Energy crisis will erode Europe’s competitiveness in 2023

• Natural gas storage in Europe is likely to be completely depleted by spring 2023, and little new import capacity will be available. As a result, the scramble for gas will be just as bad, if not worse, in 2023.

• Demand reduction is forcing industry across Europe to idle, and will raise input costs to levels that make European industry uncompetitive. This may persist for several years, causing global supply chains to move away from Europe.

• High energy prices will have long-term implications, in the form of higher debt burden, business failures and changes to the green transition.

Despite efforts to secure sufficient gas supplies for the coming winter, energy market dynamics for Europe in 2023 will be as challenging as in 2022: energy prices will remain elevated, reduced only by demand destruction across the continent, and it is difficult to see where economic growth will come from. Supply constraints mitigate against any significant lowering in price, and the primary strategies for demand destruction will have a negative long-term impact on EU competitiveness.

Supply: the scramble for gas may be worse in 2023

European governments are scrambling to fill their gas stores and are largely on track to reach their target of 95% by November 1st. However, this has largely been accomplished by importing Norwegian gas and liquefied natural gas (LNG) at close to the maximum throughput levels throughout the summer (in previous years there had generally been a summer lull), as well as small supply increases from Algeria and Azerbaijan. Additionally, the reduced supplies of Russian gas arriving between March and August still represented a significant portion of Europe’s imports in 2022. Europe’s maximum non-Russian import capacity has thus increased only slightly, and further new increases in import capacity are coming online haltingly. The installation of up to five floating storage and regasification units (specialised LNG import terminals) in Germany and one in Italy represents the biggest expected increase in supply this winter, but they will not begin to operate before January, and this installation schedule may slip. Additionally, the global LNG market will remain tight until at least 2024, providing little relief on price.

Storage capacity is typically drawn down by roughly 60 percentage points over the course of a normal European winter, with storage units remaining at least 20% full. However, this drawdown has historically occurred alongside continuing Russian gas imports over the course of the winter. Without such imports, even if gas storage were full and demand reduction successful, European gas stores would probably reach near-zero levels by early 2023. Therefore, to meet the 95% storage target in the autumn of 2023, Europe will have to acquire 20% more gas than usual, and unlike in 2022 it will have to do so without any Russian imports, exacerbating supply and price shocks.

Demand: demand destruction is not a viable long-term strategy

Until new supply comes online at scale, from 2024 at the earliest, the primary driver of gas prices will be the level of demand. Some demand reduction will take the form of shifting away from gas-generated electricity, including to coal and diesel, whereas the household and commercial sectors are likely to cut back as much as possible owing to higher retail prices. However, most decreases in demand will come from energy-intensive and gas-intensive sectors such as chemicals, steel, ceramics, manufacture of other materials and fertilisers cutting back on production or closing down for long periods. Industrial production has already begun to fall sharply in these sectors. The decline in output, and its knock-on effects on prices, the labour market and consumer confidence, will exacerbate the recession in 2022-23 and slow the subsequent recovery.

Natural gas prices will decline slightly in 2023, but this will largely stem from a significant idling of capacity in the energy-intensive industrial sector, which will prevent any robust economic recovery before 2024. Some growth is likely to come from more successful transitions in industry away from using gas in industrial processes towards alternatives such as biomethane, coal power or other substitutes. However, these substitutes are likely to be inferior to gas-related industrial processes and will incur large up-front costs. The household sector, particularly home heating, will be unable to retrofit away from gas on a short turnaround, limiting the ability of households to reduce consumption.

Sustained higher input costs will make European goods less competitive compared with North American or Asian equivalents, potentially until at least 2024. Some firms may be able to import cheaper intermediate goods, but this will further erode trade balances, which are already deteriorating as a result of higher prices for imported goods. As higher energy prices persist throughout 2023, global supply chains will begin to reorient themselves, with international buyers moving towards non-European sources. There is a risk that these changes will become entrenched over multiple years of disruption, and permanently damage European competitiveness.

Competitiveness pressures will also inform industrial firms’ decisions on whether to remain idle, relocate or move into insolvency, or to produce goods at an uneconomical price. In many sectors, most prominently the automotive sector, this is taking place in tandem with the green transition, causing European manufacturers of green goods, such as electric vehicle motors, batteries and solar and wind turbines, to operate at a cost disadvantage from the outset. German industry groups have warned that sustained high energy prices could lead to the “deindustrialisation of Germany”, and automakers in eastern Europe have threatened to move production to southern Europe, where energy costs are lower, or out of the region altogether. More industries are likely to follow suit. The policy response by national governments and the European Commission has so far focused on short-term crisis management rather than on maintaining medium-term competitiveness. A notable countervailing force may be the EU’s proposed Carbon Border Adjustment Mechanism, a carbon tariff, scheduled to be implemented by 2026. However, the EU’s export partners are critical of the Mechanism as a protectionist policy.

Second-order impacts: debt, zombification and the green transition

In addition to affecting competitiveness and growth, persistent high energy prices will have several second-order impacts on the medium-term outlook for Europe:

Fiscal policy will be further strained: To avoid passing the entire cost of the unprecedented increase in natural gas prices on to households, countries have already begun to take on providing gas to households at affordable prices. This has taken the form of price caps (as in the UK, estimated to cost upwards of £150bn or US$166bn), or the nationalisation of the energy sector (as in Germany, which fully nationalised its largest energy provider, Uniper, for €29bn or US$28.4bn, in addition to other household relief measures). Following on from the coronavirus crisis, this will further raise the debt burden in most European countries to record “peacetime” levels and will generate concern about debt sustainability as interest rates rise.

Zombie companies may be pushed over the edge: A significant concern in the lead-up to and aftermath of the covid-19 pandemic was “zombification”—slowing productivity growth driven by unproductive and often indebted firms remaining solvent owing to ultra-low debt-servicing costs. The combination of rising interest rates and rising input costs may finally push many of these zombie companies into insolvency, leading to a wave of failures. However, there is a significant risk that governments will keep national champions alive, despite their unviability, by providing subsidies rather than allowing them to fail in the cause of structural transformation.

The green transition in Europe will have to skip over gas: Before the invasion of Ukraine, the EU had expected to use gas as a transition fuel in the 2020s, before a phase-out in the late 2020s and early 2030s. Attempts to secure long-term LNG contracts from Qatar or other providers have been complicated by suppliers looking for a commitment of upwards of 20 years, which clash with this timetable. With supplies constrained until the mid-2020s, we currently forecast that gas consumption levels in the EU will never rebound fully to their pre-pandemic levels, as deployment of renewables at scale in the mid-2020s directly replaces coal. In anticipation of this, proposals to expand natural gas infrastructure in Europe have envisaged dual-purpose infrastructure that can be converted to hydrogen in the future. This strategy will increase gas infrastructure’s up-front costs, while also committing Europe to the use of hydrogen technology that is not yet proven in terms of efficiency or carbon neutrality at the scale envisaged.

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