Higher electricity, gas, and petrol costs directly impact households and indirectly affect the production of goods and services since these fuels are crucial inputs. As a result, the recent surge in energy prices will increase inflation and lower real GDP, wages, and productivity. In the UK, the current cost of living crisis is primarily due to the substantial increase in energy prices, which has significantly impacted rising food costs and inflation levels that have not been seen in 40 years. The consumer price index (CPI), which measures inflation, is affected by energy prices in two ways: domestic energy consumption (including electricity, gas, and solid or liquid fuel oil) and vehicle fuels (including petrol, diesel, and oil).
Together, these expenses make up 6.7% of the average household’s expenditures, with household energy accounting for 3.6% and vehicle fuels and lubricants accounting for 3.1%. These percentages are based on 2021 expenditures and are expected to increase significantly in 2022 due to rising prices and highly inelastic demand. Poorer households, whose expenditure shares are much higher, experience an even greater rate of inflation. This article aims to draw attention to the effect of increasing energy expenses on the overall cost of living. To achieve this, the article will begin by examining the trends in energy prices from 2020 to 2022. Next, it will explore the inflation rate, which will directly impact the cost of living. Lastly, the article will discuss the wider implications of the surge in energy costs on the cost of living.
Changes in Energy prices between 2020 and 2022
In October 2022, the Consumer Price Index (CPI) was at 1.16, indicating that prices were 16% higher than in December 2020. However, the increase was not evenly distributed among different types of energy. Solid fuels saw the highest increase, rising by 157% compared to December 2020, followed by gas at 193%, electricity at 96%, and liquid fuels at 157%. Excluding fuels and lubricants, household energy prices alone rose by 132%, contributing almost one-third of the CPI inflation during that period. Moreover, most of the increase in energy prices occurred after the Russian invasion of Ukraine in February 2022, as shown in Figure 1. Western countries responded by imposing economic sanctions on Russia, which greatly impacted the global energy supply, particularly in Europe. European countries, including the UK, turned to more expensive alternatives like liquified natural gas (LNG) from the United States to reduce their dependence on Russian oil and natural gas. While the UK does not rely heavily on gas from Russia, it is closely connected to the European wholesale market, meaning that supply issues on the continent directly affect UK prices. Other factors, such as base effects and supply chain disruptions due to the pandemic, also contributed to the rise in energy prices before the war.
In May 2021, the Bank of England’s main focus was on pandemic recovery, with CPI inflation at 1.7%. Their post-pandemic inflation forecast predicted a gradual rise, with an average CPI of 2.3% at the end of 2022, falling to 2% the following year. Similarly, the National Institute of Economic and Social Research (NIESR) predicted a rise in CPI inflation, reaching 1.8% in the final quarter of 2021, falling to 1.5% at the end of 2022, and then settling just below the 2% target between 2023 and 2025. Both organizations acknowledged the high level of uncertainty surrounding their forecasts, given issues with supply chains and the labor market. However, by November 2021, inflation had become a more pressing concern, with the rate having risen faster than expected to 3.1% the previous month. The Ofgem price cap increases in October 2021 and April 2022 were already in the pipeline and set to have a major impact. The Bank of England and NIESR both revised their forecasts to predict a peak inflation rate of around 5% in April, falling to 2% by the end of 2023 (Bank of England) or 2024 (NIESR). This change was primarily due to energy prices, and to a lesser extent, food prices, which rose significantly in mid-2021. The impact of changes to the Ofgem price cap at the end of September was reflected in October 2021, resulting in a record 1.1% increase in the CPI inflation rate, the highest since 1993. It is thus important to find the cheapest energy supplier.
Broader Effects of Energy Price Inflation
Energy prices have a direct impact on the cost of goods and services purchased by consumers, as well as an indirect effect on production costs for businesses. Almost all goods and services require energy as an input, which makes energy a vital intermediate input in all sectors of the economy. As a result, energy cost increases will add costs to all stages of the supply chain, potentially leading to further inflation in the future. Energy price inflation can also reduce the value added by UK producers, which is the difference between the value of their output and inputs (including energy). This can result in a decline in GDP and productivity compared to what would have been achieved without energy price increases.
Rising energy costs also lead to increased imports, as demonstrated by the record levels of the goods deficit reported by the ONS in the second quarter of 2022. High fuel prices contributed to a rise in oil and fuel imports by £4.4 billion in the same quarter. Energy prices also have a significant fiscal impact on the UK government, as they affect tax revenues and public spending. Government expenditure on education, healthcare, and other services will increase directly due to energy price increases. Public sector wages may also increase in response to inflation, which would further impact government spending. On a positive note, the rise in fossil fuel costs may accelerate the development of alternative energy sources, such as renewables and nuclear power.
Although it will take time to develop these alternatives, the process of reducing fossil fuel usage will be expedited by the events of 2022. Finally, the decline in economic growth caused by rising energy prices may reduce fossil fuel consumption in affected countries, including the UK and EU. While this may be an unintended consequence, it could positively impact efforts to address the looming climate crisis.
The impact of rising energy costs on the cost of living is significant and multifaceted. Between 2020 and 2022, energy prices have risen substantially, with the cost of electricity and gas for households increasing by almost a third. This has directly influenced the inflation rate, which has risen faster than expected, reaching 3.1% in November 2021. Energy is also a key input in the production of almost all goods and services, leading to an indirect and more gradual effect on inflation through increased costs at each stage of the supply chain. The broader effects of rising energy costs on the cost of living are far-reaching, including a reduction in the value-added of UK producers and a fall in GDP and productivity. Higher energy costs also lead to an increase in imports, affecting the UK’s balance of payments and having a major fiscal impact on the government’s tax revenues and public spending. On the positive side, rising energy costs may accelerate the development of alternative energy sources, but the decline in economic growth caused by higher energy prices may also reduce fossil fuel consumption. Overall, rising energy costs impact the cost of living in a significant way, affecting not only household budgets but also the broader economy and society.