Energy Crisis - Is Europe “left out in the cold” or “turbo charged”?
The global economy over the last few years has been rocked by a string of unexpected events, from a global pandemic with supply chain bottlenecks and semi-shortage to more recently - a war in Europe and a regional energy crisis. We are hearing EU politicians talk about “flattening the curve”, referring to the energy demand in Europe during peak hours where the share of non-renewable energy is at itshighest. The impact of the current energy crisis carries multiple risks; financially, that high power prices will fuel inflation and eat into both household spending and companies’ profitability, and operationally, that a lack of gas supply could force industries to shut down and households to freeze. For the environment, the crisis has also led to a comeback of coal, lignite and oil for power generation that all have a pronounced negative climate impact.
Why is this happening now?
After the pandemic, central banks and governments resorted to unprecedented stimuli to avoid the immediate harm to GDP from lockdowns. As the world reopened, the vast stimuli resulted in sharp rises in demand which supply couldn’t cope with and that drove both inflation and energy prices higher. Then in late February, Russia launched a full-scale invasion of Ukraine in an attempt to force the country under Russian rule. For the West, this crossed a line and harsh sanctions were put in place against the invader, including a freeze of Russian Central Bank assets and export bans on critical technology. To sway European politicians away from these measures, Russia “weaponized” energy in the hope that an energy crisis would shift the public support away from Ukraine and force politicians to make a deal with Russia, possibly reverting sanctions.
How important is Russian energy for Europe?
In short, very! Europe, whose economy makes up almost a quarter of global GDP, has a large industrial base that is reliant on both energy and commodity imports and the access to high quality oil and cheap natural gas from Russia has worked in favour of the region’s growth. Unfortunately, this has now turned into a double-edged sword. Few politicians expected Russia to turn off the taps (even during the peak of the cold war, business remained “as usual”), and in recent times dire decisions have been made; shutting down several nuclear plants and extending the reliance on Russian natural gas, for an interim period, while renewable energy sources were being developed.
According to Eurostat, more than half of regional energy consumption in 2020 was from imported sources, and Russia made up roughly a third of this. Natural gas in turn is roughly 20% of the total energy mix, of which 40% is normally sourced from Russia. For individual countries however, the share of dependence on Russia varies and Italy and Germany have a higher dependence on Russian gas for both industrial use and the heating of households.
Can Europe rid itself of Russian gas dependence?
While oil can with relative ease be sourced elsewhere, this is more difficult for gas. Transporting the energy source through means other than pipelines require liquifying it to LNG and then regasifying it, as well as shipping it on specialized vessels – all of which requires infrastructure that is not yet available in the scale needed to accommodate the European shortfall.
While supply is somewhat difficult to ramp up, measures can also be taken to mitigate demand. Simple measures such as reducing indoor heating temperatures by only 2 degrees would reduce the energy usage by more than 10%. Some industrial processes allow for fuel switching, where gas use is replaced by oil, or even electricity, while others may not be critical for Europe and could be shut down. Glass for example is a relatively commoditized product where it could make more sense to import it rather than producing domestically.
Europe can to some extent also manage the gas shortage by building inventories during summer months when demand is low and use this as a buffer during the winter months. The EU’s gas inventories make up roughly a third of demand during winter months and these are now close to 90% full, implying that Europe should manage, at least, the coming winter.
What are politicians doing?
While nothing has yet been decided, The EU has proposed a mandatory demand cut of 10%, a price cap of EUR 180/MWh on energy sources with low marginal cost and windfall taxes on oil & gas producers benefitting from the current crises. A price cap on natural gas has also been floated, but many politicians fear this would mean supply goes elsewhere. If the proposed measures are successful, power prices will likely stabilize, albeit at higher levels, and inflation pressure should gradually start to fade. Proceeds from windfall taxes will also be used to accelerate the build out of renewables and we should expect further measures to make permitting processes more efficient and LNG infrastructure to be built out, so that the leverage Russia currently have is eroded over the next few years.
How are East Capital Group’s investment strategies impacted by this?
East Capital Group invests into global quality companies with a focus on structural growth led by Innovation and Sustainability. Some of these companies are based in Europe and have seen their share prices under pressure this year, partly due to the energy crunch. But while their integration into Europe may be large, we have very limited exposure to gas dependent and energy intensive businesses, at least not directly. As for our European industrial companies, even at a power price of EUR 200/MWh, the cost as a percentage of sold goods is only in the range of 1-2% and with specialized products that cannot easily be substituted, these costs can be passed onto customers. This is also one of the reason most of our portfolio companies are still maintaining their outlooks, contrary to what sentiment would suggest.
While investors are currently focusing on the cost side, Europe’s best passage to the other side of this crisis is further investments into renewables, electrification and industrial digitalization that, over time, will translate to higher revenues for the companies we invest in.
This holds especially true, for example, for our Espiria SDG Solutions Fund, an article 9 fund (“deep green”) that seeks to invest in companies with tangible contribution to UN:s Sustainable Development Goals. The fund invests through a thematic lens where Energy Transition, Connectivity & Infrastructure and Circular Economy make up around two thirds, and all themes include companies we believe to be medium-term beneficiaries against the current backdrop. While our East Capital Emerging Markets Sustainable Fund, also article 9 “dark green”, lacks a footprint in Europe, the fund has material exposure to the energy transitions through investments into leading solar, wind and battery producers. As the current crisis have put reduced energy dependency at the top of every politicians agenda, this strategy offers a good way to benefit from this. Looking at solar alone, over 90% of global production is in China.
How will things develop and what does it mean for the markets and their investors?
The indirect impact on Europe from elevated power prices should of course not be ignored as GDP growth forecasts are being revised lower, consumers scale back their spending and some households risk not being able to pay their bills without government support (though we expect this will come). How this develops will drive market volatility and it is fair to say the backdrop for Europe is weak, but luckily, so are valuations. On a sector neutral basis, European stocks are now trading near a record 20-year discount to US while investor sentiment is at an absolute bottom. We don’t know for how long this crisis will last but Europe will get through it. Therefore, we continue to invest with a balanced approach in European companies we deem are well positioned for the future, especially where current share prices don’t reflect the true earnings power.
Summary
Energy has become a major source of geopolitical tensions. Europe account for almost 25% of global GDP and has a large industrial base that is reliant on Russian energy. In the short-term, oil could be sourced elsewhere but complicated logistics make this impossible for gas, leaving Europe with an energy shortage that must be addressed. There are simple solutions, but these solutions depend upon swift political decisions and the timely adoption of pinpointed efforts. Long-term, the attention to energy solutions and commitment to erode Europe’s Russian energy dependency could have a quickening effect and the European energy transformation may just get turbo charged.
