Can Europe's Industrial Sector Survive Without Russian Gas?
16 MIN READNov 3, 2022 | 17:43 GMT
EU efforts to shore up energy supplies and reduce consumption have lowered the likelihood of natural gas shortages in Europe between late 2022 and early 2023. But sustained high energy prices and demand destruction will likely hurt Europe's economic growth and industrial competitiveness in the medium-to-long term. EU countries approved on Oct. 20 a new package of emergency energy measures aimed at addressing the bloc's energy crisis, the fourth since Russia's invasion of Ukraine. EU leaders agreed on an emergency brake on price spikes through a dynamic price corridor — allowing the European Commission to work on the development of a new gas price benchmark tied to liquified natural gas (LNG) prices in the meantime — and to explore the temporary use of a price cap on gas used in electricity generation. Countries also agreed on a voluntary plan to jointly purchase gas and increase leverage in negotiations with global gas suppliers and on measures to increase energy savings, alleviate liquidity stress and price volatility in energy markets, increase energy solidarity in case of gas supply shortages in the absence of bilateral agreements, and simplify permitting procedures to accelerate the roll-out of renewables.
In May, the European Union unveiled 210 billion euros worth of measures aimed at reducing the bloc's reliance on Russian fossil fuels. To ease the impact of higher prices on households and businesses, Brussels also unveiled gas demand reduction targets In June, followed by windfall taxes on energy producers in September.
As part of the new package of energy measures announced on Oct. 20, member states agreed to pursue the creation of a new LNG price index that would help separate imported gas from the Dutch benchmark, Title Transfer Facility (TTF), by March 2023. TTF is traditionally dominated by pipeline gas transactions, the vast majority of which previously came from Russia and have since been replaced by LNG.
Member states have also tasked the European Commission with compiling a proposal for a ''temporary framework to cap the price of gas in electricity generation,'' which will include a cost/benefit analysis. This is the result of a compromise between EU members on the controversial issue of capping natural gas prices in the bloc. Most countries (including France, Italy, Spain, and Poland) have been pushing to enact such an EU-wide price cap in order to mitigate skyrocketing energy costs. But Germany and other countries have been more skeptical — fearing market interventions could endanger the security of the bloc's energy supplies by reducing European buyers' ability to outbid competitors in the increasingly tight global gas market. While Germany and other like-minded countries agreed to have the commission draw up a potential price cap, they could still veto the final proposal.
Under the new measures, joint purchasing will be voluntary, with a requirement for 15% of the volume needed to fill gas storage to be bought as a bloc.
In recent months, Europe has reduced its reliance on Russian gas by increasing gas storage levels, switching to alternative sources of energy, diversifying supply, and reducing overall gas consumption. Europe's energy supply crunch has intensified in the past month. In late September, suspected sabotage attacks damaged both of the Nord Stream pipelines that supply Russian gas to Europe via the Baltic Sea, dashing hopes that gas flows would increase anytime soon after Moscow took Nord Stream 1 offline in September in retaliation against EU sanctions. Prior to the war in Ukraine, 40% of the natural gas consumed by EU countries was supplied by Russia through the Nord Stream and other pipelines. That percentage has since dropped to just 9%, with Europe now only receiving limited amounts of contracted Russian gas via the pipelines in Ukraine and Turkey. Despite this, Europe looks increasingly prepared to withstand a winter without Russian gas, as reflected in the market by five consecutive weeks of falling prices. This is due to ongoing efforts to increase gas storage levels on the Continent, switch to alternative sources of energy, diversify supply, and reduce overall gas consumption (and with significant help from unseasonably warm October weather).
Storage: Gas storage facilities are now around 95% full. This should ensure a relatively well-supplied winter, provided that non-Russian supplies remain stable and that Europe doesn't experience colder-than-usual weather.
Substitution: Europe's consumption of coal in electricity generation increased significantly in 2022, mostly to compensate for significantly lower hydropower and nuclear electricity generation. Rising flows of crude and oil products (mostly diesel) from Asia and the Middle East are supporting the gas-to-oil switch in Europe before a ban on Russia's seaborne crude oil enters into force in December, followed by a ban on Russian oil products in February 2023. Germany decided to keep its 3 nuclear reactors running until April 2023 and Belgium postponed the closure of two of its reactors. Other countries are accelerating nuclear development plans as well.
Demand reduction: EU countries so far have agreed on a voluntary target to cut natural gas and electricity consumption by 15% and 10%, respectively, and a mandatory reduction target of 5% for electricity consumption in peak hours through March 2023.
Supply deals: Pipeline gas and LNG supplies into Europe from Azerbaijan, North Africa and Norway have increased since the start of the war in Ukraine, but remain far below those Russia used to provide. Italy has been the most active European country in this sense. New supply deals will bring an additional 24 billion cubic meters (bcm) of natural gas to Europe in 2022, 10 bcm in 2023, and 64 bcm in the next few years, according to estimates from the Bruegel think tank.
New infrastructure: Europe has been expanding the infrastructure needed to import more gas. Germany leads the way in floating storage regasification units (FSRUs) capacity additions, providing Europe with roughly 10 bcm/year of new regasification capacity by 2022, and 50 bcm/year by 2024. Countries are also building new gas pipelines, with new interconnectors already coming online in 2022. The 10 bcm/year Baltic Pipe connecting Norway to Poland via Denmark came online on Oct. 1. Other projects will also come online in the next few years, with Poland commissioning a new pipeline connecting its network and LNG terminals with Slovakia in August and asking for EU funding to finance a new gas link with the Czech Republic in September. Spain, Portugal, and France agreed on Oct. 20 to build a new hydrogen/natural gas pipeline connecting Barcelona to Marseille.
Renewables: The European Union announced the REPowerEU package less than two weeks after Russia's invasion of Ukraine, aiming to make Europe independent of Russian energy supplies by 2030. Renewables will play a key role in this strategy. EU countries have accelerated renewables deployment, particularly by setting up investment schemes in renewable energy projects and simplifying rules and tender procedures. However, it will likely be months before these measures start having a meaningful impact on Europe's energy supplies.
With short-term supply-side solutions largely exhausted, Europe will now mostly focus on coordinated demand reduction to decrease the likelihood of gas shortages this winter. The European Union's close-to-full gas storage, combined with unseasonably warm weather and lower natural gas consumption, is easing immediate concerns over the security of the bloc's energy supplies. Reducing demand, however, will be key in ensuring EU states have enough gas to get them through the winter without leaving people and businesses in the cold, given Europe has now largely exhausted its short-term alternatives to Russian energy exports. Although changes in consumer behavior (such as lowering heating in private and public buildings) have helped, the recent drops in Europe's energy usage are largely being driven by falling industrial consumption. By decoupling from Russian gas, Europe is upending its industrial model based on cheap and reliable energy supplies, with impacts likely to reverberate across the Continent's economy for the foreseeable future.
Several European governments have mandated or recommended measures to reduce energy consumption across public and private organizations, but higher prices are also incentivizing households and commercial businesses to cut back consumption.
Natural gas prices in Europe are still more than three times higher than the period's previous five-year average, but they have fallen more than 70% below the peaks seen in August, when they soared above 300 euros per megawatt-hour.
While LNG will remain the main alternative to make up for losses in volumes from Russia, only a handful of FSRUs will be operational by the end of the year, which means that the risk of insufficient supply during the winter will persist.
In case of a complete cut-off from Russian supplies, the European Union would need to reduce natural gas use by 13% over the winter to avoid energy shortages, according to the International Energy Agency's (IEA) latest quarterly gas report.
In the short term, while full storage and energy-saving plans are reducing the risk of winter shortages, gas rationing may still prove necessary given tight supply-demand balances. While looking increasingly prepared to withstand the coming winter, Europe continues to face serious challenges amid minimal Russian gas supplies and competition from Asian buyers on the global market for expensive LNG shipments. Global gas supplies will remain tight through the winter, which means prices will also remain high and volatile. Any additional disruptions that affect this already extremely fragile supply-demand balance could still force countries to impose rationing measures in the coming months. Central and Eastern European countries — which are particularly reliant on Russian gas and have few alternative supply sources — would be hit hardest by such measures, though any eventual gas rationing would also be painful for Italy, Germany, and Austria due to their high reliance on gas for heating, industry, and electricity production. In such a scenario, energy-intensive sectors would be the most affected. But even without rationing, high gas and electricity prices will continue to threaten Europe's manufacturing base, with disruption in gas-intensive sectors affecting industries down the value chain that, whenever possible, will have to source substitution inputs for chemicals, steel, and other basic products from outside the European Union. Even less energy-intensive companies in the manufacturing sector will face increased supply chain risks if their suppliers are heavy gas users. More broadly, most European corporate sectors will be affected by the overall economic downturn affecting the Continent as high energy prices negatively impact demand for goods and services by reducing consumers' purchasing power.
Any unforeseen event that further disrupts global gas supplies or increases demand could easily drive prices up and create more shortages in the months ahead. A colder-than-expected winter in Europe, for example, could increase domestic energy usage, eating into the Continent's gas stockpiles. But a colder-than-expected winter in Asia could also impact Europe's supplies by increasing competition for global LNG volumes. Any non-Russian supply disruption (for instance in the North Sea or the Atlantic due to adverse weather events) could create more global supply and price shocks as well.
While not all European regulators published details on the rank of order and gas volumes that would be made available to each sector in case of shortages, under emergency protocols in most countries, households and critical infrastructure would be allocated energy ahead of industrial operators.
In the medium term, as prices will remain high and supplies limited while replenishing stocks could be an even bigger challenge, demand destruction will continue to hurt economic growth. Europe's energy markets are set to remain tight over the next couple of years. The Continent is expected to enter March 2023 with exceptionally low energy supplies after heavily depleting its stockpiles during the cold winter months. And Europe will likely struggle to replenish its reserves for the next couple of winters as well, due to very limited access to Russian gas, only marginal gains in non-Russian import capacity, and a recovering Chinese demand exacerbating competition for LNG. This means that continued demand destruction across the Continent is probable through at least 2024, when significant new supply becomes available. Switching to alternative and/or renewable energy sources, along with price-driven drops in household consumption, will help Europe endure this period of reduced gas supplies. But while these limited gains in demand reduction will help ease natural gas prices in Europe over the next year, most of that easing will continue to come from lower industrial consumption. Energy-intensive sectors will have to continue reducing output or halting operations altogether, with knock-on effects on economic growth that will deepen the recession Europe is already expected to enter next year and prevent any strong recovery until 2024. This, in turn, may lead to significant job losses and increase the risk of social unrest in European countries. Slower growth and high prices will also put further strain on public finances across Europe, with governments keeping financial support for households and businesses and bailing out struggling utilities and insolvent companies to prevent a wave of bankruptcies, which will push debt levels higher amid rising borrowing costs and raise concerns over debt sustainability.
With Europe's non-Russian import capacity increasing only marginally, the installation of five FSRUs in Germany and one in Italy will account for the biggest increase in supply until March 2023. But competition for limited LNG will not ease until 2024.
Europe's gas storage units are typically 20% full at the end of an average winter season. But without imports of Russian natural gas that would normally continue throughout winter, storage levels are set to near zero by March 2023. In preparation for next winter, the European Union is aiming to have 95% of its gas reserves filled by November 2023. However, given the expected depletion of supplies this winter, hitting that target will require the bloc to purchase 20% more gas than in previous years, which Brussels will have to achieve without its once largest supplier: Russia.
In a report published on Nov. 3, the International Energy Agency (IEA) said the European Union would face a supply-demand gap of about 30 bcm this summer, in case of both a complete cut-off of the bloc's Russian pipeline gas supplies and a recovery of Chinese LNG imports to 2021 levels. According to the IEA, such a gap could represent almost half the gas needed to meet Brussels' 95% storage target by the start of the 2023-24 winter heating season.
In the long term, Europe's supply diversification, demand destruction and high energy prices may negatively impact the Continent's competitiveness in energy-intensive industrial sectors. While infrastructure development and long-term LNG supply deals will ensure that Europe receives adequate supplies of non-Russian energy in the future, energy supplies to the Continent will remain more expensive than they have been for the past few decades if Europe does not restore its pre-war energy relationship with Russia once the conflict in Ukraine ends (or freezes). Sustained higher input costs risk making European products less competitive compared with their North American or Asian equivalents, particularly in countries that utilize high amounts of gas in industry and/or power generation. Prior to its energy crisis, Europe was able to undercut Asian countries, which were forced to import LNG, by using cheap Russian energy, but since Europe is now also reliant on LNG imports , that competitive advantage has disappeared. Some industrial players with operations in Europe will have to decide whether to maintain lower production, operate at lower margins, shut down or relocate. However, European manufacturers have long operated at a competitive disadvantage against peers in the United States, where gas prices have been on average two to three times cheaper than in Europe for the past decade, without facing deindustrialization or large losses in market share. This indicates that while increased energy costs will create headwinds for European industries, they will not lead to a complete deindustrialization of the Continent.
Europe's industrial base employs about 35 million people, which is roughly 15% of the Continent's total workforce. However, according to research firm Rhodium Group's estimates, 81% of industrial gas consumption in the European Union is concentrated in five energy-intensive sectors — refining and coking, chemicals, basic metals (iron and steel), non-metallic mineral products (mostly serving the construction sector), and paper — that together account for only a modest share of overall economic value (3%) and employment creation (2%). While relatively small compared with other manufacturing sectors, these industries still directly employ millions of European workers and create annually several hundred billion euros of economic value, especially considering the value and jobs generated from associated supply chains.
Germany's BASF, the world's largest chemicals producer, announced on Oct. 26 that it would need to ''permanently'' reduce its costs and operations in Europe due to high energy prices, high regulatory standards and an increasingly sluggish chemicals market.
In absolute terms, Germany's economy will see the largest losses from reduced industrial production, as the country alone accounts for a quarter of all industrial gas demand in the European Union. However, the impact will be higher in countries and regions that place more importance on gas-intensive sectors in the overall economy and employment, such as Austria, Belgium, Bulgaria, the Czech Republic, Finland, northern Italy, Poland, Romania, Slovakia, Slovenia and Sweden.
Persistently high energy prices and dual-use development infrastructure will, however, also incentivize a quicker deployment of renewables, while likely EU carbon tariffs will partially offset incentives for delocalization. While current emergency responses to the energy crisis are likely to crystallize natural gas demand in Europe until at least the late 2020s or early 2030s, they are also accelerating the Continent's transition to low-carbon energy sources. As part of Europe's strategy to phase out Russian fossil fuels, a roll-out of renewables at scale will start replacing coal and oil (and then eventually natural gas) once the emergency is called off, probably around 2024. Most current projects to expand Europe's natural gas infrastructure (i.e., import terminals and pipelines) are dual-purpose, meaning that infrastructure could be repurposed for the transport and storage of hydrogen. This would commit the Continent to natural gas only for the duration of long-term LNG supply deals that its countries are signing now. By the time those contracts expire, hydrogen technology may have become an economically viable alternative to natural gas in powering energy-intensive industries, particularly considering the likely implementation of an EU carbon tariff currently set for 2026. Additionally, by the end of the 2020s, high prices will have incentivized larger companies with the financial resources to operate at a cost disadvantage while accelerating energy-transition plans to pursue technological innovation that will eventually make it advantageous again to produce in Europe.
Global green energy investment is set to rise to more than $2 trillion a year by 2030, up by 50% from present levels.
The EU Carbon Border Adjustment Mechanism has the potential to act as the most significant balancing force against European deindustrialization, as it would add costs to offsetting production in regions where carbon emissions reduction requirements are looser for goods exported to the European Union.
