What is behind soaring energy prices and what happens next?

Gas, coal and electricity prices have in recent weeks risen to their highest levels in decades. These increases have been caused by a combination of factors, but it is inaccurate and misleading to lay the responsibility at the door of the clean energy transition.

In this commentary, we provide an overview of the main drivers behind the current price increases and their near-term consequences. 

The historic plunge in global energy consumption in the early months of the Covid-19 crisis last year drove the prices of many fuels to their lowest levels in decades. But since then, they have rebounded strongly, mainly as a result of an exceptionally rapid global economic recovery (this year is on track for the fastest post-recession growth in 80 years), a cold and long winter in the Northern Hemisphere, and a weaker-than-expected increase in supply.

Natural gas prices have seen the biggest increase, with European and Asian benchmark prices hitting an all-time record last week – around ten times their level a year ago. US month-ahead natural gas prices have more than tripled since October 2020 to reach their highest level since 2008. International coal prices are around five times their level a year ago, and coal power plants in China and India, the world’s two largest coal consumers, have very low stocks ahead of the winter season.

The strong increases in natural gas prices have prompted substantial switching to the use of coal rather than natural gas to generate electricity in key markets, including the United States, Europe and Asia. The increased use of coal is in turn is driving up CO2 emissions from electricity generation globally.

The higher gas and coal prices, combined with rising European carbon prices, have resulted in higher electricity prices. In Germany, electricity prices leaped last week to their highest level on record, up more than six times from a year ago. In Spain, where gas-fired power generation plays a larger role in setting electricity prices, the increase was even higher. In recent weeks, lower-than-expected wind generation has provided additional upward pressure.

Meanwhile, global oil demand continues to recover from its 2020 lows, and prices at the pump in many countries are at or near their highest levels in years. Companies around the world are expected to continue to draw on their oil stocks to help meet demand until the end of this year.

The price increases are expected to result in sharp upward pressure on household energy bills and also present broader risks to economic activity, especially for sectors that are directly exposed to the price rises. Many governments have taken measures to alleviate electricity bills, especially for vulnerable consumers.

In Europe, many businesses are likely to face the double impact of rising energy costs and a potential decline of consumer spending due to households’ increased energy-related expenses. Rising power prices are already impacting operations of electricity-intensive industries. And several companies have temporarily curtailed ammonia and fertilizer production, citing deteriorating margins due to the sharp increase in gas prices.

In China, rigid electricity tariffs have not followed the large increase in coal prices. As a result, coal power producers have insufficient coal on hand and rolling blackouts have occurred across two-thirds of Chinese provinces. Large energy-intensive industries – including steel, aluminium and cement – have been directed to cut production. The effect on global supply chains is not yet clear. In the northeast provinces of Heilongjiang, Jilin and Liaonin, even households are suffering power cuts, which is likely to have policy implications.

In India, the economic recovery and related increase in energy demand are causing a coal shortage. India’s domestic coal mining, which accounts for 80% of the country’s supply, has been unable to keep pace with demand, and higher international prices are making imports uneconomical. Power plants that rely on imported coal have slowed or even halted operations, and some plants that rely on domestic coal are starting to run out. Despite government efforts to address the shortages, several Indian states have suffered serious power shortages in recent days, affecting both residential and industrial customers. 

The current high coal and gas prices are not the result of a single “shock event” on the demand or supply side. Rather, they result from a combination of supply and demand factors that gradually tightened markets over the course of several months and even years.

Investments in oil and natural gas have declined in recent years as a result of two commodity price collapses – in 2014-15 and in 2020. This has made supply more vulnerable to the sorts of exceptional circumstances that we see today. At the same time, governments have not been pursuing strong enough policies to scale up clean energy sources and technologies to fill the gap.

Against this backdrop, both coal and natural gas demand recorded strong gains across key markets in the first half of 2021 as the global economy rebounded. Initial estimates suggest that natural gas and coal consumption in these key markets increased by 8% and 11% respectively, compared with the first half of 2020. As well as the economic recovery, these rises were driven by a number of weather-related events, including a cold winter in the Northern Hemisphere, droughts that curtailed hydropower output in Brazil and elsewhere, and lower-than-average wind generation in Europe. 

In terms of supply, both natural gas and coal have faced constraints. The Covid-19 lockdowns pushed some maintenance work from 2020 into 2021, which weighed on supply at a time when demand was recovering. The impact was particularly tangible in the UK and Norwegian areas of the North Sea Continental Shelf. In addition, unplanned outages at LNG liquefaction plants, upstream supply issues, unforeseen repair works, and project delays all further tightened the global gas market. The amount of global LNG supply affected by outages in the first nine months of 2021 was up by an estimated 27% compared with the average for the same period throughout 2015-2020 – with most of the outages unplanned. Russia’s Gazprom, while honouring its long-term supply contracts, reduced its exposure to short-term sales and has not replenished its own storage sites in Europe to the levels seen in previous years. Gas supplies from the Groningen fields in the Netherlands, which are being closed in 2022, continue to be reduced as planned.

We estimate coal demand in China was up more than 10% in the first half of 2021 from the same period a year earlier, but coal production increased just over 5%, pushing up prices. With China by far the world’s largest coal consumer and the price setter for global coal markets, international prices followed those in China. Disruptions among major exporters – in particular Indonesia, the world’s largest thermal coal exporter, and to a lesser extent Australia and South Africa –pushed up prices further. High prices for natural gas, the main competitor of coal in power markets, also supported coal prices. 

Due to strong demand growth and tighter-than-expected supply, European underground gas storage levels at the end of September were 15% below their five-year average levels. Low storage levels are expected to further increase Europe’s reliance on gas imports through the heating season. In Brazil, the prolonged drought left the country’s huge water reservoir levels 25% below their five-year average by the beginning of October, which could lead to further demand for LNG imports in the coming months. Prospects for the coal market, with low inventories ahead of the winter season not only in China but in all key consuming regions, are little better.

Current market dynamics (forward curves as of beginning of October) suggest that European benchmarks for natural gas (TTF) and coal (Rotterdam coal) will remain high, averaging USD 30/MBtu and USD 190/t through the 2021-22 heating season respectively.

Globally, the key drivers of energy market dynamics over the coming months will be the severity of the Northern Hemisphere winter, the strength of economic growth trends and the magnitude of unplanned supply outages. Prices of both natural gas and electricity will fluctuate in Europe depending on temperatures, wind output and many other factors. In this sense, weather conditions will affect markets from both the demand and supply sides. These fluctuations may be exacerbated by reduced natural gas storage levels, since these result in lower pressure levels that weigh on the ability to withdraw gas from storage sites during periods of high demand. 

It is legitimate for countries to take emergency measures such as temporary relief from some taxes or charges to ease the burden on consumers, especially the most vulnerable, from periods of short-term market turmoil. But these measures should be implemented in such a way that they do not worsen the investment environment for low-carbon energy sources and technologies – such as renewables, energy efficiency, electricity grids, nuclear power and sustainable biofuels – which are vital for the transition to cleaner and more resilient energy systems.