Electric Shock for European Leaders
Bottom line: European political leaders will return from the beach to an electric shock, with households and industry facing soaring electricity and gas prices. National policies can only go so far, and Europe-wide coordination will rise up the crisis agenda to the EU heads of state summit on Oct. 20-21 or before. More national and EU policy action is needed beyond politicians hoping for a mild, wet and windy autumn and winter in Europe.
Market implications: Sky-high European gas and electricity prices are amplifying fears of a European recession, so any major relief for gas and electricity prices would help sentiment toward European equities and the euro. However, a peace deal around the Ukraine war remains unlikely as President Vladimir Putin plays the long game (here), but markets may become hopeful if Putin plans to meet Ukrainian President Volodymyr Zelensky at the G20 summit Nov. 15-16 in Bali. Widespread forecasts of a mild, wet and windy European winter could also help. EU politicians at this juncture are unlikely to be a game changer for markets, with incremental policy measures likely to be delivered. We do see Putin changing tactics from mid-winter and increasing gas exports to Europe for economic reasons (here) and this should substantively reduce European gas prices. If not, the recent increases in energy prices endanger the actual ability for EZ companies to produce goods at a profit, and therefore at all.
Figure 1: TTF Gas Prices and German Electricity Prices (Aug. 24, 2021 = 100)
Source: Bloomberg, Continuum Economics
Electricity Price Surge for Industry and Households
European industries are starting to balk at the huge surge in electricity prices now and in the near future (Figure 1), with intensive industries such as aluminum and fertilizers looking to temporarily close some production and the euro not helping competitiveness perceptions (here). The magnitude of the electricity price surge is so huge that it will impact across manufacturing and services as well and risk only amplifying the economic slowdown to an EZ recession. High electricity prices have a number of causes.
- Higher gas prices: Electricity requires reliable baseload production and many European countries have moved to gas being the swing energy to quickly provide electricity when needed. Most large European countries have moved away from coal as the baseload source for electricity, though Germany, Turkey and Poland have a moderate to high percentage still (Figure 2). Renewables are taking a larger share of electricity production, but are not always consistent (e.g. wind not blowing) and long-term electricity storage is in its infancy. This means that the marginal cost of gas is a big driver for the marginal cost of electricity (Figure 1). Additionally, European households use gas for heating in the winter, and heat pump technology is only getting started as an alternative. The EU has agreed a voluntary deal for a 15% reduction in gas demand over the autumn and winter (here), but this will likely not be enough if a cold winter occurs. We have long highlighted this gas addiction (here) as being something that Europe cannot quickly move away from and that without Russian gas that Europe would have to resort to volume rationing. In reality, Russia does not have enough pipeline capacity to China or LNG facilities to redirect gas from Europe, and we feel that a pragmatic Putin will likely boost gas exports to Europe once the winter peak has passed (here). This should bring gas prices down 40-50% and also electricity prices. However, European politicians cannot guarantee that this will occur and are left with sky-high gas and electricity prices in the autumn and winter.
Figure 2: Electricity Production by Source of Fuel (2021 data)
Source: BP (German nuclear has declined to 6% in 2022)
- Drought hurts Spain/Italy hydro and France nuclear: Some relief for electricity prices should come from the end of the European summer. Drought has impacted hydroelectricity production in Spain, Italy and Norway (the latter then curtailing gas exports to Europe), while the associated weaker winds mean less wind power. France's nuclear industry has also been restrained by high water temperatures for cooling. Ideally European politicians could be helped by a mild, wet and windy autumn and winter, but policy cannot be based on hopes about the weather alone.
- Nuclear power long-term underinvestment: Underinvestment in the French nuclear power industry has caused maintenance problems and restrained production. However, France at least has the capacity, with Germany having closed down all but three reactors after the Fukushima disaster prompted the government to move away from nuclear — Japan only mothballed plants and is scheduled to have 17 reactors working again by 2023! Italy has none. Some new investment in nuclear is starting up in the next 1-5 years (e.g. Turkey, Slovakia, France and UK), but the timescale remain 10-15 years before electricity production and cannot solve current problems. Nuclear capacity needs to rebuild.
- UK linked to EZ/European energy: Though the UK has left the EU, its gas and electricity prices are closely linked to Europe (Figure 3). The UK has minimal gas storage, meaning that it is a price taker in the global gas market, which is determined currently by huge demand from Europe to switch away from Russian gas. UK electricity production is also dependent on gas at the margin to quickly boost electricity production. The UK also has gas pipelines to Europe to re-export LNG and electricity cables (UK is currently exporting electricity to France). In some ways the UK is more interconnected than Spain or Portugal to the European energy system, and thus European policies have a big impact on the UK — a gas pipeline from Spain's six LNG terminals to Germany is planned but could take 2 years.
Figure 3: UK/Europe Gas Prices and UK/German Electricity Prices (Aug. 24, 2021 = 100)
Source: Bloomberg, Continuum Economics
Crisis and the Political Response
European politicians return from their summer holidays to find that the energy crisis has become a lot bigger and broader and threatens industry and households and political instability. This is all part of Putin's game plan to pressure Europe into providing less support for Ukraine, as he knows that the energy self-sufficient U.S. will not be swayed. European politicians know that Putin is playing this political game with gas to Europe and have been determined not to be bullied or to break consensus.
Even so, the first step will likely be national measures to further protect the household sector and select industries. France has restrained household electricity price increases to 4% via subsidies, but at the other extreme UK gas and electricity household bills are set to jump 80% in October and by a further 50% in January. Pressure to reduce gas and electricity demand ranges from active in a crisis mindset Germany to nonexistent in other countries (e.g. UK). The new UK Conservative Party leader will likely soften the blow to households by increasing the existing partial subsidy and hoping that gas prices come down, but divergent government policies across Europe mean different economic fallout on consumption, growth and inflation. More needs to be done to help industries, especially smaller concerns where electricity costs are a major input, but the spiraling costs for government could restrain early action. Some countries could also follow the Spain/Portugal model of capping wholesale electricity prices (here), which are now 1/3 of other major European countries.
Indeed, EZ fiscal support has already been considerable but largely to households. Discretionary fiscal support in response to the war in Ukraine is estimated at close to 1% of GDP in 2022, only some of which are support payments.As Figure 4 highlights, three-quarters of this support represents further compensatory measures introduced in response to the increase in energy prices after Russia's invasion of Ukraine. It should be noted that several EZ countries had already adopted measures to address rising energy costs before the invasion. The rest of the war-related support is associated with defense spending and refugee support. A large part of the fiscal support, particularly the energy-related component, is estimated to unwind over the period 2023-24 but still could exceed 0.5% of GDP. As a result, and with the EZ budget gap seen at least being 4% of GDP this year with upside risks given the likely recession into 2023, governments may be wary of financial markets doubting their fiscal credentials if they are seen as being profligate. In addition, governments have to be careful that any support measures do not curb the need to reduce energy consumption.
Figure 4: EZ Fiscal Measures Related to the War in Ukraine
Source: ECB
At an EU level, measures may be only incremental rather than revolutionary in September. National interests diverge, due to different dependencies on gas overall and Russian supplies of gas. The EU normally takes bigger steps in a crisis, and a sense of crisis may have to grip the European establishment before the EU heads of state summit on Oct. 20-21 — an informal summit in Prague is due Oct. 6-7 and reports suggest that an emergency meeting could be called in September. The EU also needs a united front before a confrontational G20 leaders meeting Nov. 15-16 in Bali, where Putin and Chinese President Xi Jinping are due to attend and potentially Zelensky — a peace deal is unlikely, as we see Putin playing a long game (here).
EU leaders can focus on emergency coordination planning and secondly a consistent EU-wide approach to security of gas and electricity supplies. In the unlikely event of a complete shutoff by Russia of gas exports to all EU countries, the EU could ensure pre-emptive contingencies (e.g. Spain agreeing to redirect Algerian gas into Italian pipelines instead). However, EU leaders are unlikely to substantively increase sanctions on Russia, both as major measures are still being implemented (e.g. seaborne oil ban) and as a ban of gas imports from Russia would hurt Europe severely.