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The energy crisis in Europe and the ensuing cost-of-living crisis are Russian President Vladimir Putin's two most powerful weapons in his conflict with the West. Russia has had a massive setback in the kinetic war in Ukraine after Kyiv’s stunning counter-offensive retook all of the Kharkiv Oblast and is now driving into the Luhansk region. But Putin’s hand in the economic war seems to be much stronger.
Soaring food and energy prices have rammed up inflation and are hitting the average European hard in the pocket. A rash of public protests in Albania, Prague, Cologne and most recently in Moldova show the public are starting to feel the pain, but so far all these protest have either happened in very poor countries, where the rising cost-of-living has pushed millions of people into poverty, or they were organised by fringe pro-Russian elements. However, as winter approaches the danger is that the pain will bite deeper and discontent will become more widespread.
Support for the Ukrainian cause remains very high, but the danger is that if life becomes too expensive then that support will fade. And it’s not just a question of driving up prices, but keeping them high. More insidiously, the “massive package” of sanctions introduced in the first weeks after the invasion of Ukraine were, according to European Commission President Ursula von der Leyen, not a diplomatic tool, but a weapon designed to degrade the Russian economy. The goal of Putin’s economic warfare is to inflict the same sort of damage on the EU and there is already talk of Germany’s economic model – cheap gas used to make high quality export products – being wrecked, although it remains far too early to know.
The West is fighting back, spending hundreds of billions of euros on relief packages. The EU last week announced a €140bn windfall tax on energy companies to provide funds and governments are spending heavily on subsidies or introducing price caps on power in an effort to prevent the lights going out in Europe this winter. That spending has also seen commodity prices tumble, including many fuels like gas, but others, like coal, stay at record highs and all of them remain well above normal.
“Fiscal support to protect households and businesses from sky-high energy prices generally amounts to around 2-3% of GDP across Central and Eastern Europe,” says Nicholas Farr, an EM economist with Capital Economics. “This will cushion, rather than fully offset, the hit to real economic activity from the energy crisis, which is why we still expect a sharp regional slowdown and for some economies to fall into recession.”
Businesses continue to downgrade their expectations for the global economy. On average, respondents of an Oxford Economics survey released on September 20 judge there's a 47% probability of a global recession over the next 12 months.
“The risk of stagflation is also rising, according to businesses. Respondents see more than a 1-in-5 chance of a high-inflation regime scenario materialising. The perceived odds of more severe energy market disruption, including a rationing of natural gas in Europe, are even higher,” Oxford Economics said in a note.
So just how bad can it be? bne IntelliNews took a look at some key factors with a series of charts.
Inflation is the most damaging of Putin’s weapons, as it hurts everyone, and the poor the most of all.
As the dynamic chart shows, most of Western Europe had inflation under control in 2020 with rates higher in CEE but still well within acceptable boundaries. Rates started to rise during the pandemic and then were given a boost by the strength of the post-coronavirus (COVID-19) recovery. But it wasn’t until the start of this year that central banks lost control, forcing the European Central Bank (ECB) to hike its prime rate by 75bp for the first time ever in September, and economists say the tightening cycle in most of Central and Western Europe is far from over.
Inflation is soaring to multi-year highs nearly everywhere. At the extreme in Moldova it is over 30% and Ukraine it was up to 23% in August, despite the fact that the National Bank of Ukraine has put in place an emergency 25% prime rate and the NBU was the very first central bank in CEE to start hiking rates more than a year ago. In most of Central Europe inflation is well into double digits and even in Western Europe it is either already in double digits or about to go into them. Eurozone inflation was confirmed at 9.1% y/y in August in the second reading, up from 8.9% seen in July and above market expectations.
“The composition [of August’s inflation] follows the same old story – energy and food prices combined contributed almost 70% to the headline number, despite representing only around 30% of the consumption basket. Energy prices slowed further from their June peak but remained very high at 38.6%. Food prices meanwhile jumped further up to 10.6% with a 1% month-on-month increase,” says Oxford Economics.
A few countries like Czechia and Russia seemed to have reached their apex, but for most the best economists have to offer is to hope there is a really bad recession that will destroy demand and bring prices down again.
“There's little sign of slowing demand having any tangible effect on prices yet, although we expect demand pressures to abate more sharply as the economy enters a recession over the winter,” Oxford Economics said in a recent note. “However, with supply pressures remaining rife and the continued pass-through of the high commodity prices into core inflation, the risks of higher underlying inflation persist… We expect a 50bp hike at the [ECB’s] September meeting with an outside chance of a larger move.”
Surging energy and food prices are still the key drivers, but price pressures continue to pass through to core inflation as well, which is now at 4.5% in Europe, says Oxford Economics.
“We expect inflation to remain very high over the coming months and to only start moderating substantially in 2023, but less so than we previously expected as a result of higher for longer energy prices. We've highlighted Italy as being particularly susceptible to the volatility in gas prices and potential shortages due to little to no reduction in gas demand so far,” Oxford Economics added.
Food price inflation: index with 2015 equal to 100
Along with food, power is the biggest contributor to inflation. While many of the food prices remain elevated – wheat up 21.1% year on year in August, potatoes (52%, corn (28.6%), eggs (76.4%) – most prices for things like meat, poultry and fish are back to normal. Not so power. There prices are up ten-fold from the five-year average and many are still double their price from a year ago. And with gas disruption likely to continue all winter, the prospect of power prices falling in the near term is limited.
CEE is the most vulnerable to surging energy prices as many countries in the region remain heavily dependent on Russian oil and gas. But Western Europe is also vulnerable. As things like fuel and power are commodities, if the prices rise in one country, they rise in all countries. Price inflation is extremely infectious.
“Europe’s energy crisis deepened in recent months as Russia cut gas supplies through the NS1 pipeline and wholesale TTF gas prices briefly surged above €300/MWh in August. Prices have fallen sharply this month to €200/MWh on the back of high gas stocks as well as expectations for weaker demand in the winter and greater intervention by the EU. But wholesale gas and electricity prices remain 10 times higher than normal and we think this will last for some time. This will have a huge impact on households and businesses,” says Liam Peach, an emerging market economist with Capital Economics, in a recent note.
“Household gas prices are very similar across Europe but electricity prices in 2021 were on average 40% lower in CEE than in Western Europe due to lower network costs and taxes. Energy consumption per household is higher than the EU average in most CEE countries too, reflecting less efficient gas heating systems. Coal is only a major part of heating in Poland and Czechia,” Peach added.
Capital Economics calculates that total household spending on electricity, gas and coal generally amounts to 5-7% of gross household disposable income in CEE, Germany and Italy. In the Baltic States, it is around 3%.
In the extreme case governments could choose to let the rises in the wholesale prices pass through to consumer prices. That would have a devastating effect, with spending on electricity, gas and coal more than doubling to 12% of disposable income in Hungary, Czechia, Slovakia and Bulgaria in 2023, 8% in Poland and 5-6% in Estonia, Latvia and Lithuania. But for most governments that is politically impossible.
The same argument goes for industry: the higher the input prices go the more businesses will go bust, starting with the most energy-intensive ones first.
Purchases of energy accounted for 1-3% of total production costs in manufacturing in 2019, according to Capital Economics. But there are large differences across countries and sectors. Energy accounts for 1% of production costs in low energy-intensive sectors such as machinery and motor vehicles but for more than 10% in high energy-intensive sectors such as metals and chemicals and nearly 20% in iron and steel, fertilisers, glass and cement manufacturing in Romania and Bulgaria. Energy accounts for 15% of production costs in mining in Bulgaria, Slovakia and Croatia. As bne IntelliNews reports, many energy-intensive industries in Europe are already shutting down, as their businesses are no longer viable.
And because these energy-intensive industries tend to make basic things like metals, chemicals and glass, any upsurge in energy costs then trickles down the supply chain, increasing the cost of everything. Central European economies are particularly vulnerable given the size of energy-intensive manufacturing and have already started to shut down the most energy-intensive industries.
“We had already expected most economies in Central and Eastern Europe to enter recession this year and into early 2023, with peak-to-trough falls in GDP of 0.5% or so. But given the extent and length of the energy price shock and the vulnerability of households and businesses across the region, it now looks more likely that those downturns will be deeper than we had thought,” says Peach.
Power bills in the UK have been climbing to painfully high levels and will jump again in October when new tariffs are introduced that pass more of the recent high energy bills on to the consumer.
UK power was around €30/MWh in 2020 and stable until it picked up in the last quarter of that year as inflation kicked in and the stronger than expected post-COVID economic recovery started to push up prices.
But as 2021 wore on, the gas problems with Russia began as countries raced to fill storage tanks ahead of the winter season. Gazprom complained that it didn’t have enough gas and also failed to fill its own tanks in the summer.
The first spike in the UK came October 24 when prices soared to €292 as the heating season began, but that was followed by a much bigger spike at the end of the year in December of €550.
After a brief respite in the first quarter of 2022 prices spiked again to €400 on March 7 after the war in Ukraine got underway and the first round of sanctions was imposed, worrying traders that energy-related fuels would be targeted.
Those fears receded in the summer as the first four packages of sanctions were mostly targeting people and entities such as banks. One by one Gazprom started cutting off customers after the Kremlin tried to introduce its gas-for-rubles scheme following a presidential decree in May. Gas flows to Bulgaria, Denmark, Finland, Lithuania, the Netherlands and Poland were all terminated, and voluntary reductions by, or partial cut-offs towards, Austria, the Czech Republic, France, Germany, Italy and Slovakia were also put in place.
The fifth package of sanctions in April specifically targeted coal and the sixth package in June talked about oil and gas, although no concrete actions was taken. However, also in June Gazprom first reduced flows of gas to Europe by 60%, to be followed with another cut to only 20% in July before cutting off gas supplies to Europe completely in September “indefinitely.”
Despite the recent fall in gas prices in the last few weeks in Europe, UK power prices remain at extremely high levels of €357 at the close of trading last week, up 134% y/y.
German power had been on a similar ride but as the German gas tanks passed 80% full earlier this month the panic is now subsiding and power prices have plunged from a peak of €720/MWh on August 26 to only €62/MWh as of the end of last week.
Electricity prices in Germany tumbled to around €70/MWh after Chancellor Olaf Scholz promised that his government would quickly implement a power price cap to help households and businesses cope with surging costs. Scholz also promised a third subsidy package worth €65bn, bringing the total German government spend this year to €95bn – a little bit less than four times more than the entire international community has collectively sent Ukraine as macro-economic relief year to date.
Germany’s decision to take all six of its nuclear power plants (NPPs) and most of its coal-fired power stations offline has also turned the country from being a net exporter to a net importer. As bne IntelliNews reported in “Lights out for Europe?” Germany’s policy choice to reduce its generating capacity so significantly has been poorly timed.
The recent fall in both gas and power prices in Germany will bring very welcome relief to the government and should cut the size of any new relief package if there are no new spikes in either during the rest of the winter.
Power prices in France soaring to unprecedented levels above €1,100 on August 26th, but then plunged to €600/MWh on European Union’s plans to intervene in the market to curb prices were announced. But even that lower level is some 20-times more than usual.
With 56 reactors France should be immune to the gas wars but it is contending with its worst nuclear outages in decades after Électricité de France (EdF) extended shutdowns of several key nuclear reactors due to corrosion problems while drought curbed hydroelectric production: 70% of the electricity generated in France comes from its NPPs but 32 are currently offline for maintenance.
France, which was a power exporter, switched to being an importer, intensifying the squeeze on energy supplies in the European continent that was already grappling with low supplies from Russia.
France has one of the biggest increases in power costs; these are up 440% y/y to €592/MWh as of last week, the highest of any of the major European countries.
Italy’s energy security is one of the weakest amongst any of the big European powers. It decommissioned its two NPPs about a decade ago but never replaced the retired capacity and remains the biggest single importer of power on the Continent, and is especially dependent on German for energy supplies.
After Russia cut off gas supplies in August, Italian electricity prices hit a record-high of €720/MWh at the end of August, tracking the surge in other European countries.
Electricity prices in Italy fell back to around €450/MWh in mid-September amid efforts to reduce power consumption and success in seeking alternative sources of natural gas as supplies from Russia wane.
However, despite the soaring costs of energy, Italy has been remarkable in that it has not managed to reduce demand for power or gas at all year to date and continues to rely heavily on its neighbours.
However, the Italian government has proposed cutting natural gas usage by 7% this year by placing limits on heater temperatures during the winter and restarting coal plants.
Since the start of Russia’s invasion of Ukraine, Rome has also struck new deals with Algeria and Angola to boost natural gas imports from Africa, reducing its vulnerability to recent supply cuts from Russia.
Italy’s power prices were also extremely high at €486/MWh last week, up 190% y/y, as Italy is heavily dependent on imports and heavily exposed to Russian gas imports.
Compared to the rest of Western Europe, Spanish power prices are remarkably low and stable. Its price for power at €171/MWh is still very high by historical standards but is only up by 3% y/y.
Spain is not very exposed to Russian gas imports and its price of power has only increased marginally as the price of power has risen across the whole EU market.
As a result, Spain, along with Greece and Portugal, refused to join von der Leyen’s plan to reduce gas consumption by 15% on July 26. It buys little Russian gas and has few interconnectors to northern Europe. Portugal also is not connected in any meaningful way to the rest of Europe’s gas pipelines as it imports almost all its needs in the form of LNG.
If both countries were completely cut off from the rest of the European power grid their power prices would be even lower.
Power prices hit a record-high of nearly €300/MWh in March before the spot electricity price fell under €200/MWh throughout September, showing a sharp contrast to the price surges for countries in northern Europe. Still, electricity prices remain three times higher than the averages from the previous decades, lifted by the global energy crisis and extreme heat waves in the Iberian Peninsula that dried up rivers and sent Spain’s hydroelectric power output to a three-decade low this summer.
Spain and Italy both have access to African gas coming via Algeria, which is another factor keeping prices lower. The government has also imposed strict energy-saving measures that have successfully reduced demand for gas. In May the Spanish government implemented a cap on wholesale natural gas prices to curb energy bills for households. Authorities also mandated businesses to turn off lights during the evening and implemented lower limits for air conditioning in stores.