Running on empty – How global energy markets turned dysfunctional (and what to do about it)

Have policymakers left us in energy limbo rather than transition?

As winter fast approaches for the Northern Hemisphere, crisis increasingly describes the state the global energy system has reached; right now it's easy to confuse graphs of energy markets with illustrations of the latest crypto-currency fad. Natural gas, coal and electricity prices around the world are unprecedented. Everywhere you look there are record highs and dislocations.

A combination of post-pandemic recovery, extreme weather and turbulent geopolitics all played a role in the current crisis. But the underlying cause allowing such events to play out so poorly is a failure of policymaking over many years to effectively manage the - admittedly hugely challenging - transition from fossil fuels to clean energy.

How did we get here? How will the current drama unfold? And, most importantly, what can be done?

Fossil fuel prices 2021 – Out of control

These startling statistics, showing movements in wholesale markets to mid-October 2021, set the scene for where we are:

• UK natural gas: up six-fold since October 2020. Record highs.
• European natural gas: up 400% since the start of the year and seven-fold compared to September 2020. Record highs.
• US natural gas: doubled since April 2021. Higher than any time since 2008.
• Asian liquid natural gas: record highs.
• Chinese coal: has doubled since April 2021. More than twice the level reached in at least five years. Record highs.
• Brent crude oil: up 30% since April 2021. Highest since April 2019.

Prices for wholesale natural gas and coal around the world are complex in the nuance but the main cause of recent spikes is simple: fears of shortages are gripping the market.

The impact on electricity prices

Given the key role natural gas and coal play in flexible power generation, their price surges have translated into record electricity prices. Witness how this plays out globally:

• in Germany, France and the UK wholesale electricity prices reached record highs in September and again in October 2021;  
• Japanese electricity prices hit record highs this January and in October they continued climbing back towards similar levels;
• in China power generators face caps on the prices they can charge. This has meant many coal-fired power stations simply stopped generating rather than continue operating at a loss.

Market breakdown - The consequences for industry and consumers

Surging energy prices have reverberated globally, with serious and sometimes unpredictable consequences. For example, in September and October China's industrial sector was hit hard by power outages, with factory activity falling to its lowest level in September since lockdowns in February 2020. Goldman Sachs estimates 44% of China's industrial activity has been hit by outages.

In the UK, meanwhile, several rail freight companies have had to switch back to diesel locomotive due to electricity prices, while 22 energy suppliers have ceased trading so far this year. Meanwhile, CF Fertilisers paused production as natural gas prices made it uneconomic. The move triggered chaos in supply chains as the company supplies 60% of the UK's commercially-deployed CO2, generated as a by-product of fertiliser production. The UK Government unusually agreed a short-term deal ensuring continuous production.

Across the European region, many firms in energy intensive industries are already rationing production or halting operations. And, as winter approaches, it is increasingly likely that large industrial energy users will be required to cease operating to protect priority end-users such as hospitals and consumers in exceptional circumstances.

Higher energy prices are also feeding through to households. Many jurisdictions have measures to mitigate the impact on the most vulnerable, including price caps, temporary tax breaks or vouchers and subsidies. Such tools have also all been used to help businesses. Price caps are an understandable policy response to limit harm to vulnerable consumers and even smooth business impacts. But by intervening too broadly there is a risk, already seen in some jurisdictions, of perverse incentives and the loss of the most valuable existing tool for balancing supply and demand: clear price signals.                     

Behind the crisis - A series of unfortunate events?

2021 has had several aggravating extreme weather and supply events. For example:

• a cold winter in Japan, China and South Korea set 2021 off to a bad start with localised shortages and LNG prices hitting all-time highs;
• in February, Texas was hit by one of the worst winter storms in modern history. This led to unprecedented demand for electricity and natural gas, with rolling power cuts as the weather hit Texas' gas production and exports;
• low wind speeds across Europe from April to June slashed renewable power generation;
• overall natural gas production declined 9.3% in OECD Europe countries from 1 January to 1 July
• heavy rains this autumn forced the closure of 60 coal mines in the Chinese province of Shanxi.

And while it is too early to be clear on the immediate impacts of the pandemic on the global energy system, the following two dynamics appear to feed into the current crisis. Firstly, the pandemic caused global energy demand to fall 4% in 2020. However, the strength of the recovery in 2021 took many by surprise, with increased demand for goods further pushing up industrial energy use. And although growth in hybrid working may mean overall energy use has fallen, due to less personal transportation, increased post-Covid demand for heating and ventilation have exacerbated the energy crisis where it hurts: natural gas, coal and electricity.

Geopolitical factors

Russia and Nord Stream 2

The gyrations in European wholesale gas prices on 6 October, when prices hit intraday records of around 10 times the level at the start of the year, gave insight into the geo-political clout of Russia - with remarks from President Putin halting price spikes. The European market opened near €130/MWh, peaked at over €160/MWh just prior to Putin speaking, before falling to just above €100MWh to close. Putin said: “Let’s think through possibly increasing supply in the market, only we need to do it carefully. Settle with Gazprom and talk it over."

While Russia has apparently met its long-term commitments to supply natural gas to continental Europe, and also has its own storage facilities to fill for the winter, the International Energy Agency (IEA) told the Financial Times, following Putin's comments, that its analysis showed Russia could increase exports by roughly 15% of peak winter supply - making an enormous difference.

Russia is seen by many to be drawing a link between the approval it wants for the Nord Stream 2 pipeline by the German Government and the likelihood that Russia would increase gas exports. At the date of this article, gas supplies from Russia to Europe have shown tentative increases, though this must be balanced in market sentiment against recent Belarus threats to stop gas transit to the EU.

China's unofficial ban on importing Australian coal

In the second half of 2020 China began a de facto ban on importing coal from Australia, widely seen as retaliation for Canberra's call for an international probe into the pandemic's origin. Analysts asking how long China could sustain this policy amid a global energy crisis apparently got their answer in October when reports of some unloading of Australian coal in China were made in various news outlets.

A failure of energy policy and what is now required

The IEA's World Energy Outlook 2021 report published on 13 October sets out why an energy market crisis is sweeping across borders, noting, "the world is not investing enough to meet its future energy needs". The report cites a global failure to make the necessary investments in clean energy for Paris Agreement targets and to meet rising demand for energy services. The IEA says the amount invested in oil and gas has been "dragged down by two price collapses in 2014-15 and in 2020" in a market which is "geared towards a world of stagnant or even falling demand for these fuels". The IEA suggests "deployment of clean energy technologies and infrastructure provides the way out of this impasse, but this needs to happen quickly" and policymakers need to offer "clear signals and direction" to achieve this. Crucially, the investment must be flexible with "robust grids, battery storage and dispatchable low emissions sources of electricity". In the IEA's view this can and should include nuclear.

In the meantime, all governments can do is put in place financial mitigation to help the most vulnerable consumers and to prevent viable heavy energy use businesses from becoming insolvent. And hope this winter is mild.