Why this energy crisis is different

An energy supply crunch is looming in Europe as soaring energy prices are contributing to inflation, posing risks to economic recovery, and hurting households and firms. Whether this emerges into a full-fledged energy crisis now depends on luck: how severe or mild winter weather is in Europe and other regions that compete with it for energy supplies.

There's nothing new about boom and bust in the energy sector, of course, but Europe's price surge is a harbinger of more volatility to come as the world copes with the impacts of climate change and accelerates its transition to clean energy.To safeguard both the economy and the clean energy transition, policymakers should develop stronger tools to manage energy market swings and smooth the inevitably messy transition process.

The gathering storm in Europe's energy market has been thrown into sharp relief in recent weeks as customers and firms have paid staggering prices for their electricity in response to surging natural gas, coal, and carbon credit prices. As of September, European natural gas spot prices were about six times what they were at this time in 2019, the last pre-pandemic year. Prices in Europe are closely linked to those in Asia, as gas prices need to rise high enough in Europe to attract supplies that would otherwise head to Asia. Asia has seen prices surge to four times what they were at this time in 2019. Benchmark natural gas prices in both Europe and Asia recently soared past $20 per million British thermal units. Coal prices have similarly skyrocketed for several reasons, including the gas price surge since coal can substitute for gas in electricity generation.

In response, the price for electricity, much of which is still generated from gas and coal, is soaring. In the United Kingdom, wholesale electricity prices have risen to more than 10 times last decade's average. The key European Union benchmark power contract has doubled this year. In Spain, soaring electricity prices are front-page news and have prompted protests against the government. In Germany, power prices have exceeded their 2008 peak. As a result, firms are curtailing output, and the price of electricity-hungry commodities, such as aluminum, is surging. In Britain, several smaller power companies have gone bankrupt, and power-intensive factories shut down. Households are feeling the pinch too, with the U.K. energy regulator hiking the maximum price utilities can charge retail consumers to reflect surging wholesale electricity rates.

A confluence of factors is responsible for Europe's energy crunch.

First, a series of extreme weather events and unusual seasonal patterns have impacted both gas demand and supply. Winter in much of the Northern Hemisphere, especially Asia, was unusually cold early this year, followed by an unusually cold spring in Europe, all of which boosted demand for gas heating. The deep freeze in Texas also hampered US gas production, resulting in lower US liquefied natural gas (LNG) exports to Asia and elsewhere during February. Subsequently, unusually severe summer heat waves in China, Europe, the United States, and some other parts of the world boosted gas demand for electricity for cooling.

Wind generation in Europe has been far below average this year due to long periods of less windy weather.

Second, other potential sources of electricity generation have been hampered. Wind generation in Europe has been far below average this year due to long periods of less windy weather. Gas and coal demand has risen to offset reduced renewable energy output, pushing up prices. Demand for fossil fuels is set to spike further as Germany takes another three nuclear reactors off the grid this year as part of its nuclear shutdown. Meanwhile, drought conditions in China and South America have led to reduced hydropower output, drawing supplies of globally traded gas into those markets instead.

Third, economic recovery from the pandemic has been strong in both Europe and Asia, pushing up demand for energy to power homes, factories, and other businesses. China's LNG demand during the first half of this year increased by more than 25 percent over the same period the year before, making it the largest LNG importer ahead of Japan.

Fourth, despite worsening market tightness and surging benchmark prices, Russia's state-owned gas company, Gazprom, has not increased its pipeline gas shipments to the European Union beyond its long-term contractual commitments either because it is unable or unwilling to do so (a topic of much debate among analysts). This is perhaps most evident in the sharp drop in Gazprom-owned gas stocks within the European Union. With Gazprom announcing the completion of its controversial Nord Stream 2 pipeline, the severity of Europe's natural gas price crunch this winter may depend on how quickly Russia starts up gas deliveries through the pipeline or boosts shipments via the existing pipeline through Ukraine. Supplies into Europe were further hampered by production and maintenance issues in several gas-producing countries. And Europe's own domestic gas production has been in decline.

Fifth, climate policy itself is pushing up European energy prices. Europe has an allowance trading system to put a price on carbon. Recent EU carbon allowance prices have hit record levels, driven by European reforms to reduce the number of permits, and are projected to continue rising for the rest of the year. Higher carbon permit prices pushed up natural gas prices by preventing gas-to-coal switching that would otherwise have occurred. As natural gas prices recently surged, those higher gas prices have incentivized switching to coal, notwithstanding the carbon price. And since coal is more carbon intensive and thus requires more carbon permits, the price of allowances rises as a result, creating a cycle that pushes up electricity prices.

Pipelines at the Nord Stream 2 receiving station in Lubmin on Germanys Baltic Sea coast on September 21, 2021.

As a result of all these market dynamics, European natural gas storage facilities are at their lowest levels in a decade (measured in percent filled). Normally, inventories fill up at this time of year to prepare for the winter. Even if Russia was delivering, there'd be little time left to bring stocks to the level they've been in recent years. If the European winter is unusually cold, natural gas stocks may be insufficient to meet demand, surging prices and forcing customers, especially energy-intensive industries, to curtail their electricity use and manufacturing production as European utilities compete with other parts of the world to attract supply. Some large industrial plants have already shuttered in Britain because of high energy prices. Businesses in China face similar risks.

As a result, Russia will be in a particularly strong position, especially as Nord Stream 2 ramps up service, to dictate terms to a European market desperate to find more natural gas supplies. Indeed, if Europe faces a gas shortage, it will boost Russia's leverage to demand Germany to allow gas to flow through the pipeline even before final certification is given, which would require it to comply with a set of European Union regulatory requirements aimed at preventing Russia's exercise of monopoly power. This week, as gas prices soared, the Kremlin made a point of saying Nord Stream 2 approval would ease the gas price crunch, fueling suspicions that Russia has held back supplies as leverage to get the project approved. Even as some analysts argued Russia does not have extra gas volumes to send to Europe, the International Energy Agency called on Russia to boost shipments, European lawmakers asked for an investigation into Gazprom, and the United States warned of market manipulation.

Energy markets are no stranger to periodic supply crunches, but policymakers should pay heed to what's new about today's energy crises.

Moreover, in a global natural gas market that has grown more interconnected with the rise of gas shipped by LNG tankers and prices set in global trading hubs, what happens in Europe does not stay in Europe. The high prices needed to pull gas supplies into the European market will be felt in other markets competing for those supplies. Natural gas prices in the United States have already soared to $5 per million British thermal units, the highest level in seven years. Partly, that is because US natural gas exports are rising as new gas liquefaction plants operate at capacity in response to high overseas prices. And that is because US gas supplies are not responding as quickly to higher oil and gas prices as producers face growing pressure from Wall Street to demonstrate capital discipline rather than grow output and as investors sour on oil and gas in response to social pressures to transition to cleaner energy.

Energy markets are no stranger to periodic supply crunches, of course, but policymakers should pay heed to what's new about today's energy crises: climate change and the policies to curb it. Europe would be facing a gas crunch as it emerges from economic lockdowns no matter what, but several of the factors contributing to Europe's current market imbalance stem from either the impacts of climate change or efforts to limit it by transitioning to clean energy. The market dynamics causing today's supply and demand imbalances have long been there, such as supply disruptions and demand spikes. But in the same way that flooding, drought, and wildfires have long existed but are now being intensified by climate impacts, so too are market forces that long existed are now being supercharged by climate change impacts and responses.

Climate change means more extreme temperatures: It will bring hotter summers, and although it means warmer winters on average, it may also contribute to cold snaps (though this is a subject of scientific debate). Climate change exacerbates droughts, which curtail hydropower and make it harder to use freshwater sources to cool nuclear and fossil fuel plants. Policies to address climate change may lead to carbon price volatility, which, in turn, could feed energy price volatility. Uncertainty about the pace of transition may lead to periodic shortfalls in supply if climate action shutters traditional fossil fuel infrastructure before alternatives can pick up the slack—as may be starting to happen in some places now. And if fossil fuel supply is curbed faster than the pace at which fossil fuel demand falls, shortfalls can result in market crunches that cause prices to spike and exacerbate existing geopolitical risks. In fact, this is what the International Energy Agency just warned is happening in oil markets—a striking contrast to what it said only a few months ago, when it warned that new fossil fuel supplies would not be needed if nations were on track to achieve net-zero emissions by 2050.

Anticipating and managing the increased volatility of energy markets that will accompany the energy transition is important not only to protect consumers and firms from harmful economic impacts of higher prices but also to maintain support for the much stronger climate action urgently needed to keep temperature rises below the 1.5 degree Celsius threshold climate scientists have warned about. In the face of growing evidence of climate change—such as worsening heat waves, floods, droughts, and storms—public support for stronger climate action is growing—an encouraging trend. Yet if reliability, affordability, or security of supply is impacted by climate action—in perception or reality—support for stronger climate action is sure to wane. When the Colonial Pipeline went down on the US East Coast or when the lights went out in Texas or Louisiana, little else mattered beyond getting the fuel and lights back on as quickly as possible. The same will be true for public support of climate policy if price volatility hurts consumers, as recent backlash in parts of Europe has demonstrated.

A grower walks past apple trees covered in ice in La Palazzetta, a village near Milan on April 8.
None of this suggests slowing the pace of the transition to clean energy. On the contrary, it must be accelerated. Yet many projections for how quickly and how much clean energy can be scaled are based on stylized models of what is technically and economically possible. The problem is there is no master planner who will build the energy system this way based on government fiat. The transition will result from unpredictable fits and starts in policy action (as evidenced by current climate policy debate in Washington) and from myriad individual and firm decisions about what type of car to buy, electricity to generate, or plant to build. Energy supply and demand have always been hard to keep balanced, and that will be even more true during an unprecedented transition process to clean energy with uncertainty about innovation timescales, cost curves of various energy sources, the pace of new technology adoption like electric cars, stringency and durability of climate policy, and more. History suggests transitions are harder to realize and take longer than ambition and rhetoric would suggest.

The challenges in anticipating how the transition will unfold extend far beyond Europe. California, for example, is having trouble keeping the lights on as it rapidly scales the use of intermittent solar and wind power. It recently requested an emergency order from the US federal government to maintain system reliability by, among other actions, allowing the state to require certain fossil fuel plants scheduled to retire to stay online and by loosening pollution restrictions. California is also proposing to build several temporary natural gas plants to avoid blackouts, even as the state shuts down the Diablo Canyon nuclear power plant, which produces more zero-carbon electricity than all the state's wind turbines combined.

Policymakers should develop new tools and build on existing ones that have proven effective in mitigating price volatility.

Governments have long played a role trying to smooth the inevitable energy boom and bust cycles. The most notable example is the oil-producing nations of OPEC, which have, at times, stepped in to add or remove supply to keep markets in balance—to their geopolitical advantage. In response to the 1973 Arab oil embargo, oil-consuming nations banded together to form an agreement to hold oil stocks for emergencies; they have released them during severe supply disruptions, such as the Persian Gulf War and Hurricane Katrina. In the United States, the federal government subsidizes the cost of heating oil for low-income households. Some nations, like South Korea, require natural gas firms to hold minimum levels of inventory.

Governments' role in mitigating energy price volatility is not straightforward, however. Higher prices help markets rebalance by incentivizing producers to bring more supply online or consumers to curb their usage. Yet this laissez faire approach has limits. First, markets can fail, as seen earlier this year in the electricity market's performance during Texas's deep freeze. In a system designed to let markets solve supply problems, scarcity pricing surged out of control, with prices disconnecting from fundamentals and causing widespread economic damage. Second, the economic harm from energy price shocks comes not just from the overall price level but from volatility itself, which creates uncertainty and thus deters consumer spending and firm investment. Third, letting markets work assumes a level of public acceptance of price spikes that rarely exists in reality.

The current response to Europe's price surge is a case in point as politicians across the continent are stepping in to protect consumers, such as with price caps in Spain and subsidies in Greece. Maintaining support for efforts to curb climate change will become increasingly difficult if climate policies exacerbate price volatility, cause energy shortages, or otherwise negatively impact energy security, affordability, or reliability—a risk European Union Climate Commissioner Frans Timmermans acknowledged last week.

Wind turbines are seen near the open-cast mining and the coal-fired power station Neurath of German energy giant RWE in Garzweiler, Germany on March 15.
As the world accelerates the transition away from fossil fuels, governments must thus expand their toolkits to manage volatility in energy prices. For starters, it would be foolish to get rid of existing tools, such as the US Strategic Petroleum Reserve.

Going forward, policymakers should develop new tools and build on existing ones that have proven effective in mitigating volatility. For example, improved capacity markets for the power sector would more effectively pay suppliers—especially gas-fired plants that can fire up at a moment's notice—to be available to meet peaks in demand. Similarly, better and more efficient power market structures would compensate resources based on their capability to perform at periods of peak system stress (measured by an obscure metric known as effective load carrying capability). And expanded use of batteries or other forms of storage once they are available at scale can provide greater grid stability as variable renewable resources continue to grow. We should not forget tools to adjust usage as well: demand response programs create incentives to reduce or shift customers' electricity use during peak periods. Finally, regulatory and infrastructure policies can facilitate more integration, flexibility, and interconnectedness in the energy system—from power grids to pipelines—so there are more options to pull energy supplies into a market when needed. As the energy transition unfolds, policymakers should be careful not to shed such tools prematurely as countries shift away from fossil fuels.

Most importantly, policymakers should accelerate the transition to clean energy.

Other policy instruments may not mitigate energy price volatility but can reduce its impact on consumers and businesses. For example, tax rates on energy may rise or fall in response to extreme swings in energy market prices; Spain, for example, just slashed its electricity tax rate for consumers from 21 to 10 percent. Similarly, higher revenues from a rising carbon permit price can be recycled back to households to offset the higher carbon fee's effects. And increased energy efficiency and fuel economy standards can reduce the exposure of consumers and the economy to price shocks while also reducing emissions.

Most importantly, policymakers should accelerate the transition to clean energy. Improving energy efficiency, electrifying heating, and scaling up the use of low-carbon fuels like biomethane and hydrogen that use existing natural gas infrastructure will not only curb emissions but also reduce natural gas demand—and thus, exposure to gas price volatility. Rapidly deploying more renewable energy sources can also reduce price volatility. The cost of solar and wind is largely set at the time the projects are built rather than being dependent on swings in commodity markets resulting from conflict, infrastructure attacks, accidents, and more.

Climate change's urgency means efforts to scale clean energy must accelerate rapidly, but Europe's energy crisis today offers a taste of what is to come as climate action and climate impacts result in a potentially unpredictable and disruptive transition process. Maintaining support for strong climate action as well as cushioning the economic harms of energy price shocks will require policymakers to strengthen existing and develop new tools to smooth energy price volatility in the years ahead.

Disclaimer: This article first appeared on foreignpolicy.com, and is published by special syndication arrangement.