12 Jul 2022

Unpacking the sense and nonsense behind energy price caps

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A tense debate is taking place on what to do about spiralling gas and oil prices. A special meeting of the European Council on energy was originally scheduled for the autumn but is now being brought forward. Meanwhile, the European Commission is working on an emergency plan to prepare for a complete cut-off of Russian gas.

Energy prices dominate the agenda but it’s a confused – and often confusing – debate that is worth unpacking.

Until recently, the EU imported up to 40 % of its oil from Russia. The European Council has in principle decided that by February 2023 all imports of oil and refined products from Russia will stop, except for smaller amounts going to Hungary, the Czech Republic and Slovakia, as well as Croatia for vacuum gas and Bulgaria for shipped oil.

An even more consequential measure was the limit on EU (and UK) maritime insurance companies to provide cover for cargoes containing Russian crude, potentially limiting Russia’s capacity to export, not just to Europe, but worldwide, driving oil prices even higher.

Given that a Russian oil embargo has already been decided, the discussion over the oil price cap would only reduce Russian revenues if enacted between now and the end of the year, when the EU embargo kicks in.

Gas is thus the more interesting and more complicated story – and this is where policymakers need to tread very, very carefully.

The sobering politics of gas

After six sanctions packages, the EU’s political appetite for passing a seventh, let alone one that includes gas, is low. This implies that a price cap, or a tariff, would be the next best thing that Europeans could do to reduce the billions of euros they continue pouring into the Kremlin’s war coffers.

Gas prices, and consequently electricity prices, are also more of a problem because they have risen to levels never seen before. Gas prices on the major European trading platform, the Dutch TTF, are going through the roof (up to 10 times higher than last year), even though gas supplies from Russia, whilst reduced, continue to flow.

This has led many to believe that the TTF price does not reflect physical fundamentals, and perhaps not even market dynamics. The argument is then that a price cap does not distort the market because the market is already distorted.

The fact that Russia is gradually reducing supplies also means that another key argument against a gas price cap – the fear of Russian gas interruptions – does not hold water.

Russia seems to believe that if it cuts gas supplies, it can endure the pain temporarily, while Europeans, with a far lower level of political pain endurance in the Kremlin’s view, will divide amongst themselves, with this generating an irresistible drive to lift sanctions.

But Russia cannot be oblivious to the fact that it would suffer far more than Europe from a gas decoupling between the two. It is betting that Europeans will give in politically well before this happens. After all, liberal democracies, first and foremost European ones, are fundamentally weak and fragile according to the Kremlin’s (completely illogical) ideology.

Unpacking the price cap options

Politically, the idea of a price cap is thus gaining adherents. But what is meant by a gas price cap? One needs to distinguish three cases, of which only two make sense.

One meaning of a price cap would entail a ceiling on gas and electricity prices paid by EU consumers. This has been implemented indirectly in Spain and Portugal. However, this encourages demand, leaving less gas available for storage and consequently increases further upward pressure on prices for all.

Given the energy isolation of the Iberian Peninsula from the rest of the EU, the damage to other Member States is limited. But if implemented in more interconnected areas, this would certainly trigger ‘beggar thy neighbour’ dynamics.

Added to this, the gas price cap for consumers amounts to an undifferentiated subsidy to fossil fuels – which is the opposite of what we need to reach net zero emissions. This subsidy would also mostly benefit the largest and wealthiest households that consume the most energy.

In short, it is a price cap that makes little sense both in climate and socio-economic terms.

Another meaning would be a price cap on Russian gas only. This, like a tariff, would be aimed at reducing Russian revenues. But it would only make sense if Russia does not actually interrupt flows first.

As of now, it is highly uncertain whether Russia will resume flows through Nord Stream after 21 July, which is when scheduled maintenance should be finished. Were those flows to resume, a gas price cap on Russian imports should be envisaged and speedily implemented.

This would mean agreeing on a Russian gas embargo and terminating all existing long-term contracts, followed by a take-it-or-leave-it renegotiation of such contracts at the capped TTF price. If, however, those flows were not to resume after 21 July, there would be no Russian gas prices to cap.

Finally, one might think of a price cap on all gas imports, not just those solely coming from Russia. Such a cap would not affect existing long-term contracts at lower prices. But the key issue is what happens when it is applied to new LNG supplies, which Europe desperately needs.

In LNG, Europe competes with Asia. The European cap cannot be lower than the Asian price because available gas would otherwise go to Asia (and it would not make sense to set it higher).

Such a price cap would not make a huge difference given that European and Asian spot prices tend to track each other. However, it would still limit the price increases in Europe to those of our most important competitors and would neutralise any speculation on the TTF market.

As the energy crisis is yet to peak, let alone subside, the European and transatlantic energy price cap discussion will remain high on the agenda. There are crucial economic, and above all social and political, reasons for this. Precisely because of this, breaking down this debate and dissecting sense from nonsense is essential in the days and weeks ahead.