Europe learns the hard lesson of diversification
Europe learns the hard lesson of diversification
by Matthias Martensen & Karl Villanueva, founders at Ostrom
In the immediate aftermath of the illegal Russian invasion of Ukraine, Germany and Europe had a bit of soul-searching as it realized its extreme dependence on Russian fossil fuels. For years, the mantra was that cheap Russian natural gas was the bridging technology needed for the transition to renewables. This culminated in July 2022, when the EU Parliament even voted to classify gas, and nuclear, as green.
What has happened? After the invasion, the European Union had passed multiple sanction packages — many of them targeting the Russian energy sector to varying degrees. The sanctions were targeted at banning coal and oil imports, yet natural gas remains relatively unscathed, highlighting Europe’s dependence on it for industry and heating.
Even months into the war, several European governments and politicians naively believed that Russian gas flows would normalize. All the time, Gazprom and Russia were throttling the tap so to speak — reducing flows to 40%, then 20% and then eventually shut down all together. This has further crystallized the view that Russia cannot be a reliable business partner, much less a supplier of a crucial resource like energy.
Due to the crisis, the EU enacted a voluntary 15% gas usage savings target, set minimum storage levels, took decommissioned coal power plants back online, and sought alternative energy supplies — most notably with liquified natural gas (LNG). More than 20 projects across Europe are planned to build new or expand existing import terminals. Ministers across Europe were also busy flying around to secure new deals from major exporters like Qatar, Algeria, the UAE. Thus starts another Age of Exploration in Europe, this time for reliable energy partners.
The question remains whether the current efforts are enough to survive the winter, and whether this trend towards the green energy transition will continue.
Is the much-feared energy crisis overblown?
Despite elevated prices, gas-hungry Germany and the rest of Europe have managed to fill up their storage facilities for winter as you can see in the chart below. The self-imposed targets were 80% in Europe and even higher at 95% for Germany by the 1st of November, 2022. In Germany, storage levels were only higher in two of the last 10 years, and we still continue to see gas inflows as other exporters have picked up the slack. As of the time of this writing, Europe is in a good position to get through the winter without the much-feared rolling electricity and heating cuts.
In the next chart below, we can clearly see two spikes throughout this year. The first in February/March once the Russian-Ukraine conflict started and the second one starting in June once Russia started to cut the deliveries. Prices reached an all-high in August at almost 350€ / MWh. For comparison, the long-term average in Europe was only about 10-20€ / MWh in the last decade.
Fortunately for the continent, we have seen a huge drop in prices starting in September resulting from the above-target gas storage levels, lower demand and even warmer than usual temperatures. We also saw a huge spread between the spot rate (price today) versus the forward rate (price next month). This indicates some oversupply even as the market still prices a risk premium for the coming months. To sum it up, Europe seems to be in a pretty good position but clearly the market still anticipates potential risks like a cold snap driving up demand.
What needs to be done to accelerate the energy transition
Though the situation today appears positive, it will take another 1-2 years to fully resolve the current crisis. At the moment, the largest constraint is the missing LNG infrastructure, in particular for Germany which had no regasification terminals in 2022. As these terminals are built, they will help relieve long-term gas prices while accelerating the push towards renewables.
Investments into renewables have never been as profitable as they are now with an environment of sky-high wholesale energy prices. One could argue that cheap gas depressed the urgency for investment into renewables. More importantly, consumers are adapting — buying heat pumps and home solar panel systems in droves to replace gas heating and be more independent from fossil fuels. Our view is that it will be very unlikely that energy prices will go back to pre-war levels, and hence, the pressure and demand for those technologies will remain effectively speeding up the energy transition.
We fundamentally believe that to make this transition happen, European governments must invest even more boldly into renewables, storage and others and smart technologies which are required to manage this more decentralized future. We must further accelerate the digitalization of energy such as through smart meter installations, especially in Germany, to allow for demand response and peak shifting. The German government plans to spend 200 billion euros on relieving consumers from the financial pressure off energy bills for the winter of 2022. The same amount invested into renewables would pay dividends for decades to come.
Energy Crisis = Energy Solutions
Our view at Ostrom is that an energy crisis needs energy solutions. Fiscal, monetary and political mechanisms can and do help but improvements in energy use transparency, a smarter grid management and increased renewables capacity are why we believe in the future of the industry.
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