Will the energy crisis plunge Europe into recession?


According to the most recent Bank of America institutional investor survey 92 percent believed Europe would sink into a recession in the next 12 months. In the previous month’s survey, the figure stood at 75 percent.

A European recession would most likely come about due to the energy crisis. Recently, both electricity and natural gas prices have fallen significantly from their peaks. However, there is of course a risk that a similar episode recurs during the winter when energy demand peaks. At least the war is not showing signs of a quick end despite the recent Ukrainian successes on the battlefield.

To gain an idea of the magnitude of the energy crisis size, Blackrock estimates that before the beginning of the Russia-Ukraine war the European Union spent roughly two percent of its GDP on oil, coal, and natural gas. As energy prices peaked the figure reached nearly twelve percent, an amount larger than experienced during the 1970s oil shocks. This amounts to an enormous drain, since oil, coal and gas are mostly imported into the European Union.

Europe would be dealt a serious economic blow if the economy were forced to face such a large negative shock. Many European countries have already activated a number of economic countermeasures to ease the pain on households. The European Union has also proposed measures to combat the energy crisis. The measures include energy price cuts, tax breaks, subsidies, price ceilings and windfall taxes. These measures amount to a large dose of fiscal stimulus and shift the burden from households to energy companies and to future generations in the form of national debt.

A silver lining amidst the crisis is that the present inflation surge is melting the mountain of debt amassed by many European countries. Inflation is raising tax revenues as the price of everything is rising, which means value added taxes are rising in proportion. The increase in revenue will make dealing with rising interest rates easier.

Russia has weaponized natural gas

Russia has weaponized its energy exports. Close to 45 percent of European natural gas is imported from Russia. Russia has reduced its exports of natural gas from close to 300 billion cubic meters to below 50 billion cubic meters.

Electricity and natural gas prices have now fallen significantly. The risk is that come winter, we will see a new surge in electricity prices. To understand electricity prices, it is important to understand, that as in other homogenous goods markets, the price is set by the highest marginal cost producer that meets demand.

The supply of energy can be thought of as a curve rising in price as the mode of electricity production changes. Marginal cost is equivalent to the cost of producing a unit of power along with the carbon emissions charges. With low demand, power is produced using the cheapest power plants, such as wind power. As demand rises, other low-cost energy producers enter the fray, such as nuclear power. As demand climbs, more expensive production modes such as coal and eventually oil set the price for all energy. Hence, wind and nuclear production make large profits when they receive prices set by high-cost coal plants.

As natural gas rose to high levels the cost of natural gas plants rose, which meant higher electricity prices in many markets, because natural gas plants set the market price. Other factors meant that other forms of power production were not available. Many nuclear plants were undergoing maintenance and low water levels in the Rhine meant coal transportation problems.

The energy shock will result in structural change… again

Large shocks inevitably lead to system change. The 1970s oil shocks resulted in the West embracing fuel efficiency. In similar vein, the European economies will respond to the crisis by severing their dependence on Russian natural gas. This is a significant problem for Russia. With oil, oil tankers can deliver to alternate, Indian and Chinese, ports. Russian natural gas is mostly delivered via pipelines that run to Europe. The construction of alternate pipelines would involve both astronomical cost and time.

Europe will embrace alternatives by turning to liquified natural gas, wind power, and in some instances nuclear power. The change will be costly and involve a loss in economic competitiveness, especially with countries dependent on natural gas, but geopolitical outcomes offer little alternative.

The electricity industry is set for regulatory overhaul that is even more extensive than that seen with the financial sector after the financial crisis of 2007-2008. Both sectors are vital for the functioning of society and hence contain too big to fail players such as gas giant Uniper. Banks and quasi banks were regulated by forcing them to deploy more capital, which reduced the appeal for risk taking. Regarding the energy market, it seems that major operators in France and Germany will simply be taken over by the state. The change is hence more extreme.

European policy support will be wasted in the absence of coordination and proper design

The full gambit of policy measures runs from price ceilings, windfall taxes, tax breaks, subsidies, and demand cuts. What is crucial is coordination. If all countries simply subsidise consumers by supporting the cost of energy consumption, then aggregate European demand will not fall as much. European countries will bid for the same scarce electricity and end up footing a larger electricity bill.

Policy should be delivered lump sum benefit, which leaves the incentive to cut electricity consumption intact.

Regardless of how efficient these measures are, the will to soften the energy blow is clearly there as manifest by measure on both a national and an EU level. The fiscal stimulus should render a possible recession shallow and enable Europe to finally cut its shackles to cheap Russian energy.