How the energy crisis is transforming the global economy? How the energy crisis is transforming the global economy?

To understand the situation today, this is worth doing a refresh on the weight of Russia in the global energy landscape and especially in Europe since this is the region of the world which is the most dependent on the energy supply from Russia. I will be focusing solely on energy, but everyone shall keep in mind that we are also very much relying on other resources from Russia (cereals apart), copper, nickel, palladium, titanium, lithium, rare earths which are key to many industries, including the energy sector notably for the renewable energies and the batteries.

The energy consumption worldwide is still heavily dependent on fossil fuels as the decarbonization policies implemented here and there are too recent to have an impact on the energy mix today.

In Europe, fossil fuels represent approximately 70% of the final energy consumption (22% gas/43% oil) and the electricity which represents roughly 22% of the energy consumption, is largely generated from fossil fuel as well, mainly gas and coal. Over the recent years we have had an increase in gas consumption, as the gas was seen as an energy transition as considered cleaner than oil and coal and more acceptable by the population than other power generations such as nuclear.

As it relates to natural gas, the European economy is overly dependent on Russia with situations which vary from country to country (with some countries notably in the Baltics which are 100% supplied by Russia).

• (41%) from Russia, and the rest primarily come from Norway (24%) and Algeria (11%).
• The EU is the largest importer of natural gas in the world

The EU is also dependent on Russia for its imports of oil and coal: 27% of oil imports and 46% of coal imports are from Russia.

If we look at the US, the situation is very different as the US is a net exporter of fossil fuels and has barely no imports from Russia. As such, the decision of the US to ban the energy imports from Russia does not really impact the US economy nor does it has real effects on the Russian economy.

That strong dependence is now forcing European countries to find alternatives to maintain the security of supply in the region: diversifying the energy sourcing is indeed the key to energy security.

What are Europe’s alternatives ?

In the very short term, Europe has no other choice than acting rapidly to avoid any disruption in energy supply during this winter which would be clearly detrimental to its economy as well as an additional factor of instability. Though the options are somehow limited as it relates to gas and thus pressure on energy prices will remain high:

• The first one is to work on the diversification of suppliers of gas (EU has announced a commitment to end the import of gas from Russia by 2027). Two possibilities:
  • An increase in pipeline imports from non Russian Suppliers of gas: Azerbaijian for instance, but this will be limited, combined with.
  • Higher LNG imports, which will be very costly, there will be indeed incremental cost given that globally traded LNG cargoes typically ship wherever prices are highest, the demand from Asia is strong and spot prices are extremely high. Drawing more LNG would leave EU nations with a 70 billion euro ($78 billion) bill to refill gas storage facilities this summer which is six times the price in previous years.
  • European countries have agreed to fill up their existing storage capacities by at least 80% before the beginning of the winter season.
• The second one is the revival of some coal power plants: with the increase in the energy prices and the will to maintain energy affordability for the population, the temptation will be extremely high to revive some coal power plants which have been closed on environmental grounds, which would imply that the net zero ambitions set by Fit for 55 would be temporary put on hold.
• The possible life extension of nuclear power plants on the European territory : for instance, Belgium which had initially planned to exit nuclear power generation by 2025 has recently announced it would postpone that deadline by 10 years.

In the medium to longer run, and in line with the net zero ambitions and the decarbonization of the energy supply, three main possible solutions:

• The absolute necessity to accelerate beyond what was initially planned the electrification from renewables: this expansion of renewables implies as well significant additional investment in the distribution network, the grids are not adapted to a power generation which is decentralized vs in majority centralized today. The acceleration of power generation from renewables will though face a second challenge, which is the increase of prices of copper, nickel and aluminium which are reaching all-time highs. And there Russia is also a key supplier in that arena. The cost of production of renewable energy projects and batteries will be thus facing rising production costs and significant supply chain challenges.
• Greater focus on energy efficiency, we have seen various announcements on energy savings recently.
• The role of nuclear: nuclear technology has resurfaced since a couple of months on the ground of the energy price increase while it was very unpopular in certain countries. Building new power plant are however long term projects and in any case would not solve our dependence issue right away. In addition, the recent developments with the Ukraine war might have affected further the acceptability of that energy by the populations.

Inflation: the energy price increase will have a significant effect on inflation impacting all sectors of the economy

After a decade of very low inflation, inflation hit its highest level in the past 25 years, with an annual inflation rate in the 27 EU countries of 9.8 percent in July.
When we look at the energy prices, they are record highs and they remain extremely volatile. Before the invasion of Ukraine, wholesale gas prices were around 200% higher than a year ago, today benchmark gas prices are trading around €250 per MWh and peaked at above €340€ per MWh in July, more than ten times than a year ago. Wholesale electricity prices had followed a similar trend. These high prices were also fueled by strong global demand for gas in the post covid 19 economic recovery.

Uncertainties about supplies from Europe’s main supplier, Russia, is increasing market instability thriving up volatility and prices even further. One thing is certain: the outlook for the medium term indicate that the energy prices will remain higher than the recent average for quite a while.

Energy companies have benefited of these high prices in first instances but we can see increasing political intervention across the EU aimed at capping energy costs for households and businesses given growing inflationary pressures (it has already happened in a number of countries). The European Commission is currently contemplating a cap at € 200 per MWH for electricity generated from other sources than gas as well as a goal to reduce electricity consumption by 10% per month compared to the 5-year average of that given month.

Temporary Crisis Framework are being put in place to anticipate liquidity support to energy-intensive consumers, and revisions to ETS guidelines on state aid could mitigate some pressures on affected sectors, such as steel or fertilizer production.

Foreign exchange effect and recession

The euro sank below USD 0.99 to a 20-year low after Russia’s halt to gas supplies down its main pipeline to Europe. The weakness of the euro vs. the USD is threatening to inflict further pain on an economy that is already having to contend of a surge in inflation. In recent months, the euro value has been increasingly correlated with natural gas prices, with the euro falling when pricing of the energy source rise. Because of the oversized reliance of major economies such as Germany and Italy on Russian gas, economists are forecasting a much quicker and more painful recession in the euro than is the US, clearly explaining the weakness of the European currency vs. USD.

Financial impacts and risk of reputational damage: Western companies have been facing mounting pressure to cut ties with Russia. Several companies made varied announcements to exit agreements and divest following the invasion of Ukraine.  This is resulting in major financial impacts for these companies. BP has announced it would divest its shares in Rosneft who accounts for around half of BP's oil and gas reserves and a third of its production. Divesting the 19.75% stake will result in charges of up to $25 billion.

Increased shipping rates: Freight rates for hauling crude from Russia are surging as sanctions imposed on the country push up the risks of carrying cargoes on those routes, while a scramble for alternative supplies boosts the rates for other passages.

Energy policy developments on the energy mix and the promotion of renewable energies: The current energy crisis is accelerating the energy transition, requiring increased investment in renewables, particularly in those countries heavily reliant on Russia where a new strategy is needed. With REPower EU, the EU has announced its target to reduce by 2/3rd its gas import by the end of 2022 and to zero by the end of 2030.