Energy crisis: The bill is getting heavier

Facing the threat of a recession, the ECB either denies it or sees it as a necessary evil…

Uncertainty about energy production and consumption next winter is greater than ever, causing gas and electricity market prices to skyrocket. These prices exaggerate the real costs borne by businesses and households, but the increase in energy bills is still massive. Eurozone net energy imports absorb about 3 points of GDP more than 2021. That’s how many resources are diverted from productive or growth-generating use. Even with compensatory measures, inflation is bound to accelerate, fueling the ECB’s inflation phobia.

Recession and double-digit inflation on the horizon

The energy crisis in Europe that began last summer has assumed gigantic proportions. The price of natural gas averaged 238 euros per megawatt hour in August, when the usual level did not exceed 20 euros until 2019. The price of electricity, which largely depends on the price of gas, is also beating record after record, ten times higher than usual, and even more than twenty times if we consider future prices for next winter’s deadlines. The cause, the repeated interruptions in Russian gas supplies, gives rise to fears of a structurally inadequate supply of energy and electricity in the coming months.

Overall, at current prices, this would put the eurozone energy bill at more than 16% of GDP, instead of 3% in 2019 and 5% in 2021. This calculation is exaggerated as it is about prices not those actually paid by all companies, some with long-term contracts with their suppliers, and even fewer by households benefiting from caps or tax breaks. A more accurate estimate of the energy bill is to evaluate the balance of trade in energy products. It is currently around 5% of GDP, i.e. almost 3 percentage points above the pre-pandemic norm or 350 billion euros. Even before the usual winter surge in demand, European consumers, businesses or households are suffering a severe strain on their resources that is likely to disrupt production, depress demand, in short, cause a recession.

Pending adjustments

The recent price surge reflects expectations of continued imbalances in energy markets. On the supply side, this imbalance is due to tensions between Europe and Russia. In this balance of power, Russia has a keen interest in reducing or shutting down its gas supplies before the EU has had time to build the infrastructure to diversify its purchases or change its energy mix. Supply shortages related to tensions with Russia are exacerbated because energy markets are poorly integrated from one country to another in Europe.

On the demand side, the response appears muted so far due to the delayed transmission of the price shock and the relative insensitivity of demand. For gas, the IMF estimates the price elasticity of household demand at -0.15 and the transmission coefficient from wholesale prices to retail prices at 20%. From there, a 500% increase in wholesale prices would result in a 15% drop in demand, a proportion considered by the European Commission to be sufficient to absorb the end of Russian gas supplies. In fact, the transmission in the price chain is more muted. For households, energy consumption primarily covers primary needs. Therefore, a strong incentive is needed to change it, either through regulation or through market forces. This adjustment is yet to come.

Despite delays in the adjustment of energy supply and demand, the recent rise in wholesale prices still comes as a surprise. How do you explain it? First of all, overreactions in connection with technical adjustments as part of the market participants’ hedging strategy cannot be ruled out. Furthermore, with Russian gas supplies finally halted, storage demand is certainly stronger than normal, fueled by governments looking to head into the winter period with maximum reserves. However, no one can say today whether winter temperatures are within the norm or deviating from it and in which direction. In short, current prices risk overestimating the real imbalance between supply and demand.

So far, half of eurozone inflation is directly related to energy, more if you count the indirect effects. At 8.9% over a year in July and with upside risks, average double-digit inflation in the Eurozone in late 2022/early 2023 is quite possible. Under these conditions, the ECB will further tighten with the aim of reassuring its anti-inflationary credibility. There are serious doubts about the disinflationary effect of raising interest rates in the face of a supply shock. On the other hand, it is certain that this will increase the negative impact on domestic demand and activity. According to the latest news, faced with the risk of recession, the ECB is either in denial or believing it is a necessary evil…

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