The current surge in gas prices has its causes in the ongoing war in Ukraine: tensions over supply have resulted in an unprecedented surge in market prices, which is or will ultimately be passed on to consumers in Europe. While this unprecedented crisis has major geopolitical implications, it should also raise questions about the organization of the market put in place in Europe over the past twenty years and in particular its consequences on long-term contracts: is this organization optimal for in the face of crises?

An unprecedented surge in gas prices, major impacts for households and businesses in Europe

On Tuesday March 8, 2022, natural gas market prices in Europe reached 345 euros per MWh: these are unprecedented price levels, 10 to 15 times higher than the “usual” pre-crisis market prices. Reduced to the average consumption of a French household (15 MWh per year for a single-family house), maintaining prices at this level could result in an increase in the annual gas bill of several thousand euros per year.

Since October 1, 2021, the French government has adopted a "tariff shield" allowing the evolution of gas prices to be frozen for all households still having a regulated tariff contract (intended to disappear in June 2023) or indexed to the regulated tariff. Without this device, prices would have had to increase by 66% on February 1, 2022 compared to October price levels [1]. But this device has a high cost, which will ultimately have to be borne by gas consumers via a catch-up on future bills, or even by taxpayers if the State were to bear part of the costs of this tariff shield. Moreover, companies are directly subject to these increases in gas prices, leading to considerable increases in their production costs, raising fears of temporary or even permanent closures for certain activities.

First adaptations of the European regulatory framework to deal with the crisis

While the price spike is largely due to Europe's heavy dependence on Russian gas imports and the consequences of the conflict in Ukraine, the organization of the European gas market does not seem suited to dealing with a crisis of this magnitude.

After two decades marked by the gradual liberalization of the European gas market, the European Union has urgently adopted interventionist measures marking a radical shift from its recent vision [2]. It will thus impose that the gas storages be filled to 90% for the next winter (in most countries, the filling of storages was supposed to be ensured by market players but in practice, the cost of this physical insurance being often more expensive than purchases on wholesale markets, gas storages were often underused). The European Union also wants to reduce Russian gas imports by two-thirds, which will require intervening in the framework of bilateral contractual relations between European gas importers and Gazprom.

Do long-term contracts still contribute to supply security?

The majority of natural gas imported into Europe is under long-term contracts between producers such as Gazprom (Russia), Equinor (Norway), Sonatrach (Algeria) and downstream resellers, mainly the former national monopolies such as ENGIE in France. These long-term contracts have historically been signed to ensure security of supply for several decades, a concept which, according to the definition of the International Energy Agency, includes both security of supply in volume (the gas must be physically delivered) and in price (the price level must be sustainable for both parties).

It is worth considering whether, in their current form, long-term contracts still play this role. Since the liberalization of the markets, their structure has changed considerably. Historically, long-term gas contracts were indexed to the price of oil and petroleum products. Some contracts contained so-called “solidarity” mechanisms making it possible to avoid extreme prices through less strong correlations with oil prices in the event of low and high levels, or even the integration of price floors and price ceilings [3]. Today, the prices of long-term contracts are essentially set by wholesale market prices: this is the case at 99% for ENGIE supplies [4]. Even if the gas arrives physically, consumers are thus bearing the brunt of market tensions, with no protection mechanism on the part of producers.

In addition, it is no longer certain that all of the gas contracted over the long term will actually be delivered. In order to develop wholesale markets and competition in Europe, European authorities and regulators have in fact encouraged long-term contracts, which were traditionally delivered at network interconnection points between importers and exporters, to be delivered on market places[5]. While this measure was based on a laudable intention in terms of downstream competition, it also offers producers a strategic lever: instead of producing the contracted quantities of gas in order to deliver them, they can buy part of the gas on the market places. and resell it to honor their long-term contracts. If this strategy has no relevance for a small player and when the markets are well supplied, it can be carried out by a dominant player to drive up wholesale prices, and all the more so if this player has rationales other than economic ones.

Adapt long-term contracts to materialize a “new deal” between Europe and certain producing countries?

By deciding to reduce Russian gas imports by two-thirds by the end of the year, European Union has already chosen to intervene in bilateral relations and replace market players. An even greater intervention could make sense, so that all long-term contracts once again contribute to the security of supplies in Europe, both in volume and in price. This could be the case by reintroducing “solidarity mechanisms” between buyers and producers in order to counter the surge in gas prices in the short term.

Because if Europe currently needs large quantities of gas at affordable prices to replace Russian gas, it ultimately wants to massively reduce all its fossil gas imports to achieve its carbon neutrality objectives by 2050. It could there will thus be material for a “new deal” between Europe and some of its suppliers to implement an economically sustainable energy transition for all stakeholders.

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References

[1] From CRE, French energy Regulator : www.cre.fr/Actualites/publication-des-baremes-applicables-pour-les-tarifs-reglementes-de-vente-de-gaz-naturel-fevrier-2022

[2] « Competitive markets ensure security of supply », Agency for the Cooperation of Energy Regulators “European Gas Target Model Review and Update 2015”

[3] « The pricing of gas in international trade – an historical survey », Jonathan Stern, Oxford Institute for Energy Studies 2012.

[4] French Energy Regulator CRE « délibération 2021-203 du 24 juin 2021 portant sur le projet d’arrêté relatif aux tarifs réglementés de vente de gaz naturel d’ENGIE ».

[5] « The evolution of European traded gas hubs », Patrick Heather, Oxford Institute for Energy Studies 2015.