‘The great green renovation’ or the buildings sector path to net-zero; Rallying ruble & the weaponization of finance

The one who doesn‘t (always) tell you what you want to hear, but tells you what you need to hear. Keep the latter! Applicable to our analysis of how much more ambitious the EU’s targets for reducing emissions need to get to meet Paris climate goals and details on the crucial role the buildings sector will play with the two key levers – improving energy efficiency and switching to greener fuels. Our second report this week is our take on the recent ruble rallye and the turning point we see coming up with the risk of fiscal challenges and what we call the “weaponization of finance” - aimed at paralyzing Russia’s economy but with the potential for long-lasting consequences on the global financial system. And our weekly wrap-up on relevant economic events this week.

Weekly wrap-up: Oil embargo, inflation surge & Biden's plan

• European embargo on Russian oil likely to further fuel the surge in commodities prices. Given the unprecedented surge in energy inflation and clogged agricultural supply chains at the global level, there is a rising risk of even further increases in commodity prices. This will further dent households’ disposable incomes and firms’ profit margins.
• Inflation momentum to pick up again in the Eurozone. While fiscal support measures will help contain some price pressures. we expect that the post-lockdown pick-up in services inflation and the indirect effects of increasing commodities prices will keep inflation elevated going into summer.
• With growth still holding up, the ECB will prioritize fighting inflation through a relatively swift interest rate lift-off. Ending the QE program will pave the way for a 25bps-rate hike at the July policy meeting, with two additional 25bps-rate hikes following later this year (in September and December).
• US President Biden’s plan to rein in inflation as the housing market keeps heating up. We find that these proposals hardly go beyond existing initiatives, with the overall legislative agenda likely to remain stuck in Congress until the mid-term elections.
• China edging towards a mild recovery. As the Omicron wave of abates and sanitary restrictions are being waived, we expect economic activity to improve in the coming quarters.
• Markets put the ECB to the “hawkishness test”. There is a 67% market-based probability of a policy rate hike of even 50bps in July.
• Uncertainty around monetary policy keeps risky assets on guard. After a relief week, equity markets have, once again, come under pressure.
• Corporate credit markets are getting used to bond and equity volatility. Corporate credit markets continue to have a balanced response to policy and inflation repricing.

The great green renovation - The buildings sector transition pathway

The EU aims at slashing emissions in all sectors by a minimum of 55% by 2030, implying a 60% GHG emission reduction for the buildings sector. But is that really the bloc’s “fair share” in achieving the Paris climate goals, and what will the transition cost? Please find the latest of our sector pathway mini-series here; previous reports, i.e. on utilities or agriculture/forestry can be found here. The highlights:

The EU’s targets for reducing emissions are not ambitious enough to meet the Paris climate goals: Taking into account its “fair share”, calculated by dividing the remaining carbon budget by its share of the global population, the EU needs to slash emissions by 65% by 2030 instead of the aspired 55% and needs to achieve climate neutrality by 2040, 10 years earlier than currently planned. In this context, the buildings sector will play a key role: Buildings account for 40% of the EU‘s total energy consumption and 36% of energy-related greenhouse gas (GHG) emissions.

There are two key levers to reduce emissions in the buildings sector: improving energy efficiency and switching to greener fuels. The former, energy savings, can be mainly achieved through renovations, reducing the energy demand by at least a quarter over the next decade. The latter implies thorough electrification: The electricity share is expected to climb from around 20% to 45% (residential buildings) and from 45% to 60% (service sector) in 2050. In the process, the share of natural gas in the energy consumption mix – today at 50% – will plunge to almost zero.

Since up to 95% of existing buildings are likely to still be around in 2050, ramping up the renovation rate is essential. While around 16% of all of EU buildings undergo partial to full renovation per year, little to no attention is being paid to assessing and improving the energy performance of those buildings. As a result, the “real” renovation rate, weighted by effective energy savings, is close to 1% for residential buildings and 0.5% for non-residential buildings. The EU is aiming for a 2% energy-renovation rate to reduce GHG emissions from buildings, but we find that it needs a much more ambitious target of 3%.

Overall, the annual energy-renovation investment needs to achieve the EU goal of a 2% energy-renovation rate range between 0.2% and 0.8% of GDP in the EU countries, with an average of 0.5% of GDP. This amounts to EUR82bn per year in the EU or EUR95bn if the UK is included as well. However, the necessary 3% renovation rate would increase the energy investments needed by EUR47bn in the EU and UK per year. Against the backdrop of the EU’s residential sector currently investing about EUR 200bn per year in energy renovations (though rather inefficient ‘light’ than efficient ‘deep’ energy renovations), these investment needs seem feasible if energy renovation becomes the first principle in renovation.

Rallying ruble and the weaponization of finance

The recent rally of the Russian ruble due to stringent capital controls and external rebalancing might have reached a turning point and could eventually backfire by creating fiscal challenges. At the same time, war-related sanctions have also triggered a debate on the implications of the “weaponization of finance” for the global financial system over the longer term. This analysis hopes to shed light on both topics. You will find our comprehensive analysis here.

• Against initial expectations, comprehensive sanctions did not plunge Russia into a currency crisis. Unlike other emerging market currencies during times of stress, the Russian ruble experienced a short-lived depreciation. After plummeting in the early days of Moscow’s invasion of Ukraine, the ruble has staged a remarkable comeback and has more than doubled against the US dollar from its March slump, becoming the best-performing emerging market currency so far this year.
• Several factors explain why Russia averted a currency crisis despite the freeze of most of its central bank reserves. The current account surplus soared to a record USD58bn in the first quarter of 2022, and could climb as high as USD250bn (in the absence of a comprehensive embargo on energy exports). The Russian authorities also took timely countermeasures to orchestrate an “FX intervention by delegation,” including stringent capital controls, a temporary gold fixing of the ruble and asking energy importers to switch payments to rubles – together with a steep policy rate rise to stabilize the ruble after it plummeted.
• However, the ruble’s rapid ascent might have reached a turning point and could eventually backfire. Since the ruble trades in a very thin market (and mostly domestically), its recent appreciation belies a struggling domestic economy, which is expected to slump into a severe recession this year – but it has real consequences. Since the most energy exports remain FX-denominated, a stronger ruble hurts the government’s budget balance by lowering the local currency value, which could be further impacted by the potential for EU tariffs on Russian energy exports during the phase-out of oil imports. Last week, the central bank has responded with the third rate cut since April to tame the currency’s appreciation. Going forward, the current upward pressure on the ruble is likely to subside over time as some of the Russian countermeasures expire, Russian energy exports become less competitive and the deteriorating economic outlook begins to weigh on the FX rate.
• Beyond the effects on Russia’s currency, the “weaponization of finance” aimed at paralyzing Russia’s economy could also have long-lasting consequences on the global financial system. While some of the sanctions, such as the freezing of almost two-thirds of Russia’s FX reserves, were politically expeditious, they also raise questions about financial sovereignty in a strongly USD-dominated monetary system. We could reasonably see some countries start diversifying away from the US dollar and/or the Western-dominated global financial architecture over time, especially those that feel they could be targeted by sanctions at some point). Furthermore, Russia’s short-lived gold fixing might serve as blueprint for a more serious attempt by countries that have sufficient gold reserves (or commodities exports) to depart from the current system of fiat currencies.