By Linus Claesson
Policymakers have moved from a single objective of net-zero, to a “trilemma” of goals including net-zero, supply security, and affordability.
Even in the depths of the Cold War in the 1970s and ’80s, Russian natural gas continued to flow into Europe. A severe reduction of gas supply would mark a sharp deviation from history – but, alas, could be a real possibility given today’s rapidly changing geopolitics.
European natural gas consumption stood at about 527 billion cubic meters in 2021, of which roughly 170bcm was supplied by Russia; clearly, interrupted flows would prove highly disruptive. The European Commission’s plan to lower reliance on its eastern counterpart depends heavily on offsetting Liquified Natural Gas imports and accelerating the deployment of renewables. Higher LNG imports represent the largest short-term contributor to energy diversification, but this market is already tight, and extra demand would tighten it further. To attract large additional quantities of LNG, European gas and LNG prices would need to rise to a level where demand destruction would take place elsewhere, most likely in Asia. In the short term, LNG demand has low price elasticity, which means that European gas prices may need to rise from current record levels. Further, power prices in Europe are driven by variable operating cost on each marginal unit of production – meaning that if natural gas prices go up, power prices would rise in tandem.
These dynamics put European households in a particularly vulnerable position. Besides cost inflation in gasoline and food, the average household would see its gas and power bills increase by nearly €900 per year or about 76%. On the other hand, policy actions including claw-backs and tariff freezes are set to cover about 40% of the implied increase – limiting the average household increase next year to around 47% versus 2020.
The “trilemma” of balancing the conflicting dynamics of net-zero ambitions, supply security, and affordability clearly brings challenges to the investment decision-making process. How should investors juggle policy intervention, a cost-of-living crisis, and rising investment needs and higher capital intensity, while also facing the tail risk of curtailed European natural gas imports? We believe an answer lies in power network assets and renewables developers, which we consider to be positively exposed to many or all of these dynamics. These assets benefit from higher inflation as well as current and pending policy initiatives, which we think is likely to raise their earnings power. Companies with such assets may represent an interesting place to start the search for attractively valued ways to mitigate the impact of the inflationary European energy squeeze on credit portfolios.
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