Europe's Profound Gas Challenge

Europe is trying to extinguish any number of simultaneous fires on the energy front. Gas needs to be saved for winter heating amid dwindling Russian supplies. A drought has limited hydro power and dried up rivers needed to transport coal to power plants — and to cool already-underperforming French nuclear reactors. The EU’s upcoming bans on Russian crude and products imports will hit efforts by some industries to switch from high-priced gas to fuel oil — although any return of Iran’s oil to the market could help ease some of that pain.

Still, Europe is not expected to suffer rolling power blackouts this winter. Industry, however, will take a considerable hit. And for EU leaders, managing the economic and political fallout from the price burden facing households and industry alike is a top concern.

Scenarios

Mike Fulwood, a research fellow at the Oxford Institute for Energy Studies (OIES), said in a recent podcast that Europe can “just about squeak by this winter” assuming Nord Stream flows at roughly current levels (20% of capacity), a normal-to-mild winter, high LNG imports and no Chinese demand rebound. The EU has already cut demand by 45 billion-50 billion cubic meters in 2022 relative to 2021, based on the first seven months of this year, mostly because of high prices, Fulwood told Energy Intelligence.

A full Russian gas supply halt from October would drive down EU demand by a further 60 Bcm in 2023 as a result of demand destruction and reduction measures, OIES modeling suggests. More of that burden would be borne by Germany and Central European countries, given their greater reliance on Russian supply and insufficient gas connections across Europe. Germany would "have to reduce its gas demand by around 25%" over the heating period to April 2023 if Russian gas stopped completely in the coming weeks, Brussels-based think tank Bruegel said in an Aug. 5 report analyzing the economic consequences of such a halt.

The expectation of further Russian gas cuts is meanwhile driving prices to record highs. The front-month September Dutch TTF gas futures contract reached an intraday high of €295 per megawatt hour ($86 per million Btu) following the announcement of a three-day Nord Stream maintenance outage. Before 2021, the front-month TTF contract had never broken above €40/MWh.

The crisis could also easily extend further into 2023 and beyond. Europe is likely to exit this winter with depleted storage, requiring a sustained rebuild of gas stocks next year that will keep demand high, supplies tight and wholesale gas prices elevated. This reinforces gas demand curtailment as a key pillar of EU energy strategy. But the effects could be profound for Europe’s industrial base, given Germany's vulnerabilities. Political leaders’ attempts to manage price pain also have implications for Europe’s political make-up — and EU resolve on Russia sanctions.

Industrial Hit

European gas demand from the power and industrial sectors is already falling in the high-price environment, even ahead of government-mandated savings measures. But the industrial sector has been hit especially hard, with factories reducing production or shutting down altogether for lack of alternative fuels.

In the event of a Russian cutoff, “a reduction in consumption will not be possible without temporary declines in production in the manufacturing sector, especially the chemical industry,” Bruegel said. Industry should focus instead on sourcing products from countries not reliant on Russian gas, which could be aided by lower import tariffs, it said, while warning of the need to support workers throughout the downturn or even retrain them.

This is already happening. German chemicals company BASF is partly substituting ammonia production with US ammonia imports, Bruegel noted, while Arcelor Mittal is importing some steel components rather than producing them. Slovakian aluminum producer Slovalco is already planning to halt production for lack of affordable electricity supply but has warned that imports of “dirtier” aluminum from China could replace it. Some manufacturers are turning, where possible, to fuel oil and coal as substitute feedstocks — but ahead of EU bans on Russian oil imports, these shifts bring their own price spike risks.

Household Pain

High wholesale gas and power prices have translated into higher household energy bills, sparking concerns of spiraling energy poverty. The Covid-19 pandemic demonstrated the levels of government spending that can be mustered in an emergency to support populations. But all-out support also risks fueling the very demand governments are trying to rein in. It’s a difficult needle to thread.

The below-cost price freezes backed by some governments — such as in France and Austria — can be blunt instruments, while some governments will simply be unable to avoid passing on the economic pain. Some also argue that messaging on, and enforcement of, energy savings goals is still lacking.

In France, a power and gas tariff freeze will be extended to Dec. 31, and possibly replaced next year by more targeted measures for the poorest households. Paris has also coughed up heating relief funds for poorer households as well as value-added tax (VAT) cuts on transport fuels.

In Germany, the government had to bail out its energy companies from potential bankruptcy — with utility Uniper alone getting a €15 billion rescue package — given the mounting costs of replacing Russian gas with alternative supplies. To finance its bailouts, Germany introduced a new levy on natural gas. Reports say this could cost households close to an additional €500 per year and millions of euros more for industrial users. To ease the pain of the levy, Berlin cut the VAT on gas from 19% to 7% until 2024.

Fears of Populism

The new burden on citizens has already rung alarm bells about potential social unrest, which could bolster populist or nationalist parties in the West, potentially rattling EU unity. German Chancellor Olaf Scholz said German citizens can “count on us not to abandon them” in the face of mounting energy costs. The far-right AfD party is already feeding on rising bills to attract support — and reportedly advocating for a relaxation in Russia sanctions.

The unity government of Mario Draghi in Italy was the crisis’ first political victim. It collapsed in July in part over a failure to agree on an aid package to address the cost-of-living crisis. Giorgia Meloni of the far-right Brothers of Italy party, known for more sympathetic views of Russia, is expected to emerge the winner from Sep. 25 elections. Heading into winter, European leaders know the policy stakes couldn’t be higher.

For more coverage of the Ukraine crisis, visit Ukraine Crisis: Energy Impact >