Beating the European Energy Crisis

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Beating the European Energy Crisis

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• Authors: JEROMIN ZETTELMEYER, SIMONE TAGLIAPIETRA, GEORG ZACHMANN, Conall HEUSSAFF
• Published: December 1, 2022

Europe’s energy crisis: context and urgency

• Supplies of Russian gas—critical for heating, industrial processes, and power—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, with severe effects for households and businesses.
• Europe may be about to experience its first winter without Russian gas, risking even higher prices, gas shortages, and a major recession.
• 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.

Causes and wholesale price dynamics

• Primary cause: reduction of Russian supply.
• 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: surge in natural gas prices; shortfalls in nuclear and hydroelectric generation; substitution by more expensive coal and gas plants.
• In most European power markets, gas currently sets the marginal (most expensive) price, causing lower-cost producers to realize extremely high profits unless hedged.
• Market tightening has reached the point where small changes in supply have large effects on prices, producing high volatility and "demand destruction" where some customers stop consuming.

Government policy responses observed

• Two broad classes of policies:
  • Mitigation of higher costs for consumers and businesses: retail price caps, regulated tariffs, support programs for energy-intensive companies, liquidity or capital backing for energy companies, and nationalization options.
  • Stabilization and reduction of wholesale prices and securing supply: policies to encourage energy savings, increase supply, and cap energy costs (particularly wholesale gas prices).
• Trade-offs and risks highlighted:
  • Subsidies or price caps can worsen the underlying problem by increasing demand.
  • Cross-border spillovers: subsidizing consumption in one country raises EU-wide wholesale prices and can hurt consumers in other countries.

Assessment of wholesale price caps

• Three cap approaches discussed:
  • Regulating all gas import prices: judged counterproductive; would make it impossible to attract sufficient gas to the EU and could raise prices.
  • Cap only on Russian gas: potentially sensible but risky—Russia could retaliate by stopping remaining supplies.
  • Iberian exception (Spain and Portugal model): caps price of gas used for generating electricity, effectively limiting electricity cost; has contained wholesale electricity costs in Spain and Portugal but incentivized burning more gas for power.
• A 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 price and the European price, funded by the EU budget.
  • Would lower wholesale gas and electricity prices but risks enforcement difficulties: trading could move off-caps to over-the-counter higher prices; sellers might withhold supply; demand would increase if prices are substantially limited; rationing could be required.
• Conclusion on caps: emergency interventions like gas price caps risk worsening the situation, especially if implemented as a patchwork of uncoordinated national policies.

The "grand bargain" proposal: coordinated demand reduction, supply increase, and market openness

• Core elements:
  • Combine support payments that do not depend on energy consumption with subsidies for reducing usage while retaining price signals for demand reduction.
  • Subsidies could be proportional to recent energy consumption.
  • Use design principles like Germany’s "electricity price brake": subsidize the retail price of electricity up to a calculated frugal household level; additional usage faces sharply higher costs.
  • Resolve free-rider problems politically and legally through regulation and financial incentives such as access to an EU fund.
• Supply-side initiatives:
  • Leverage EU purchasing power as a single buyer to negotiate long-term contracts with gas suppliers; goal to replace the 150 billion cubic meters Russia used to export annually to Europe.
  • Maximize domestic supply in the short term (examples in text): The Netherlands raising gas output; Germany continuing to operate nuclear power plants scheduled to close.
  • Consider reciprocity mechanisms and joint EU funds to compensate countries or citizens bearing additional risks (example: compensating citizens of The Netherlands for increased earthquake risk from greater gas production).

Recent EU actions and gaps

• July commitment: member governments committed to reducing gas demand by 15 percent during the winter.
• September regulation: endorsed four sets of 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),
  • support for small and medium enterprises.
• Mechanism: low-cost power producers are to return profits above the revenue cap to their national governments to finance consumer support.
• Critique: these measures emphasize coordinated gas and electricity demand reduction but largely ignore the supply side.

Key findings and policy recommendations (enumerated)

• Findings:
  • Russian supply cuts are the primary driver of the crisis.
  • LNG costs have more than doubled since February 2022.
  • Market volatility is extreme; small supply changes produce large price swings.
  • Fully insulating consumers via government support could cost €1 trillion (about 6 percent of EU annual GDP).
  • Replacing 150 billion cubic meters of Russian gas imports is a core supply challenge.
• Policy recommendations:
  • Avoid uncoordinated national wholesale price caps that can increase demand and create cross-border spillovers.
  • Pursue a coordinated EU "grand bargain" combining:
  • collective demand reduction targets and mechanisms,
  • coordinated efforts to increase short-term and long-term supply,
  • retention of internal energy market openness,
  • protection for vulnerable consumers via consumption-independent support and consumption-reducing subsidies.
  • Use EU-level financial tools (e.g., funds, contract-for-difference mechanisms) to stabilize imports and compensate national policy trade-offs.
  • Negotiate long-term pooled contracts with suppliers to provide predictable revenue streams and secure gas affordability.
  • Consider short-term domestic production increases and temporary operation of existing low-carbon plants where politically feasible, supported by reciprocity or compensation mechanisms.

IMF F&D Magazine — "Beating the European Energy Crisis" (December 2022) by Jeromin Zettelmeyer, Simone Tagliapietra, Georg Zachmann, Conall Heussaff

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