Power struggle

European leaders must strike a grand bargain to untangle the crisis in the energy market.

In energy annals, 2022 will be remembered as the year of Europe’s great energy crisis. This year, Europe has experienced an energy situation every bit as concerning as the oil shocks of 1973 and 1979, which profoundly impacted the global energy and political order. Over the course of the year, three shocks have rapidly converged, pushing the continent into an energy crisis and upending Europe’s energy market: the effects of Covid-19; Russia’s invasion of Ukraine and related sanctions on oil and gas; and a series of unlucky coincidences.

Public policy has discouraged upstream fossil fuel investment, but has not accelerated sufficiently the deployment of alternative clean energy sources or reductions in fossil fuel demand. This has resulted in a profound energy supply–demand imbalance in the context of the bounce-back of global energy demand after the peak Covid-19 crisis. Next came Russia’s weaponisation of energy and its invasion of Ukraine. Russia has been manipulating European natural gas markets since summer 2021 by substantially reducing exports and failing to refill Gazprom-owned storage sites in the EU ahead of last winter. This move, initially considered to be part of Russia’s strategy to push Germany towards a quick certification and entry into operation of the newly built Nord Stream 2 pipeline, saw another potential explanation when war began.

Since spring, Russia has used its remaining supplies as a geopolitical weapon to divide the European front in support of Ukraine, notably, by reneging on long-term supply contracts that were considered sacred by European partners. After initial cut-offs to Poland and Bulgaria, Gazprom cut supplies to a dozen additional European countries and substantially reduced flows to its main markets, Germany and Italy. By early July, Russia was only sending one-third of previously anticipated volumes of gas overall. As a result, gas prices in the EU have exploded more than tenfold and governments are nervously trying to protect consumers against this price shock by handing out billions in subsidies. Europe managed to compensate for reduced Russian supplies by importing record levels of liquefied natural gas (LNG), most notably from the US. At the same time, several new gas deals have been signed by European governments with alternative suppliers, namely in Africa, with additional supplies expected to come online over the coming years.

Finally, a series of unlucky coincidences exacerbated an already tight energy situation. Corrosion problems pushed France to temporarily shut down half of its nuclear power plants, increasing the need for gas in power generation. A severe drought in parts of Europe compromised not only hydropower generation, but also thermal plants that require cooling and coal-fired power plants that rely on waterways to deliver coal. As extreme weather events become more frequent, this situation raises a longer-term issue around the impacts of climatic change in electricity production.

Disruption to demand

The consequence of the convergence of these three shocks has been an extremely tight supply–demand balance both globally and within the EU. As almost all fuels are affected, short-term fuel-switching supply elasticities are close to being exhausted (a typical example would be between gas- and coal-fired power generation). Instead, demand reductions – both actual and anticipated – now play an outsized role in price setting (any bearish outlooks for energy prices are typically predicated on a recession eroding demand).

High prices and forced demand reduction result in a huge political problem for all countries. Accordingly, governments have tried to address this exceptional situation with exceptional policies. European countries are spending more than 1% of GDP propping up energy systems, with subsidies often tied directly to the consumption of energy, thus boosting demand. An ever-growing range of ideas for how to intervene into energy markets to address the crisis are being discussed, from the joint purchase of natural gas to energy price caps, rationing plans and nationalisations.

Both the impact of the energy crisis – which varies between regions – as well as differing national policies to address the crisis will shape the physical and institutional setting of the European energy sector. For example, excessive nationalisation of energy policies will substantially undermine the ability of Europe to cope with the current crisis and imply jointly choosing a steeper path toward decarbonisation. With each government focused on ensuring its own security of supply, the EU as a whole risks building substantial gas overcapacity. This would be an inefficient use of resources and risk entrenching new interest groups opposed to a speedy phase-out of natural gas.

The reality is that Europe might not have enough energy to fully meet desired demand over the coming winter. This represents Europe’s greatest systemic risk right now from both an economic and political perspective. A disordered energy crisis would not only push Europe into a spiral of economic recession and social tensions, but also expose its political unity to the risk of energy protectionism. This would weaken its foreign policy, most notably its stance against the Russian aggression in Ukraine.

Putin’s strategy to weaken Europe’s support for Ukraine by weaponising energy is now clear to all. For European leaders not to succumb, they must rapidly prepare a counter-offensive for what will be a difficult winter. Choices over how to manage limited energy supply will shape the future of Europe’s energy system and have wider political ramifications. If managed correctly, deeper integration and accelerated investments can allow Europe to defeat Putin’s strategy and drive transition toward cleaner and more affordable energy.

EU’s grand bargain

To this end, European leaders must strike a grand bargain to pool the diverse untapped energy potentials of member states in order to unwind the EU from the dependency on Russia and lay the foundations for a rapid wave of clean energy investments. But what steps must be taken for this to happen?

First, all countries must honestly and immediately exploit every available supply-side flexibility to the European energy market. This will require painful political compromises. German nuclear power might reduce gas dependency on Russia by 10%. Dutch gas fields could contribute a significant amount. Stronger imports from Ukrainian nuclear plants could displace a few percentage points of gas-burn, and temporarily lowering pollution and labour-time standards even in less Russian energy-dependent countries would help supplies. Energy security is challenged as never before, and some trade-offs with social and environmental goods must be temporarily reassessed.

Second, agreeing to jointly procure gas on international markets will reduce the risk that the unity among member states might erode as they outcompete each other over limited supplies. Moreover, joint procurement promises to lower financial and political costs for gas and might allow the EU to use pooled gas volumes to provide energy to the most severely hit consumers.

Third, all countries must make honest and comprehensive efforts to reduce demand. This requires serious and straightforward communication to the public. Policymakers must explain to citizens the impending trade-off between household energy consumption and the preservation of jobs and peace. To achieve this, countries need to ensure that all consumers have strong incentives to reduce consumption. European leaders should agree to stop directly subsidising energy consumption and instead agree to subsidise energy saving. Regulatory tools such as vehicle speed limits or changing minimum temperature rules for buildings need to be on the table. Politically unlocking untapped energy supply and demand reduction potential in Europe will substantially alleviate market pressures.

The fourth crucial element of the grand bargain will be to secure a political commitment to maintain a well-functioning European energy market that ensures that molecules and electrons flow to where they are most needed. Instances of fragmentation of the EU energy market, such as the ‘Iberian exception’ (in which the European Commission allowed Spain and Portugal to decouple the price of gas from that of electricity for a fixed period), must be contained as much as possible and be, indeed, exceptional.

Fifth, European money should be pooled for providing compensation for difficult domestic decisions. For example, households in Groningen should be compensated for increased tremor risk from gas drilling, and it is not the Dutch government who faces strong incentives for doing so. Given the importance of the gas field for the EU’s security of supply, the compensation should come from an EU instrument. Likewise, in terminating Algerian gas contracts and allowing gas to flow into Italy, Spain should be reimbursed the substantial price differential to more expensive LNG. Compensating demand reduction in southern Europe might also be facilitated by providing joint incentives.

Sixth, and crucially, the poorest in society exposed to energy poverty are more vulnerable than ever and continue to need support. National governments should provide lump-sum transfers or other social aid that does not weaken price signals for reducing energy consumption. Given the massive fiscal imbalances in the EU, in this case, a joint European fund might be considered.

Finally, short-term imperatives must not detract from the deployment of long-term solutions to reduce fossil fuel consumption. Investment in clean energy technology and the associated infrastructure is an essential part of escaping the energy crisis and meeting the EU’s decarbonisation targets. This crisis is an opportunity to invest in further connecting Europe’s energy grids, which will improve resilience to future shocks and facilitate a cost-efficient transition. One estimate, from green thinktank Ember, is that the EU must double the pace of wind and solar deployment to meet its goals based on limiting global warming to 1.5C. The current permitting process is slow and a major obstacle to rapid renewables deployment; it should be simplified and accelerated.

Scaling up deployment of renewables and long-duration storage, more rapid electrification for heating, public transport solutions and clean mobility, among many other decarbonisation measures, should all be reinforced. Such long-term investment will improve energy security and decisively eliminate Europe’s dependence on Russian gas.

Underpinning this bargain will be commitments to ensure efforts are equalised around the continent. In many cases, however, efforts will not be equally distributed. Relatively well-supplied countries will have to take action largely for the benefits of their neighbours. The creation of the above-mentioned European fund, alongside an EU-level agreement on redistribution, must be accompanied by a political commitment to maintain a well-functioning energy market ensuring flow to where it is most needed.

By sealing a special declaration on a European grand energy bargain, EU leaders would commit their governments to a coordinated and fair approach to the energy crisis. This would bind ministers and regulators, guiding them through the difficult choices they will have to make. Choices over how to manage limited energy supply will shape the future of Europe’s energy system. If managed correctly, deeper integration and accelerated investment can allow Europe to defeat Putin’s strategy while also pushing the transition toward cleaner and more affordable energy.

Ben McWilliams and Giovanni Sgaravatti are research analysts at Bruegel, a European thinktank specialising in economics. Simone Tagliapietra is a Senior Fellow at Bruegel and an adjunct professor at Università Cattolica del Sacro Cuore (Milan, Italy) and The Johns Hopkins University (Baltimore, USA), and Georg Zachmann is a Senior Fellow at Bruegel

Follow the authors on Twitter: @McwilliamsBen, @GSgaravatti, @Tagliapietra_S, @GeorgZachmann

This article first appeared in the RSA Journal Issue 4 2022.