as finance, infrastructure gaps, and limited access to technology are slowing the transition, particularly given the restricted fiscal space in these regions.

The energy price increases have intensified structural pressures in some European industries, according to Heinz. Energy-intensive sectors in Europe have lost competitiveness due to higher energy costs, with European electric car and solar panel manufacturers facing growing competition from China.

This situation presents political challenges, as the potential for job losses in the European manufacturing sector raises concerns about political stability and social cohesion.

What’s affecting government ratings?

Heinz noted that high inflation and rising living costs are impacting government approval ratings. The affordability challenges posed by these factors, especially for lower-income households, have influenced recent election outcomes and could affect the progress of the energy transition, depending on how policies are designed and whether the impact is distributed unequally.

In some Eastern European countries, high inflation has been accompanied by falling government approval ratings, reflecting concerns over the cost of living.

Balancing energy affordability with supply security and sustainability remains complex, according to Heinz. The increase in energy prices since late 2021, exacerbated by the Russia-Ukraine war, shifted the focus from energy transition to energy affordability and supply security. The distributional effects of the energy transition are becoming more important as the process accelerates.

Social aspects related to climate policy are increasingly visible, with lower-income households, who spend a larger share of their income on energy, disproportionately affected by rising costs.

The threat of decreased competitiveness in Europe, particularly in energy-intensive industries, has raised concerns about job losses, Heinz highlights. The experience of previous job losses in the manufacturing industry, which contributed to rising inequality and political polarization in several advanced economies, could lead to increased protectionism or a slowdown in the energy transition in advanced economies.

Developing countries may cite this slowdown as justification for prioritizing economic growth over climate action, particularly in regions struggling with limited fiscal budgets and access to basic services.

Different approaches across different governments

Countries are taking different approaches to funding high energy transition investments, according to Heinz. EU governments are mainly relying on carbon taxing, while the US and China are pursuing more active industrial policies.

These approaches create different incentives for companies to develop green technologies locally. Instruments such as the US Inflation Reduction Act, which represents the largest investment in carbon reduction in US history, are influencing global trade by redirecting capital flows to US companies. Meanwhile, Chinese companies are increasing competitive pressure in global markets.

Heinz said that the recent spike in energy prices has highlighted the importance of stable energy supply at affordable prices, potentially delaying the energy transition in the short term. However, Europe’s dependence on energy imports and the growing energy needs of developing countries could ultimately accelerate the transition.

High fossil fuel prices have incentivised governments to improve energy efficiency and adopt social measures, particularly as subsidies may become fiscally untenable in the long run. The push for higher renewable investments was most pronounced when energy prices in Europe peaked, as policymakers sought to increase energy independence from Russia. In developing countries, rapidly growing energy demand indicates a need for larger investments to ensure adequate supply.

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