oil
The transmission channels of geopolitical risk
Samuel Smith and Marco Pinchetti
Recent events in the Middle East, as well as Russia’s invasion of Ukraine, have sparked renewed interest in the consequences of geopolitical tensions for global economic developments. In this post, we argue that geopolitical risk (GPR) can transmit via two separate and intrinsically different channels: (i) a deflationary macro channel, and (ii) an inflationary energy channel. We then use a Bayesian vector autoregression (BVAR) framework to evaluate these channels empirically. Our estimates suggest that GPR shocks can place downward or upward pressure on advanced economy price levels depending on which of the two channels the shock propagates through.
The channels of GPR
To assess the effects of geopolitical tensions on the macroeconomy, it is first necessary to quantitatively measure GPR. Our approach to measuring GPR follows the work of Fed researchers Caldara and Iacoviello (2022), who develop an index GPR based on the number of articles covering adverse geopolitical events in major newspapers. This index reflects automated text-search results of the electronic archives of 10 major western newspapers. It is calculated by counting the number of articles related to adverse geopolitical events in each newspaper for each month (as a share of the total number of news articles).
Chart 1 shows the behaviour of the GPR index from 1990 to 2023. The index is relatively flat during large parts of the sample, and spikes around major episodes of geopolitical tension, such as the outbreak of the Gulf War, 9/11, the beginning of the Iraq invasion in the 2000s, and the Russian invasion of Ukraine in 2022.
Chart 1: The GPR index
Source: Caldara and Iacoviello (2022).
In the same paper, Caldara and Iacoviello (2022) show that on average, an increase in the GPR index is associated with lower economic activity, arguing that these effects are associated with a variety of macro channels, ranging from human and physical capital destruction, to higher military spending and increased precautionary behaviour.
However, episodes of geopolitical tension often involve increased concerns about the supply of energy to global markets. Chart 2 shows the cumulated percentage change in the three months ahead West Texas Intermediate (WTI) futures around key geopolitical events. Oil future prices rose following most of these episodes, potentially reflecting expectations of supply cuts to energy production or disruption of the flow of energy.
Chart 2: WTI futures three months ahead prices during the 30 days following major recent geopolitical events (associated with tensions on energy markets)
Source: Refinitiv Eikon.
This suggests that GPR can also transmit via an additional energy channel, whose effects are more akin to an adverse supply shock. Whether the shock transmits through this channel, and how strong it is relative to the macro channel, will depend on the wider context and/or location of the events relating to the shock. Disentangling the two effects is, therefore, important for correctly assessing the economic consequences of a GPR shock.
Measuring geopolitical surprises
We begin our analysis by constructing a series of exogenous surprises in (i) GPR, and (ii) oil prices that can be assumed to be entirely driven by geopolitical events to a reasonable degree of approximation.
In order to construct our surprise series, we adopt a selection of 43 main GPR events from 1986 to 2020 proposed by Caldara and Iacoviello (2022), which we update to include four important events that have occurred in the past three years: the escalation of the Afghanistan Crisis in August 2021; the Russian invasion of Ukraine in February 2022; the Istanbul bombings in November 2022; and the events in the Middle East in October 2023.
We compute the GPR surprise as the daily log difference in the GPR index around these events. For the oil price surprise, we compute the daily log difference in WTI future prices from one to six months ahead around the same dates. We then take the first principal component of these to capture movements in energy prices driven by the geopolitical shock.
Decomposing the macro and energy supply components of geopolitical surprises
We then use our event-study data set in a Bayesian-VAR setting for the euro area, the UK, and the US from January 1990 up to October 2023 to disentangle the effects of the macro uncertainty channel from the energy supply channel of GPR. We adopt the two-block VAR structure proposed by Jarociński and Karadi (2020), which uses high frequency data combined with narrative and sign restrictions to identify shocks.
Within the high-frequency block, we include our surprise series of (i) log changes in the GPR index in the main geopolitical event days, and (ii) the first principal component extracted from changes in WTI futures from one to six months ahead in the main geopolitical event days, both cumulated at monthly frequency in case of multiple events occurring in one month. Within this block, we impose the sign restrictions at the core of our identification strategy, which we outline in Table A.
We impose that the response associated with the macro channel drives upward surprises in the GPR index and negative surprises in the oil future curve during the first day the news is reported, as oil prices drop following a contraction in economic activity. Conversely, we impose that the response associated with the energy supply channel drives upward surprises in the GPR index jointly with positive surprises in the oil future curve during the first day the news is reported, as precautionary oil demand rises in response to concerns about future supply cuts or shipping disruption.
Table A: The sign restrictions associated with each channel of GPR
GPR MacroGPR EnergyGPR surprises++WTI surprises–+
In our monthly frequency block, we include the GPR index in logs, real Brent crude prices spot in logs, real natural gas spot prices in logs (as measured by the IMF benchmark), and the monetary-policy relevant price indices in levels (in deviation from their long-run trends, as is standard in the VAR literature).
Identifying two distinct channels of GPR
Chart 3 plots the response to a geopolitical shock that leads to a 100 basis points increase in the GPR index. The first row reports the responses of oil and natural gas prices to an ‘average’ geopolitical shock, which does not disentangle the effects of the macro and the energy channel, along the lines of Caldara and Iacoviello’s work. The second and the third rows display the responses when we assume that all of the increase in the GPR index propagates via just the macro channel and just the energy channel respectively.
Chart 3: Impulse response functions associated with an ‘average’ 100 basis points GPR shock, as opposed to a 100 basis points shock acting exclusively either through the macro or the energy channel
In the ‘average’ case, the real Brent price spot rises by about 10% on impact, before then dropping of beyond 10% after around six months. However, these dynamics mask the two underlying channels. On the one hand, the energy supply channel is associated with a rapid 20% surge in the oil price. On the other, the macro channel is associated with a more gradual decline of beyond 20%.
The response of gas prices tends to be more persistent than oil prices: the effect of the energy channel on oil prices is concentrated in the first six months whilst the effect on gas prices wanes only during the second year after the shock.
The response of price levels across regions follows a pattern that is broadly consistent with energy price dynamics. As Chart 4 shows, inflation unambiguously drops in the ‘average’ case: the price level drops persistently by about 0.1% in the US, and shortly by about 0.25% in the euro area, while the response is not statistically significant for the UK. This finding is consistent with the interpretation of Caldara and Iacoviello (2022) of geopolitical shocks behaving, from an empirical perspective, as contractionary demand shocks.
However, this similarly masks the effects of the different underlying channels. On the one hand, the pure macro channel gives rise to a more pronounced drop in the median price level than in the case of the ‘average’ GPR shock, reaching -0.5% in the US and the UK, and -0.4% in the euro area. On the other hand, the response associated with the energy supply channel is inflationary, with the price level rising persistently by about 0.5% in the US, 0.7% in the UK, and 0.6% in the euro area.
Chart 4: Impulse response functions associated with an ‘average’ 100 basis points GPR shock, as opposed to a 100 basis points shock acting exclusively either through the macro or the energy channel
Summing up
This analysis highlighted the existence of two separate and intrinsically different transmission channels of GPR: (i) a deflationary macro channel, and (ii) an inflationary energy supply channel. Policymakers should be aware of these distinct channels: GPR shocks may propagate in different manners and require different responses.
Samuel Smith works in the Bank’s International Surveillance Division and Marco Pinchetti works in the Bank’s Global Analysis Division.
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A Just Transition: Making Energy Poverty History with an Energy Mix – review
In A Just Transition: Making Energy Poverty History with an Energy Mix, NJ Ayuk argues that Africa can address “energy poverty” and become a global energy leader by developing a mix of non-renewable and green projects. Alejandra Padín-Dujon is unconvinced by Ayuk’s proposal of a “just transition” for African countries which relies on scaling up fossil fuels and lacks any real engagement with renewable energy or climate-focused policy.
A Just Transition: Making Energy Poverty History with an Energy Mix. NJ Ayuk. Made for Success. 2023.
Find this book: 
In 2021, the International Energy Agency stated that there should be “no new investment in fossil fuel supply projects” if containing global warming to 1.5ºC above preindustrial levels – a crucial threshold for human welfare – is to remain a possibility. With greenhouse gas-reducing initiatives on the rise, the concept of “just transition” has become increasingly prominent. “Just transition” refers to the greening of markets in economically inclusive ways, taking climate action while ensuring that vulnerable people are not left behind.
One might be forgiven, then, for assuming that Cameroonian oil and gas attorney NJ Ayuk’s book A Just Transition: Making Energy Poverty History with Natural Resources – grounded in Africa – would reckon with socioeconomically inclusive energy decarbonisation in Africa. It does not. This glaring omission is especially disappointing given the book’s potential to address a dearth of literature on just energy transitions in African countries. Ultimately, Ayuk’s work capitalises on public interest in this knowledge gap, though he does very little to bridge it.
In A Just Transition, Ayuk touts the importance of encouraging and scaling up fossil fuel extraction and use.
In A Just Transition, Ayuk touts the importance of encouraging and scaling up fossil fuel extraction and use. He expresses trepidation about renewable energy while he pays lip service to climate priorities. He likens renewable energy in Africa – often tenuously – to failures of foreign food aid and continued energy poverty. Ayuk writes that one day,
African countries will be in a position to install more and more solar panels and wind turbines—not as primary sources of power or as alternatives to fossil fuels, but as complements to the gas-burning TPPs [thermal power plants] that make sure the lights can always stay on” [emphasis added].
Strikingly, inconsistently, and more sensibly (given the title), Ayuk writes in an earlier chapter that “Africa ought to develop its gas reserves, but with the goal of replacing gas with renewable energy in stages.”
Perhaps a better title for the book might have been Generally Against Transition – but alas.
Very little of A Just Transition is dedicated to renewable energy at all: the text is primarily an apologia claiming that oil and gas will deliver Africa from energy poverty.
Very little of A Just Transition is dedicated to renewable energy at all: the text is primarily an apologia claiming that oil and gas will deliver Africa from energy poverty. In fact, only one short chapter out of 23 in total sets aside this fixation to address arguments for and against (read: against) the rapid development of renewables in Africa.
As this section of the book is the most pertinent to the question of interest – just energy transition in Africa – let us touch upon Ayuk’s major claims about renewable energy:
- Renewables will fail to address energy poverty.
- Renewable energy projects cost more than most African countries can pay, both in terms of upfront costs and subsidies thereafter.
- Renewable energy infrastructure requires more technological capacity than the continent currently has.
- As intermittent energy sources, solar and wind power require expensive battery storage solutions.
(As a “bonus” claim: Ayuk affirms that green hydrogen is the best alternative energy. He neglects to explain clearly that hydrogen is only classified as “green” if zero-carbon renewables and nothing else are used to synthesise it – making the development of green hydrogen entirely dependent on the development of wind power, solar power, etc.)
None of these are especially new arguments, whether for countries in Africa or for developing countries in other regions that feel squeezed by dual pressures to develop economically and decarbonise – all with minimal financial support from wealthier countries
Mostly, Ayuk’s reservations are policy and technological questions: how can foreign actors, domestic policy, and public-private partnerships reduce the upfront costs of renewable energy projects and help ensure proper maintenance?
Mostly, Ayuk’s reservations are policy and technological questions: how can foreign actors, domestic policy, and public-private partnerships reduce the upfront costs of renewable energy projects and help ensure proper maintenance? What forms of capacity-building are needed in domestic workforces to facilitate the rise of “future-proof” jobs? How can World Trade Organization intellectual property rights policies be reformed to facilitate greater tech transfer to Africa? These are big, but not intractable problems.
The biggest outstanding question is a speculative and slippery one: can renewable energy address severe and widespread energy poverty on the continent?
The major intervention Ayuk considers – and dismisses – is decentralised energy “mini-grids” or “micro-grids” powered by wind or sun, which he claims are too expensive to install and too inconsistently upkept. These are real issues, and they can be addressed through microfinance, investment by regional development banks, government subsidies, and innovative policy solutions.
Truthfully, the question of whether renewables can end energy poverty in Africa is a false one. Posing it as an if question – particularly when the African continent is systemically under-researched and suffers from significant gaps in data collection – is a deft rhetorical move that permits the response, “We can’t bet on it because we don’t have the evidence.” Certainly, evidence supporting the potential developmental contributions of fossil fuels abounds, even when the benefits percolate inequitably through society. 250 years have passed since the inception of fossil fuel-driven development: the Industrial Revolution. That is a lot of evidence.
Ultimately, the “question” of renewables in Africa must be posed not through the lens of if or when, but how.
Ultimately, the “question” of renewables in Africa must be posed not through the lens of if or when, but how. Indisputably, Africa emits very little in greenhouse gases – a nearly negligible amount in the context of global output. However, rapid population growth and ongoing economic development mean that investment in fossil fuels in the region could become globally significant.
The COP28 international climate conference this year will feature another showdown of epic proportions surrounding the terms fossil fuel “phase-out” versus “phase-down.” “Phase-in” isn’t part of the global vocabulary.
More importantly from a regional economic development perspective, the world is decarbonising, and fast. Already, the EU is imposing tariffs called “carbon border adjustment mechanisms” on imports from countries with high carbon intensity to protect its own green policies from decay. The International Energy Agency, as cited above, is calling for a total end to new fossil fuel extraction. The COP28 international climate conference this year will feature another showdown of epic proportions surrounding the terms fossil fuel “phase-out” versus “phase-down.” “Phase-in” isn’t part of the global vocabulary.
Ayuk prefers to speak in generalities about “Africa,” picking a handful of case studies per chapter to illustrate a broad point about 54 countries. In this way, his rhetoric paints a picture of a continent unified by suffering and neglected business potential.
Neither does the author, by and large, acknowledge that Africa is a vast continent composed of rural, urban, more prosperous, and less prosperous societies, all with different electricity grids, economies, and institutional structures. Ayuk prefers to speak in generalities about “Africa,” picking a handful of case studies per chapter to illustrate a broad point about 54 countries. In this way, his rhetoric paints a picture of a continent unified by suffering and neglected business potential. This is an attractive image to the foreign and well-intentioned businessperson – in fact, A Just Transition topped the Wall Street Journal bestsellers list – though it is antithetical, in its simplistic victimhood, to the anti-colonial framing Ayuk experiments with early on:
I’ve begun to wonder whether there isn’t a whiff of colonialism about the prospect of African countries remaining on hold, pining for solar panels and wind turbines until such time as they are allowed access to solutions handed down from on high.
One would think, to read Ayuk, that Africa is a monolith; that fossil fuels are not regressive, but futuristic; that oil and gas have not historically been colonial ventures; and even that green policy is foreign – that there are no African environmentalists.
What Ayuk fails to acknowledge is that energy poverty must be addressed through renewables
Ultimately, what Ayuk fails to acknowledge is that energy poverty must be addressed through renewables, and stalling will only make future economic sacrifices worse. Any set of countries, however entrepreneurial, that gambles its future on fossil fuels today will lose.
Note: This review gives the views of the author, and not the position of the LSE Review of Books blog, or of the London School of Economics and Political Science. The LSE RB blog may receive a small commission if you choose to make a purchase through the above Amazon affiliate link. This is entirely independent of the coverage of the book on LSE Review of Books.
Image credit: Milieudefensie on Flickr.
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