A rise in prices for the long haul

With an annual inflation rate[1] estimated at 4.1% in December 2021 and 3.6% in January 2022[2] by STATEC, the rise in prices continues at a sustained rate, threatening the consolidation of the Luxembourg economy and weighing on the costs borne by companies. The effect on their competitiveness is undeniable, with the latter seeing their margins and profitability decline, and as a consequence, their capacity for innovation and investment reduced in the medium run, particularly in the digital and environmental transitions. In the long run, this can have a negative impact on the growth potential of the economy, leading to the fear that companies will fail, resulting in a loss of tax revenue for the State, a decrease in the attractiveness of Luxembourg, and a hindrance to economic diversification. In order to counter this vicious circle before it takes hold, it is time for action.

An abrupt economic recovery at the root of skyrocketing inflation

After a year of global health and economic crises in 2020, the year 2021 was characterised by a gradual economic recovery. This recovery brought strong demand for raw materials and energy products, first from the United States and China, and then from Europe. The supply side has found it increasingly difficult to keep up with this high demand, due to interruptions in supply chains caused by the pandemic, shortages of raw materials, and a lack of skilled and available labour, among other things. As a result, the surge in commodity and energy prices has led to the start of a global inflationary surge. Its effects are all the more marked in the European Union, which is heavily dependent on imports, particularly of heavy and light rare earths, most of which come from China.

In addition to the bottlenecks in the global production and supply chains, there are exogenous market reasons which accentuate the surge in energy prices. A long and cold winter in Europe in 2020-2021 increased demand, while global climate hazards reduced global supply. Add to this the geopolitical tensions involving Russia and Ukraine, the principal gas suppliers to Europe, as well as the increase in energy prices induced by the ecological transition, and everything is in position for the cost of energy, to be borne by households and companies, to skyrocket.

Energy explains half of inflation, exacerbating the costs of the ecological and energy transition

In the Eurozone, energy prices saw an annual increase of 28.6% in January 2022 (and +6% compared to December 2021). 

In Luxembourg, the annual inflation rate for gas was 61.3% in December 2021 and for liquid fuels 63.4%. Despite a slight decline in the price of black gold in recent months, a growing number of experts expect energy prices to remain high until at least 2023. 

The annual inflation rate, calculated on the basis of the Harmonised Indices of Consumer Prices (HICP), was 4.6% in Luxembourg in January 2022, 8.5% in Belgium, 5.1% in Germany and 3.3% in France.[3]  This high inflation comes on top of the major challenges facing companies, namely the energy and environmental transitions. Policies in this area are setting ambitious targets. These transitions, which are very rapid, especially in view of the 2030 deadline, have a cost, however, which is exacerbated by shortages of raw materials and energy costs, disruptions in supply chains and labour shortages.

The production costs of companies are directly affected by several concomitant factors: an overly slow development of electricity production from renewable energies in Luxembourg and Europe, the desire to gradually stop producing electricity from non-renewable energies, Europe’s dependence on other parts of the world, especially for gas and rare metals, and the rise in price of carbon, raw materials and fossil fuels. Added to this is the lack of skilled labour, which undermines the productivity of companies and puts additional pressure on production costs. 

A global problem that first requires a strong European response

This trend is likely to continue in 2022 and beyond, putting the economy in long-term jeopardy if no European, but also national, solutions are found.

The European Union must work on solutions in several areas to solve the energy crisis and succeed in its ecological and environmental transitions: strengthening energy storage facilities and considering a common gas supply in order to have better market power, or promoting ‘Made in Europe’ renewable energy by reducing dependence on fossil fuels from other countries. This contribution should also include support for research and innovation in these areas.

Luxembourg, because of its small size, cannot act alone and therefore has every interest in collaborating in a collective effort for research and implementation of European solutions, particularly because of the significant energy needs of its economy.

We need to find an answer to Europe’s dependence on the production of non-EU raw materials, which are essential for high value-added goods. More than ever, we need to strengthen the resilience of value and supply chains, especially for rare metals. Indeed, the International Energy Agency (IEA) forecasts a quadrupling of demand for raw materials by 2040, in order to limit global warming to less than two degrees by the end of the century.

To achieve this, a European strategy must be rapidly implemented, including the European Chips Act presented on 8 February by the European Commission, which aims to increase the production of microchips throughout the European continent in response to growing demand and to reduce dependence on suppliers located outside Europe. Currently, the European Union accounts for 10% of global microchip production and aims to reach 20% by 2030 as part of its quest for ‘strategic autonomy’. From this perspective, the European Commission’s communication of 1 December 2021 on the Global Gateway seems to be moving in the right direction. One of the challenges of this strategy is to collaborate with partner countries around the world in order to create the necessary infrastructure for sustainable and resilient value chains and to reduce dependence on China, in particular. In addition, the creation of the European Raw Materials Alliance (ERMA) is a step in the right direction to strengthen the different European ecosystems, and Europe’s resilience. However, it does not provide short run solutions.

Moreover, in view of the current context, the geopolitical tensions involving Ukraine are having an impact on Russian gas imports and on the European economy, notably through higher gas prices. Faced with the risk of shortages due to low levels of reserves, European countries are trying to diversify their sources of supply.

It is also urgent to act at national level in Luxembourg

In addition to the European actions and strategies to be implemented – but which will take time – Luxembourg must act quickly, particularly in order to curb ‘home-made’ inflation and to support in a targeted way the companies most affected by the rise in their energy bills.[4] 

…by increasing efforts in the development of renewable energies

The effort initiated by Luxembourg to reduce its energy dependence must continue. The country imports 80.7% of its national electricity consumption.[5] With 11.7% in 2020, the share of renewable energies in Luxembourg’s final consumption remains nevertheless very low compared to the vast majority of European countries [6]. The Grand Duchy must therefore continue its efforts in this area, whether on Luxembourg territory or by continuing to collaborate on cross-border and European projects. To diversify and ‘make sustainable’ the country’s energy mix, and in particular the development of renewable energies, this must remain a priority.

…by encouraging an increase in productivity in our companies 

In order for Luxembourg’s economic stakeholders to be able to increase their productivity while managing to reduce the consumption of new resources and their energy consumption, it is essential to encourage and support our companies to ‘do better with less’. At least in the short and medium run, the ecological and energy transitions entail additional costs for these stakeholders, who must combine their sustainable development objectives with their profitability objectives. It is essential to further support companies in this change of business model through new funding programmes or through more funding for continuing education (especially in response to the lack of skilled labour) that meets future needs, especially in terms of the circular economy. The latest edition of the Chamber of Commerce’s economic barometer bulletin, Baromètre de l’Economie, confirmed these expectations from Luxembourg’s business leaders.[7]  

…by rethinking the automatic indexation mechanism 

Today, energy products, such as gas, liquid fuels and fuels and lubricants, account for 5% of the NICP basket of goods and services. Between March 2020 and December 2021, a volatility of 32.3% could be observed due to the current inflation conditions.     

It is therefore necessary to ask whether, in view of the ecological and energy transition, as well as the high inflation we are experiencing, the mechanism, as currently in effect, still corresponds to the characteristics of our current society. The automatic indexation system has contributed to social cohesion in Luxembourg until now. However, in these times of high inflation, a new indexation bracket will not be sufficient for the lowest incomes to compensate for the rise in energy prices while adding additional pressure to companies. As announced by the Minister of Finance on 9 February, this new bracket could already occur in Spring 2022. 

Through this automatic and full indexation of wages, companies suffer a double penalty when energy prices rise, by bearing these rising prices as well as the rise in labour costs. Neutralising fossil fuel products in the NICP would make it possible to meet the objectives of ‘stabilisation’ (by no longer subjecting companies to the ‘double shock’ of supply and indexation) and of environmental logic. It is indeed paradoxical to promote an ambitious environmental policy while indirectly approving and supporting non-virtuous consumption patterns.[8] However, such a reform of the basket and the weighting underlying the consumer price indices would take time. In view of the urgency and persistent soaring inflation, quick solutions for a temporary modulation of the Luxembourg system are required, with parallel compensation of the households most affected by the significant increase in energy prices. 

 …and by accelerating the transition from a linear to a circular economy 

Actions to address the problem of raw material shortages must be taken. The shift from a linear to a circular economy, already initiated in Luxembourg, will be essential to achieve this objective. There are many circular economy practices that optimise the use of raw materials, while reducing their need and cost. To give just a few examples of new business models: with industrial symbiosis, one company’s waste becomes another’s raw material; sustainable sourcing, the economy of functionality, recycling/upcycling, and extending the useful life of products all allow the same resources to be reused in multiple production cycles. Whenever possible, the re-use of commercial waste or raw materials should be encouraged by supporting companies with aid and awareness programmes in order to have more secondary raw materials, i.e. waste that has been transformed and/or combined, in order to obtain a product that can be used in manufacturing processes to replace the initial raw material.

A future contribution on this blog will be dedicated to the topic of the circular economy.

[1] The annual inflation rate is obtained by comparing the total price of the basket of consumer goods and services in a given month with that of the same month in the previous year. The monthly inflation rate is obtained by comparing the price of the basket in a given month with that of the previous month.

[2] The decrease in the annual rate from 4.1% to 3.6% is explained by a base effect following the shift of the 2021 winter sales period, which were reflected in the February 2021 results. Adjusting for this effect, the annual rate is 4.7%. Some elements of energy pricing have also been adjusted downwards. On the other hand, a rebound in the prices of oil products is noted, due to the rise of Brent and gas on the international markets as well as the increase in the CO2 tax.

[3] Source: Eurostat.

[4] In order for the Luxembourg Government to do so without violating European competition rules, the Minister for the Economy and the Minister for Energy have sent a letter to the European Commission requesting ‘exceptional aid’ for these companies in difficulty.

[5] By way of comparison, in 2018, the country imported 85.9% of its national consumption, producing 14.1% locally. (Source: ILR)

[6] In 2020, the share of renewable energy in final consumption was 22.1% on average in the EU, with 10.7% in Malta, 11.7% in Luxembourg, 13% in Belgium, 19.1% in France, and 19.3% in Germany, compared to 60.1% in Sweden. (Source: Eurostat)

[7]  See the Chamber of Commerce’s economic barometer bulletin, Baromètre de l’Economie, from the second semester 2021, on the circular economy, published in French.

[8] For more information on the sliding scale mechanism and the Chamber of Commerce recommendations on it, please consult the publication, Actualité & Tendances N°24: Un ‘Panier durable’ pour le Luxembourg, published in French.

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