Net Zero = zero productivity? We offer a fresh perspective on the UK’s ‘productivity puzzle’ by analysing the role of declining supply and rising costs of energy over the past two decades.
Using data from 189 countries, we show a strong positive correlation between living standards and energy consumption – showing a clear link between falling energy capacity and weak productivity in the UK.
Our analysis suggests that the government’s plan to rebuild UK energy capacity over coming decades should help remove the headwind to growth and productivity coming from the chronic energy shortage.
UK productivity puzzle. Across all measures, productivity growth in the UK has slowed sharply over the past two decades. The weakness has hurt economic performance and growth in living standards. In this note, we outline the potential role of the UK’s chronic energy shortage.
A simple observation. The decline in UK electricity supply, which started in 2006, coincided with the start of structural weakness in productivity growth – Figure 1. While advances in energy efficiency have reduced energy waste, especially in advanced economies, our large cross-country sample shows a positive relationship between energy consumption and living standards.
Questions over Net Zero. Our analysis challenges the government’s claim that there is no trade-off between Net Zero and economic growth. Two decades of experience suggests otherwise. The result of the UK’s decarbonisation efforts, so far, appear to be weak economic growth, high energy prices, de-industrialisation and no significant impact on the overall trajectory of global emissions.
Better times ahead? Elevated costs and low energy supply remain a near-term headwind. But the UK’s electricity supply looks set to rise appreciably by the middle of the century – this should support economic growth and productivity and help to reduce energy costs. But after years of delays with key projects – especially in nuclear – success hinges on the government’s ability to deliver on its planned pipeline of energy investment and perhaps even a willingness to expand exploration and drilling of the UK’s domestic oil and gas fields.
Productivity puzzle – a missing factor?
Most analysis links productivity weakness to the long-term effects of the global financial crisis
• UK living standards (GDP per capita) and estimates of productivity (the major driver of living standards) rose steadily along a predictable trendline from 1970 until the Global Financial Crisis in 2008/09 – Figure 2 – which engulfed the UK in a deep balance sheet recession.
• Following the 2008/09 crash, growth in living standards has been meagre, while productivity gains have slowed to a crawl – Figure 3.
• The financial crisis inflicted lasting damage on the UK. The process of correcting years of capital, credit, and labour misallocation, as well as repairing the balance sheets of banks and households, came at the price of weaker potential growth – hurting gains in measured productivity.
• In addition, an absence of creative destruction through the years of ultra-low interest rates probably extended the lifetime of many unproductive firms and prevented the redistribution of labour and capital towards more productive activities.
• The crisis also had lasting effects on risk-appetites, which impaired investment in the most productivity-enhancing (but risky) projects.
• Productivity weakness has continued – and recently worsened – even as the major balance sheet and financial system problems that caused the 2008 crisis had been repaired, as interest rates normalised, and as AI offered productivity-enhancing opportunities in services – which makes up almost 80% of GDP. This oddity suggests another factor at play.
• In the two years to 3Q24, UK productivity (output per hour basis) declined by 1.3%. Per capita GDP suffered a similar fall.
Energy matters for prosperity
Per capita energy consumption and per capita GDP show a strong positive correlation
• Our dot-plot analysis of 189 countries shows a clear positive trend between per capita GDP, the broadest measure of living standards, and per capita energy consumption – Figure 4.
• Energy is a critical factor of production. All economic activities require power in some form or another. The more (cheap) energy available, the more goods and services can be produced at competitive prices.
• Our dot plot provides an easy rule of thumb guide to energy efficiency – economies above the trend line are more efficient in their use of energy relative to the average, economies below are less efficient. The UK sits close to the Eurozone and above the trendline – it enjoys a high standard of living relative to its per capita energy consumption.
• The US, meanwhile, which sits above the best-fit line too, consumes more energy per person than the UK. But living standards are much higher.
• In 2005, which is when UK electricity supply peaked, UK energy per capita was 50% of the US level – and living standards were around 79% of the US level. By 2022, UK per capita energy consumption had declined to around 38% of the US level, while per capita GDP had fallen to 74%.
• While both the UK and the US plan to decarbonise, they have taken a very different approach so far. While the US has been growing its living standards while keeping per capita energy consumption roughly stable (much like the UK from 1990 to 2005), the UK has been holding its living standards broadly stable while cutting per capita energy consumption – Figure 5.
Poland and South Korea can overtake the UK
On current trends, UK living standards will be overtaken by South Korea and Poland by 2030
• Energy demands vary a lot by country. Large geographies require more energy for travel and haulage, while economies oriented towards industry may demand more energy than services-oriented economies.
• But the argument goes the other way too. The cost and availability of energy influences economic activity. Countries with access to large supplies of cheap energy can produce manufactured goods cheaper than countries with scarce and costly energy. As Germany is showing in the wake of the 2021-23 gas shock, rising energy prices are a recipe for de-industrialisation – production has declined by 17% since 2018.
• We compare the trends in the UK to the US, Poland, South Korea, and Germany to illustrate our point. Some clear themes emerge.
1. Between 1990 and 2022, UK energy consumption per capita slid from third in the group to joint last with Poland – Figure 6. While UK energy consumption declined on trend in the 20 years to 2022 (by a total of 32.5%), Poland’s has risen by 15%.
2. The US is the biggest consumer of energy per capita in the group and also enjoys the highest living standards. South Korea, meanwhile, has shifted from the lowest per capita energy consumer to the highest between 1990 and 2022 – and has enjoyed the fastest rise in living standards over the period.
Projecting per capita GDP trends going forward, the UK looks set to fall to the bottom of the pack in 2031, while Germany – whose energy trends are similar to the UK’s – would fall into second-last place by 2034 from second place in 2022 – Figure 7.
What happened in 2005?
A relevant fact? The UK’s productivity troubles coincide with peak electricity supply
• In 1920, the electricity available for use in the UK economy was 4.1 TWh. By the 2005 peak, available electricity had risen to 385 TWh – Figure 8. Over the same period, productivity measured in output per hour terms rose by a staggering 700%.
• However, electricity availability has declined by 21% since peaking in 2005. This decline has occurred, by and large, due to the planned decommissioning of various types of electricity production facilities – most notably coal and oil, but also nuclear.
• As capacity has been destroyed or mothballed, it has not been replaced with like-for-like output, and overall electricity availability has declined precipitously – Figure 9.
• Figure 8 shows that peak UK electricity coincides with the kink in the productivity trend. Put simply, once the electricity available to the UK economy starts to decline, the trend rate of productivity slows sharply.
• This story fits with our earlier analysis across countries, which shows a clear positive trend between per capita GDP and per capita energy consumption.
If an economy throttles its production of energy, it impairs its capacity to produce all types of goods and services. Productivity is the major driver of per capita GDP.
The big turn away from hydrocarbons
The UK has turned into a net importer of oil and gas while domestic extraction has slumped
• In the mid-2000s, the UK shifted from being a net exporter of oil and gas to a net importer. While this shift has had little impact on the price the UK pays for oil and gas – such prices are set on international markets – it has nonetheless had two important economic consequences.
1. The trade balance in oil and gas has shifted from +0.5% of GDP in the early 2000s to c.-1.0% – Figure 10. The UK is now dependent on foreign imports of oil and gas and thus vulnerable to external energy supply shocks – such as the one in 2022 following the Russian invasion of Ukraine, which abruptly ended the post-Covid economic rebound and caused economic activity to de facto stall for almost two years.
2. Whenever global oil and gas prices surge, the UK has to pay even more to foreign producers which drags on real GDP via a deterioration in the balance of trade. Previously, when the UK was a net exporter of oil and gas, rising prices would have a positive effect on the trade balance, while higher costs of energy for consumers and businesses showed up as a de facto transfer to energy producers as their incomes increased. Note that for the US, which remains a major net exporter of energy and key global swing producer, higher gas prices since 2021 have improved the US terms of trade and boosted revenues for domestic energy prices.
• Figure 11 shows the dramatic decline in the extraction of oil and gas in the UK. Total output has fallen by almost 90% since peak in 1999.
UK Net Zero in a global context
Reductions in UK territorial emissions are meaningless against the rising global trend
• The 2008 Climate Act committed the UK to cutting greenhouse gas emissions by 80% by 2050 relative to 1990 levels. In June 2019, the-then Conservative Government strengthened the UK’s climate commitments. The current legislative target is to bring all greenhouse gas emissions to Net Zero by 2050.
• The UK has taken major steps to dramatically reduce its territorial emissions of carbon dioxide. The UK has reduced emissions relative to its peak by more than any other G7 economy. Whereas total UK emissions have more than halved versus peak – Figure 12 – the US has cut its emissions by around 20%.
• The UK now makes up less than 1% of all global emissions. However, this reduction has come partly by way of deindustrialisation, i.e. carbon emissions have just been shifted abroad.
• Emissions from China and other emerging markets – which are still intensive users of hydrocarbons – have continued to rise – Figure 13. Even if the UK hits its targets, it would not change the overall global trajectory - which is what matters for the climate.
The result of the UK’s current shift to decarbonise is higher prices and lower supply of energy – which hamper economic growth, productivity and industry – that do not change the global story on emissions.
A self-inflicted headwind
Economics 101: when supply shrinks relative to demand, prices rise
• Advances in energy-saving technologies have reduced the amount of energy wasted during consumption and production.
• As obvious examples, lightbulbs, autos, computers, and machines all give off much less heat than in the past. Energy emitted as heat from a light or machine is energy wasted.
• But while better energy efficiency may reduce the energy required per unit of economy activity, it need not follow that overall energy demanded declines. Consistent with rising living standards, as we use less energy for some things, that energy can go towards doing something else.
• Indeed, there is an easy check to see whether demand or supply explains the major reason for the fall in electricity availability. Have energy prices declined or risen as availability has fallen? The answer is that prices have risen, suggesting an even greater decline in supply relative to demand.
• Across all types of industrial and household energy, prices have risen appreciably since the mid-2000s – which coincides with the start of the trend decline in electricity availability – Figures 14 and 15. Until then, prices had been broadly stable for almost a decade as supply increased.
• Note that, relative to inflation, industrial energy prices were actually declining until 2005 – implying a positive effect on producers’ margins as input costs decline relative to final prices.
UK – top of the league for energy costs
Over the past 20 years, UK energy prices have risen sharply relative to other countries
• Across almost all members of the International Energy Agency (IEA), domestic electricity prices have risen sharply over the past 20 years – with a recent surge linked to the 2021-23 gas price shock.
• But the UK stands out as the country where prices have risen the most, both on an absolute and relative basis – Figure 16.
• Up until about 10 years ago, UK electricity prices were only slightly above the average for IEA members, with prices occasionally falling below the average in some years. But since 2014, UK prices have remained consistently above the average.
• In 2023, the UK had the highest domestic electricity prices in the IEA – at some 80% above the average price – Figure 17.
• Even though prices in 2023 were abnormally high in almost all markets due to the gas market disruption caused by Russia’s invasion of Ukraine and Western sanctions on Russia, the impact on the UK nonetheless remains outsized.
• Only neighbouring Germany, which is in the throes of deindustrialisation in response to surging energy costs, looks as bad as the UK.
In focus – 2021-23 energy crisis
The global energy crisis has forced the UK to ask serious questions about energy security
• By August 2022, the combination of Covid-19 demand-supply imbalances and an acute supply shock caused by the Russian invasion of Ukraine pushed natural gas prices up by 950% relative to their five-year pre-Covid average.
• Headline inflation, measured by the consumer price index, surged to a four-decade high of 11.1% year-on-year in October 2022 – Figure 18. Although global market adjustments have brought gas prices down, they remain some 150% above their pre-Covid average.
• Surging energy prices, combined with the dramatic Bank of England (BoE) policy tightening – which included a 515 basis point rate increase between December 2021 and August 2023 to a peak of 5.25% – upended the post-Covid recovery, squeezed living standards, and caused retail sales and industrial production to slump – Figure 19.
• To shield households and businesses from the rise in wholesale and retail energy prices, the UK Government spent £78.2bn between 2022 and 2024. Although half of that cost may be recouped through windfall taxes on energy producers over time, the net amount will be close to 1.5% of annual GDP.
• This truly costly economic shock has brought questions of energy costs and security to the fore. The UK Government intends to respond with various steps to accelerate the increase in domestic supply capacities – measures include faster planning process and deregulation of nuclear energy to increase the proliferation of small modular nuclear reactors.
Better times ahead?
If the government can stay on track with plans to build new renewable capacities, electricity supplies can rise sharply
- The Department for Energy Security and Net Zero sets out annual projections for UK electricity supply based on planned investments in new energy capacities and the planned decommissioning of existing capacities.
- The most recent projections were published in December 2024 and can be found here. Rising energy supplies will be necessary to serve the growing energy demands coming from AI and datacentres, EVs and heat pumps and carbon capture.
- The projections show a c.60% rise in electricity supply by 2050 relative to 2024, when total supply will reach approximately 450 TWh. By 2050, total supply will be approximately 20% above its 2005 level, but that 2005 peak will be surpassed by 2036 – Figure 20.
- The majority of the supply rise will come from renewables, including wind and solar, as well gas – which will be necessary to deal
with potential issues arising from the intermittency of renewables – sometimes the sun does not shine and the wind does not blow – Figure 21. - But renewable energy capacities require large purchases of critical minerals from abroad during the investment phase and for maintenance down the road. This carries risks.
- Much like the UK’s current dependency on imported hydrocarbons, by relying on renewables for the vast majority of electricity capacity, the UK would remain vulnerable to potential future shocks in global markets for critical minerals and the like.
- UK policymakers will need to strike deals around the world to ensure secure and accessible supplies of the materials needed to grow and maintain energy infrastructure.
