by Thomas Fazi
Wednesday, 21
December 2022
Analysis
13:00

The EU’s energy price cap is destined to fail

The bloc is failing to address a crisis of its own making
by Thomas Fazi
A protest over rising energy prices in Brussels, December 2022. Credit: Getty.

After months of wrangling, EU energy ministers finally approved the first ever cap on gas prices, which is scheduled to come into force in February. The aim of the measure is to curb the crisis that has been rocking Europe over the past year as a result of gas and energy prices surging to unprecedented levels.

To understand how the cap works, it’s important to understand what is driving the energy crisis in the first place. It’s commonly thought that the spike in gas prices is a consequence of Vladimir Putin ramping up bills in retaliation for Western support of Ukraine. But that’s not how energy markets work.


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Today, the price of European gas is no longer determined by long-term semi-fixed contracts linked to the price of oil — as was the norm until a decade ago — and neither can it be unilaterally changed from one day to the next based on the whims of exporters. Rather, it is linked to the price at which gas is sold on virtual trading markets, or spot markets, such as the TTF in Amsterdam (for the EU) or the NBP in the UK, where every day hundreds of energy traders and financial operators buy and sell large volumes of gas. This means that the price of gas essentially depends on the fluctuations of financial markets.

The shift from oil-indexed contracts to spot market pricing has been a pet project of the European Commission ever since the early 2000s, in line with the European technocrats’ faith in the virtues of economic liberalisation and marketisation: the idea that market forces, if left to their own devices, will always produce the optimal outcome — and the optimal price. As a result, over the last decade spot pricing has become the norm across Europe.

As it turns out, allowing financial markets — which are notably prone to irrational behaviour, speculation and price manipulation — to set the price of an economy’s most crucial commodity, energy, was a very bad idea. This became apparent in early 2021, a year before the start of the war in Ukraine, when the price of gas traded at the TTF, to which most EU gas contracts are linked, started to climb substantially.

By the end of the year the price of European gas had reached €100/MWh — the highest ever recorded, and a staggering 1,000% increase from the beginning of the year, when the price had been around €10/MWh.

There was no economic fundamental to justify such a drastic rise. Yes, there was a rebound in energy demand due to economies beginning to reopen after lockdown, but global oil and gas production also increased compared to the previous year. And yes, the supply of Russian gas to the EU — which in 2021 accounted for around half of the bloc’s overall supply — did decline a bit in the second half of the year. To the extent that there was a mismatch between supply and demand, though, this was not sufficient to warrant a tenfold price increase.

The reality is that the main factor driving the surge in the price of TTF gas was, quite simply, speculation (which was then further exacerbated by the actual drop in supplies caused the war in Ukraine and the sanctions regime).

Enter the newly-approved EU cap, which sets the maximum price at which gas can be traded on the TTF at €180/MWh. This isn’t a cap on price-gouging by Russia (or anyone else); it’s a cap on the system of speculative trading that the EU has deliberately foisted upon its energy markets. In other words, it’s yet another case of the organisation attempting to fix a problem of its own creation. What’s worse, it’s likely to fail: not only is that price (and even the current price of €100/MWh) still a massive increase compared to pre-2021 rates, but there’s also a risk that the measure may actually lead to a drop in gas supplies. And the winter has only just kicked in.

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D Glover
D Glover
1 month ago

Good article. Thanks for explaining that.

Andrew Buckley
Andrew Buckley
1 month ago

I might be missing something but if there is a price cap as described what is the mechanism or incentive to charge less than the price cap?
And on the converse; should someone be able to get more than the EU prescribed price elsewhere where does this leave the EU getting gas from?

Matt M
Matt M
1 month ago
Reply to  Andrew Buckley

Reminds me of the UK’s student tuition fees system. They set the cap at £9500 (or something) and rather then different courses/institutions charging different fees up to the cap, they all just set them at £9500. Won’t all spot prices become E180/MWh?

Thomas Fazi
Thomas Fazi
1 month ago
Reply to  Andrew Buckley

From what I can gather, transactions above a certain price simply won’t be allowed to take place. There’s some info here: https://www.theice.com/publicdocs/Oxera_Study_into_the_Functioning_of_the_European_Gas_Market.pdf

Matthew Powell
Matthew Powell
1 month ago

It was indeed speculation that raised prices, speciation that Russia would invade Ukraine and the result would be gas supplies would be cut. Guess what, they were right. It’s entirely rational when faced with any potential future shortage to buy up as much as you can in advance and fill your storage to the max, if you think the price in the future will be even higher.

If it hadn’t been for evil speculators preparing for a potential invasion, gas supplies may have run out last winter and broken western resolve before Ukraine could have repulsed the initial Russian assault.

Last edited 1 month ago by Matthew Powell
Thomas Fazi
Thomas Fazi
1 month ago
Reply to  Matthew Powell

So speculators knew about the invasion a year in advance? Amazing foresight! They should go and work in military intelligence.

Matthew Powell
Matthew Powell
1 month ago
Reply to  Thomas Fazi
Thomas Fazi
Thomas Fazi
1 month ago
Reply to  Matthew Powell

Yeah, and meanwhile Russia (and Germany, and others) were investing huge sums of money in Nord Stream 2. The notion that speculators were moved by a rational understanding of military-geopolitical dynamics is simply a post hoc fallacy.

Matthew Powell
Matthew Powell
1 month ago
Reply to  Thomas Fazi

All major commodity traders employ or consult geopolitical analysts, it comes with the territory. Nord Stream 2 investment continued as there was no guarantee that conflict would erupt but the potential risk was certainly there and markets responded to it.

Speculation only works if you’re proven correct. Either supply falls or demand rises, as predicted. If this doesn’t happen, then the speculator makes a loss, having bid up the price they are unable to sell at a profit. It’s not a good strategy.

Thomas Fazi
Thomas Fazi
1 month ago
Reply to  Matthew Powell

You’re assuming it was a rational hedging strategy based on supply/demand. But prices kept rising for a year with little correlation of supply/demand. Besides some countries (UK) don’t even import Russian gas, while others (like Italy) even increased Russian gas imports for a long time. And if it was all about supply/demand, US LNG should be trading at much lower prices. There’s simply no case for using ultra-volatile financial markets for pricing crucial commodities. Seems pretty clear the old long-term contracts system was better in every respect.

Matthew Powell
Matthew Powell
1 month ago
Reply to  Thomas Fazi

You’re right, prices were not moving in line with supply demand in terms of usage, they were moving in line with extra demand caused by buyers filling their storage sites at a faster rate than usual because of the potential of Russia severely curtailing supply or ending it all together. It’s the threat of this which drove up prices but this was an entirely rational fear, one which the market is perfectly justified in reacting to.

With regards to the idea that because some countries, like the UK, don’t buy directly from Russia, it shouldn’t affect them, that’s not how markets work. The countries who lost or feared loss of supply from the Russians, are bidding for gas from other suppliers, who are unable to increase supply in relation to this extra demand, driving up the global cost. If you removed or threaten to remove a significant proportion of global supply, prices will rise, regardless of where you source the gas from.

Would a return to the the old system be better, I don’t know, but there’s nothing irrational about how markets have reacted to the energy crisis.

B Emery
B Emery
1 month ago
Reply to  Matthew Powell

I think I agree here – regarding the reaction the market, from the latest imf report, it backs up much of what you say:
The market would adjust to gas supply disruptions by accessing new supplies where feasible, using alternative
sources of energy, and via demand reductions. In 2021, the EU imported around 155 bcm of gas from Russia,
while Türkiye and the UK imported around 16bcm and 3bcm, respectively. Our analysis suggests that, in
aggregate, there is scope for Europe to reduce this reliance considerably in 2022, with further gains likely
beginning in H1 2023.

Executive Summary

Russia’s invasion of Ukraine has placed natural gas supply in Europe at risk. Russia has been Europe’s largest supplier of natural gas and distribution networks are geared towards Russian supply. Russian pipeline
flows to Europe have been dropping since the second half of 2021 and following recent cuts in deliveries,
Russian exports to the EU are now down roughly 60 percent compared to June 2021. As of early July, Russian
gas has ceased or been significantly reduced to a growing list of countries, beginning with Poland and now
including the Netherlands, Germany, Austria and Italy, among others.
Fully replacing Russian gas imports may prove difficult in the short-term. So far, Europe has been able to
offset reductions in Russian deliveries and build up storage to reach average historical levels in June. However,
with the recent reductions in deliveries the situation has escalated further. Alternative gas and power sources—
including higher non-Russian pipeline gas imports, an increase in LNG imports and fuel energy switching in
power generation—could likely replace some two-thirds of Russian gas over the next 12 months. Nevertheless,
there is uncertainty about global supply, and countries’ and firms’ ability to switch between energy sources.
Moreover, transmission constraints limit the ability to transport gas from alternative sources across some
regional distribution systems and even within some countries, leaving several countries in Central and Eastern
Europe, including Germany, and Italy, which are heavily reliant on Russian gas, particularly vulnerable.
Demand compression in response to high energy prices will help reduce supply gaps. On aggregate, Europe
could avoid shortages if Russian deliveries continue at the current reduced levels or in the event of a temporary
but full disruption through the summer. A full and longer disruption through the peak winter season, however,
could lead to costly regional shortages, very high prices, and rationing in some countries.

https://www.imf.org/-/media/Files/Publications/WP/2022/English/wpiea2022145-print-pdf.ashx

Last edited 1 month ago by B Emery
B Emery
B Emery
1 month ago
Reply to  B Emery

Would also say, I can’t find it again now, but I read an article the other day that said the energy market is very herd like, and at the moment it reacts with great volatility to every new piece of news, it was being discussed as a problem, you could probably track each big headline gas development to the UK gas market graph if you had time…
Being electricians people keep asking us if they need to buy a generator, why there electric is so much, forgetting we just fit the gear 🙂 I try to keep up if I can….
Regarding us lng
https://www.google.com/amp/s/oilprice.com/Energy/Energy-General/US-LNG-Production-Declines-Despite-Robust-Demand.amp.html
I agree with Fazi that the markets are big problem though, I see that point he’s making, us lng is making big money off this, and there is the argument that big oil has big money with which I dare say it could throw around in such a way as to fuel the volatility. Opec is pressuring the oil price up at the moment simply by failing to raise production for example.
The derivatives thing is never mentioned or discussed and is an enormous problem with the electricity price ill share one more time, by yaris varoufakis the ex greek chancellor guy Greek financial crisis fame.
https://m.youtube.com/watch?v=NicE0-N9ux0
Also there is much evidence suppliers are taking advantage, vitol is a recurring name:
https://www.rigzone.com/news/wire/vitol_threatens_gas_halt_in_1_billion_standoff_with_germany-05-nov-2022-170957-article/?rss=true
https://www.bloomberg.com/news/articles/2022-12-12/vitol-s-uk-gas-power-plant-cashes-in-on-low-wind-at-cost-to-consumers

Steve Elliott
Steve Elliott
1 month ago

I don’t understand how it would work either. It says that they will cap the price at which gas is traded on the TTF. So who is buying and selling in that market? Would it be the case that the sellers might just sit on it? If the going rate was less than the cap then the things would operate normally but if the going rate reached the cap then the sellers might just say “Not for sale” and walk away. I don’t understand how the market works.

Matthew Powell
Matthew Powell
1 month ago
Reply to  Steve Elliott

It’s a buyers cartel. If the price does hit that amount, then the seller either must accept that price or find an alternative buyer. Since Europe is a major consumer, it’s gambling that the the price cap is high enough that sellers won’t be able to find significant alternatives to sell to in the developing world and won’t retaliate by refusing to sell to them at all. Better take the reduced, but still very high price, than have to find new markets or find viable storage.

B Emery
B Emery
1 month ago
Reply to  Steve Elliott

Posted some links above, bit more info, this is from the first one:

Under the current proposal, the EU price cap would not fall below €188/MWh, even in the event that the LNG reference price falls to far lower levels. However, the EU gas price cap would move with the LNG reference price if it increased to higher levels, while remaining €35/MWh above the LNG price. This system is designed to ensure the bloc can bid above market prices in order to attract gas in tight markets.

Once triggered, the cap will prevent trades being done on the front-month to front-year TTF contracts at a price higher than €35/MWh above a reference price that comprises existing LNG price assessments.

Thomas Fazi
Thomas Fazi
1 month ago

A few people are asking how the price cap would actually work. From what I can gather, transactions above a certain price simply won’t be allowed to take place. There’s some info here: https://www.theice.com/publicdocs/Oxera_Study_into_the_Functioning_of_the_European_Gas_Market.pdf

Steve Elliott
Steve Elliott
1 month ago

Who pays for the EU price cap or is it just absorbed by the traders? Will it affect the prices we pay in the UK?
When the price cap was reduced in the UK they were saying that it would cost the country X billions of pounds. I don’t know how it works but presumably the energy companies were forced to keep their prices to the consumers below a certain level. I assume that the energy companies were compensated by the Government which is where the cost to the country came from. If that is the case and if the EU price cap comes at no cost to the countries involved then doesn’t that mean that the EU price cap mechanism is better?

Brian Villanueva
Brian Villanueva
1 month ago

Why would smart, wealthy people be speculating on a rise in the price of natural gas in mid-2021? Could it be that energy traders and speculators were looking ahead and pricing in future risk vis-a-vis Ukraine and Russia? The intelligence agencies all missed this call, but markets often make better calls than experts.

Simon Humphries
Simon Humphries
1 month ago

I’m sure there are many speculators in the gas market. But, at the beginning and end of the chain, is a physical seller and a physical buyer and the laws of supply and demand operate. Speculators may well be able to influence the market in the short term, but it is unlikely that the fundamentals will be defied over a two year period. Nor is any cap likely to survive a tightening market.

trevor fitzgerald
trevor fitzgerald
1 month ago

Has a price cap ever addressed a supply side shock? Don’t we need the price action to refocus EU trade offs on Dutch and Irish gas?

Rocky Martiano
Rocky Martiano
1 month ago

I can’t recall any instance of a price cap working in any commodity or any market. They simply eliminate price discovery based on supply and demand and cause market distortions. Why would producers whose cost of production is higher than the cap sell at a loss? And you are right in saying that it will likely lead to a drop in supplies.
As it only applies to European markets, what is to stop any EU country that finds itself short of supply going and buying gas elsewhere? This would in all likelihood be at a higher price than the cap, due to the mad scramble to replace Russian supplies on world markets.