international analysis and commentary

Soaring energy prices and the Eastern European crisis: the need for a European market redesign?

in cooperation with CESI - by Matteo Codazzi

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After the economic downturn in 2020 caused by the pandemic, the global economy witnessed a rather fast recovery in 2021, with a 6% rise in GDP compared to the previous year, mainly thanks to a growth in demand for consumer goods. Nevertheless, the supply chain of key input components, which was also disrupted by lockdowns in several areas of the world, has not fully recovered to its normal state. This is causing severe delays in product deliveries, hitting Europe as the Old Continent is largely dependent on imports of basic components needed for the automotive and green technologies sectors. The second half of 2021 was characterized by soaring commodities prices putting further strain on the economic recovery. For instance, the average wholesale natural gas (NG) price in December 2021 hit a record of 113 €/MWh in Italy, which was about seven-fold the NG price 12 months before.

The upward trend in commodity prices combined with a persistent slowdown in the supply chain from the Far East to Europe has been further exacerbated by the ongoing war crisis that began on February 24th. In March 2022, the average NG price in Italy attained a historical record of 128 €/MWh, but on the TTF spot market spikes up to 348 €/MWh were reached. Clearly an unsustainable price for consumers, considering that NG is setting the electricity prices on the power market since many EU countries are largely relying on CCGT (Combined Cycle Power Plant) units.

The debate on the root causes of such a surge in commodity prices – especially NG – has been ongoing since last year. Analysts highlight possible causes such as the arbitrage of LNG between Europe and the Far East markets, notably Japan and China, together with the drought in Brazil. However, liquified natural gas (LNG) import in Europe accounts only for 20% of the total imports, which were about 360 bcm in 2021.

An LNG carrier downloading methane at the Panigaglia regasification plant in La Spezia, Italy.

 

Fully aware of its energy vulnerability, EU sanctions are therefore not hitting Russian fossil fuels yet: coal imports will be phased out in August and the embargo on oil imports by sea, already ruled by the European Council, will come into force only at the beginning of 2023, whereas NG imports are not currently under discussion, and a conclusion on the NG price cap debate has been postponed to the fall of 2022. According to RePowerEU, gas imports from Russia will be progressively phased down by 2027.

Shifting to NG, the situation until June 2022 was not showing a significant strain in availability. It was not the same situation as in January 2009, when Russia halted gas flows through Ukraine for 13 days. This brought several analysts to draw the conclusion that the spike in the EU’s NG market prices might also be the result of certain characteristics of the specific market design in Europe: the NG spot price formed at the Amsterdam TTF exchange (where relatively limited NG quantities are exchanged in comparison to the full bulk of NG gas supplies to EU) has become a de facto standard benchmark against which many long-term gas supply agreements anchor the indexing of their price.

To make things even more complex, such prices are then fully passed on to the power market, through the so-called System Marginal Price mechanism implemented in many countries, as in many hours of the day the marginal units setting the price for the whole electricity market are namely CCGT (or gas-fueled) power generation units. The result of this situation is that the huge spike in the TTF market price set by the exchange of “marginal” volumes of NG gets transferred to the market price of “marginal” electric power and then influences the whole energy market in the EU, largely affecting consumers and businesses and potentially endangering the level of economic activity of the bloc.

Recognizing that Europe is in the middle of a double storm, due to a heaving reliance on imported commodities and the crisis in Eastern Europe, we need to ask ourselves whether the current market model is truly adequate. The European Commission (EC) communication published on  May 18th (COM (2022) 236 final) on short-term energy market interventions and long-term improvements to the electricity market design represents a key step to curb speculations and ensure better independency.

Short-term measures are aimed to mitigate the impact of rising prices on household consumers and businesses. These measures are based on the “Toolbox” already proposed by the Commission in October 2021, and they include emergency income support for energy-poor consumers, targeted reductions in taxation rates for vulnerable households, and aid to companies or industries, in line with EU state aid rules. Part of this financial support will rely on EU ETS (Emissions Trading System) revenues.

Starting from the end of June, the situation has unfortunately further worsened due to Russia reducing its pipeline exports to the EU – officially claiming several “technical” reasons. The Russian move clearly aims at preventing the EU from fully replenishing its gas storage capacity in view of the next winter. In this way, Russia is laying the ground for an unprecedented gas shortage in the EU this winter  – an occurrence against which EU countries must quickly draw a plan on how to cope and respond.

In the last few months, the discussion over imposing a wholesale price cap on NG has been hotly debated in the EU. So far, the EC foresees the establishment of an EU-wide price cap of gas only in the case of a major disruption scenario — unfortunately a more likely winter scenario given the recent curb of NG exports by the Russians. A price cap would surely help to limit gas price spikes avoiding the possibility of speculative actions and with an immediate positive consequence on the power markets, in which marginal prices are driven by gas. Unfortunately, though some member states (notably Italy) are supporting the adoption of a gas price cap, a full consensus has not yet been reached due to a fear of creating market distortions. Some market players claim that a European price cap on gas could even worsen the gas supply since LNG flows can be diverted to other markets with higher gas prices and would also limit the potential for price-driven reduction of gas demand. In fact, the potential adverse consequences could be easily offset by an appropriate value of the price cap that would be cost reflective of the various gas supply sources (pipelines and LNG). The last European Council held at the end of May gave a mandate to the EC to investigate the feasibility of a gas price cap.

There are, however, several measures in terms of market design that can be implemented in the midterm to protect consumers against high prices and excessive volatility. The simplest solution is to foster and rely on liquid, long-term forward markets, where standardized multi-year supply contracts can  be exchanged between supply and demand and priced transparently on a market platform. Italy is a forerunner in this context, as it already has in place a multi-year capacity market for power system adequacy, new procurement mechanisms for gas and power storage facilities, and auctions for fast reserve and long-term (twenty years) procurement auctions for new renewable  power plants. This is coherent with the recent  report by ACER (The European Union Agency for the Cooperation of Energy Regulators) suggesting to base the energy transition on long-term efficient markets.

The market redesign measures would also aim to accelerate the deployment of renewable generation across Europe. This would help to meet the triple objective of reducing vulnerability against external shocks, having energy at more affordable prices, and pursuing the roadmap towards net-zero emissions. Specifically, three key measures are worth being recalled:

Strengthening long-term markets, as already mentioned, and introducing hedging mechanisms with a timeline even exceeding a decade as to foster massive upfront investment costs called for by the energy transition. Referring to renewables, several tools can coexist such as “physical” power purchase agreements (PPA), Contract for Differences (CfD: an arrangement made in financial derivatives trading where the differences in the settlement between the open and closing trade prices are cash-settled) as financial hedging, and pooling between sellers and off takers.

Setting up new mechanisms, also with public funds, to support and stabilize multi-year revenues in favor of RES power plants. These mechanisms may be differentiated by technologies, if they are market based and include contributions from all possible RES technologies.

Fostering liquidity of long-term markets through market makers to allow an effective competitiveness between market operators. In general, the importance of well-structured, liquid and functioning long-term markets for standardized energy supply contracts is crucial to attract investments, particularly in the power generation and storage segments that are already fully liberalized. This would, on the one hand, offer a chance to electricity consumers to purchase electricity on a long-term basis (from 2 to 10 years forward) fixing their forward price with certainty and, on the other hand, it would provide generators (especially renewables ones, who are operating basically at zero marginal cost) to lock-in their long-term revenues and thus their return on investment — thus reducing their business risk and financing costs. Promoting the implementation of a long-term forward market platform for renewable energy will greatly foster the growth of renewable energy – the only power generation source not relying on burning natural commodities.

A solar energy field stands next to the Lippendorf coal-fired power, in Germany

 

The importance of an accelerated renewable energy penetration is also emphasized in the RePowerEU plan, which suggests increasing the ratio of renewable energy in the energy demand from 40% to 45% by 2030, as predicted by the “Fit for 55” package. This would lead to a total renewable power plant capacity in the EU exceeding 1,200 GW by 2030.

 

Read also: Economics and climate change: the complexity of transition

 

The importance of an accelerated deployment of renewables has already been investigated by CESI in its analysis aimed at identifying solutions for Italy to phase out its gas imports from Russia. The installation of 40 GW of wind and photovoltaic plants, together with 5.7 GW of additional storage facilities and the maximization of gas import from existing assets (pipelines and LNG plants), would allow for full energy independence from Russia and still maintain Italy on its course toward decarbonization

In conclusion, whilst the current EU gas and power market model has performed efficiently so far, in an exceptional situation such as the current one (with fears of potential bottlenecks in the supply chain and even a disruption of gas imports from Russia) the current model is showing some limits. A price cap on gas could well be an appropriate temporary solution to mitigate prices, also in power markets. However, in the mid- to long term, more structural and less “interventionist” solutions should be pursued to preserve and improve the ability of fully functioning energy markets to operate in an efficient way, not only in times of stress, but also during the “new energy normal” that awaits us following the end of this tragic war.

In this regard, any market design improvement shall be grounded on the fundamental consideration that renewable generation plants are not “commodity-linked,” – rather their cost-base is mainly tied to the up-front capital investment and its financing. In this context, the challenge is how to design power markets that can be efficient, resilient and liquid even in a situation in which we have zero-marginal-cost energy sources acting in the markets along with commodity-driven, marginal-cost-based generation sources. Mechanisms based on long-term PPA between producers and off-takers, capacity markets, or long-term forward markets for standard power supply contracts should be introduced and fostered.

In this respect, Italy has pioneered the introduction of forward markets and can certainly act as a leader in pointing the rest of EU towards the most appropriate market reforms to cope with the global energy future. The recent energy shocks will not quickly fade away with the end of the Ukrainian war and will definitely be remembered as a game changer. Ensuring not only a “just” energy transition, but also a resilient future for our EU economies, will require brave decisions from policymakers.

 

 


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