Monthly Economic Letter

November 2021
Feature article

Buckle up for the rocky path to energy transition

World leaders have returned from the 2021 Glasgow Climate Change Conference, or COP26, where many reiterated their commitment to achieving a net carbon neutral economy.

However, there is little room for error if this goal is to be achieved by 2050. A successful energy transition will not be painless and will bring a host of challenges for societies. As we navigate through the necessary changes, what impact will the transition have on businesses and the economic environment?

Over the past few months, energy prices have been rising at a rapid pace. The price of natural gas has spiked, and electricity, oil and coal prices have also surged. Most of the current energy crisis, especially in Europe, can be explained by an imbalance between supply and demand as economies reopen from the COVID-19 pandemic.

However, the energy crisis also highlights the many challenges that accompany the fight against climate change. These include geopolitical tensions, technological limitations and financing issues.

Getting off fossil fuels—more complicated than expected?

Renewable energy is often seen as inexhaustible, but it is constrained by one important element—the weather. The variability of wind and rainfall have complicated renewable energy production this summer. A lack of wind for turbines in Europe and precipitation to power hydroelectric plants in China and South America are examples of how weather can constrain renewable energy supply and have contributed in part to the current crisis. Significant investments in research and development will be required to optimize the use of these new technologies and increase storage capacity.

Today, renewable energy supply falls far short of total global demand. As a result, the use of fossil fuels, including coal, the most polluting energy source, is increasing. Coal-fired power plants are running at full capacity.

In fact, fossil fuels account for 80% of the world's energy production, while renewables account for only 15%. It will take time and major investments to reverse this imbalance.

Decarbonization comes into play

The use of oil and other forms of hydrocarbons will decrease in the coming years, but their share of the world’s energy supply will remain important for a long time to come.

Knowing that demand for polluting energy sources will diminish, and fearing they will be stuck with assets that are less and less attractive to the markets, many financial institutions are seeking to decarbonize their portfolios. Meanwhile, several countries, including Canada, have pledged to completely end foreign financing of fossil fuel projects that don’t include carbon capture technologies by next year.

This type of initiative is necessary in the fight against climate change, but a slowdown in fossil fuel investment could undermine markets in the longer term. More restricted access to fossil fuels will continue to push prices higher.

A costly transition?

The recent surge in energy prices is pushing up inflation. Higher prices at the pump obviously reduce the purchasing power of consumers, but also the profit margins of companies.

In its latest Monetary Policy Report, the Bank of Canada said it expects prices to fall once high energy demand in the winter has passed and production starts to increase again. Until then, inflation is expected to remain elevated in 2022, given high energy costs. Indeed, the central bank expects about one-third of inflation to be driven by energy prices.

Bottom line

An energy revolution is needed to combat climate change, but the transition will undoubtedly lead to disruptions, especially in the markets.

The energy transition comes with a realignment of investments towards clean technologies at the expense of their more polluting counterparts. The difficulty is that fossil fuels still represent a huge share of the world's energy usage.

We cannot change our consumption patterns overnight and the path to carbon neutrality in 2050 is narrow. As a result, expect volatile episodes in energy markets between now and then.

Canadian economy at a glance

Economic recovery under stress

The Canadian economy grew by 0.4% in August, with 15 of 20 sectors continuing to recover from the COVID recession. Preliminary data suggests anemic growth in September. If these expectations come to pass, Canada's economy would have grown at an annualized rate of 1.9% in the third quarter, well below expectations.

The economy would then be running at 98.6% of its pre-pandemic peak at the start of the fourth quarter. At this rate, full GDP recovery will not be achievable by the end of the year.

More than 30% of the GDP growth in August was attributable to the accommodation and food services sector. Manufacturing and retail sales also contributed positively to the country's economic recovery in August after July slowdowns.

Change of course for the Bank of Canada

In late October, the Bank of Canada sent shockwaves through the markets. Governor Tiff Macklem announced a complete end to the Bank’s quantitative easing program and a possible acceleration of rate hikes as early as April 2022.

This announcement came just days before the release of GDP data. While Statistics Canada expects growth of just 2% in the third quarter, the Bank of Canada forecasted a 5.5% increase for the quarter in its latest monetary policy report. Given this gap, it would be surprising to see the first interest rate hike as soon as April, but the Bank of Canada's main concern remains inflation.

The trend in the consumer price index will now be the focus of future monetary policy decisions. In October, inflation reached 4.7%. This is the seventh consecutive month above the Bank’s target range (between 1 and 3%).

Pandemic still weighs on economic outlook

Last November, the first announcement of an effective vaccine against COVID-19 created renewed optimism around the world. One year later, we still cannot claim victory over the pandemic, but the situation has certainly improved. Half of the world's population has received at least one dose of COVID vaccine.

In Canada, the fourth wave induced by the Delta variant is gradually fading and will not have affected the reopening of the Canadian economy too much. However, despite a high vaccination rate (75% of the population fully vaccinated) and the continued reopening, economic activity is still being adversely affected by the pandemic, which is moderating growth and pushing up prices.

Higher inflation is being driven by a surge in energy prices, a rebound in demand for services such as air travel, and of course, supply constraints. These inflationary pressures, which are considered transitory, are weighing more heavily on the outlook and will last longer than initially estimated by the Bank of Canada.

Households remain in good shape

Households hold the key to a strong economic recovery—disposable income and excess savings continue to rise from already high levels.

Consumption and residential investment should remain strong, despite the withdrawal of some federal transfers, amid healthy job gains. After creating more than 157,000 jobs in September to bring employment to full recovery from the pandemic, the economy added another 31,200 jobs in October.

Employment gains will prove more challenging in the coming months even though the unemployment rate is still at 6.7% (one percentage point above the February 2020 level).

The impact on your business

  • Sectors most affected by health restrictions continue to rebound, but overall the recovery has stalled.
  • Households are in a good position to continue supporting growth as employment continues to rise. But inflation is reducing consumers’ purchasing power.
  • Inflationary pressures may continue longer than the Bank of Canada had anticipated and it has indicated it is prepared to raise interest rates to keep prices under control. Financing conditions will tighten in 2022; try to take advantage of low rates to finance your projects while there is still time.
U.S. economy at a glance

The post-crisis boom appears to be over

Despite passing the level of GDP reached before the COVID-19 crisis, the U.S. economy’s performance in the third quarter was disappointing. Gross domestic product grew by a meagre 2.0% in the third quarter compared to the previous quarter.

The rise of the Delta variant during the summer accounts for much of the small increase in economic activity as a resurgence of cases forced new health restrictions across the country. Other important factors limiting growth were supply chain disruptions and labour shortages.

Household spending dampened

The growth slowdown in the third quarter was largely due to weak household consumption and a decline in residential investment. Consumer spending grew at a much more modest pace than the previous quarter's 12%, recording just 1.6% growth over the previous period. Household spending is the largest component of GDP and accounts for nearly 70% of the U.S. economy.

The increase was enough to offset a further decline in residential investment (at an annualized rate of -7.7%), but the shortage of workers and supply chain challenges are being felt. Growth in goods consumption went into the red (-9.2%), mainly due to difficulties in the automotive sector, while growth in services lost momentum (+7.9%) between the second and third quarter.

The Fed follows suit

The U.S. Federal Reserve announced it is slowing down its asset purchase program, following in the footsteps of most other central banks, including the Bank of Canada. Fed Chairman Jerome Powell has stated that similar reductions in the pace of the program are expected in the coming months.

Unlike the Bank of Canada, the federal reserve has a dual mandate that could make its job even more difficult. Not only does it have to maintain and control inflation, it must also support full employment. (The Bank of Canada does not have a target for employment.) After good job gains in October, attention is turning to inflation, which reached 6.2% that month. But the Fed management committee still believes that inflation will stabilize and has been clear a rate hike will not happen anytime soon.

Good start to the quarter for employment

After some employment misses this summer, the U.S. economy added 531,000 jobs between October and September. In other good news, the unemployment rate fell from to 4.6% from 4.8%, thanks to a drop in the number of long-term unemployed.

Labour needs are still high south of the border. In fact, despite the addition of more than half a million workers, the economy is still short 4.2 million from pre-pandemic levels.

As of August (the latest report available), there were nearly 10 million job openings.

The tightening of the labour market is being reflected in wages. The employment cost index jumped 1.3% in the third quarter of 2021 from the previous quarter. This is the fastest pace of growth for this index in over 20 years.

The impact on your business

  • U.S. consumption is slowing. While much of this slowdown is due to transitional problems in the auto sector, it could have an impact on Canadian exports.
  • The Federal Reserve has finally started to ease its massive asset purchase program. The markets were not too shaken by the announcement and a rate hike by the Fed is not expected anytime soon, a stance that should continue to support the U.S. economy.
  • Employment performed well in October and there are indications that wages are rising in the U.S., which also bodes well for growth.
Oil market update

A market imbalance pushes oil prices higher

Crude oil prices have not escaped the price surge experienced by natural gas, electricity and coal.

Limited oil supply and a strong rebound in demand continue to put upward pressure on prices. Brent crude was trading near US$84 per barrel this month and WTI exceeded US$82 per barrel.

Demand for oil is rising sharply

Asia is recovering from the most recent wave of COVID, brought on by the Delta variant. The reopening of these economies is leading to a further rebound in oil demand. Meanwhile, to counter the current natural gas shortage and the fear of running out of energy during the winter in the Northern Hemisphere, many countries are turning to oil. Substitution between these two energy sources is contributing to an increase in oil demand by about 1 million barrels per day.

Demand is also being supported by the resurgence of air travel as more governments ease requirements (particularly the large U.S. market). Global jet fuel demand is still 15-20% below 2019 levels. However, increased vaccination levels globally, and the accompanying boost in confidence, have translated into increased flight bookings in recent weeks.

OPEC and its allies are not budging

Despite pressure on prices from rebounding demand and calls from some leaders, including U.S. President Joe Biden, to increase crude supply, the Organization of the Petroleum Exporting Countries and their allies (OPEC+) are maintaining the status quo.

The policy agreed to in August of gradually increasing oil production by 400,000 barrels per day each month is working for the cartel so far. At their monthly meeting in November, the organization reiterated its commitment to maintaining a stable and balanced oil market and blamed other energy producers for the rise in crude prices. Meanwhile, OECD countries' commercial oil inventories are at their lowest level since 2015.

Since an adjustment of supply by OPEC and its allies is not in the cards, several countries are considering tapping into their strategic reserves to increase supply and temper prices. This is what China did earlier this month.

Even if the U.S. were to adopt such a policy, it would probably not be enough to stabilize prices until supply and demand are more balanced, according to many analysts. Moreover, this is a rather drastic measure typically reserved for emergencies, such as natural disasters or war, rather than trying to preserve consumer purchasing power.

Bottom line

The effects of the Delta variant on the global economy have finally begun to dissipate, but the recovery may be proven to be too strong for energy markets. The rebound in oil demand is fast, and the determination of OPEC+ to stay the course is pushing prices toward 2014 highs.

A milder winter in the Northern Hemisphere could provide some respite for consumers, but the risk that these price levels will persist through 2022 is very real.

Other economic indicators

Change of course at the Bank of Canada

On October 27, the Bank of Canada announced that it was completely ending the massive asset purchase program initiated more than a year and a half ago to support the economy through the COVID-19 crisis. In his speech, the Governor also stressed that although inflation is due to transitory factors, it will remain above the target range for longer than the Bank had initially anticipated. He thus opened the door to a rate hike as early as April 2022. It is important to note that the Bank of Canada's announcement came out just days before the release of gloomier data regarding the economic recovery.

Loonie went down recently

The Canadian dollar rose to around US$0.81 following the announcement of the Bank of Canada that it would possibly tighten the monetary policy earlier. For several weeks now, high energy prices, including oil, have supported the appreciation of the Canadian dollar against its U.S. counterpart. October's U.S. inflation hit a 30-year high and the possibility of the American government adding barrels to the market from the strategic reserve to soften prices have both disadvantaged the CAD more recently. The loonie has fallen back slightly below the 80-cent mark.

Business confidence is still low

The Canadian Federation of Independent Business (CFIB) argued that the election had created uncertainty among Canadian entrepreneurs. This explained the sharp drop in the Business Barometer index in September. With the election behind us, confidence among Canadian SMEs barely improved in October. The long-term index, which measures business optimism over a 12-month outlook, rose from 57.8 in September to 60.5 in October. The short-term index remains below 50 (at 45.5), meaning that business owners expecting their companies' performance to deteriorate in the next three months outnumber those that expect it to improve.

The cost of doing business is increasing

Input costs are rising in this country. Whether it is physical capital or labour, production costs are rising due to supply chain problems, container shortages, labour scarcity and high energy prices. Now financing costs are also increasing. The effective interest rate for businesses has risen to the level reached in July 2020, which is close to 2.5%. Of course, credit terms remain attractive and affordable at such low rates. However, the trend is upward and the tightening of monetary policy by the Bank of Canada should continue to put pressure on financing costs in the future.

Key indicators—Canada