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In recent weeks, there has been mounting concern that Russia could cut off gas supplies to Europe, in retaliation for its aid to Ukraine so far and to deter further support by Western countries. Ironically, this is a mirror image of the near-term embargo on Russian gas that was considered, but then dismissed, by the EU. In what follows, we offer some assessment on how plausible this scenario is, and, if it were to come to pass, what its economic consequences would be.
In a nutshell, to us, such an eventuality looks by no means impossible – although it is not our baseline case. The Eurozone would feel the most acute economic pain in this environment, with a loss of output of perhaps six percentage points. Repercussions would, however, be felt worldwide. Even so, the rapid expansion of energy infrastructure would limit the scale of the downturn and sow the seeds for an eventual recovery. A financial crisis being avoided, we would expect the rebound to be relatively brisk. The eventual and comparatively swift transition to a more diversified, secure and environmentally sustainable energy mix would also be a long-term positive. But the picture for 2023 itself, and to a lesser extent 2024, would seem bleak.
A shutdown of gas supplies is realistic, and particularly problematic
Russia shutting down gas supplies to Europe is not unrealistic. The downside to doing so, from Russia’s perspective, is that gas cannot easily be diverted to a different customer base in Asia in the short term, because this would require pipelines and/or liquefied natural gas (LNG) facilities that currently do not exist. However, domestic gas storage can be filled instead, and from a technical perspective, halting gas production is easier than stopping oil production. Nor is the foregone revenue prohibitive: EU sanctions on oil are yet to truly bite, and Russia earns far more from oil exports – as of 2021, $180bn, around $100bn of which came from Europe – than it does from gas exports – in 2021, it only made $60bn from gas, of which around $23bn were sales to Europe. Indeed, lower gas volumes can be compensated by record gas prices.
From Europe’s perspective, the situation is, however, very problematic. This is because of the sheer scale of dependence on Russia as a gas supplier: through 2021 the EU imported around 155 billion cubic meters (bcm) of natural gas from Russia – 140bcm via pipeline and the balance via LNG. This accounted for around 40% of total EU gas demand. Relatively limited quantities arrive into the UK (via LNG) but the regional UK/European gas market remains closely linked, with disruptions in supply pushing prices up across the region.
Five options available
In principle, there are five options available to countries faced with being cut off from Russian gas supplies, some or all of which may be used in practice:
a) Switch to alternative energy forms;
b) Obtain gas from alternative suppliers;
c) Run down gas in storage;
d) Save energy voluntarily, including through efficiency gains;
e) Force energy savings through rationing.
In the long run, a) and b) are the only viable and sustainable options on the supply side. These form key parts of the European Commission’s REPowerEU plan. But the infrastructure needed is not yet in place. The scope for more oil, coal and nuclear to replace gas is limited, even though climate change and political objections have been put to one side for now to a remarkable degree. Renewable energy projects, as well as new pipelines and LNG facilities to enable a switch to other gas suppliers, will require huge investment – both public and private.
During the construction phase, this will add to gross domestic product (GDP), cushioning the fall in output. Completion, however, will take time. And, even with the existing infrastructure, to attract the limited supplies of LNG that are available on the spot market to Europe – 70% of global LNG supplies are already under long-term contract – requires much higher gas prices. This has already occurred: since the invasion of Ukraine by Russia, the restriction in gas supplies from Russia has pushed spot prices to record levels; and the forward curve indicates prices are expected to remain multiple times the 10-year average for the next three years. Enabling option c) in the interim, but also adding to prices now, are efforts by EU countries to refill gas storage to 80% by November. Storage levels have reached roughly 60% but stalled following restrictions in gas supply via the Nordstream 1 pipeline – which carried around 30% of pre-invasion Russian gas supplies directly to Germany.
The Eurozone would be hit the hardest, with ripple effects everywhere
As regards the demand side, option d) is pursued too, partly by encouraging households and firms to cut gas consumption through efficiency measures. More importantly, however, surging energy prices – to the extent consumers and firms are not sheltered through government intervention – will do their part to discourage energy use. Hope will also rest on the vagaries of the weather: a mild rather than a cold winter can make for significant savings in annual European gas demand – some estimate the difference could be as much as 5%.
However, these measures do not suffice to bring energy demand and supply into balance, making energy rationing inevitable. Within the Eurozone’s largest economies, Germany and Italy meet the highest share of their primary energy consumption through natural gas imported from Russia and are therefore the most exposed – at 18.6% and 19.7% compared with the EU19 average of 11.6%. Out of the two, Germany is the most out on a limb, as it has no LNG terminals of its own, relying instead on facilities elsewhere (Belgium) to supplement the gas received directly from Norway and the Netherlands. Rationing is also a possibility in Italy.
Chart 1: Germany & Italy meet a sizeable part of primary energy consumption from Russian gas
Russian gas imports as % of primary energy consumption (2020), Sources: Eurostat, Macrobond, Investec
The degree to which rationing may be required will vary substantially by country. Best placed are France, Portugal and Spain, which, according to Bruegel analysis, are unlikely to need energy rationing to see them through the next winter even without Russian gas – the latter due to its good LNG import facilities. But their relatively sound position cannot help other European countries, due to the limited interconnectivity of gas pipelines. At the other end of the spectrum are some of the smaller countries – such as Estonia, Finland, Latvia and Lithuania – that will have to cut back even more on energy consumption than Germany. This will be reflected in different economic performance: within the Eurozone, the GDP hit is not going to be even. Outside the EU19, we factor in no need for energy rationing.
But even if rationing energy usage was limited to Germany – which is currently at stage two of a three-stage emergency gas-rationing plan – this would have severe repercussions for the rest of the Eurozone given the close trade linkages: Germany accounts for 17.1% of the other 18 Eurozone countries’ goods exports, as well as 16.1% of their goods imports. Meanwhile, the UK is less exposed, importing both less gas from Russia and having below-average trade links with Germany – 9.2% of exports and 11.3% of total goods imports.
Even less at risk in both regards is the United States. Indeed, generating sufficient gas to meet all its domestic needs, and with the added incentive to extract more given the rocketing price, the terms of trade surge for gas may even be a net plus for the country. But that needs to be set against losses in households’ real purchasing power from higher inflation and higher interest rates, and against the negative impact of weaker world demand, which are likely to dominate. In summary, a negative impact on global GDP is likely – at the epicentre of which we see the Eurozone, followed by the UK and then the US.
Of course rationing has a direct impact on GDP, as restrictions on inputs inevitably mean less output being produced. Markets are likely to push energy prices up even further in this scenario, making the limited gas that is available from storage and through imports more expensive still. The high price will, by discouraging the use of energy, have further indirect negative impacts on output, above and beyond the rationing itself – and also for countries not subject to rationing themselves. In other words, rationing may be local but falling energy demand will be global, owing to market forces.
The end result, in our projections, is a 50% rise in gas prices at the European consumer level.
How big a price rise would occur relative to what has already taken place is hard to pin down. The head of the German federal network regulator has warned that households could face a threefold rise in gas prices in this scenario. We doubt a surge in consumer bills as crippling as that would be politically tolerable. Various fiscal support measures have been put in place to limit the pain for consumers. We would expect the government to pick up the tab again to curb the price paid by households and certain businesses – funded by further windfall taxes but especially higher government borrowing – and skew increases towards the better off. However, a higher price is likely to be tolerated, as it gives incentives to reduce consumption voluntarily. The end result, in our projections, is a 50% rise in gas prices at the European consumer level. Given pressures on other competing primary energy sources, we assume a motor fuel rise of approximately 20%.
As regards rationing itself, this is clearly far from straightforward. A simple haircut for all end users of gas is obviously undesirable; rather, protecting essential services such as hospitals will be a priority. Some households and firms are able to reduce energy consumption more easily than others. In certain cases, permanent damage to production facilities can occur if gas is unavailable for a prolonged period of time, for example in ceramics. Careful industrial planning is hence needed to minimise the wider economic impact of rationing. The task is extremely challenging, and it is inevitable mistakes might be made.
To sum up, the scenario we envisage entails an immediate halt to Russian gas exports to Europe. Given the limited scope for substituting the missing Russian gas supplies with gas from other markets or by switching to other forms of primary energy in the near term, this would lead to a further spike in the price of energy worldwide, and to rationing of gas supplies in most of the EU19 to prioritise essential services and distribute supplies in the least damaging way. This would depress energy demand and thus output for all net importers of gas, albeit to varying degrees. We see the largest hit in the Eurozone, with a six percentage point drop in GDP. Taking into consideration trade linkages and energy price changes, we pencil in a fall of 4.5% and 3.2% for the UK and the US.
Rate rises may be sharp – but followed by cuts before long
In the immediate aftermath of the Russian gas import stop, notwithstanding timely fiscal transfers to limit the price rises for end consumers, higher energy prices would push up headline Eurozone inflation. We have pencilled in a peak of over 14% in October, versus 8.6% in the latest June numbers. Initially, energy rationing, by curbing production of goods and services that use energy as an input, would also exacerbate the supply chain shortages that are currently rife. These would also be most acute within the Eurozone, but spill over to the rest of the world.
Once other EU sanctions bite (no Russian oil or oil product imports are allowed as of the end of this year), the lack of Russian diesel (currently accounting for 50% of European supplies) may push up its price even further above the current record levels, affecting the cost of haulage and shipping. Central banks would thus see even further reasons to act by raising policy rates to keep inflation expectations in check. We have pencilled in peaks of 1.25% for the ECB deposit rate, 3.00% for the UK bank rate and 4.00% for the Federal Reserve Funds target, respectively.
We doubt it would be long, however, before cost squeezes, supply disruptions and rising interest rates lead firms to shed staff. This, in turn, would lift unemployment rapidly from its current lows: we factor in peak unemployment rates of 11%, 8% and 6% in the Eurozone, UK and the US, respectively. Painful though this would be, this would help cool price pressures. Indeed, we foresee a swifter cooling in service prices than in goods price inflation. By the first quarter of 2023, as the danger of high inflation becoming embedded in wage demands recedes, we expect central banks to switch tack and start cutting rates again. With the usual lags – seen typically as a year to 18 months – a less restrictive monetary policy stance should eventually help support activity and lower unemployment.
We would put the likelihood of the downside scenario as playing out at roughly 25%.
Undoubtedly, this is a gloomy scenario in the near term. However, the seeds of an eventual rebound are already being sown, through high government investment. Eventually this will pay off in the form of a more secure, resilient and ultimately more climate-friendly energy supply. In our scenario, alternatives to Russian gas will start to come onstream in meaningful size from the end of 2024. Energy prices, plateauing at very high levels until then, would start to retreat. But because of the high cost associated with energy investments, we only foresee a fairly gentle and partial fall in consumer-level energy prices, largely concentrated through 2025. Altogether, we pencil in Eurozone core inflation troughing in early 2024 but headline inflation bottoming out only in mid-2025.
In conclusion, the scenario we have just described is clearly more negative than our baseline view, in which Russia maintains gas flows to Europe. Indicatively, we would put the likelihood of the downside scenario as playing out at roughly 25%.
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