## BEATING THE EUROPEAN ENERGY CRISIS

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**Canonical URL:** [BEATING THE EUROPEAN ENERGY CRISIS](https://www.imf.org/-/media/files/publications/fandd/article/2022/december/zettelmeyer.pdf)

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### Nature of the crisis and price dynamics
- Supplies of Russian gas “have been cut by more than 80 percent this year.”
- Wholesale prices of electricity and gas “have surged as much as 15-fold since early 2021.”
- Liquefied natural gas (LNG) is the primary replacement option; “The cost of LNG has more than doubled since Russia’s February invasion of Ukraine.”
- Wholesale electricity prices reflect the surge in natural gas prices and shortfalls in nuclear and hydroelectric generation, requiring more expensive coal and gas plants.
- In most European power markets “the most expensive energy source to meet demand … is now gas,” causing lower-cost producers to earn extremely high profits unless they sold forward.
- Markets have tightened to the point of “demand destruction” where some customers stop consuming; small changes in supply have large effects on prices, producing high volatility.

### Costs and macroeconomic risks
- If governments “were to fully cover the projected increases in energy costs, that would easily add up to €1 trillion, or about 6 percent of EU annual GDP.”
- Massive government support could delay adjustment to a new price equilibrium and create the need for even more support.
- The crisis could accelerate inflation, force the European Central Bank to tighten policy further, and trigger liquidity squeezes and insolvencies in the energy sector.

### Wholesale price caps — options and risks
- Cap on all gas import prices: would be counterproductive, hampering Europe’s ability to attract sufficient gas and potentially leading to higher prices.
- Cap only on Russian gas: might reduce Russia’s profits and lower costs for Europe but risks Russian retaliation (e.g., stopping remaining supplies) and could worsen the situation.
- Iberian exception (Spain and Portugal, June 2022): capping the price of gas used for generating electricity has contained wholesale electricity costs in Spain and Portugal but “has also provided an incentive for Iberian generators to burn more gas to produce electricity.” Broad application across the EU would likely raise gas prices for direct gas consumers and have uneven distributional consequences across member states.
- Cap on all transactions at Europe’s gas hubs and on over-the-counter trading: could be paired with a contract-for-difference mechanism paying importers the difference between international and European prices, funded by the EU budget; would lower wholesale gas and electricity prices but:
  - Difficult to enforce; trading at capped hubs could dry up as sellers go over the counter at higher prices.
  - Caps would increase demand for gas and electricity, risking supply shortfalls, foreign pushback (notably from Russia), and heightened competition from outside the EU, possibly necessitating rationing.

### A grand bargain: coordinated demand reduction and supply increase
- Policy principle: combine support payments that do not depend on energy consumption with subsidies for reducing usage while retaining price signals for demand reduction.
  - Example: subsidies proportional to recent energy consumption.
  - Example: Germany’s “electricity price brake” design—subsidize retail price of electricity up to the needs of a frugal household, but not beyond, so additional usage faces sharply higher marginal cost.
- Coordination across EU member states to avoid free-rider problems: countries should agree to undertake broadly comparable efforts to reduce demand and increase supply; political and legal resolution of spillovers required; financial incentives (e.g., access to an EU fund) are possible.
- EU actions to date:
  - July commitment to reduce gas demand by 15 percent during the winter.
  - September regulation endorsing four policy actions: electricity demand reduction; a revenue cap for low-cost power producers benefiting from high electricity prices (except those burning coal); a “solidarity contribution” from fossil-fuel companies (including coal producers); and support for small and medium enterprises.
  - Low-cost power producers are to return profits above the revenue cap to their national governments to finance consumer support.

### Supply-side initiatives and leverage of EU bargaining power
- Replace the 150 billion cubic meters Russia used to export annually to Europe by pooling EU demand and negotiating long-term contracts as a single buyer to provide suppliers predictable revenue streams while securing gas affordability and security.
- Maximize domestic energy supply in the short term:
  - Examples: additional gas output from The Netherlands; continued operation of nuclear power plants in Germany that were scheduled to close.
  - Such measures are politically difficult but could be enabled via reciprocity and joint compensation mechanisms (e.g., an EU fund to compensate citizens of The Netherlands for increased earthquake risk from greater gas production).

### Key policy recommendations (summary)
- Avoid uncoordinated emergency interventions like unilateral gas price caps that risk worsening the situation.
- Implement a coordinated “grand bargain” at the EU level that:
  - Reduces energy demand and encourages savings while preserving retail price signals.
  - Increases supply via pooled long-term contracting for LNG and maximizing short-term domestic output.
  - Uses targeted consumer protection (support payments not tied to consumption; subsidy designs like the “electricity price brake”).
  - Ensures coordination and enforcement across member states, potentially backed by financial incentives or an EU fund.
- Use revenue caps and solidarity contributions to redistribute extraordinary rents from low-cost power producers and fossil-fuel companies to finance consumer support.

*Jeromin Zettelmeyer, Simone Tagliapietra, Georg Zachmann, and Conall Heussaff — Finance & Development, December 2022.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/december/zettelmeyer.pdf_