The Great Electricity Shock: Manufacturing Edition

Europe’s electricity woes stayed in headlines globally Thursday and Friday, this time with the news several British factories were starting to cut back due to soaring electricity costs. Two fertiliser plants owned by a US company announced indefinite closures, steel plants revealed they were idling during peak hours, and a survey showed about two-thirds of UK factories worried about energy prices impacting their operations.^[i] Analysts at one big US financial firm warned Continental Europe could face similar fallout, especially if winter is colder than usual.^[ii] Several financial commentators we follow warned the associated fall in manufacturing output could jeopardise the economic recovery from lockdowns not just in the UK and Europe, but globally. In our view, this thesis falls apart when you gather a few basic facts, and we don’t view the current troubles as a major economic or equity market risk.

It does logically follow that if a factory closes fully or in part for any length of time, it will reduce output. We aren’t dismissing that or the impact on the affected businesses, workers and communities. But we think extrapolating anecdotes into widespread trouble is a well-travelled road to error, as companies can adapt in different ways. Fertiliser companies were likely the first to close outright because chemical production is one of the most electricity-intensive segments of the manufacturing industry—one US research report put it at the top of the list a few years back, responsible for just over 20% of manufacturing’s total electricity use.^[iii] Iron and steel were fourth, at just over 6%.^[iv] Transportation equipment, which has a heavy presence in the UK (e.g., autos and aircraft), uses a smidge less than that. Food and beverage production, also big in Britain, is much further down the list. (No word yet on how this has impacted electricity-intensive cryptocurrency mining—stay tuned for that, we guess.)

Rather than zero in on specific industries, we think it is more helpful to take a higher-level view and consider a country’s overall sensitivity to electricity costs. One way we do this is to scale manufacturing as a percentage of GDP, then compare it to services, which is overall much less energy-intensive. (GDP, or gross domestic product, is a government-produced measure of economic output.) In the UK, manufacturing was just 8.7% of GDP in 2019, which we use instead of 2020 to avoid lockdown skew.^[v] Services, by contrast, was a whopping 70.9%.^[vi] Not that services are immune to high electricity prices, but it generally costs a lot less to keep the lights on at a hair salon or keep the computers running at a bank than it does to keep complex automated assembly lines running.

The four largest eurozone economies also derive the majority of their economic output from services. France’s 2019 GDP was 70.1% services and just 9.8% manufacturing.^[vii] Spain was 67.6% services and 11.2% manufacturing.^[viii] Italy? 66.4% services and 14.9% manufacturing.^[ix] Even Germany, widely regarded as Europe’s industrial powerhouse, was 62.6% services and just 19.1% manufacturing.^[x]

Our study of economic history shows the shift from manufacturing to services is part of all these countries’ long-running economic evolution, and it has helped all of them become more energy-efficient in recent years, to varying degrees. Exhibit 1 charts the amount of GDP derived from a single terawatt hour (TWh) of electricity consumption since 1990, the earliest year for which electricity usage data are available. To make it easy to navigate variables like the euro’s introduction and German reunification, we used the World Bank’s measures of real (inflation-adjusted) GDP in US dollars for all nations. As you will see, the UK has almost doubled its electricity efficiency since 1990. Now, similarly efficiency gains don’t hold across the entire Continent—Italy and Spain, which both started and ended the period with heavy industry accounting for a larger share of national GDP—saw efficiency gains start rising later, and they haven’t reaped as much benefit yet.^[xi]

Exhibit 1: The UK and Europe Are Growing More With Less Electricity

Source: International Energy Agency (IEA) and the World Bank, as of 16/9/2021. Analysis limited to every fifth year and 2019 due to IEA data availability.

Another fun fact: In all nations, total electricity consumption has fallen in recent years. The UK used 378.8 TWh in 2005—in 2019, it used just 318.3.^[xii] Electricity consumption was last at that level in the early 1990s, when GDP and population were significantly smaller.^[xiii] Spain’s consumption fell from 266.8 TWh to 255.6 over that same stretch.^[xiv] France’s consumption is down from 503.2 TWh in 2010 to 474.3 in 2019.^[xv] Over that same span, Germany’s fell from 594.2 TWh to 558.9, and Italy’s from 325.7 to 311.9.^[xvi] All countries’ GDP is bigger now than it was at peak electricity use.^[xvii] Overall, we think this is strong evidence that all nations have more resilience to electricity costs than the fearful stories suggest.

As for the global impact, several financial commentators we follow argue that if spiking electricity reduces UK and European factory output, it will add to the world’s supply shortages. Which, fair enough, but shortages of lumber, semiconductors and other key components have reigned for several months now without materially denting output.^[xviii] Perhaps industrial production is growing more slowly than it otherwise might without shortages, but the counterfactual is impossible to know, especially with COVID lockdowns still a variable in the developing world. So yes, there may be some impact, but we doubt this packs the punch to knock economies into recession.

Overall, therefore, we see this as one more area where expectations are dim for now, widening the gap between sentiment and the likely reality ahead. That should add to the positive surprise power fuelling equities—typical fodder to propel shares higher up the proverbial wall of worry that generally characterises long expansions.