Energy price crisis:
The EU's dilemma

1. The EU has proposed market-related measures to shield consumers and companies from rising energy costs. What has been debated so far?

"While the EU is still debating the details and the introduction of one or more of these measures, some member states have temporarily adopted some of these emergency measures."

Discussions are being held both at EU and member state levels, with the focus on several potential market interventions with the aim of reducing energy prices. These include:

·       Caps on wholesale and/or retail gas prices

·       Uncoupling the price of electricity from natural gas

·       Setting a price ceiling on imports of liquified natural gas (LNG)

·       Capping the price of Russian gas imports, and potentially the price of other imports

·       Reforming or developing complementary price indices to sit alongside the benchmark TTF

·       Demand reduction measures

·       Liquidity support for energy companies  

While the EU is still debating the details and the introduction of one or more of these measures, some member states, such as Austria, Croatia, the Czech Republic, Portugal, Romania and Spain, have temporarily adopted some of these emergency measures.

2. Why are price caps seen as an option?

Governments have a responsibility to protect vulnerable citizens and businesses from being fully exposed to soaring natural gas and electricity prices. With winter approaching and consumers increasingly concerned whether they can afford to cover their heating requirements, capping energy prices is a natural – and default – option for policymakers. This is because caps, whether introduced on wholesale prices or retail tariffs, help to reduce bills, presenting tangible proof of immediate action in defence of consumers.

3. What might the impact of price caps be?

"Price caps on residential and commercial consumer bills may be the most realistic emergency instrument available to policymakers ahead of winter but they will have the same effect: they run the risk of failing to incentivise a reduction of consumption while not dealing with the supply issue, therefore making the supply and demand balance even tighter."

Discussions over a wholesale market price cap, either on all imports of gas or on imports of Russian gas only, are ongoing at EU level.

Despite the short-term attraction, policy interventions like price caps pose high risks of distorting energy markets and ultimately making the crisis worse.

The extraordinary high wholesale natural gas prices have largely been driven by the weaponisation of Russian energy supplies through the reduction of pipeline gas exports to continental European markets.

As a result, a higher price is needed to attract additional gas from sources other than Russia to replace the missing Russian supplies. This price increase also sends a signal to consumers who help to rebalance the energy network by using less energy. For example, German industry has seen substantial reduction in natural gas consumption which, so far, has been price-led as opposed to policy-led.

If the price of wholesale gas is capped, the risk is that the price would be too low to attract the necessary supply in a globally competitive market, or to drive demand reduction. This would make the supply shortage worse.

Price caps on residential and commercial consumer bills may be the most realistic emergency instrument available to policymakers ahead of winter but they will have the same effect: they run the risk of failing to incentivise a reduction of consumption while not dealing with the supply issue, therefore making the supply and demand balance even tighter.

As an example, in June, Spain and Portugal’s governments capped wholesale gas prices for electricity generation at €40.00/megawatt-hour (MWh) until the end of 2022, allowing them to increase by €5.00/MWh every month until the end of May 2023.

As a result of the cap, Iberian electricity prices have been trading at half the value of wholesale prices elsewhere, or even lower. While this may have been immediately helpful to Iberian consumers, it has nearly doubled gas demand for electricity generation year on year. It also led to an increase in electricity exports to France, as cheaper Spanish electricity was sent to the premium French market, making domestic supply in Spain tighter still.

4. What has been discussed with regards to capping the price of Russian gas?

"A cap on the price the EU is prepared to pay for Russian gas imports would help lower overall gas prices for European consumers while barring Russia from raising profits to finance its war against Ukraine."

The EU is continuing to discuss the option of a price cap on imports of Russian gas specifically, as well as a wider cap on all imported gas.

A cap on the price the EU is prepared to pay for Russian gas imports would help lower overall gas prices for European consumers while barring Russia from raising profits to finance its war against Ukraine. A similar measure was proposed by the G7 group of advanced economies with regards to Russian oil exports.

But unlike the oil price cap, where implementation is now being discussed, there are signs the EU has retreated from imposing a gas price cap, at least for now.

The measure would involve setting a calibrated ceiling on the price of Russian gas imports that would be high enough to encourage Russian company Gazprom to export gas, but low enough to deprive it of profit. 

Member states such as Hungary, which is keen to preserve working political relations with Russia, dismissed it out of hand, while Russian president Vladimir Putin threatened to cut all remaining supplies to Europe if the EU were to adopt it.

Not only are there significant logistical challenges in implementing it, but a cap on Russian gas would establish a two-tiered pricing system that could lead to corrupt practices, for example, buyers could source cheap Russian gas and sell it to more expensive pricing zones.

In any case, with the recent closure of a major gas pipeline called Nord Stream 1, the share of Russian gas in Europe’s wider supply mix has fallen from up to 40% to around 10% today, and the reality is that this will ultimately weaken its influence on European gas prices.

5. European Commission president Ursula von der Leyen has said the EU would look at options to intervene in how natural gas is priced in Europe. Why?

"Von der Leyen said that while the gas market had changed to accommodate more LNG imports to replace the missing Russian pipeline gas, the TTF had not adapted, and therefore the Commission would look at developing alternative and ‘complementary’ indices."

While Ursula von der Leyen’s state-of-the-union address on 14 September mainly focused on a proposed windfall tax on power companies that do not burn gas, with the proceeds aimed at softening the blow of record high energy prices, she also used the speech to bring the role of the TTF as Europe’s primary reference price for natural gas into focus.

Von der Leyen said that while the gas market had changed to accommodate more LNG imports to replace the missing Russian pipeline gas, the TTF had not adapted, and therefore the Commission would look at developing alternative and ‘complementary’ indices.

This was partly a reaction to stakeholders in some member states who raised concerns about the ability of the benchmark TTF price to define the value of natural gas in Europe, citing increased volatility, reduced physical liquidity and decreasing relevance for other European gas markets, for example the Italian gas hub, the Punto di Scambio Virtuale (PSV).

While there is no specific mention of what a more representative potential index could be, ICIS understands that discussions are centred around an index based on LNG transactions. This is because the price for LNG arriving in Europe is currently at a discount to some mainland European gas hub prices such as PSV, Germany’s THE or TTF, and from the increasing relevance that LNG has in the European supply mix.

A comparison of a range of LNG and European gas hub prices, assessed by ICIS, underlines the current market dynamics.  

6. Prices in some markets seem to be uncoupling from the TTF. Why?

As the most mature European gas market, the Dutch TTF hub is established as the reference point for all markets across the continent. This is due historically to high interconnection capacity that the TTF has with surrounding countries, which puts it in a position to act as a physical gas ‘intersection’. Its high degree of liquidity is also well above any other European gas market.

7. Why has the Dutch TTF been the benchmark of choice for European and, increasingly, global gas companies?

The TTF gas market has for the last two decades been the envy of the world. Not only is it one of the most developed globally, underpinned by a predictable, transparent and stable regulatory environment, but it also has depth in liquidity due to hundreds of market participants of all types taking part.

Trading occurs in multiple venues, on exchanges, broker platforms and through bilateral, over the counter (OTC) transactions. TTF not only neighbours other highly liquid markets such as the British NBP, the French PEG and the German THE, but it also has many sources of importation such as LNG and pipelined gas from the North Sea.

Despite recent pressures on the European gas markets TTF remains one of the most liquid and important gas trading hubs in the world and it has a global influence in a way that no other European gas market does. In the same way that Brent has a global reach and importance in the oil world, TTF truly has global reach.

8. How have recent curtailments in gas supply from Russia affected trading at the TTF?

"Trading at the TTF overall has held up well despite the uncertainty caused by Russia’s invasion of Ukraine in late February 2022."

The extreme price levels and increased price volatility have resulted in very high margin costs and collateral requirements for market participants who need to trade to manage this risk. Norwegian state-controlled producer Equinor earlier this month estimated that European energy companies, not including those in the UK, need at least $1.5 trillion in collateral requirements to cover those margin calls. The higher risk management costs have meant that a number of European energy companies have been frozen out of markets while others have been forced to turn to governments to secure liquidity support.

The Commission has asked the European Securities and Markets Authority (ESMA), the EU’s market watchdog, to present options on how it can support with collateral requirements such as broadening the list of eligible collateral beyond cash.

Despite the higher costs of trading and the reduction in the number of participants able to access markets, trading at the TTF overall has held up well despite the uncertainty caused by Russia’s invasion of Ukraine in late February 2022.

9. What are the impediments to introducing new complementary LNG indices?

"High prices are not the root cause of the issues Europe is facing but, like market fragmentation, they are a consequence. The root causes are a lack of supply, the need for more import capacity, more pipelines and better infrastructure."

"Creating a new index in this scenario will still require these issues to be dealt with. A new index will not overcome high prices and fragmentation. In fact, it risks being only representative of countries with high regasification capacity and the best access to LNG supply."

Market participants remain sceptical that a new LNG index would be widely accepted, citing a number of factors, including:

·       LNG markets are illiquid with high barriers to entry. This means that only a handful of producers, utilities and trading houses are actively buying and selling spot LNG cargoes into Europe, significantly fewer than those that are active on Europe’s regional markets let alone the wider range of market participants – including end users – active at the TTF every day.  It is much more difficult to set a price acceptable to market participants in an illiquid market

·       Because LNG is a global market many participants will be trading cargoes outside the EU’s jurisdiction and therefore there is no obligation on them to be subject to the EU’s data transparency requirements. Authorised benchmark administrators, such as ICIS, have robust methodologies that provide transparency on spot LNG prices and ICIS augments this with its LNG market intelligence platform with real-time tracking of every cargo and the nature of its business into Europe. But there remains no obligation on LNG market participants to provide transaction data that would enable the development of a transaction-based index

·       TTF prices are already referenced in long-term contracts. Depending on the scope of measures to develop a complementary index, replacing them would create further turmoil in markets

·       An LNG index may rely on long-term contract prices which in turn are pegged to European hub prices, potentially leading to an unworkable deadlock that does not represent the costs of supplying energy

High energy prices in Europe have not been caused by speculation or financial trading but are the result of a supply and demand crunch: an unprecedented scenario where security of supply is at risk unless demand reduction materialises, and infrastructural issues are resolved.

Therefore, high prices are not the root cause of the issues Europe is facing but, like market fragmentation, they are a consequence. The root causes are a lack of supply, the need for more import capacity, more pipelines and better infrastructure.

Creating a new index in this scenario will still require these issues to be dealt with. A new index will not overcome high prices and fragmentation. In fact, it risks being only representative of countries with high regasification capacity and the best access to LNG supply.

Any new index would have the same issues, if not more, than the current one, with one more problem to solve: a lack of liquidity. It took years for the TTF to become the European and global benchmark.

Any trader wishing to buy a commodity will normally do so on the cheapest terms they can. If they agree to the use of an index then this would normally be designed to reflect fair market value, using the most liquid and representative market. There are a number of ways that such an index could be created using both LNG data and data from the most relevant local market hubs.

In order to be useable, any reference price must be transparent, very liquid and representative of the whole European market. In any case, the EU would have to complement this by working on improving infrastructure and access to sources of supply.