Why energy prices are so high right now

UK energy prices are going through the roof – and not just here. They are rising all around the world. Saloni Sardana explains what’s going on.

Energy prices have soared in recent months all across the world, with natural gas, electricity and coal just some of the commodities that are surging in value.

Energy prices fell when Covid-19 lockdowns were introduced, but demand returned with a vengeance as the world eased restrictions and grappled with the “new normal”. Wholesale European gas prices rose by more than 300% last year, pushing up the cost of electricity and driving around 30 providers to go bust in the UK alone.

Higher energy prices also resulted in a rise in the UK’s energy price cap, which rose by £693 last week, and will come into effect in April. This is exacerbating a cost of living crisis in the UK.

With so many moving parts, it is easy to get confused about which factors are contributing the most to the current energy crisis

MoneyWeek has rounded up some of the biggest factors behind energy inflation right now.

The Covid-19 effect

Calling Covid-19’s effect on the energy market profound would be an understatement. Unsurprisingly, demand for energy plummeted due to the pandemic-related restrictions over the last two years, as did supply, but roared back after restrictions eased. But supply still lagged demand, taking us to where we are now.

The supply side of the gas market has been complicated by the push to reduce fossil fuel use, as well as international political factors. The switch from gas to less carbon intensive energy such as wind and solar has made it harder for gas suppliers to project demand.

That is the crux of the problem in the UK, which has been particularly hit hard by the crisis due to its reliance on natural gas.

Wind generation has been unreliable

More and more of the UK’s power is coming from onshore and offshore wind. The problem with this, says Sky News’ Ed Conway, is that wind output is both unreliable and inconsistent. For example, in recent weeks wind has generated more than half of the UK’s electricity, while on other days it generated just a tenth, with the shortfall being made up by gas.

Nevertheless, “that wind power (or for that matter solar power) are inherently intermittent is not going to stop this country from eliminating greenhouse gas emissions in the coming years,” he says.

The UK has to “develop cost effective and viable” alternate forms of energy “when the sun isn’t shining and the wind is not blowing,” points out Peter Bruce, professor of materials at The University Oxford.

The UK’s energy market has faced other setbacks in recent months, including outages at nuclear plants, and a fire that shut down a vital electricity interconnector last year, all of which have increased demand for gas and caused higher prices and even food shortages.

Global gas crisis has boosted the demand for LNG

Another major factor propelling energy prices to new highs is unusually high demand for liquefied natural gas (LNG), natural gas that has been converted to liquid form to make it easier to transport by sea rather than via pipelines.

The UK could have simply just bought more LNG to account for the deficit from other sources of energy, but LNG prices have been rising fast as several Asian countries including Japan, South Korea and China have snapped up huge quantities of LNG to pivot away from using coal.

Indeed, Chinese imports of LNG were 22% higher between the first and third quarter of last year compared to the same period in 2020, says consulting giant, McKinsey & Company.

As Rupert Harrison, former chair of the Council of Economic Advisers and multi-asset manager at BlackRock, points out higher demand from China as the country tries to meet huge energy needs of its growing economy and shift away from highly polluting coal is driving up the price of LNG.

“In December so much LNG was heading for China that the wholesale price of gas in Europe almost doubled again in the space of a week as energy companies scrambled to secure enough supplies.”

Production of gas is falling in the EU and the UK

European gas production has also been falling for several reasons.

In the UK, gas production has been affected by planned maintenance that has been delayed from the summer of 2020, says The Oxford Institute for Energy Studies. Gas production has also been in decline in The Netherlands’ Groningen field – Europe’s largest gas field –, and is due to completely end in 2022, eight years earlier than planned, because of the risk of earthquakes in the region caused by production drilling.

“Therefore, not only was European production in 2021 down in comparison to 2019, but in 2022 any rebound in the UK will be offset by a further decline in the Netherlands,” says The Oxford Institute for Energy Studies.

The UK also has much less gas storage compared to its European peers, roughly at around nine terawatt hours of stored gas reserves compared to 168 for Italy and 151 for Germany, the New Statesman reported last year, citing data from Gas Infrastructure Europe, a non-profit association.

Governments aren’t spending enough on green projects

The Paris-based International Energy Agency points out that investments in oil and natural gas have declined in recent years due to two commodity price collapses – in 2014-2015 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.”

Conway echoes this view. Even though several countries have ambitious targets on reaching net zero emissions by 2030 or achieving similar emission reduction targets, government spending doesn’t reflect that, he says.

“On the contrary, investment in primary energy – those plans and solar panels and wind turbines we need to give us power – has flatlined since 2015,” he adds. Conway believes the crisis is long-term in nature and will result in many years of high energy prices due to chronic under-investment in the sector.

How does Russia factor into this?

Russia’s importance to global energy markets cannot be dismissed, it provides one third of Europe’s natural gas.

Russian president Vladimir Putin has been accused by Europe of using gas as a bargaining chip to garner faster approval for its contentious Nord Stream 2 natural gas pipeline.

Nord Stream 2 is a $11bn gas pipeline project that is owned by Russian state-owned Gazprom which runs from western Siberia to Germany and is at the centre of a disagreement between Germany and the US.

The project intends to double the capacity of the Nord Stream 1 pipeline which is already operational. But, while proponents of Nord Stream 2 say it will improve energy supply in Europe, its critics fear it will adversely affect Ukraine as the project potentially will eradicate $2bn in transit fees that Ukraine currently earns from Russia to allow gas to pass through its territory.

Tensions between Russia and Ukraine have also been simmering and reached a new low in recent days after Russia assembled more than 100,000 troops near Ukraine’s borders. Although Russia has denied that it intends to invade Ukraine, the developments have still prompted jitters in financial markets, and mainly energy markets.

While the UK is not as reliant on Russia, wholesale prices rising in Europe will mean they rise here too.

Ofgem, the UK’s energy regulator, warned MPs last week on the Business, Energy and Industrial Strategy Committee that electricity prices could rise further before next winter if Russia were to invade Ukraine.

“We are not experts in geo-politics but we expect that if Russia invades Ukraine – there is a sanctions regime and that Russia limits gas supplies to Europe,” Ofgem’s chief executive Jonathan Brearley said. “That would drive high price rises and that would ultimately feed through to customers.”

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