Gas: a sustainable upward trend
How are gas prices set?
Firstly, it is important to differentiate between the prices paid by suppliers on wholesale markets and the retail prices paid by consumer; the situation varies from country to country. In Canada, for example, the retail price varies with the wholesale price, which is determined on the North American market. The regulator requires that the energy (wholesale gas purchase) and transportation (pipeline service) parts be charged at cost. Hence, the supplier only makes a profit on the distribution part, which is only approved once a year by the regulator. In the United States, regulation varies between states but is more like that of France, with its tariffs being updated every month.
In Germany, regulation is more flexible and retail contracts are generally renewed once a year with a tariff increase. In France, retail prices depend on the Energy Regulation Commission which decides on the evolution of regulated tariffs. The price of gas is updated every month, while the price of electricity is updated twice a year. Finally, taxes represent about one third of the regulated price. On 1st October, the annual bill for an average household was €1,482 including tax – the highest it has been in the last six years. In France, this is a tariff that serves as a signal to the market and applies to the 2 million households supplied by energy company, Engie. Alternative suppliers offer prices around the regulated tariff. In other countries where tariffs (regulated or not) also evolve according to forward contracts, signed one month in advance, the increases observed are similar. These prices depend on what producers and suppliers anticipate the price to be for the following month.
What are the factors of price variation?
Price variations are linked to the status of importer. A country like France imports 99% of its natural gas. For the EU, the main importers are Russia (41%), Norway (16%), Algeria (8%), Qatar (5%) and the Netherlands (3%). But Russia accounts for more than 50% of the market share for Germany and Eastern European countries. Price variations are determined by three important players. Firstly, there is the increase in demand due to the recovery of production after the Covid crisis. Secondly, there is a limited supply due to a lack of stocks and geopolitical tensions. And finally, there is the weight of environmental policies.
As far as the supply effect is concerned, countries usually build up stocks to smooth out peaks in demand. So, when price rises, stocks are reduced and there is a short-term adjustment. As such, over the past year prices have risen sharply while stocks have fallen sharply, partly due to a cold winter. However, because of the high price, these stocks were only partially replenished. On the demand side, peaks cannot be smoothed out, so we are currently subjected to the shocks of the economic recovery.
Furthermore, geopolitical tensions do not encourage producing countries to export more. The Russians, for example, are ready to double their gas production for Europe, but they demand something in return: the commissioning of the recently completed North Stream 2 pipeline. A pipeline through the Baltic Sea and Germany to avoid dependence on the high-tax pipeline through Ukraine.
Finally, there is the environmental factor. Joe Biden’s climate plan is an example, which strictly regulates unconventional extraction methods (hydraulic fracturing) and the reduction of subsidies for fossil fuels. In addition, the European CO2 market is now a major determinant of energy prices. The price of allowances per tonne of CO2 was €6 in 2017, rising to €20–35 in 2020. It has now reached €62 per tonne.
Is this increase sustainable or temporary?
In the short term, six months, the situation is cyclical, linked to the economic recovery. If we look at future prices, they indicate a return to normal for the second quarter of 2022. The flaw in this analysis is that it is difficult to predict the evolution, as the price of gas varies according to numerous trade-offs, between current and future prices, between storage and de-stocking decisions, or even according to international events. But in a few weeks’ time, we will know a little more about the commissioning of the Russian gas pipeline, which would be a real turning point towards stable or even lower prices.
What can we expect from energy prices in a context of continued decarbonisation?
In the long term, there is an upward trend in energy prices that comes from environmental commitments. Governments want to encourage the consumption of low-carbon energy, yet it is more expensive than fossil fuels. This is the whole point of the European CO2 market. Moreover, price volatility is likely to increase due to the intermittent operation of renewable energies. Gas-fired power plants are the quickest and easiest way to provide energy when there is no wind or sun.
What are the consequences of higher prices and what scope do governments have for action?
Companies will pass on the increased cost of energy in the price of their goods and services and so the consequence is likely inflation. Households can be expected to reduce their gas consumption, but this remains largely a constraint. For governments, it is a political opportunity to send a signal in favour of purchasing power.
Interview by Clément Boulle
Contributors
David Benatia
David Benatia is an affiliated researcher at ENSAE (IP Paris) where he was an assistant professor. He did his PhD in economics at the University of Montreal. His research focuses on econometrics and industrial economics with a specific interest in energy markets. In particular, he studies how modern quantitative methods can improve the detection and analysis of anti-competitive behaviour in electricity markets.
