New OECD figures show the UK has taken the humbling title of being the G7 economy hardest hit by the energy crisis. The group downgraded UK growth this year by 0.5ppts to 0.7% and raised its inflation forecast by 1.5ppts to 4%. It reflects how the UK is more vulnerable than our competitors to energy shocks. There's a number of reasons why this is the case.

First, we’re especially exposed to spikes in the price of natural gas due to our reliance on imports and the major role gas plays as the marginal price setter in the electricity market. This means rises in wholesale gas prices have a bigger inflationary impact.

Second, we’re entering the crisis with inflation at 3%, compared to below 2% in the eurozone.

Finally, the economy was weak coming into the crisis, meaning there’s less scope for households and businesses to absorb rising prices without economic damage. Combine all the above and it means inflation will go higher in the UK than elsewhere and growth will be damaged more than in our G7 competitors’ economies.

What happens, when in an energy crisis?

It’s a truism that the longer the war in Iran goes on, the worse things will get. But, the disruption to supplies and damage to energy infrastructure mean that even if there’s a swift resolution to the crisis, then energy supplies will be disrupted for months and prices will stay elevated. This means we already have an idea of how energy prices will affect the economy over the next year.

The first impact is on fuel prices. This typically takes 4−6 weeks to flow through. Anyone who’s filled up a car recently will be well aware that petrol and diesel prices have soared − and there’s worse to come. Heating oil and jet fuel prices have also jumped by more than 100%, prompting the government to introduce support for billpayers in oil-heated homes and airlines to raise fares sharply, impose fuel surcharges and curtail unprofitable routes. A rough rule-of-thumb is that every $10 per barrel rise in oil prices adds 0.1ppt to inflation in the short term and 0.2ppts in total. The rise in oil prices we’ve already seen could add 0.5ppts to inflation by April.

The second phase is when higher energy prices flow through to utility bills. Because the Ofgem energy price cap resets every quarter and takes an average of futures prices over several months, it takes a few quarters for wholesale prices to be reflected in energy bills. What’s more, after the Ukraine energy crisis, many more businesses have hedged energy prices, meaning the impact on business costs will take longer to flow through now than previously. However, this lag also means that utility prices will remain heightened, even once wholesale prices have fallen back.

The lasting impact of higher energy prices

Further ahead, there are indirect effects. Prices in the supply chain will rise as contracts reset. Spot shipping prices have already jumped, but most shipping is on a contract basis, which means there’s a lag before companies have to start paying more and reflecting that in their own costs.

There’ve also been huge rises in the prices of non-energy commodities, such as fertiliser and plastics. This will feed into food and packaging prices towards the end of the year. It typically takes about nine months for increases in agricultural commodity prices, which are up by 10−20% so far, to register in prices on supermarket shelves.

Finally, there’s the risk that second-round effects lift inflation even further. This is where firms across the economy are passing on increased energy costs and employees are bargaining for pay rises to offset the hit to their real incomes. This is what happened after the last energy price crisis in 2022.

However, the economy is in a different place now compared to 2022. Interest rates are at 3.75%, rather than February 2022's 0.5%, and the unemployment rate is higher and rising. This lessens the chance of second-round effects. For example, an employee might want a 10% pay rise, but if the company isn’t as profitable, then it won’t be in a position to grant inflation-busting pay rises. Plus, if the job market is weak, then employees will be less able to switch to get better pay. That makes second-round effects less likely to emerge.

Ultimately, even if the conflict ends soon, we’re certain to see inflation rise in March and it will probably finish the year above 4%. Second-round and indirect effects will prolong the initial inflation impulse well into 2027 and mean that firms will have to brace for multiple rounds of input-cost inflation.

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