Since January 2021 , natural gas prices have soared by more than 170% in Europe, raising concerns about possible macroeconomic consequences. Both demand and supply factors have contributed to straining the European gas market.
European demand for gas is increasing in household heating, industry and power generation. Increased demand for residential heating due to a cold winter and widespread telecommuting caused global gas demand in Europe to increase by 7.6% in the first quarter of 2021. Furthermore, the combination of a continued rebound in Industrial production, summer heat waves with increased use of air conditioning and the rebound in carbon prices in the EU , which encourage the switch from coal to gas in energy production, kept European gas demand at a low level. elevated during the second quarter of the year.
Supply problems have also arisen. Russia has limited pipeline exports to Europe due to high domestic demand, production interruptions and high prices for liquefied natural gas (LNG) related to the economic recovery in Asia. Russia is also potentially limiting the supply of natural gas to Europe and the start of flows through the Nord Stream 2 pipeline will not start until 2022.
European gas reserves are scarce and what was used during the winter could not be replenished in the summer months. The need to replenish these reserves implies an increase in European imports of LNG and gas in the coming months, which encourages competition between Europe and Asia for the supply of LNG and, therefore, a further increase in gas prices.
The advanced structure of the European gas market, ironically, makes the situation worse. Since 2005, gas pricing in Europe has evolved from the classic oil indexing formula to gas-to-gas competition, similar to that in the US market. Around 80% of the natural gas consumed in Europe in 2020 was priced based on such competition, and only the remaining 20% was still indexed to oil.
For comparison, the price of gas in East Asia is still predominantly based on oil indexation. This characteristic makes the European gas market more flexible, but exposes Europe to strong fluctuations in the international market.
Although natural gas only supplies about a fifth of Europe’s electricity, rising gas prices are putting disproportionate upward pressure on electricity prices. Gas-fired power plants have become pricing units due to increased demand for electricity (thanks to recovery and lower production of renewables due to heat and low wind speeds during the summer), rising global coal prices and the unprecedented rise in the price of carbon in the EU. Hence, wholesale electricity prices are rising rapidly.
Rising energy prices have become a problem with macroeconomic effects in Europe . On an annual basis, a doubling of wholesale electricity prices from around € 50 / megawatt hour to € 100 / MWh would mean that EU consumers would pay up to € 150 billion (€ 50 / MWh for 3 billion MWh) more for its electricity. High gas and electricity prices affect supply chains and cause inflationary pressures. Drastic increases in energy expenditure will reduce the disposable income of the poorest households with their high propensity to consume.
Energy poverty across Europe is a major problem: the percentage of people who report that they cannot afford to keep their home adequately warm is high in many EU countries, such as Bulgaria (30.1%), Lithuania (26.7%) , Cyprus (21.0%), Portugal (18.9%), Greece (17.9%) and Italy (11.1%). This price increase will have socioeconomic implications.
If mismanaged by governments, low levels of gas storage and a cold winter could even lead to a supply shortage. The current high prices are therefore an economic signal that demand must be controlled to prevent the situation from worsening during the winter.
The key question for policy makers is whether this price evolution is a one-off shock stemming from a rapid recovery and bad weather. This would imply that letting the market run in the short term is the best way to return to “normal” prices. A temporary government intervention could help protect the most vulnerable households from rising energy prices. For example, additional revenue from the EU carbon price and energy VAT could be returned to citizens in the form of fixed amounts per capita.
In our opinion, however, there are more fundamental reasons for the high volatility and excessive price spikes. The industry knows that the energy system is undergoing a deep and rapid transformation . Investments in fossil assets are not sustainable in the long term. But governments have yet to make a clear enough commitment to a low-carbon future. Therefore, the balance between energy supply and demand in the EU will be volatile depending on how quickly fossil fuels are phased out and green energy is introduced.
Clearer commitments by governments to introduce low-carbon energy sources, for example by financing necessary infrastructure and committing to substantial carbon prices in all sectors, could help move this precarious balance away. As the move to net zero emissions energy will imply an ever-increasing demand for electricity, investors will not have to worry about overinvesting in low-carbon energy systems.
At the EU level, the early approval and implementation of the “Fit for 55” package would thus represent a more structural solution to avoid future spikes in energy prices and to ensure an orderly transition from brown to green.