Explainer-Why is the UK at high risk from iran-fuelled energy price surge?

Why the UK Faces Higher Risks From Iran-Fuelled Energy Price Shocks

By Susanna Twidale, Andy Bruce and William Schomberg

UK Vulnerability to Middle East Energy Price Shocks

LONDON, March 6 (Reuters) - Britain faces bigger risks from a jump in inflation driven by the conflict in the Middle East than many other European countries, just as the country's high rate of price growth seemed to be coming to an end.

British government borrowing costs have soared by more than those of other European countries and the United States, and investors have scaled back their bets on the Bank of England cutting interest rates this year.

Drivers of Rising British Gas Prices

Why Have British Gas Prices Risen?

Wholesale British gas prices have leapt by around 70% this week as energy shipments were halted through the Strait of Hormuz, and Qatar - which provides a fifth of the world's liquefied natural gas - halted production.

Only around 1% of Britain's gas supply comes from Qatar but the disruption has led prices to soar globally.

Around 30% of Britain's electricity comes from gas-fired power plants - compared with 17% in Germany and just 3% for France - and it is used for heating in more than 70% of homes. Prices are almost always set by gas, which is more expensive than power from renewable sources.

Britain Has Little Gas Storage

Britain gas storage sites can hold around 12 days' worth of demand compared with 90 in Germany and more than 100 in France.

Unlike the European Union, Britain does not have a gas storage target, which the EU set after the energy crisis caused by Russia's full-scale invasion of Ukraine in 2022.

A gas storage site off the coast of northern England, owned by utility Centrica, accounts for about half of the country’s gas storage capacity. But operations were paused last year when running the site became uneconomical. Centrica hopes the government will offer support to make the site viable.

Impact on Consumers and Businesses

When Will Bills Go Up?

Household energy bills will not go up now because UK gas prices are capped on a quarterly basis by Ofgem, a power regulator. Prices will fall in April after the government shifted some levies to general taxation. But Ofgem's "observation period" for setting prices in the three months from July 1 will capture the current surge as it runs from February 18 to May 18.

Some analysts are forecasting a 10% rise in the price cap.

Most businesses are likely to have hedged their energy supply, protecting them at least in the short term.

Broader Economic Effects

How Will This Affect Inflation and Growth?

Analysts say the hit to headline inflation could be slightly higher in the euro zone than in Britain where fuel and utilities represent a smaller part of the inflation basket. Oxford Economics said UK inflation could be 0.4 percentage points higher if shipping through the Strait of Hormuz is disrupted for up to two months, compared with 0.5 percentage points in the euro zone.

However, the longer-term impact of an inflation shock could be more problematic in Britain where inflation fell back more slowly than in other countries after hitting 11.1% in 2022. It stood at 3% in January, compared with 1.7% in the euro zone.

Long-term inflation expectations among the British public remain higher than before the start of the Ukraine crisis, raising the risk that the current energy price shock becomes embedded in wages and prices if it persists.

Analysts say economic growth could be weaker than expected as households feel the pinch of faster inflation.

Government and Central Bank Responses

What Policy Responses Might Be Coming?

It's too early to know how the government and the Bank of England might respond. If energy prices fall back soon, the need for action might be limited. But if prices don't fall, potentially conflicting policy pressures will mount for the two institutions that oversee Britain's economy.

Fiscal and Monetary Policy Challenges

The previous Conservative government spent a total of 44 billion pounds ($58.6 billion) in 2022 and 2023 to soften the Ukraine-linked energy price surge for households and businesses. A similar programme would make it hard for finance minister Rachel Reeves to meet her targets for repairing the public finances which could cause further alarm in the bond market.

The BoE is now likely to slow its run of interest rate cuts as it waits to see how long the energy price surge lasts. Investors see the chance of a quarter-point rate cut this year as a 50-50 possibility. Last week, they were fully pricing two cuts in 2026.

($1 = 0.7504 pounds)

(Writing by William Schomberg; Editing by Andrew Heavens)