European governments have been adopting a series of measures meant to alleviate the impact of rising energy prices on people and businesses. These include price caps on retail consumption, regular energy tariffs, and expansive programs for energy-intensive businesses, while taxing or nationalizing energy-producing companies in an effort to influence their pricing policies. The purpose of these measures is to encourage energy conservation, increase energy supply, and decrease energy costs, particularly in relation to gas prices.
These European solutions, however, are faced with significant obstacles, chief among them being the competing objectives, as energy subsidies or meddling in the determination of energy prices can exacerbate the primary issue and lead to an increase in demand. There is also the issue of cross-border repercussions that extend beyond European countries. While domestic energy subsidies may help people in one country, they also encourage more consumption, which drives up gas prices across the European Union (EU), hurting the purchasing power of people who aren’t receiving subsidies. This situation calls for concerted action on the part of European governments to lower energy demand and boost supply while keeping internal energy markets free and competitive.
Price Instability and High Prices
Since the Russian invasion of Ukraine in February 2022, the price of natural gas has more than doubled in Europe as a result of the decrease in Russian supply, which has caused European gas prices to increase. This led to the consideration of substituting gas with liquefied natural gas (LNG). In addition, the increase in electricity and natural gas prices, as well as the deficiency in nuclear and hydroelectric generation, necessitated the reactivation of coal- and gas-fired power stations, which are the most expensive in terms of electricity generation. Gas has consequently emerged as the most expensive energy source in the majority of European energy markets, meaning that the majority of other low-cost energy producers are making sizable profits.
Figure 1: Russia’s monthly gas delivery to the EU in comparison to other countries (January 2019 – August 2022)
However, as a result of price increases brought on by insufficient increases in power production from coal- and gas-fired plants to meet demand, some consumers cut back on consumption altogether, a phenomenon known as “demand distraction”. Energy product demand was so high that even a modest shift in supply would have far-reaching consequences, driving up energy prices by an inflated amount.
Perhaps the current circumstances will accelerate the switch to renewable energy sources and more efficient electricity use, or perhaps governments will choose a more expensive course of action, which is to do nothing but provide financial support to businesses and households until prices decline. However, this second option is very expensive because it might increase demand, which would increase the amount of financial assistance that governments would give to citizens. The amount of financial assistance needed is approximately €1 trillion, i.e. 6% of the EU’s annual GDP. Continuing the current level of subsidies, however, will cause further price increases and inflation, with disastrous consequences for the economy and the financial system as a whole. This could lead the European Central Bank (ECB) to tighten monetary policy even further, and could also lead to liquidity pressures in the energy sector and the potential failure of some financial institutions.
What policies can be implemented to reduce demand and price volatility?
Setting Price Caps
There are two different forms that the proposal to cap prices could take. The first would cap the wholesale price of gas in the EU, while the second would cap the cost of imported gas. A price cap on imported gas would have the opposite effect, making it difficult or impossible to attract enough gas to the EU, potentially leading to further price increases. What about capping the price of Russian gas alone? A Russian gas price cap would make more sense because it would lower costs for Europe while cutting profits for European gas companies. However, such a strategy was developed on the fundamental premise that Russia won’t be able to simply divert gas supplies to other locations, so its commercial interests will drive it to supply gas to Europe at all costs. The reality, however, shocked the logic of the Europeans: Russia has implemented policies to undermine its commercial interests by slashing supplies to Europe by 80% and may be on its way to slashing the remaining 20%, which will worsen the situation.
The Iberian Exception
Portugal and Spain adopted the so-called “Iberian exception” in June 2022, in which they set a low price for gas used in power plants. This helped limit the increase in electricity costs, as natural gas-fired stations price electricity according to a price margin added to the price of gas. While this policy helped to keep electricity costs in check, it also gave electricity production companies incentives to increase their gas production to generate electricity. If this strategy is widely adopted in the EU, it will have an impact on the price of gas for end-consumers and result in significant inequalities between factories that run on electricity and factories that run on natural gas, as well as significant imbalances in the process of distributing gas among the member states.
Setting an All-Inclusive Price Ceiling
This option involves establishing a price cap for all gas hubs in Europe on transactions and exchanges outside of the stock market. The policy will be implemented for all long-term agreements, including those with the Russian firm Gazprom. Importers will be compensated for the difference between the global import price and the exchange price of the gas futures contract that is traded on the European market in order to mitigate the possibility that these price differences will hinder Europe’s ability to attract LNG from other regions. The wholesale cost of gas and electricity would drop as a result of this policy, but taxes on citizens might go up. Nevertheless, citizens will benefit from access to cheaper energy prices.
However, the main issue with that scenario is that there is no way to establish a maximum limit for all transactions because sellers may choose to sell gas in an unregulated market, like by agreement over the counter. Furthermore, in this scenario, foreign sellers, especially Russia, may block supply in response to the rise in demand, and foreign buyers (from outside the EU) may subsidize gas for their own citizens, leading to increased competition and, in some cases, higher consumption, necessitating re-regulation of prices in order to restore market equilibrium.
Oversupply
An alternative to the previous scenario might be to boost supply and promote energy conservation. But how to achieve this while safeguarding consumers and limiting disruptions to the energy market is the key concern here, taking into account the political considerations of each EU member state. Perhaps providing subsidies that are independent of energy consumption, reducing energy use, and maintaining energy prices at levels that allow consumption to decline are the best answers to the first question regarding consumer protection and economic efficiency. Another strategy that might be more practical is the “electricity price brake”, which entails a government subsidy given to households in accordance with the fair use of energy and any use above that rate is deemed unfair and will not receive a subsidy. To discourage excessive electricity use and consequently high electricity costs, an option to purchase electricity for excess consumption will be made available at a price significantly higher than the average cost.
Concerning the second issue, coordinated policymaking is the only way for Europe to emerge from this crisis. In this regard, it is necessary to address the “free-rider problem”, in which some countries choose not to make such efforts or choose to disregard the knock-on effects on their neighbors. Political and legal regulation, or financial incentives like easier access to the EU, may help improve coordination and thus solve the problem. The EU has already begun moving in this direction, with member governments pledging to cut gas consumption by 15% throughout the winter. In this regard, a regulation was passed last September obligating member governments to take three basic sets of measures: reducing electricity demand, setting a maximum revenue limit for low-cost energy producers who benefit from higher selling prices for electricity (except for coal-generated electricity), and requiring fossil fuel companies (including coal producers) to make a solidarity contribution to the state to cover electricity costs. According to these policies, low-cost energy producers are obligated to return a portion of their profits to their respective national governments, which will then use the funds to subsidize consumers. Those are demand-side measures; however, what about the supply side?
The first scenario put forth is that the EU gains from having a significant purchasing power and the second-largest combined economy in the world, behind the United States. Since this is a win-win situation for all parties involved, the EU bloc can negotiate with gas suppliers as a single buyer and obtain a better price. Suppliers need long-term contracts to better manage investment plans, so the EU has a great opportunity to replace the 150 billion cubic meters imported from Russia with long-term deals with suppliers that provide predictable supplies while ensuring Europe’s gas security and affordability. This scenario is advantageous in the long run, but what about in the short run?
The second scenario is that, in the near future, the EU must maximize its domestic energy supplies. To do this, countries like the Netherlands will need to increase gas production, and Germany will need to keep its nuclear power plants operational. These politically challenging measures can become feasible, and the establishment of a common EU fund could be considered, for instance, to compensate the Netherlands for the increased seismic risks resulting from increased gas production.
Clearly, the energy crisis is a formidable obstacle that no single European country can overcome alone. Capping gas prices and other emergency interventions could make the situation worse if they are implemented in a manner inconsistent with the policies of the various European countries. Since current policies determine Europe’s energy future, the EU must take into account its strength as an economic bloc and establish a unified course of action. Overcoming this crisis and hastening the transition to cleaner, renewable, and more affordable energy will require integration between European countries and increased investment.
