Can Europe Keep the Lights On?

Andrew Kenningham, of Capital Economics, considers how the energy crisis triggered by the economic conflict with Russia threatens to cause a recession in Europe.

Economic war

Prospects for Europe were looking reasonably bright at the beginning of this year. The pandemic was finally fading and Europeans were looking forward to socialising and travelling again, and to spending some of the savings they had accumulated while they were stuck in lockdowns.

But those hopes suffered a setback when Russia launched a full-blown invasion of Ukraine in February. The consequences were not immediately obvious but measures of consumer confidence slumped as people sensed that the war spelt trouble for the economy. Those fears have proved to be well founded.

Energy price shock

The war has had a number of unexpected consequences. For example, it turned out that some vital components used in Germany’s powerful auto sector came from Ukraine. And Ukraine was a major producer of sunflower oil, phosphates (used in fertilisers) and nickel. But the biggest problem is with energy. Russia has long been a crucial source of oil and gas for Western Europe. Oil can be obtained from other countries as it is easily transported by ship, but that is not true of gas, which is mostly transported in huge pipelines. Much of Europe’s industrial infrastructure was set up on the assumption that there would be a reliable and plentiful supply. This had not been a problem until recently because the Soviet Union, and Russia after the fall of communism, had always kept the oil and gas flowing – even at the height of the Cold War.

A recession looks unavoidable even if the gas keeps flowing. If the gas tap is turned off, a major downturn is now on the cards.

Turning off the taps

Now, though, there is a risk that Russia will cut Europe off from all its gas exports. In late March, President Putin passed a decree demanding that “unfriendly” governments should pay for gas in rubles. A month later Russia simply stopped exporting gas to Poland and Bulgaria. And in the past few weeks, Gazprom, the Russian gas producer, has cut the volume of gas flowing through its main pipeline to only a fifth of its normal level.

If Russia permanently turns off the tap, European governments would be in a tricky situation. Essentially, they would have three options. The first, which they have already been doing, is to look for alternative sources of energy. Governments have bought more liquified natural gas (LNG) on the global market, and Germany’s coalition government has re-started coal-fired power stations and extended the life of its nuclear power stations. But there is a limit to how much more energy they can source from to replace Russian gas. The second option is to use less gas. Some progress has been made on that front too. A number of aluminium and steel smelters have been closed or reduced their output because of the cost of energy. More recently governments have turned off the neon lights on their public buildings and the hot showers in public swimming pools. Some households have been buying hot water bottles and small electric heaters to prepare for a chilly winter. But there is a limit to how much energy use will be reduced on a voluntary basis.

Rationing: a wartime response

That leaves the third option: rationing. Outside of wartime, it is rare for governments to ration any product. After all, governments do not like to choose how people spend their money. And economists prefer to use high prices to limit demand. However, the rationing of gas now looks a distinct possibility.

Picking winners (and losers)

Germany has been working on a plan to ration gas for some time now. It intends to prioritise essential services such as hospitals and the army followed by households (who use a lot of gas to heat their homes). That leaves businesses to take the brunt of the cuts.

Within business, every factory owner argues that their own needs are greatest or that it is not possible to stop and re-start production at short notice. But ultimately, it is likely that the most energy-intensive factories will have to make the biggest cuts, and particularly those that use a lot of gas as an input to production. That means metal and chemical firms, glassmakers and paper manufacturers are likely to face the biggest cuts. The upshot is that there may be a big fall in manufacturing output. Even without actual rationing, we think a recession is likely as a result of higher energy prices as well as rising interest rates. Rationing of gas would make any downturn more severe. The damage would be greater for countries such as Germany and Italy, where the economy could shrink by 3 to 4 per cent, than countries such as France and Spain, where rationing is less likely.

Europe struggling

Either way, the short-term prospects for Europe are not bright. A recession looks unavoidable even if the gas keeps flowing. If the gas tap is turned off, a major downturn is now on the cards. None of this will be helpful for European equity markets, bonds or indeed the euro.