## Impact of High Energy Prices on Germany’s Potential Output

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### Introduction: recent developments and observed responses
- Energy prices surged after Russia’s invasion of Ukraine, reducing energy-intensive sector production while non-energy intensive sector production remained resilient.
- Natural gas import prices at their peak in 2022 reached nearly tenfold their 2021 average, before falling to below threefold the 2021 average as of April 2023.
- Production of energy-intensive industries declined almost 20 percent from pre-war levels between late 2021 and late 2022.
- German industries’ gas consumption during the second half of 2022 was on average 22 percent below their 2018–22 levels.
- Gas intensity (output per unit of gas) improved by around 25 percent since 2021, with about two-thirds of that improvement driven by within-sector efficiency gains and one-third by cross-sector shifts in production.
- Survey and market signals:
  - Ifo Institute survey: 75 percent of German firms were able to save natural gas without reducing production.
  - DIHK survey: three-quarters of manufacturing firms planned to pass higher production costs onto end-users.
  - More than half of manufacturing firms planned to invest in energy efficiency measures.
  - Public spending on clean energy R&D and the number of new clean energy start-ups increased.
- Corporate margins and costs:
  - Unit profit per real output has exceeded trend and increased by almost 20 percent in the last two years.
  - The average profit share between 2022Q1 and 2023Q1 was 2 percentage points higher than the 2019 average.
  - Unit labor cost has not surpassed its trend after a temporary spike in 2020Q2, with an uptick in late-2022.
  - Utility sector experienced windfall profit gains due to inframarginal pricing in the electricity market.

### Analytical approach: directed technical change model and calibration
- Framework and mechanisms:
  - Closed-economy, directed technical change model (following Acemoglu (2002) and related literature) where firms allocate R&D toward technologies complementing specific factors.
  - Two competing effects determine direction of technical change: price effect (favors technologies for more expensive/scarce inputs) and market size effect (favors technologies for abundant inputs).
  - The elasticity of substitution between energy and labor-capital inputs, 휖휖, determines which effect dominates.
- Structural assumptions and estimation:
  - Firms’ production function includes capital-labor productivity parameter 퐴퐴푡 and energy productivity parameter 퐴퐴푒푒,푡, with CES aggregation and share parameter 훾훾.
  - A Bayesian estimation approach jointly estimates 휖휖 and shock variances.
  - Posterior estimate of 휖휖 for Germany is 0.03.
  - With a relatively low elasticity of substitution (휖휖 = 0.03), the price effect is dominant, prompting firms to direct technical change toward energy efficiency when energy prices rise.
- R&D and technology trade-off:
  - At each period, a fixed amount of R&D is allocated between improving capital-labor productivity and energy efficiency, subject to a technology constraint 퐺(·)=0; increasing one reduces the other.
  - Under the baseline scenario where energy prices are assumed 20 percent higher than pre-pandemic levels in 2028, energy efficiency is higher by 6 percentage points in 2028 compared with a no-shock counterfactual.

### Impact of higher energy prices: simulations and quantitative findings
- Baseline scenario and headline estimates:
  - Baseline: energy prices (consumption share-weighted average of coal, oil, and natural gas prices) assumed to stay 20 percent above pre-pandemic levels (based on futures prices as of June 2023).
  - Staff’s baseline quantification (abstract): effect could be around 1¼ percent of GDP, with uncertainty depending on shock magnitude and energy efficiency mitigation.
  - Model simulation: energy prices that are 20 percent above the 2018–19 average are estimated to reduce Germany’s potential output by 1.2 percent in the medium term.
  - By 2028, potential output is estimated to be lower by 1.2 percent compared to the no-shock scenario.
  - The adverse impact on potential growth diminishes to well below 0.1 percentage points by 2028.
- Timing and peak effects:
  - The largest adverse impact is estimated to have taken place in 2022, when energy prices rose by 232 percent from the 2018–19 average.
  - Annual incremental impacts diminish over time as energy efficiency growth increases and capital-labor productivity growth slows.
- Mechanisms and long-run dynamics:
  - Energy price shocks prompt a reallocation of R&D/investment from capital-labor productivity toward energy-saving technologies, raising energy efficiency but reducing capital-labor productivity relative to the balanced growth path.
  - In the short-to-medium term, efficiency gains cannot fully offset the adverse price effect and the transition cost of shifting investment, producing a temporary deviation and a permanent output loss relative to the no-shock scenario.
  - Over the long run, the economy is expected to adjust and return to the balanced growth path, but the transitional deviation causes a lasting output gap relative to the no-shock scenario.
- Sensitivity:
  - Output losses become larger if energy efficiency is less responsive to energy price changes or if price shocks are greater.
  - Directed technical change mitigates negative consequences, but mitigation depends on the elasticity of substitution and responsiveness of energy efficiency.

### Section 2 — Scenarios and alternative estimates
- Main scenario outcomes (percent deviations from the no-shocks scenario in 2028):
  - Baseline (20% higher) = -1.2
  - Baseline with Low Efficiency = -2.0
  - Adverse (70% higher) = -2.9
- Alternative scenario specifics:
  - If energy efficiency is less responsive (energy efficiency gain of only around 4 percentage points by 2028 instead of 6 percentage points), the level of potential output is estimated to be 2 percentage points lower than in the non-shock scenario.
  - In an adverse scenario where energy prices are assumed to be 70 percent higher than the pre-pandemic level, the estimated reduction in potential output is 2.9 percentage points.
- Limitations:
  - The approach does not fully capture multi-sector input-output effects and the potential re-allocation of production across sectors and across countries, which could influence the overall impact.

### Policy implications and recommendations
- Preserve and strengthen price signals:
  - Increased energy efficiency is key to mitigating the adverse effects of the energy price shock.
  - Suppressing price signals (for example, subsidizing energy prices) could delay improvements in energy efficiency (and the climate transition).
- Support productivity and innovation:
  - Increasing productivity (particularly capital-labor productivity) can help offset transitional losses from reallocated R&D.
  - Government policy can help boost productivity by fostering innovation and human capital development, as discussed in more detail in the 2023 and previous year’s Article IV reports.
- Direct the transition to cleaner energy:
  - Government interventions can help direct the transition in ways that support the green transition and Germany’s goals to significantly reduce CO2 emissions.
  - Recommended measures include continuing to gradually increase carbon pricing while also increasing public investment in renewable energy infrastructure and energy efficiency.
- Facilitate firm-level adjustment:
  - Policy emphasis on facilitating firm-level energy-efficiency investments and preserving price signals that encourage conservation and renewable deployment is supported by behavioral and market evidence.

*Prepared by Yushu Chen, Ting Lan, Aiko Mineshima, and Jing Zhou (IMF Selected Issues Paper SIP/2023/059, completed July 17, 2023).*

### Section 1

### Impact of High Energy Prices on Germany’s Potential Output

### Introduction: recent developments and observed responses
- Surge in energy prices since Russia’s invasion of Ukraine reduced energy-intensive sector production, while non-energy intensive sector production remained resilient.
- At their peak in 2022, Germany’s natural gas import prices reached nearly tenfold their 2021 average, before falling to below threefold the 2021 average as of April 2023.
- Production of energy-intensive industries declined almost 20 percent from pre-war levels between late 2021 and late 2022.
- German industries’ gas consumption during the second half of 2022 was on average 22 percent below their 2018–22 levels.
- Gas intensity (output per unit of gas) improved by around 25 percent since 2021, with about two-thirds of that improvement driven by within-sector efficiency gains and one-third by cross-sector shifts in production.
- Survey and market signals:
  - Ifo Institute survey: 75 percent of German firms were able to save natural gas without reducing production.
  - DIHK survey: three-quarters of manufacturing firms planned to pass higher production costs onto end-users.
  - More than half of manufacturing firms planned to invest in energy efficiency measures.
  - Public spending on clean energy R&D and the number of new clean energy start-ups increased.
- Corporate margins and costs:
  - Unit profit per real output has exceeded trend and increased by almost 20 percent in the last two years.
  - The average profit share between 2022Q1 and 2023Q1 was 2 percentage points higher than the 2019 average.
  - Unit labor cost has not surpassed its trend after a temporary spike in 2020Q2, with an uptick in late-2022.
  - Utility sector experienced windfall profit gains due to inframarginal pricing in the electricity market.

### Analytical approach: directed technical change model and calibration
- Framework:
  - Closed-economy, directed technical change model (following Acemoglu (2002) and related literature) where firms deliberately allocate R&D toward technologies complementing specific factors.
  - Two competing effects determine direction of technical change: price effect (favors technologies for more expensive/scarce inputs) and market size effect (favors technologies for abundant inputs).
  - The elasticity of substitution between energy and labor-capital inputs, 휖휖, determines which effect dominates.
- Key structural assumptions and estimation:
  - Firms’ production function includes capital-labor productivity parameter 퐴퐴푡 and energy productivity parameter 퐴퐴푒푒,푡, with CES aggregation and share parameter 훾훾.
  - A Bayesian estimation approach jointly estimates 휖휖 and shock variances.
  - Posterior estimate of 휖휖 for Germany is 0.03.
  - With a relatively low elasticity of substitution (휖휖 = 0.03), the price effect is dominant, prompting firms to direct technical change toward energy efficiency when energy prices rise.
- R&D and technology trade-off:
  - At each period, a fixed amount of R&D is allocated between improving capital-labor productivity and energy efficiency, subject to a technology constraint 퐺(·)=0; increasing one reduces the other.
  - Under the baseline scenario where energy prices are assumed 20 percent higher than pre-pandemic levels in 2028, energy efficiency is higher by 6 percentage points in 2028 compared with a no-shock counterfactual.

### Impact of higher energy prices: simulations and quantitative findings
- Baseline scenario and headline estimates:
  - Baseline: energy prices (consumption share-weighted average of coal, oil, and natural gas prices) assumed to stay 20 percent above pre-pandemic levels (based on futures prices as of June 2023).
  - Staff’s baseline quantification (abstract): effect could be around 1¼ percent of GDP, with uncertainty depending on shock magnitude and energy efficiency mitigation.
  - Model simulation: energy prices that are 20 percent above the 2018–19 average are estimated to reduce Germany’s potential output by 1.2 percent in the medium term.
  - By 2028, potential output is estimated to be lower by 1.2 percent compared to the no-shock scenario.
  - The adverse impact on potential growth diminishes to well below 0.1 percentage points by 2028.
- Timing and peak effects:
  - The largest adverse impact is estimated to have taken place in 2022, when energy prices rose by 232 percent from the 2018–19 average.
  - Annual incremental impacts diminish over time as energy efficiency growth increases and capital-labor productivity growth slows.
- Mechanisms:
  - Energy price shocks prompt a reallocation of R&D/investment from capital-labor productivity toward energy-saving technologies, raising energy efficiency but reducing capital-labor productivity relative to the balanced growth path.
  - In the short-to-medium term, efficiency gains cannot fully offset the adverse price effect and the transition cost of shifting investment, producing a temporary deviation and a permanent output loss.
  - Over the long run, the economy is expected to adjust and return to the balanced growth path, but the transitional deviation causes a lasting output gap relative to the no-shock scenario.
- Sensitivity:
  - Output losses become larger if energy efficiency is less responsive to energy price changes or if price shocks are greater.
  - Directed technical change mitigates negative consequences, but mitigation depends on the elasticity of substitution and responsiveness of energy efficiency.

### Policy implications and discussion
- Policies that promote effective adjustment can reduce the adverse impact on potential output by:
  - Increasing productivity (particularly capital-labor productivity) to offset transitional losses from reallocated R&D.
  - Maintaining strong price incentives to conserve energy and to invest in renewable energy production.
  - Supporting investments in energy efficiency, given its central role in mitigating price shocks under a low elasticity of substitution.
- Behavioral and market evidence supports policy emphasis on facilitating firm-level energy-efficiency investments and preserving price signals that encourage conservation and renewable deployment.

*Prepared by Yushu Chen, Ting Lan, Aiko Mineshima, and Jing Zhou (IMF Selected Issues Paper SIP/2023/059, completed July 17, 2023).*

### Section 2

### sipea2023059 - Section 2

### Main findings on the impact of higher energy prices
- Under the scenario in which energy prices are above the 2018–19 average by 20 percent, the energy price shock could reduce Germany’s potential output by around 1.2 percent and potential growth by 0.1 percentage points over the medium term, compared to the non-shock scenario.
- In an alternative scenario where energy efficiency is less responsive to the high energy price shock—i.e., an energy efficiency gain of only around 4 percentage points by 2028, instead of 6 percentage points assumed under the baseline—the level of potential output is estimated to be 2 percentage points lower than that in the non-shock scenario.
- In an adverse scenario where energy prices are assumed to be 70 percent higher than the pre-pandemic level, the estimated reduction in potential output is 2.9 percentage points.
- Figure 5 (staff estimates) reports percent deviations from the no-shocks scenario in 2028: Baseline (20% higher) = -1.2; Baseline with Low Efficiency = -2.0; Adverse (70% higher) = -2.9.
- The approach has limitations: it does not fully capture multi-sector input-output effects and the potential re-allocation of production across sectors and across countries, which could influence the overall impact of higher energy prices on the economy.

### Interpretation and dynamics
- Some of the adverse impact of permanently higher energy prices is expected to be offset by firms’ endogenous response via improving energy efficiency.
- The adverse impact becomes larger if firms’ energy efficiency response to price increases is low and/or energy prices turn out to be higher.

### Policy recommendations
- Price signals are important.
  - Increased energy efficiency is key to mitigating the adverse effects of the energy price shock.
  - Suppressing price signals by—for example, subsidizing energy prices—could delay improvements in energy efficiency (and the climate transition).
- Boosting labor and capital productivity remains critical.
  - Higher labor and capital productivity can help offset output losses from higher energy prices.
  - Government policy can help boost productivity by fostering innovation and human capital development, as discussed in more detail in the 2023 and previous year’s Article IV reports.
- Government interventions can help direct the transition to cleaner energy.
  - It is important that Germany respond to the energy shock in ways that also support the green transition, given Germany’s goals to significantly reduce its CO2 emissions.
  - This can be achieved by continuing to gradually increase carbon pricing while also increasing public investment in renewable energy infrastructure and energy efficiency.

*Source: sipea2023059 - Section 2*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2023/english/sipea2023059.pdf_