Balázs Kotnyek, Partner and Associate Director at BCG’s Budapest office speaks about the recent turbulence on the energy market, the reasons behind soaring prices, the impacts of energy transition and how we should prepare for similar price shocks in the future.
Europe is facing an energy price crisis, with gas and power prices reaching unprecedentedly high levels. What do you think is the main cause and how long is it going to last?
This price increase we see now on the European natural gas and electricity markets is indeed very steep, and unprecedented. So far, we have not had to deal with an over five-time increase in less than a year. But this is due in part to the fact that these markets are now more liquid and transparent than they used to be. Crude oil, meanwhile, has been traded in a globally integrated market for quite long now and has seen similar volatility occasionally. Just remember that since spring 2020, the Brent oil price has declined from 60-70 US dollars a barrel to 20 US dollars and by now it is back to over 80 US dollars. Now, that gas is also being traded globally, it is almost natural that its price has become similarly volatile.
But electricity is not traded globally, it is still a regional product at best. And still, it shows the same price volatility now.
Yes, that’s right. But the price of power is directly driven by the price of gas. In the European merit orders, especially in winter, gas power plants are the price-setters. When demand cannot be satisfied by the cheaper nuclear or renewable generation, coal or gas power plants determine the market equilibrium price. Trading is executed at the marginal price of the last running plant, that is, at the price level of the most expensive plant needed to supply the demand. This is, by the way, the market logic I mentioned earlier that is behind the occasional volatility. Historically, when power trading was not so liquid and transparent, but mostly happened through bilateral agreements or intercompany decisions, such steep changes were not transparent.
So, the energy transition, the market liberalisation and the increasing role of renewable do matter in the power price crisis we see now.
Yes, they influence the market indirectly, but the current power price increase is rather driven by the gas price increase, which is caused by the temporary supply-demand imbalance on the global natural gas markets. After the virus lockdowns, there was a fast increase in gas consumption everywhere, especially in Asia and supply could not keep pace with it. Similar issues are seen on other markets too, such as paper manufacturing, logging and timber trade and so on. If there were no other factors at play, we could see the markets correcting themselves and price fluctuations would tamper. By the way, this is the expectation for natural gas too, forward prices for 2022-2023 and beyond are to fall back to the level we saw before 2020.
And we will then see the same for electricity markets too?
Partly yes. As gas prices fall, power prices will follow. But in the longer term, power markets will change. The energy transition will increase the volatility of the market. Partly because there will be fewer lignite or nuclear power plants, whose costs are not driven by the short-term changes in fuel commodity markets. Renewable generation, however, is inherently volatile and weather dependent. And we have seen what happens if gas power plants determine the market price, which – at least in the next decade or so – is going to be the dominant way to balance renewable generation. On top of this, the cost of gas-based generation is increasing due to emission costs. For the record, the cost of coal-based power generation is increasing even more as they emit more CO2. Overall, we expect a gradual increase in the average price of electricity, with much more fluctuations than now.
Shouldn’t we expect cheaper power in the long term? If renewables – and in some parts of the world, nuclear plants – dominate generation, with their close to zero marginal cost, we could have zero power prices too, couldn’t we?
I don’t think so, at least not with the development in technology we can foresee now. We have done long-term power market modelling to see what happens if the European economy reaches the net-zero target by 2050. Renewables will indeed dominate generation capacities, and they will also provide the majority of electricity over the years. There will be many hours when only renewables will run and in those hours the market price of electricity will be close to zero. But the models show that there will be many other hours when there is not going to be enough sun or wind, and we have to source electricity from either storage or power plants running on gas or hydrogen. None of these is cheap now, and even if we assume an optimistic cost decrease due to scale and technology development, they will still be costly ways to provide power in these hours.
And there is another factor, the fixed costs. To build all these renewables, nuclear capacities, balancing storage, or power plants, plus the network infrastructure needed to avoid bottlenecks – they all require huge investments. Someone will have to pay the financing costs of these investments through capacity costs, regulated prices, state budget contributions (for example, taxes) or in any other form. The total cost of electricity will surely not be zero.
Coming back to the shorter-term horizon. What can we expect in terms of gas and power prices?
I can only share with you my hypotheses, of course. I don’t see all the factors and cannot judge how some key players will behave. Still, I think, in the shorter term, the combination of economic growth and weather will be the key factors. Currently, gas demand and supply seem to be balanced as prices have stabilised at this high level. But storage levels are lower than optimal. If there is not going to be another widespread lockdown, and the global economy continues to grow, and the winter turns out to be cold, gas supply can become scarce by next February-March. If we are lucky and we have a milder winter, we can stay at this price level and then start to see a decline from spring 2022 onward.
But even until then, there will be a lot of negative impacts. Consumers and companies will suffer from high prices. Is there a way to handle this?
In the short term, I think there is room for central government actions to cushion the impact, for example through some kind of financial compensation for the most vulnerable consumers. This is not unheard of, just very recently there were programs to help restaurants, hotels and other sectors which were badly impacted by the lockdowns. The key is that these programs should be targeted at the right segments and limited in time. They should be crisis-management tools, not permanent features of the system. I would refer to the oil market again, where we see everywhere that permanently subsidised petrol prices do not work – subsidies cost too much and distort behaviours that in the long term would be beneficial, for example, improving energy efficiency.
In the mid-term, we should rather get prepared for similar price shocks. This is going to become part of life, the consequence of climate change, like more storms or floods. Preparation can mean, for example, new regulations that enforce effective risk management practices for energy suppliers (for banks this has been in place and considered as normal for quite long) or setting up a central fund to reduce risks for end-users (similarly to the system of securing bank accounts and debits). Energy suppliers that behave responsibly would do this anyway – they already run strict risk management systems. Regulation is required to make sure all the others also comply and thus cannot cause havoc.
In an even longer term, we need to reform the way energy systems work. For example, flexibility will play a much more important role. Just to build more and more solar or wind plants will not be sufficient, we must figure out how to balance the electricity system. If we are serious about energy transition – and I think we should be – then we have to find the optimal way to manage it. Turning back is not an option.