Author(s): Marco Protopapa
Date published: Sep 2022
SUERF Policy Brief, No 413*
By Marco Protopapa, J.P. Morgan
*This SUERF policy brief includes research content published by J.P. Morgan on 08/05/2022. J.P. Morgan has granted SUERF a limited right to re-publish this research on an information only basis. J.P. Morgan has no liability in any regard for the publication of this SUERF policy brief or SUERF’s decision to reproduce any J.P. Morgan research content contained herein. It is not an offer to buy or sell any security/instruments or to participate in a trading strategy or trading activity; nor does it constitute any form of personal financial advice or investment recommendation by J.P. Morgan. This information should not be relied upon for any reason whatsoever by any natural or legal person. For important current standard disclosures that pertain to J.P. Morgan’s research please refer to J.P. Morgan’s disclosure website: https://www.jpmm.com/research/disclosures .
Download: SUERF Policy Brief, No 413 (0.66 MB)
Anticipating a worst case scenario of a complete halt to Russian supply of gas, the EU Council has adopted a gas savings plan; the aim is to immediately, albeit gradually, reduce gas demand to minimize the risk of shortages next winter. These preventive gas savings are calibrated to withstand a shutdown of Russian supply from an EU-wide perspective, allowing gas to be redistributed within the region from countries in (relative) surplus to countries in deficit.
The initial plan, according to an earlier EC proposal, was a compulsory 15% cut to gas consumption (measured over the last 5 years) uniformly across countries, over August– March. This plan was subject to predictable criticism from several countries, as it was perceived as too harsh towards countries which either: (i) have less dependence on Russian gas or are not connected to the EU grid, (ii) have made more progress towards diversifying supply sources away from Russia, and (iii) have made more progress on replenishing their storage levels. Bluntly put, the EC plan was perceived as biased in favour of Germany, who remain by far the most exposed large economy, after Italy has nearly halved its dependence on Russian gas in the last 6 months. Not surprisingly, vocal opposition came from Italy and Spain, among others, while Hungary continued to remain an isolated contrarian, given PM Orban’s pro-Russian stance.
Despite these misgivings, a compromise agreement has been found. The agreement is on a voluntary basis in the first instance, which may become compulsory in the case of a region-wide emergency. And it includes a set of exemptions/exceptions which allow tailor made gas savings targets to country specific situations, while safeguarding the principle of intra-EU solidarity.
The final plan will see both country specific targets and a less ambitious overall total cut (arguably closer to 10%). But, in our view, the ability to reach agreement in the space of a week shows that so far Europe maintains a united front against Russia– with the usual exception of Hungary. Of course, there are question marks about the future, with politically weakened leaders like Macron and with a departing leader like Draghi. The loss of the latter is potentially a big issue but at this stage we don’t see a concrete risk of Italy turning pro-Russian, given the solid pro-NATO stance professed by the BoI leader Meloni, who is in the driving seat of a potential right wing government.
This said, preparedness ahead of the winter is crucial, and it will be important to monitor how the gas reduction plan proceeds. There is an open question as to how the general population will react to the gas savings message at the same time that the economy is set to weaken sharply, as per our forecast. The further spike in gas prices (and hence electricity prices) since mid-June may already be enough to elicit more significant behavioral responses in the next few months, and the latest consumer confidence data suggest significant retrenchment in consumption after the surge in services spending in 2Q22.
The EU Council plan has been heralded with satisfaction in the main European capitals, as a tangible show of solidarity within constraints. The practical implication is that, pending effective implementation, the risk of rationing during the winter and its economic impact would be materially smaller. But it would certainly remain and could arguably be large in certain cases given differences in exposure to Russian gas. Hence, there will be a clear pecking order among countries in terms of the potential economic shock, in turn proportional to the degree of Russian dependence. We have flagged that gas rationing is a major source of downside risk for our Euro area outlook.
Among the largest Euro area economies, Germany is by far the most exposed and its savings effort will presumably exceed the 15% target, give the exemptions granted to other countries (including Italy, France and Spain). Italy has already made substantive progress leading to only modest rationing risk. However, we have noted that this assessment is conditional on Italy staying the course on moderate gas savings (7%) and further planned progress on strengthening LNG facilities. The Draghi administration will continue to deliver on that front in the interim, but it’s clear that soon this matter will be in the hands of the next government. France and Spain, instead are not dependent on Russian gas but remain exposed, like every other country, to international gas prices. To the best of our knowledge, government plans where planned gas savings are well below the 10% mark are considered feasible and not likely to elicit a material impact on activity.
According to the EU plan, France and Spain and, to some extent Italy (at least as a transit for LNG) will be crucial in assisting North West Europe ensure its energy supplies through the winter. Below we discuss the key features of the EU Council deal.
Before the war, Russia supplied roughly 40% of the EU gas consumption, which in turn is close to 9% of total energy consumption (Table 1). However, there are major differences across countries, as regards both the share of gas over total energy consumption and the dependence on Russian imports.
In Germany, Russian gas imports accounted for nearly 16% of total energy consumption before the war, and several other countries in Northern Europe are also significantly dependent on Russian gas. Italy was also heavily dependent (12.5% of total energy), but a major diversification effort has nearly halved that figures in the last months.
The EC has calculated that a complete stop to Russian gas flows ahead of the winter would involve a net supply loss for the EU worth 45 billion cubic meters (bcm) of gas (or 30% of total Russian supply on an annual basis), in the case of a harsh winter. In the case of an average winter the loss would fall to 30bcm. The EC calculates that the 45bcm loss could be made up by reducing gas consumption by 15% in the aggregate over August-March, or 10% in the case of a 30bcm loss. Under these assumptions, and considering that the EU gas storage target of 80% are set to be surpassed (current EU storage levels are already at 71%, thanks to offsetting increase in LNG supply, Table 2), the EC estimates that it would be possible to minimize the risk of rationing (and hence the economic shock), provided that countries are willing to share their supply.
Table 1: EA dependence on Russian gas imports (% share, 2019-20 data)
Source: Eurostat, J.P. Morgan
Table 2: EU Gas storage (% of total, as of 2 August )
Source: AGIE, J.P. Morgan
Even if storage levels were to reach 100% , that alone wouldn’t be sufficient to avoid rationing without advanced and coordinated gas savings. The reason is that gas consumption is very seasonal (Figure 3), with 55% of the total consumed in the cold season (Nov-Mar). In fact, the full storage capacity corresponds only to 27% of EU gas consumption, which essentially means that gas storage levels would be depleted at some point in Jan-Feb depending on country heterogeneity.
Figure 3: EU natural gas consumption - monthly pattern
Source: Eurostat, J.P. Morgan
The EU Council agreement is on a voluntary basis, but, as discussed, the current price levels are already providing strong incentives, as the fiscal space for more domestic supports shrinks. The voluntary mechanism would become compulsory in the case of a crisis, defined as a “substantial risk of a severe gas shortage or an exceptionally high gas demand” –a definition that clearly applies to a stop of Russian flows. Such an alert would be triggered when at least 5 member states make a request, pending a qualified majority vote in the EU Council (55% of member states representing 65% of the EU population).
The Council agreement includes a list of exemptions. These exemptions are not automatic but require a green light from the EC. The spirit is that exceptions are granted to allow for country specific targets, but that is conditional on a demonstrable commitment from countries in likely surplus (like France and Spain) to help countries in deficits. Of course, this mechanism raises the question of how countries may react under duress.
Eventually, the end result of the exemptions is that gas savings will fall below 10% in large economies such as France, Italy and Spain, so that their gas savings target will align with the already existing domestic plans (i.e. for instance 7% in Italy). As a result of these exemptions, and with some uncertainty linked to the voluntary nature of the plan, it is likely that total gas savings will be closer to 10% of total gas consumption, i.e. the target calibrated versus an average winter. Examples of exemptions allowing below 15% gas savings include:
The EU Council agreement explains that “member states agreed they should prioritise measures that do not affect protected customers such as households and essential services for the functioning of society like critical entities, healthcare and defence. Possible measures include reducing gas consumed in the electricity sector, measures to encourage fuel switch in industry, national awareness raising campaigns, targeted obligations to reduce heating and cooling and market-based measures such as auctioning between companies.”
Essentially, the deal gives member states the freedom to choose how they pursue their gas-reduction objectives. Although minimizing the impact on the households sector (which on average accounts for 36% of total gas usage, Table 4) and strategic industries will be sought, everybody will be involved. Tools will include (i) temperature limits on heating and air conditioning both in public sector buildings, residential building where enforceable, and services establishment, (ii) switching and optimizing fuels in the industrial sector, including whereby electricity savings (as gas is also used in electricity production), (iii) surcharges and incentive schemes, likely in the industrial sector. Specific provisions will apply to industries where capacity cannot fall for technical reasons below certain levels (damage to machinery, etc.).
Table 4: EA gas usage by country and sector (2019, % of total energy consumption)
Source: Eurostat, J.P. Morgan