Money, it's a gas

Key Points

• We look at the implications for the Euro area of higher natural gas prices in the context of the Ukrainian crisis.
• We discuss Francois Villeroy de Galhau’s proposal to provide the ECB with more flexibility on the timing of its lift-off.

As tension between Russia and Ukraine continues to mount, we look in details at the impact a sudden stop in Russian gas supply would have on the Euro area economy. Natural gas has become crucial for purchasing power dynamics. The direct effect of higher gas prices has already shaved 0.5% off real disposable income over one year in December 2021. More importantly, the indirect impact through electricity prices has also become significant, since gas-fired power stations are now the “marginal supplier” without which electricity demand cannot be fulfilled. The correlation between gas and electricity prices has thus got very tight, and this channel has shaved another 0.7% off purchasing power over one year in December 2021.

There is no easy alternative to Russian supply in the short run. Europe has increased its capacity to receive liquefied natural gas from the US and Qatar, but these two key exporters do not have much spare room to lift their output further. Raising the contribution from coal, as it has already been the case last year in Germany, is not palatable given its huge carbon footprint. Raising the share of nuclear power supplied to distributors at below-market prices is in general not an option outside France. The solution probably lies in a fiscal accommodation of the income shock – possibly offset by some windfall tax on low-cost electricity producers –  but the countries where the rise in electricity prices has been the steepest are also the “fiscally fragile” ones, such as Italy and Spain.  Beyond the short-term management of a possible additional energy shock, the renewed tension with Russia may prompt a re-think of the EU’s overall energy strategy. Even some costly new nuclear solutions get more attractive if raising baseload capacity becomes a priority as the cost and sheer availability of the currently dominant “marginal energy” become problematic.

The ECB will be one of the key players in dealing with the fallout of an exacerbation of tension with Russia which would be reflected in even higher energy prices. In an interview with the Financial Times board member Isabel Schnabel was reassuring: the ECB would not “accelerate the normalization of monetary policy” in such a configuration. Still, a geopolitical shock would add to what is already a very uncertain trajectory for the Euro area. In this context, we discuss Francois Villeroy de Galhau’s recent proposal to provide the ECB with more flexibility on the timing of the lit-off in policy rates.