A Perfect Storm: Understanding the European Energy Crisis

October 28, 2021

by Frederico Carita

These are unprecedented times for energy markets. After centuries of fossil fuel dominance, the energy sector is taking real action to decarbonize, and renewable resources are contributing more and more to the generation mix, even as electricity demand grows. But the world is still highly dependent on fossil fuels, and the dynamics of global energy markets are complex. What’s more, the COVID-19 pandemic has complicated these global dynamics a great deal, presenting unique and unprecedented challenges for heating and powering our homes and businesses.

For months, Europe has been gripped by rising energy prices and is now facing a full-blown crisis. As of September, wholesale electricity prices in Germany neared €130/MWh, and in France, they were even higher. In the UK, September wholesale prices nearly reached £200/MWh — up four-fold from a year before. Italian wholesale prices exceeded €150/MWh in September, and in early October, Spanish wholesale prices reached an astonishing €216/MWh. How are such sky-high prices even possible, and what’s causing the relentless rise of European electricity prices?

Natural Gas Stockpiles are Running Low

As with most things, there is no single answer. To understand this crisis, let’s first zoom out and look at the global energy landscape. As nations around the world pledge to reduce emissions, coal has (in most places) begun to fade from the picture, with natural gas stepping in to fill the gap. During the initial pandemic lockdowns, global energy demand fell significantly, and as a consequence, natural gas prices decreased. But since lockdowns began to ease in the first half of 2021, energy demand has risen significantly, and supply has struggled to keep pace.

Natural gas prices are normally higher in Asia, which means most gas importers prioritize Asian markets before European ones. This typically isn’t an issue: Europe is working to decarbonize and has been trying to reduce its use of natural gas. European nations tend to opportunistically stockpile gas reserves when prices are low for use in peaker plants (which are turned on when grid demand is high). But since Asian demand began skyrocketing over the past several months, global natural gas supply has become strongly constrained, and Europe has been unable to replenish its natural gas stockpiles. As winter — with its peak electricity demand — looms just a few months away, many countries are rightfully concerned over their low gas supply.

To compound these issues, pandemic-related lockdowns reduced production from Indonesian, Australian, and Indian coal mines (with India’s monsoon season making matters even worse). This has caused Asia (particularly China) to rely even more on natural gas to fuel its economic recovery, further reducing available supply for Europe. While several Russian gas pipelines flow into Europe, much of this capacity — particularly through Poland and Ukraine — has been largely inactive. Russia is pushing for German approval of its Nord Stream 2 pipeline and is hesitant to sell Russian gas on the spot market. While more Russian gas could alleviate some of Europe’s supply troubles, the approval of the pipeline and signing of long-term contracts with Russian gas companies represent politically fraught decisions for European leaders.

Carbon Prices Spike With Demand

A perfect storm of difficult market dynamics and pandemic-related economic fluctuations have left Europe in a very tough position. Another factor driving electricity prices even higher is the price of carbon in Europe, which has been rising consistently. With the passage of the “Fit for 55” package — committing the EU to a 55% reduction in emissions by 2030 — carbon prices have spiked from around €20/tonne in March of 2020 to more than €60/tonne in September 2021. The cost of these carbon allowances is added to the price of gas, driving costs up even further.

Reduced Wind Speeds and Scheduled Maintenance Reduce Energy Supply in the UK

The UK has endured sky-high electricity prices as well, but with a unique story of its own. A few extremely high-priced days in September, caused by a precipitous drop in capacity, drove wholesale electricity prices sky high. So what happened?

Because of pandemic-related delays, maintenance was occurring on several combined cycle gas plants at once, as well as on a 1.1 GW nuclear facility that’s being prepared for decommissioning. At the same time, wind speeds dropped almost 65% below the seasonal average, reducing wind generation capacity factors by half. This confluence of circumstances left the system with only 2 GW of spare capacity — an extremely tight reserve margin — sending wholesale prices soaring. These events speak to the complexity of the current energy moment: the simultaneous decommissioning of historical generation facilities, transitions between fossil fuel generating sources, and a growing reliance on renewable sources (with pandemic economics complications) present new challenges for grid operators when balancing the grid and planning.

Government Responses Stir Up Markets

So what actions are governments taking? In Italy, the government has set aside €3.4 billion to support low-income households and suspended grid charges for private residents, in addition to subsidizing electricity costs. The French government plans to raise gas prices a final 12.6% and then freeze prices until April, while handing out energy vouchers to struggling households. The Spanish government has suspended supply cuts to vulnerable residents until 2023 and introduced a Royal Decree Law that reduces revenues for renewable facilities, tying compensation for clean energy generators to average Iberian gas prices.

The Royal Decree has sent shockwaves through Europe’s hottest renewable PPA market. Major developers are pausing new investments and reassessing project economics. It is projected Spain could lose as much as 1.5 GW of potential solar additions in 2022 due to the Decree. After many quarters of rapid growth and dropping PPA prices, the European energy crisis and the Spanish government’s response may slow Spain’s PPA market competitiveness. LevelTen’s Q3 Price Index Report shows Spanish P25 solar PPA prices have leveled out after decreasing for several quarters, while Spanish wind prices rose during Q3.

In the UK, extreme wholesale prices have impacted wind and solar PPA prices, which spiked during Q3. Italian solar PPA prices remained level during Q3. However, it’s uncertain if Italian PPA prices can remain resilient amid increased wholesale prices. The decisions made by European governments in response to the wholesale price crunch may impact PPA markets differently, depending on policy choices.

Renewables Key to Reducing Reliance on Natural Gas, Though Challenges Remain

How can a crisis of this nature be prevented moving forward? There must be a focused and proactive effort to expand and modernize the European electrical grid to accommodate more renewable resources and those that will allow renewable generation to serve as baseload power. The nature of these updates and strategic additions can and should be debated. Options for creating a modern, resilient grid include pumped hydro, compressed air, hydrogen, battery storage, smart grid software for agile load shifting, and co-located wind and solar for complementary generation. A combination of these elements may be seen in the coming years.

It's crucial that citizens elect leaders who prioritize and understand the urgency of climate change and how to create a decarbonized grid. Germany’s Green Party achieved remarkable success in the recent election, and central governments must continue to prioritize regulatory changes and policies that support a sustainable future. This current energy crisis illustrates what happens when multiple factors converge. However, with strategic planning and forward-thinking decisions, it is possible for many elements to align positively. If policymakers can think holistically about facilitating the clean energy transition, it is possible to significantly speed interconnection queues and permitting for renewables, invest strategically in the grid, and create broad economic benefits that lead to a sustainable future.