The European energy crisis is on everyone’s minds and has major implications for Europe as a region and European equities as an asset class. This is a fast-moving situation, notes Niall Gallagher, Investment Director, Europe Equities, and the energy transition is far from straightforward.
How did we get here? It is worth taking a step back to think about a few elements that are key to our assessment of the energy crisis. Firstly, gas prices are very extended versus history and relative to energy fundamentals. The gas price has been trading in recent weeks somewhere between 15 and 20 times the average price of the five years up to the end of 2020. It is also worth noting that gas prices are expensive in Europe and the UK versus other regions of the world. In addition, gas prices have driven electricity prices higher in Europe, which have also become elevated versus history, trading at between 20 and 25 times the average levels up to 2021.
Much has been said and written about how this is ultimately the result of the Russian invasion of Ukraine; this is convenient for politicians because they feel it absolves them of blame. But actually many of the foundations for what we have seen in gas and electricity were set long before then. There are some serious fragilities in the European energy system, and this at least in part can be attributed to a flawed energy transition, in our view.
That is certainly not to undermine the importance of the transition or to suggest we do not need to reduce carbon emissions in our energy system. But if the transition is not done effectively the outcome will likely be accidents such as those seen in the third quarter, which we believe are the direct result of poor energy policy over an extended period across the European continent.
There are also significant divergences across markets and regions of the world in terms of energy prices. While the US has had an increase in gas prices since the pandemic of a little under 400%, in Europe this is closer to 2000%.
The electricity system has also received a lot of commentary in the press, particularly the idea that gas sets the price of electricity. Many are confused as to why that should be the case. We have renewable and low-carbon sources of energy such as hydro, wind, solar and nuclear which in theory do not cost much to run if it is the wind or the sun that is generating the electricity. But this misses the point that we have a system where the cost of electricity is driven by the marginal cost driving the marginal revenue. The logic behind it when it was designed a long time ago was that if you had higher cost electricity driving the price, this would incentivise lower cost electricity to come on stream and drive out the higher priced electricity or the higher cost electricity. It is a classic economics 101 argument where the cheaper drives out the more expensive. This worked well in a traditional electricity system, which was designed essentially for coal to gas switching while nuclear would run more or less all the time. Depending on what was cheaper between coal and gas, one would drive out the other.
Where this ran into difficulties was in how carbon prices were factored in, for example through introducing carbon pricing reflecting the greater carbon intensity of coal relative to gas. This led to the arbitrage, or switch, between coal and gas breaking down. On top of that, renewables are intermittent. This all means gas has become much more important in the energy mix and that it increasingly sets the price for electricity.
What does all this mean? For a typical household in the UK, for example, energy prices have increased dramatically, despite the government imposing a cap on domestic energy tariffs. It could lead to large numbers of people spending a big chunk of their post-tax income on utility bills; this will have a knock-on effect on consumption. And for those on lower incomes it could be potentially catastrophic, on top of which the impact on small business could be huge.
These costs will go all the way across Europe because it is exposed to the same drivers as the UK, although they have not necessarily flowed into bills just yet. A longer-term implication is that if the cost of gas and electricity in Europe is many multiples of the prices in the US and Asia, it could lead to significant deindustrialisation in Europe. Heavy industry could move to other regions if it becomes too expensive to produce goods in Europe. As a consequence, we think there is a high chance of interventions in European markets where governments will likely seek to cap or heavily subsidise the price of electricity. Indeed this is something that has already happened in the UK.
As I mentioned earlier, governments would like us to believe the energy crisis has been precipitated by Russia. Russia invaded Ukraine, they stopped sending gas to Europe, therefore, their logic goes, we should blame the Russians. But it is not as simple as that. Investment in oil and gas has fallen by about two thirds since 2014. Environmental pressures are quite rightly pushing oil & gas companies not to invest in oil and gas, but this is occurring at a point in time when demand for both is still growing globally, driven by emerging market development and global population growth. We can hope that we move away from oil and gas quite quickly, but it needs to be managed and we need to recognise that 80% of the population still lives in the emerging world; their demand will grow as their economic development catches up with ours.
The energy transition is not straightforward. There are some bottlenecks in scaling up renewables, particularly around transmission. There is no point building offshore wind farms in the North Sea if you cannot put the transmission lines in to bring electricity to the big demand centres. There are also periods when low resources require a backup – that backup is likely to be gas for the next few decades. In terms of demand-side reduction things can also be done; making buildings more energy efficient will reduce energy consumption.
If there is one key message it is that policymakers need to start taking this seriously. For a long period of time energy policy has been suboptimal. Policymakers need to focus on implementing a properly planned energy transition so we move away from the fragile energy system we have seen over the course of the last few years.
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