Good news - and goodbye cheap energy

30 January 2023

The European economy seems to have dodged a very big bullet. Russia’s invasion of Ukraine created a very real risk of widespread energy shortages, blackouts and a deep recession in Europe. None now seem likely. This week’s briefing explains why – and why rejoicing is not in order.

Europe has avoided blackouts so far and seems likely to avoid gas shortages this winter. Instead of running out of gas, EU storage capacity is more than 80% full, a record for January, and almost twice the levels seen this time last year. Storage levels in Germany, which was heavily dependent on Russian gas, are close to 90%.

Lower energy demand and a surge in imports of liquified natural gas (LNG) have helped Europe manage the energy price shock. Luck and judgement, in the guise of weather and adaptation, have saved the day.

Unseasonably warm weather has significantly dampened demand for energy. At the start of the year, eight European countries experienced record January temperatures, by wide margins. In Bilbao temperatures of 25°C eclipsed average temperatures for January by 10°C. Warsaw hit 18.9°C, 5°C above the previous record.

Higher energy prices and the risk of shortages have spurred innovations in energy efficiency. Governments have pushed energy-saving measures, with the German government, for instance, limiting the maximum temperature in offices to 19°C. High prices have driven some energy-intensive operations in areas including fertilisers, chemicals and paper production, out of Europe.

Together, these factors reduced demand for gas in the EU27 by over 20% in the final quarter of 2022 on a year earlier. Things have changed on the supply side too. Europe has reduced its use of Russian gas by over 80% in the last year. The gap has been filled by imports of LNG, by reviving idled coal-fired power stations and by extending the life of nuclear plants. Hydropower and wind generators have recently benefited from improved weather conditions and French nuclear plants, which were turned off for maintenance for much of last year, are returning to the grid.

The most intense phase of the energy crisis may well be past. Energy prices are off their summer highs, with European gas prices at a sixth of August’s peak. The oil price is down roughly 30% since last March. Lower energy prices are feeding through into lower levels of consumer price inflation.

And that, pretty much, is where the good news stops. Energy prices seem likely to remain high. We will probably have to live with elevated energy prices for the foreseeable future.

Despite recent reductions, European gas prices remain high by pre-pandemic standards. The current UK price stands at £1.40 a therm, rising to £1.80 next winter. This compares with an average price of under £0.50 a therm between 2015 and 2019.

In response to Russia’s invasion of Ukraine, Europe has chosen to replace Russian pipeline gas with pricier LNG. LNG has to be liquified before being exported from countries such as Qatar and the US, then shipped to Europe before being turned back into gas at regasification plants. Unlike pipeline gas, LNG is a tradeable good, and Europe is buying much of its imports in the Asian market where demand is strong and, with China’s reopening, increasing. No major new sources of gas are likely to emerge this year. Indeed, Russia could yet turn off the remaining flows of gas to Europe.

Markets do expect gas prices to ease back eventually. But even by 2025 markets are pricing gas at £1.10 a therm, more than twice pre-pandemic levels. Much the same picture holds in relation to the oil price.

Two further factors are likely to bolster energy prices.

First, governments cannot afford to keep subsidising energy bills on the scale they did last year. In the EU, some governments have spent the equivalent of over 7% of GDP shielding businesses and households from rising energy costs. This is unsustainable.

In the UK the average consumer faces a 20% increase in their energy bills this April as subsidies wind down. For UK businesses the cap on bills is being replaced by a discount scheme that will mean an even larger increase in energy costs from April. The Federation of Small Businesses says that about one in four small businesses will have to close, downsize or restructure as a result of the April “cliff edge” in energy prices.

The second reason why high prices are here to stay relates to the cost of energy transition. The marginal cost of renewable energy is, in theory, low, but the investment, in generation capacity, storage and distribution, needed is enormous. The International Energy Agency (IEA) estimates that global energy investment needs to rise from a current $2tn a year to $5tn a year by 2030 for at least 20 years to reach net zero CO2 emissions by 2050. Governments will pick up some of these costs (America’s $369bn Inflation Reduction Act, which provides generous subsidies for businesses in the US to invest in batteries, solar and wind turbines, has stoked tensions with the EU which sees the package as anti-competitive and discriminatory). But the scale of the spending needed is beyond governments and will require consumers to contribute too. Regulators in sectors such as water and energy already link charges to investment levels. The shift to renewables is likely to be financed in a similar way.

We have become used to relatively cheap and plentiful energy. In the US the share of consumer spending accounted for by energy costs has dropped from a peak of 6.0% at the time of the second oil shock, in 1980, to an all-time low of just 1.4% in early 2020. The era of ever declining energy costs seems to have passed. The transition to a clean, secure energy is a vital and hugely costly endeavour. Users will need to pay for it.

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 0.1% at 7,765.

Economics

The US economy expanded by a better than expected 0.7% quarterly growth in 4Q 2022, driven by strong consumer spending on services. Activity in housebuilding fell sharply as the sector felt the impact of higher interest rates
Amid signs that US inflation has peaked the Federal Reserve is widely expected to slow the pace of rate increases by raising rates by 25bp at its meeting on Wednesday
The Bank of England is expected to raise rates by 50bp to 4.0% when it meets on Thursday
Business confidence in Germany surged in January, according to the Ifo Institute, adding to more optimistic view of the 2023 outlook
The prices of copper, zinc and tin have risen by more than 20% in the last three months on expectations of stronger Chinese growth
A number of US banks warned that a political fight over raising the US government’s debt ceiling is a key risk for the US economy this year
The number of court orders against companies with unpaid debts in the UK rose by 52% year on year in the last quarter of 2022 with firms in the hospitality, construction and real estate sectors worst hit
UK chancellor Jeremy Hunt pledged stability over tax cuts to businesses and said that “the best tax cut right now is a cut in inflation”
Mr Hunt also confirmed that the UK’s High Speed 2 railway would stop in central London following reports to the contrary
The UK government borrowed £27.4bn last month, the highest borrowing in December since comparable records began in the early ‘90s as debt interest and spending on energy support schemes soared
Investors are buying emerging market debt and equity at their fastest pace in decades excluding the latter stages of the pandemic
Brazil and Argentina announced ambitions to adopt a common currency. Such a move would be likely to take many years
South Korea’s national pension fund forecasts that it would run out of money by 2035, highlighting the demographic challenges the ageing economy faces
The number of cars produced in the UK fell to its lowest level since 1956 due to supply chain shortages and the closure of a number of plants in recent years

Business

Banks are planning to fire tens of thousands of staff following a fall in investment banking revenues, the FT reports
Rolls-Royce’s new chief executive Tufan Erginbilgic said that the company’s performance was “unsustainable” and added “this is our last chance” as he announced a transformation programme
The UK government proposed new legislation that would make failure to prevent fraud and money laundering an offence for businesses
Rupert Murdoch has dropped his plans to combine Fox and News Corp following resistance by shareholders
Walmart revealed it would raise its minimum wage in US stores from $12 to $15 from March as it struggles to recruit staff in a tight labour market
The US Department of Justice sued Google for alleged monopolistic dominance of the digital advertising market
European fusion power start-up Marvel Fusion is under pressure from investors to move to the US to take advantage of the $1.4bn in US government funding available for fusion energy. European leaders have been critical of US subsidies for green power on the grounds that they may disadvantage European companies
Staff at an Amazon warehouse in Coventry, UK walked out in a dispute over pay, a first in the UK
UK regional airline Flybe ceased trading and cancelled all flights. The BBC reported that Ryanair and EasyJet are seeking to hire Flybe staff

Global and political developments

Following significant pressure, Germany announced it would send modern Leopard 2 tanks to Ukraine and allow exports of the tank by allies to Ukraine. The US will also send its Abrams tanks
US defence contractor Lockheed Martin said that it was “going to be ramping production on F-16s” to allow it to backfill any country that sends the advanced fighter jet to Ukraine. No country has yet committed to doing so
Former US president Donald Trump appeared at campaign events as he makes an early start in seeking the Republican nomination in presidential elections next year. No other Republicans have yet announced they will run

And finally… an investigation by New Scientist published last week found that two water companies in the UK are still using the scientifically discredited method of dowsing to detect leaks. Dowsing uses twigs or metal rods to receive ‘transmissions’ from the underground water – an act of rod

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