Iran oil price shocks have the ECB considering its next moves

Key points

• The European Central Bank (ECB) is under pressure to raise interest rates following the oil price shock due to the US-Israel war on Iran, but experts warn this will fail to stabilise volatile oil prices and will instead increase the cost of the energy transition.
• Increasing interest rates unintentionally undermines climate objectives by discouraging green investment. Renewable energy requires significant upfront capital, and rising rates make financing more expensive, locking in Europe’s exposure to future price shocks.
• Researchers are urging the ECB to reconsider a dual interest rate policy which would provide cheaper financing for green projects and lower the EU’s exposure to global energy price volatility.

An increase in interest rates by the ECB would not do much to stabilise the price of oil and could potentially increase reliance on fossil fuels, experts told Green Central Banking.

Oil prices have jumped in the past several weeks, after the US and Israel launched attacks on Iran, jeopardising shipping lanes in the Strait of Hormuz. Around 34% of the world’s oil supply goes through the strait.

The surprise attack led to stock markets tumbling and instigated an energy supply crisis that experts warn the world has never seen before.

“Fossil fuel dependency is in itself a very big macroeconomic vulnerability,” said Bruno de Conti, senior researcher at Positive Money Europe. “It’s a big vulnerability for any economy in the world, because it creates, inherently, these big financial risks related to the volatility of fossil fuel prices.”

The supply shocks from oil prices are becoming more frequent because of the geopolitical situation. And now Europe finds itself in the crosshairs.

It’s a dilemma that the ECB is taking note of. Writing in the Financial Times, ECB executive board member Frank Elderson noted that Europe’s dependency on fossil fuels has made it difficult for the central bank to maintain price stability.

While he noted that the bloc “cannot eliminate geopolitical risk … but it can significantly reduce its exposure to it” by cutting dependence on imported fossil fuels and accelerating the transition to renewables.

“If Europe were to meet its sustainable energy targets, the link between domestic energy prices and volatile global energy markets would weaken substantially,” he wrote.

Increased costs of green energy

While pressure mounts for the ECB to raise rates, doing so would have an unintended consequence of making the green transition even more difficult.

One study found that a 25-basis-point hike by the ECB is associated with a 3.2% decrease in wind turbines and a 5.3% decrease for solar panels.

Meanwhile, a separate study found that higher interest rates often translate to more carbon emissions as companies are more likely to choose short-term financial stability over longer sustainable objectives.

Renewable energy projects require a lot of upfront capital and when interest rates rise, the cost of financing such projects also increases, said Antonis Ballis, a finance professor at Aston University and one of the co-authors of the report on monetary policy and carbon emissions.

If the Iran crisis continues for much longer, central banks could be under pressure to raise rates, he said.

“Higher interest rates can unintentionally undermine climate objectives by discouraging green investment. So monetary policy is not neutral in this context. It has an important side effect that interacts with a broader sustainability agenda.”

Rising rates also won’t have an impact on oil prices which are already volatile, said Conti.

“It’s a supply shock that cannot be directly faced with interest rate hikes … [and] at the end of the day, it may be harmful for the green transition because it will increase the cost of credit”.

Stanislas Jourdan, researcher at the New Economics Foundation and the Sustainable Finance Lab, said the failure to anticipate the inflation surge is still fresh on people’s minds “so the ECB is naturally keen to reassure markets that they won’t be complacent. But they are also right not to panic.”

While inflation increased after the start of the Ukraine war, the situation with Iran is different and the world is in a different place. However, Jourdan says that “the geopolitical uncertainty triggered by the blockade of the Strait of Hormuz is unprecedented, complicating the macroeconomic outlook and creating a real risk of stagflation”.

While hiking rates could perhaps tame inflation in the short term, he also says it will increase the cost of the green transition.

“Ultimately, raising rates to fight ‘fossilflation’ creates a perverse loop: it delays the transition, which in turn perpetuates our macroeconomic exposure to the exact type of fossil fuel price shocks we are suffering from right now.”

A case for a green dual interest rate

Instead of raising rates, experts say the ECB should reconsider a dual interest rate policy.

This would mean cheaper financing for green projects, while allowing interest rates for other sectors to increase. The concept was supported by French president Emmanuel Macron several years ago and recently endorsed by the French national assembly. While ECB board members have acknowledged the need to consider a broad range of monetary policies in the face of climate change, such a measure has so far not been proposed.

If the ECB were to offer a cheaper rate for green projects, it would create a huge boon to the EU as it would lower the bloc’s reliance on energy price shocks, said Jourdan.

And it’s needed now more than ever, he added.

“A dual rate strategy precisely gives central banks a way out of the green dilemma … by allowing the central bank to engage in monetary tightening while simultaneously maintaining reasonable capital costs for core strategic investments,” he said.

A dual rate would also support European sovereignty. Jourdan pointed to the success of Spain’s renewable energies as an example of how green projects can buffer against price hikes.

In the end, Conti says we need to remember that “one of the most polluting things in the world is war”.

“There is a discourse now in the European Union that military expenditures are necessary, and so on and so forth. But then, unfortunately, we have to recognise that it goes in the opposite direction of the green transition.”

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