Fri, Mar 11, 2022

The Costs and Benefits of Energy Embargoes as a Result of Russia's Invasion of Ukraine

  • The energy embargoes imposed by the United States and United Kingdom are largely symbolic in nature but put pressure on the European Union (EU) to also impose energy sanctions.
  • EU sanctions on Russian gas would probably be prohibitively painful, so we expect oil sanctions as the EU makes a concerted effort to reduce its dependence on Russian energy.
  • In the short term, the EU will see weaker demand as a result of higher energy costs, but over the medium- to long-term, Europe could become a significant spender–a major reversal of its role in the global economy over the past few decades.

The first few rounds of sanctions that the U.S. and its allies imposed on Russia included a carve-out for energy, but this window of opportunity for Russia to earn foreign reserves is slowly closing. The U.S. announced an import ban on all Russian fossil fuels, while the UK will embargo Russian oil. These moves were largely symbolic yet added pressure on the EU to follow suit.

With only 10% of U.S. energy and  8% of UK oil coming from Russia, import bans will not be a game-changing development for either economy. The implications for growth will come through higher oil prices, which will remain volatile and elevated as the Russia's war on Ukraine persists. That said, the U.S. sent a senior delegation to Venezuela for the first time in years, signaling that Venezuela might be considered a potential substitute for oil.

The primary impact of the U.S. and UK announcements may be increased pressure on the EU to sanction Russian energy, which would have significantly more implications for both the Russian and EU economies. The pipeline infrastructure makes it difficult for Russia to sell much of its natural gas outside of Europe. The EU is reliant on Russia for roughly 40% of its natural gas, 30% of its oil and 50% of its coal.

For this reason, some EU leaders are reticent to join in the energy embargo, with German Chancellor Olaf Scholz insisting that it is “a conscious decision on our part to continue the activities of business enterprises in the area of energy supply with Russia.” Germany relies on Russia for over half its gas supplies, a quarter of its coal and a third of its oil. A recent academic study showed that a sudden halt of energy imports from Russia would reduce German GDP by between 0.5 and 3 percentage points. The high end of that estimate comes primarily from banning Russian gas and failing to find suitable alternatives. This is not merely a tail risk scenario–the liquefied natural gas (LNG) market is relatively small and could not compensate for a loss of Russian supply. And to make matters more complicated, half of the EU’s coal also comes from Russia.

An EU ban on Russian natural gas may hurt the EU more than Russia in the short term. A sudden embargo on Russian gas would send prices skyrocketing and almost certainly push the EU into stagflation (no growth or a mild contraction as inflation soars). European gas futures prices are already 13 times higher than their level a year ago.

A more likely scenario is an EU oil embargo as the bloc works to reduce its dependence on Russian gas. In 2021, Russia generated almost three times the revenue from oil exports than from gas. A more global ban on Russian oil would therefore impact the Russian economy significantly.

At the same time, the EU is already searching for ways to reduce its Russian gas dependence. The EU announced plans to cut Russian gas imports by two-thirds over the next year, focused mainly on importing more liquefied natural gas, boosting renewable energy, increasing efficiency and improving insulation. The proposal must still be adopted by EU member states at an upcoming summit. And even if it is widely adopted, it is incredibly aggressive.

The International Energy Agency also put together a plan to reduce the EU’s reliance on Russian gas over the next year and determined that the EU’s demands could reasonably be reduced by 30%. This scenario is less aggressive than the EU’s plans, yet still presses a number of assumptions to their limits. To ensure sufficient gas inventories for next winter, the initiative will have to be driven by Brussels. Otherwise, private companies would balk at paying the current elevated prices to stockpile inventories with a risk that Gazprom could later flood the market and drive prices down.

If the EU imposes an oil embargo and pivots away from Russian gas over the next year, it will drive energy prices up further and drag on growth. In the short-term, demand in the EU could fall significantly. But over the medium- to long-term, the EU is on track to significantly boost investment. The big question is how to fund it.

The European Central Bank (ECB) recently adopted a more hawkish bent, indicating its plans to accelerate asset purchase tapering and rate hikes. More clarity on monetary policy normalization will be provided after the Governing Council meeting on March 10. If eurozone member countries are willing to spend big on a green transition and on beefing up defense, the ECB will need to keep borrowing costs suppressed via continued asset purchases.

An alternative is for the EU to expand the Recovery and Resilience Facility (RRF)–a package of loans and grants for EU member states funded by joint EU debt issuance and put in place to address the economic shocks from COVID-19 across the EU –and make it more permanent. Currently, 37% of RRF funds must be earmarked for the green transition and must be absorbed by the end of 2026. There is a nascent proposal to issue EU debt and use the proceeds to make loans to member states to finance the green transition and defense spending. There will be opposition to this proposal among the so-called frugal EU countries and it could take months to work out the details. If implemented, this could boost EU member state fiscal spending significantly and could accelerate the green transition.

Whether the financing is driven by the ECB or joint debt issuance, the immediate energy crisis in Europe could ultimately provide a significant boon for EU growth. We have not seen the EU as a big spender for years, and this scenario could help to whittle away the global glut of savings that has kept inflation, growth and rates structurally low since the global financial crisis.

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