The European gas crisis of 2021: where does it come from and what should be done?

This is a lightly edited machine translation of an article I wrote for Tagesspiegel Background Energie & Klima -- it focuses on the situation in Germany, but many of the points also apply to other countries. German speakers are encouraged to read the original.

Prices on the gas and electricity markets have reached unprecedented heights. In the meantime, it is becoming increasingly clear what the drivers are. Developments in the winter cannot yet be clearly foreseen, but an interim conclusion is now possible.

What is happening in the gas and electricity markets?

There is currently a great shortage on the global gas market. There are several reasons for this:

• Low investment in new production capacity, partly due to generally low industry profitability in recent years (already 2015 to 2019 oil and gas exploration activity was 21 percent below the 2012 to 2014 average), further exacerbated by the Corona crisis, which caused another 24 percent slump
• Demand, especially in Asia, has recovered much faster than expected last year. It is additionally driven there by shortages in the coal market.
• A cold and long winter in 2020/21 in many parts of the northern half of the planet, resulting in low storage levels at the start of summer

To some extent, then, the current situation is the "normal" pork cycle of industrial oil and gas production: years of low prices, with little investment, are followed by shortages that lead to extreme price spikes. This time, however, this is exacerbated by the Covid crisis, which has led to a decline in investment and postponements of maintenance on production facilities and pipelines.

In addition, there is obvious tactical behaviour on the part of Russia, which has tightened supply volumes to the EU and once again cut back in October compared to September, especially through the supply corridors through Ukraine and Poland. Even for November, despite signals to the contrary, only little transit capacities were booked there. The big question is why, given the extremely high prices, Russia is allowing itself to miss out on significant profits it could make from additional deliveries. The following factors stand out in my view:

1. Pushing Nord Stream 2 can be regarded as a certain contributor: Russian representatives, such as Kremlin spokesman Dmitry Peskov and Deputy Prime Minister Alexander Novak, have repeatedly signalled that additional volumes could be made available to the market by accelerating the commissioning of Nord Stream 2. However, given that existing transport capacities through Ukraine and Poland are already underutilized (gas flows there in the first half of October 2021 were 51 percent and 59 percent below those in the first half of October 2020, respectively), transit capacities are not the limiting factor, and scarcity is being used for political leverage here.
2. In addition, Russia could want to achieve a return to long-term contracts by convincing buyers through scarcity to conclude new long-term supply contracts at fixed prices. Statements by Vladimir Putin support this thesis. Putin blames the crisis on the European Commission, which has advocated the abolition of long-term contracts and the pricing of natural gas on the basis of spot prices.

What are the consequences?

High gas prices also cause electricity prices to rise, as gas is the main driver on wholesale electricity markets. Those most directly affected by this are those who are directly active on the wholesale markets, especially energy suppliers and industry, and who have not hedged for the long term. In recent weeks, for example, there have already been insolvencies among smaller utilities and announcements by industrial companies that they are scaling back their production.

A major wave of bankruptcies has so far failed to materialise, but is certainly conceivable. In such cases, the German basic supplier (Grundversorger) system offers good protection in principle; however, it becomes problematic if basic suppliers also go bankrupt. In such a case, an auction system in which other suppliers submit bids to the regulator to take over the affected customers would be a viable option. Such a system already exists in the UK, where the suppliers of more than two million households have gone bust since the summer.

The bigger problem, however, is likely to be social: utilities are already starting to pass on higher procurement costs to households. The cost increase is a temporary inflationary shock that affects poor households much more than wealthier ones.

Is the gas crisis changing the logic of global gas markets?

Yes, and no. The current situation is a departure from the past decade of oversupplied LNG markets. The shortage situation described above clearly makes it easier for Russia to noticeably tighten the market by withholding supply volumes - in a more relaxed situation, the missing supplies would simply be replaced by LNG.

So how quickly might recovery occur in the LNG markets? Probably not in the short term; US export terminals, the traditional swing producer, are at full capacity and significant new builds are not expected to come online until the middle of the decade. Overall, investment decisions to date lead to a global increase in LNG export capacity of 30 percent by 2026, and another 40 percent could be added during that period if the appropriate investment decisions are made soon, which is not unlikely given the high price levels.

Thus, relief can be expected in the medium term, but not in the short term, especially since exploration activity in the US is also recovering rather poorly than well so far: the Baker Hughes Rig Count, i.e. the number of current oil and gas drilling projects, is still at about half the level of 2019, which could be due to problems with financing new oil and gas projects.

However, the incentive for any additional gas supply is currently huge - individual exporters such as Norway have already announced that they will increase production volumes. This should make it more difficult for Russia to drive up prices over the next few years - or rather, such a strategy should require ever greater supply cuts, which would then also stimulate additional investment in other countries. Of course, this does not change Europe's short-term vulnerability.

What are the right policy responses?

As usual in crises, political activity for activity’s sake threatens to take over. In Spain, where investor confidence had just returned after similar interventions in the early 2010s, the government passed a special tax for renewables that benefit from high electricity prices. The leaders of France, Spain, Greece, the Czech Republic, and Romania are calling for nothing less than a departure from Europe's electricity market design, in which the most expensive power plant needed to provide the load sets the price.

Do such initiatives make sense? Almost certainly not. Retroactive interventions destroy investor confidence, and thus increase the cost of capital for investments in the energy transition. Changes in market design should not be introduced as quick fixes: in fact, with symmetric Contracts for Difference (CfD), as they are currently increasingly demanded again, subsidised renewables would pay back significantly in the current market situation. However, the current market situation is a special case and presumably not the "new normal", so this current situation in no way devalues the other arguments in the debate on the right electricity market design.

So what is to be done? The most sensible policy response is to mitigate the short-term consequences for low-income households. Fortunately, two of the most effective measures for this also make sense from the perspective of long-term sector coupling, namely the abolition of the German renewables (EEG) levy (as envisaged in the recent explorative talks for a new German governing coalition) and the reduction of the electricity tax to the minimum of 0.1 cents per kilowatt hour permitted under European law.

Are renewables the answer?

We often read these days that the only way to reduce dependence on gas prices is to rapidly expand renewables. This is true, but not in the time frame that many proponents of this statement expect. Even with very high shares of renewables in the electricity mix, the exchange electricity price will continue to be largely influenced by the marginal costs of fossil power plants.

Aurora modelling of an exemplary electricity system in which 90 percent of generation comes from renewables and only 10 percent from gas-fired power plants shows that even then the gas-fired power plants still set the price in more than half of the hours - thus maintaining a strong coupling to the gas price. Since Germany is far from achieving a 90 percent share of renewables even in the electricity market, the price of natural gas and electricity will remain strongly coupled for at least 15 years, not to mention the heating sector, even with a (nevertheless desirable) strong increase in the expansion of renewables. This will only change fundamentally when the last shares of natural gas are replaced.