What will be the future of European energy markets?
Governments would like us to believe that the energy crisis has been precipitated by Russia, but it is not. The analysis of Niall Gallagher, Investment Director European Equities of GAM Investments
How did we get to this situation? It is worth taking a step back and reflecting on some elements that are important in formulating an assessment of the energy crisis.
First, the price of gas is very high compared to historical data and compared to energy fundamentals. It is also worth noting that gas prices are high in Europe and the UK compared to other regions of the world. Moreover, they have also pushed up the price of electricity in Europe which is high compared to historical data. Much has been said and written about the repercussions of the Russian invasion of Ukraine.
It pays for politicians to blame others to absolve themselves. In fact, many of the problems in the gas and electricity field have been around for a long time. Europe's energy system has some major weaknesses, partly due to a faulty transition process.
This is not to downplay the importance of the transition, or to say that there is no need to reduce carbon emissions in our energy system. But, if the transition is not made effectively, situations like those seen in Q3 could arise which, in our view, are the direct result of ineffective energy policy over an extended period of time across the European continent . There are also important divergences between markets and regions of the world when it comes to energy prices. While the United States has seen a gas price increase since the pandemic of just under 400%, in Europe the increase is approaching 2000%.
The electricity system attracts a lot of press interest, especially the idea that gas sets the price of electricity. There is a lot of confusion about this. We have renewable and low-carbon energy sources – hydro, wind, solar and nuclear – which in theory do not have very high operating costs when wind or sun generates electricity. However, we must not forget that in this system the cost of electricity depends on the marginal cost, which determines the marginal revenue. The rationale behind it when it was designed long ago was that if the price was driven by the highest cost electricity, that would incentivize the development of the lowest cost electricity which would replace that with a price, and cost, higher. It is a fundamental economic concept that the cheaper good cuts out the more expensive. This reasoning worked in a traditional electric system that was designed basically to switch from coal to gas, while nuclear is always operational. The cheaper source of coal and gas would have prevailed over the other.
Difficulties have arisen in the way carbon prices are calculated, for example through the introduction of emissions trading schemes which reflect the higher carbon intensity of coal compared to gas. Therefore arbitrage or the switch between coal and gas no longer worked. Also, renewables are intermittent. All of this means that gas has become much more important in the energy mix and is therefore increasingly decisive for the price of electricity. What does all this mean? For an average UK household, for example, energy prices have soared despite the government capping bills. This could lead many people to spend a large part of their after-tax income on energy bills, affecting consumption. For lower-income households it could prove catastrophic, even without taking into account the impact on small businesses.
These costs concern the whole of Europe which is exposed to the same problems as the UK, although not necessarily in the same way in relation to bills. A longer-term implication is that if the cost of gas and electricity in Europe is many multiples of the price in the US and Asia, this could lead to profound deindustrialization in Europe. Heavy industry could move to other regions if it becomes too expensive to produce goods in Europe. As a result, we believe that an intervention in European markets is very likely where governments will try to put a cap, or some form of subsidy, on the price of electricity. This has actually happened before in the UK.
As we mentioned earlier, governments would have us believe that the energy crisis has been precipitated by Russia. Russia invaded Ukraine, stopped supplying Europe with gas, so we have to blame the Russians. But it's not that simple. Investment in oil and gas has fallen by about two-thirds since 2014. Environmental pressures are rightly driving oil and gas companies away from investing in these resources, but this comes at a time when global demand is still growing driven by developments in emerging markets and global population growth. We hope to quickly move away from gas and oil, however, it is a process that needs to be managed well. We have to recognize that 80% of the population still lives in emerging countries, where demand will grow as they try to catch up with more advanced countries.
The energy transition is not easy. There are bottlenecks to increasing the use of renewables, particularly on the transmission front. There's no point in building offshore wind farms in the North Sea if you can't put transmission lines capable of carrying electricity to centers where demand is high. There are also times when scarce resources require a backup system that will probably be gas for several more decades. It is also possible to intervene on the front of the reduction of demand; making buildings more energy efficient would reduce energy consumption.
The authorities need to start thinking about it seriously. For a long time, energy policies have been inadequate. Policymakers must aim for a well-planned energy transition to move us away from a fragile energy system like the one that has emerged in recent years.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/energia/futuro-mercati-energia-europa/ on Sun, 20 Nov 2022 06:36:22 +0000.