Winter is Coming for European Energy Markets
Russia’s invasion of Ukraine in February of this year is a tragedy that has triggered major social, political, and economic consequences. Vladimir Putin’s decision to attack a sovereign democracy has shattered lives in both countries, isolating Russia from Europe and the “West” and damaging near- and long-term economic relations regionally and globally. On the economic front, a major issue has been unfolding in Europe:
The energy crisis.
Russia has an extensive background as an energy supplier as well as a historically complicated relationship with Europe. Along with developing significant military power, Putin’s regime has systematically cultivated economic leverage over Europe by increasing control of energy supplies. In recent decades, much of Europe developed a dependency on Russian-supplied oil and natural gas to fuel everything from home heating to major industrial operations. In a purely economic context this was an advantageous situation for both sides, as European countries benefited from inexpensive energy and Russia had a nearby market in which to sell its vast energy resources. Major investments were made to facilitate this exchange, including the construction of major Baltic Sea pipelines, Nord Streams 1 and 2, that convey natural gas directly from Russia to Germany. While economically beneficial, this arrangement simultaneously provided Russia with an enormous source of leverage that is now being used for political purposes in the Ukraine war. It appears that the European Union, along with the United States, hoped that Russian economic interests would prevail over any political priorities, but that assumption has proved to be false.
By restricting energy supply, Russia has weaponized its control over Europe’s energy to inflict pain on those countries that resist its efforts to conquer Ukraine. In response to the invasion earlier this year, the European Union and United States imposed severe economic sanctions on Russia and it responded predictably by restricting supplies of natural gas, including intermittently shutting down the NordStream 1 pipeline to Germany and Western Europe (Ong, 2022;McHugh 2022). The result has been a 37% overall decrease in Russian shipments compared to the prior year (Carrington, 2022). As a result this supply limitation caused natural gas prices to skyrocket. This summer, natural gas prices in Europe exceeded $3100 per 1000 cubic meters, an increase of over 600% year-over-year. In turn, electricity prices more than tripled, causing significant pain for households and businesses across Europe (Alderman, 2022). This strain is being felt particularly in Germany, where inexpensive energy has been a “pillar of the economy”, (McHugh, 2022) and in the United Kingdom, whose economy is already weak and homes are among the least energy efficient in Europe (McHugh, 2022;Askew, 2022). With inflation already on the rise globally, this sharp increase in energy prices is contributing to the cost of living crisis in the United Kingdom and Europe. If Russia fully cuts off supplies, the economic impact could be catastrophic: International Monetary Fund estimates indicate that GDPs could drop by more than 6% in some eastern European countries, and families may be forced to choose between warmth and food (Alderman, 2022).
Europe’s energy-intensive industries are also under severe strain. In order to survive, producers of metal, glass, paper, and fertilizer are cutting costs by idling factories and furloughing employees (Gimber, 2022). Europe’s largest steel producer, ArcelorMittal, has been forced to shut down blast furnaces in Germany, while global aluminum producer Alcoa has reduced production by over 30% in its Norway operation. French glass manufacturer Arc International, which has idled furnaces and asked employees to stay home for two days per week, is asking for direct governmental support to help it manage through this energy-price crunch. These industries have deep ties to the regions in which they operate, and restricting operations has the potential to profoundly impact local communities and suppliers that depend on these large manufacturers for business.
The European energy crisis is an economic challenge with an enormous political and human dimension. While it is difficult in the short-term to negate Russia’s influence over Europe’s energy supplies, a number of steps are being taken to reduce the effects until longer-term solutions can be implemented. For example, Germany, Sweden and Finland announced multi-billion dollar aid packages that will directly assist families and businesses affected by soaring energy prices. Steps are also being taken to address the energy markets themselves. For instance, if the European Union bands together to purchase energy in bulk, it may have the ability to negotiate lower prices based on economies of scale. Accordingly, EU leaders recently met to discuss collective negotiations to drive energy prices downward, producing the idea of creating a price cap across the EU, which would bring down prices directly. Price caps, however, can create unpredictable distortions in the market and would be very difficult to negotiate and enforce (Cook, Janicek and Corbet, 2022). During these discussions of collective negotiations and price caps, tensions emerged as poorer European countries expressed concern that wealthier neighbors may prefer to act unilaterally to directly offset prices for their country rather than bargain collectively to benefit the EU as a whole (Stevis-Gridneff, 2022). As of October, discussions continue on these short term solutions.
In the medium- and longer-term, the picture looks much better. Europe is working to rapidly diversify its supply of natural gas and oil, including increased supplies of liquefied natural gas (LNG) from the United States. Increasing LNG capacity by building facilities that can process shipments from overseas is essential to energy diversification (Goldman Sachs, 2022). New floating LNG facilities are currently being built in Dutch and German ports (Jayanti, 2022). Looking farther into the future, investments in renewable energy are being accelerated across Europe.
The present is grim, as winter approaches and Russia continues to weaponize energy to inflict pain on Ukraine’s allies in Europe. In the longer-term, however, Europe will benefit from diversifying both the types of energy it uses and the range of suppliers from which it sources energy. Though it was a grave mistake for Europe to depend on Russia for its critical energy needs, the current shift towards new energy sources and markets have the potential to change the way Europe consumes energy.
References
Ong, Stella Marie. 2022. “Russia Cuts off Europe's Gas Supply.” Simply Wall St. September 14, 2022. https://simplywall.st/article/russia-cuts-off-europes-gas-supply#:~:text=Russia%20has%20completely%20cut%20off,the%20concept%20to%20the%20world.
McHugh, David. 2022. “Europe Is Facing an Energy Crisis as Russia Cuts Gas. Here's Why.” PBS. Public Broadcasting Service, September 6, 2022. https://www.pbs.org/newshour/world/europe-is-facing-an-energy-crisis-as-russia-cuts-gas-heres-why.
McHugh, David. 2022. “Russia Blames Sanctions for Gas Pipeline Shutdown.” BBC News. BBC, September 5, 2022. https://www.bbc.com/news/business-62789675.
Carrington, Damian. 2022. “Energy Crisis: UK Households Worst Hit in Western Europe, Finds IMF.” The Guardian. Guardian News and Media, September 1, 2022. https://www.theguardian.com/money/2022/sep/01/energy-crisis-uk-households-worst-hit-in-western-europe-finds-imf.
Askew, Joshua. 2022. “Soaring Energy Prices: How Does the UK Compare with Europe?” euronews, September 8, 2022. https://www.euronews.com/my-europe/2022/09/08/soaring-energy-prices-how-does-the-uk-compare-with-europe.
Jayanti, Suriya. 2022. “Europe's Energy Crisis Is Going to Get Worse.” Time. Time, August 30, 2022. https://time.com/6209272/europes-energy-crisis-getting-worse/.
Gimber, Hugh. 2022.“Exploring the Economics of Europe's Energy Crisis.” Welcome, September 9, 2022. https://am.jpmorgan.com/lu/en/asset-management/per/insights/market-insights/market-updates/on-the-minds-of-investors/europe-energy-crisis/.
Alderman, Liz. 2022. “'Crippling' Energy Bills Force Europe's Factories to Go Dark.” The New York Times. The New York Times, September 19, 2022. https://www.nytimes.com/2022/09/19/business/europe-energy-crisis-factories.html.
Goldman Sachs. 2022. “Europe's Energy Crisis Is at a Tipping Point.” Goldman Sachs, September 8, 2022. https://www.goldmansachs.com/insights/pages/europe-energy-crisis-is-at-a-tipping-point.html.
Stevis-Gridneff, Matina. 2022. “Europe's Energy Crisis Exposes Old Fault Lines and New Power Dynamics.” The New York Times. The New York Times, October 7, 2022. https://www.nytimes.com/2022/10/07/world/europe/european-commission-natural-gas-germany.html.
Cook, Lorne, Karel Janicek, and Sylvie Corbet. 2022. “EU Summit Struggles to Form Gas Price Cap Plan.” PBS. Public Broadcasting Service, October 7, 2022. https://www.pbs.org/newshour/world/eu-summit-struggles-to-form-gas-price-cap-plan.