Don’t Blame Putin for Europe’s Energy Crisis

As Russia amasses troops on the border with Ukraine, fears are rising that a war could disrupt Russian shipments of natural gas to Europe in the middle of winter. With the continent already reeling from high energy prices and tight supplies, Western leaders are scrambling to find alternative energy shipments, such as tankers full of liquefied natural gas (LNG) from the U.S. Gulf coast and the Middle East.

Yet the prospect of dire energy shortages if Russia shuts the taps has grown so acute that it risks obscuring a far more fundamental threat to European energy security. No matter what happens in Ukraine, this winter is not an aberration. Even if Russian gas continues to flow, Europe will be increasingly exposed to the volatile price of imported gas in the years to come unless its leaders take steps to reduce the risk of energy price spikes and prepare for inevitable and unpredictable swings in energy supply and use.

Europe typically depends on Russia for more than one-third of its natural gas use. Although Russia has been sending less to Europe this winter, it is fulfilling its long-term contractual commitments. The difference now is that it has all but cut off the additional supplies it usually sells on the spot market. If Russia were to cut or reduce contracted deliveries to Europe as well—which half a century of energy relations suggests is unlikely—it would be exceedingly difficult and expensive for Europe to replace lost Russian gas flows. Spot prices, already skyrocketing to unprecedented levels, would go even higher as European buyers tried to pull in LNG supplies otherwise headed for Asia, energy-intensive industries would shut down, and even household heating and electricity use would likely need to be rationed to prevent power outages.

But even if Russian gas flows continue uninterrupted, Europe still faces an energy crisis this year and, more importantly, in the years to come. By late summer of 2021, it was already evident that Europe was facing a looming energy crisis with gas storage levels unusually low. As winter set in, prices predictably soared to record levels, reaching such heights late last year that many industrial firms shut down production. In Britain, nearly 30 power utilities went bankrupt. European natural gas topped $60 per million Btu, equivalent to an oil price of an astonishing $350 per barrel. (Brent crude sells for around $90 a barrel, and the comparable U.S. gas price is around $4.) European household energy bills will rise another 50 percent this year, according to Bank of America.

These high energy prices are the result of exactly the kind of system European leaders wanted.

Faced with public backlash and worries about the impact on the macroeconomy, governments with few other options to keep prices in check have resorted to subsidizing energy costs for people feeling the pinch. Denmark has announced it plans to send checks to households using natural gas for heating to offset the rise in prices. Norway, France, and several other European countries have done the same.

Energy prices have eased in recent weeks, but only because Europe has been lucky with the weather. Winter temperatures have not been as cold as feared. The same has been true of Asia, allowing Europe to draw some cargoes of LNG that otherwise would have been needed there.

Luck, however, is not a long-term strategy for energy security. Already, markets are telling us that Europe’s luck won’t hold out. Natural gas contracts for 2023, 2024 and 2025 are trading between 50 percent and 100 percent higher than their average over the past decade.

European leaders are quick to lament Europe’s energy woes and cast blame. Lost amid the recriminations, however, is a recognition that these high energy prices are the result of exactly the kind of system European leaders wanted. Price spikes are a feature, not a bug, of Europe’s decade-long gas market reform program.

Natural gas historically was sold in Europe based on long-term contracts, usually linked to the price of oil, with little flexibility to divert supplies from one destination to another. Over the past two decades, European regulators enacted a gas-market reform plan aimed at letting market forces work. They deregulated the gas sector and encouraged expanded investments in natural gas pipelines and LNG import facilities. After the 2009 crisis, when a Russian-Ukrainian standoff over pipelines led to a sudden cutoff in gas deliveries to some European countries, the European Union improved the capability to move gas more flexibly across borders.

The result was increased competition and the creation of gas-pricing hubs. After a quick oil price recovery following the 2009 crash, long-term oil-indexed contracts became more expensive than gas spot prices on a sustained basis. This prompted European buyers to seek a renegotiation of these rigid and expensive long-term contracts and move to spot prices that were cheaper at the time. That helped bring down European gas prices compared to oil-indexed gas prices.

Rather than be set by higher oil prices, natural gas prices were now going to be set by supply and demand for gas itself, and the result was lower prices for buyers in Europe. As countries invested in infrastructure to import gas from more diverse sources, buyers had a stronger hand to bargain for better prices, as demonstrated by Eastern European countries like Lithuania negotiating large discounts on their contracts with Gazprom after building LNG import terminals.

But market forces are a two-edged sword. Buyers pay lower prices when supply is flush than they would under long-term contracts, yet when supplies are tight, prices need to rise high enough to attract additional LNG cargoes, spur more production, induce a switch to other fuels such as oil or coal, or curb demand. In short, they may mean lower prices for buyers when averaged out over the long term, as the International Energy Agency has found, but the price for those savings are more volatile prices with unpredictable spikes.

The problem, as we know from France’s “yellow vest” protests and Kazakhstan’s recent unrest over fuel price hikes, is voters have demonstrated little willingness to accept high energy prices. Yet this exact specter looms for many years to come. After a period of energy abundance, the world is now at risk of tight markets and price spikes due to underinvestment in the energy supply. Faced with uncertainty about the outlook for oil and gas use because of climate policies, poor past financial performance, and pressure to divest from fossil fuels, energy firms’ investment in maintaining the flow of oil and gas is at record lows today. Their level of investment would be sufficient if the world were on track to net zero emissions by 2050, but the world is nowhere close to this trajectory. On the contrary, oil and gas use is still rising. If clean energy were to pick up the slack given today’s level of investment in oil and gas, investments in alternative sources of energy would have to triple from their current level.

European countries should avoid retiring other sources of energy generation until new sources are able to pick up the slack.

Natural gas prices are especially prone to volatility because gas use fluctuates far more than oil use does. Natural gas is used for heating, as well as electricity generation, and thus the amount needed spikes in the winter to roughly 2.5 times what it typically is in the summer. Gas-fired power plants are also increasingly important backup capacity for weather-dependent renewable energy, ready to fire up at a moment’s notice when the sun doesn’t shine and the wind doesn’t blow, as happened more than usual in Europe this winter. Meanwhile, Europe’s domestic natural gas production has been on a long decline, accelerated by the phase out of the Groningen field in the Netherlands, and imports have been filling the gap. And climate change itself—by causing more extreme temperatures and droughts that stymie hydropower output—can exacerbate the seasonal swings in gas use.

As a result, European companies must rely more on gas imports and storage to balance the market each winter. If inventories fall short, as they did this time, spot prices must rise high enough to compete with Asia for additional supplies or force residents to lower their thermostats and factories to slow or stop production, with all the concomitant economic pain to firms and households.

Russia’s reduced deliveries are why people such as International Energy Agency executive director Fatih Birol blame Russian President Vladimir Putin for Europe’s energy crisis, even though Russia is fulfilling its contractual commitments. While there is likely some geopolitical motivation to Russia’s refusal to sell Europe more gas on the spot market, Russia is under no obligation to sell more gas. It may be seeking to maximize gas revenues by propping up prices or using those high prices as an inducement to push European firms to sign new long-term contracts, as Russia has been inviting them to do. Relying on Russian charity when markets are tight is not a sound strategy for European energy security.

Europe benefited from the creation of gas market hubs and reliance on spot prices for a decade, but today’s energy crisis demonstrates the risks of this approach. Excessive price spikes are harmful economically and unacceptable politically. At the same time, the increased flexibility that gas market liberalization provides will be essential to the European Union as its reliance on variable renewable energy sources grows over time. The answer is thus not to undo the market-based reforms, but rather supplement them with additional measures to smooth volatility and cope with inherent gas market uncertainty.

First, European governments should ensure that gas storage can be counted on to provide supply security and system flexibility, including by strengthening storage requirements. This can take the form of minimum storage obligations for private firms or strategic gas reserves where appropriate, just as the United States and other Western countries created for oil after the 1973 Arab Oil Embargo. The need for regulators to impose obligations on private firms to fill their inventories to minimum levels was reinforced this winter, as Gazprom, which owns a sizeable share of Europe’s gas storage capacity, chose not to refill its facilities ahead of the heating season.

Second, although it takes time to deliver benefits, European governments should double down on efforts to curb demand through efficiency in home heating systems and through regulations and mechanisms such as variable pricing or technologies to shift demand from peak to off-peak times of day.

Third, European countries should avoid retiring other sources of energy generation until new sources are able to pick up the slack. Europe should also ensure adequate investments in zero-carbon electricity generation that can produce energy at any time such as nuclear energy, hydropower, and biogas. Germany’s decision to retire several additional nuclear reactors in the middle of the energy crisis this winter has only exacerbated the situation.

Fourth, Europe should ensure adequate investment in transportation and import infrastructure, not just for LNG but also for low-carbon gases such as biomethane and hydrogen to support both system reliability and decarbonization goals.

The jagged energy transition that lies ahead is going to increase, not decrease, the need for tools to smooth jarring volatility in energy markets. Even if Russian gas continues to flow uninterrupted to Europe, Europe is in for a rocky road ahead. Ironically, Europe’s energy woes today reflect the success of its own reforms to liberalize European gas markets and shift to reliance on market prices. That success, however, was incomplete, as European regulators failed to simultaneously put in place the necessary measures to deal with the market’s extreme—and inevitable—swings. To avoid even more economic and geopolitical chaos than this winter’s, European leaders must urgently complement their successful gas reform with the necessary tools to buffer price volatility in the years ahead.