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Gas: a sustainable upward trend

david Benatia
David Benatia
Assistant Professor of Economics at ENSAE (IP Paris) and HEC Montréal

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

Assistant Professor of Economics at ENSAE (IP Paris) and HEC Montréal

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.