The EU’s free market principles: standing the test of time

THE 2022 CRISIS (THAT NEVER WAS)

Early in 2022, in the aftermath of Russia’s invasion of Ukraine, the EU unveiled a radical ambition: to reduce reliance on Russian gas by two-thirds that year, followed by complete independence from Russian fossil-fuels well before the decade’s end.

What followed has become known as the energy crisis of 2022. But, as global gas flowed into Europe, infrastructure build was rapidly accelerated and public buildings from Berlin to Brussels lowered heating and dimmed lights, the much-assumed and widely-feared ‘crisis’ never materialised.

What did emerge was evidence of an extraordinarily durable market design. One that withstood the most extreme stress test and, ultimately, did what it was intended to do: safeguard supply security through the formation of price signals that reflected the stark reality on the ground.

Two years on from the Russian invasion of Ukraine, Europe’s structural pivot away from Russian gas has proved a resounding and unlikely success. The continent’s gas prices are stable, its stocks are full, and its import capacity is booming.

The integrated electricity and gas markets established by the EU over the last three decades have saved consumers billions of euros over the years, driven technological progress and helped the EU avert an energy crisis that even the most optimistic of experts in early 2022 considered inevitable.

By comparison, the controversial market interventions of 2022 are yet to prove of any lasting value.

The liberalised market model has come through extreme stresses and emerged intact. Its next challenge will be the energy transition. Provided the market model’s guiding principles – free trade, fair competition, deeper integration – remain unchanged, it should prove as fit for our next generation’s low-carbon future as it has for the unexpected challenges of the recent past.

1. HOW WE GOT HERE

EU energy market liberalisation began in the 1990s. Security fears subsided after the Cold War, and market forces were unleashed to guide policy and shape behaviour. The liberalisation of strategic sectors such as electricity and natural gas became the narrative of choice across Europe.

The aspiration found fertile ground. The EU’s founding treaties and acts had outlined a vision for achieving prosperity and peace by guaranteeing the free movement of goods, services, capital and people through common rules for all states.

The EU’s electricity and gas markets were established in that spirit, aiming to provide affordable and secure energy supplies by integrating competitive forces.

Energy market reforms were rolled out across five packages. Although the initial two were timid in scope, the third package of 2009 went much further, becoming the cornerstone of the internal energy market.

The remaining two packages adopted in recent years reflected the EU’s newer challenges, aiming to prepare markets for the energy transition and the phase-out of fossil fuels.

There is clear evidence that free markets have brought concrete benefits including cheaper prices, significant savings and greater energy security.

Competitive prices

The early stages of development of the UK’s NBP gas market – the first to liberalise across Europe – show the emergence of competition brought not only greater flexibility but also more competitive prices.

Before 1990 markets were firmly under the control of monolithic state-owned incumbents. But after 1990, coinciding with the ‘dash for gas’ encouraged by booming North Sea production, the price of natural gas was increasingly set by supply and demand rather than embedded in long-term contracts between producers and consumers.

Because of competition in both gas production and wholesale gas market expansion, the British NBP price generally traded below Germany’s border import (BAFA) price.

Security of supply

Another goal pursued by the EU has been supply security. With limited gas production of its own, the bloc has historically been dependent on pipeline imports from Russia, Norway, Algeria and Libya.

Growth in global LNG supplies allowed countries such as France, the Netherlands, Italy and the UK to expand LNG import facilities and secure volumes from emerging producers.

The incentive provided by the price signals at gas hubs sparked private investment in new infrastructure including new pipelines and LNG regasification terminals which allowed member states to diversify supplies.

This proved of critical importance in 2022 when Russia, as Europe’s main supplier of gas, stopped most of its exports.

2. AVERTING CRISIS

Between the second half of 2021 and the end of 2022, Europe witnessed a sharp decline in gas supplies which left wholesale prices and trading volatility spiralling. The situation unfolded against a background of factors:

• Rising demand following the lifting of Covid-related restrictions
• Production problems at various LNG plants across the world
• Russia’s curtailment of supplies to Europe before and after its invasion of Ukraine

Considering the experience of 2022, is the liberal market model adopted by the EU in the 1990s fit not just for today, but for the challenges of tomorrow too?

From one extreme…

Concerned by the developments of 2022, the EU adopted a raft of interventionist measures ranging from mandating storage stocks across all EU member states to designing tools to intervene in wholesale gas prices.

The sheer volume of regulations designed to shield consumers was unprecedented. However, while some regulations such as the introduction of mandatory storage quotas were useful as they forced member states to ensure backup supplies, others were not needed or failed to make an impact.

For example, the market correction mechanism was introduced in February 2023 and subsequently extended to all EU hubs in May of that year. It was intended to cap gas prices in the event of extreme and sustained price increases.

But as global trade patterns have realigned, hub prices have progressively fallen since the end of 2022, and the increase in supply flexibility from a global LNG market means the type of extreme supply shock seen in 2022 will not be repeated.

This means the market correction mechanism is highly unlikely to be triggered and will have no impact on markets, a fact that was highlighted by the EU’s Agency for the Cooperation of Energy Regulators (ACER) in a report. Instead, the report noted prices rebalanced as markets responded correctly – even during periods of extreme stress.

And data collated by ICIS confirms the ACER findings. Gas consumption fell on average 12% in 2022 in response to price signals and another 8% in 2023 as markets rebalanced. Overall, in 2023, European gas consumption dropped 20% below the 2017-21 average.

On the supply side, as Russia cut pipeline supplies to Europe, buyers turned to the global LNG market to secure alternative supplies.

ICIS data shows that as Russian supplies fell from 155 billion cubic meters (bcm)/year in 2021 to 69bcm/year in 2022 and further to 30bcm/year in 2023, LNG imports nearly doubled from 46bcm/year before the war to just over 90bcm/year in 2023.

The rush for LNG sparked interest in expanding and building regasification capacity, and by the end of 2023, 19 new terminals were proposed across the bloc.

Even countries such as Germany, which had been dependent on Russian gas for more than 50% of its imports, pivoted towards LNG, lining up regasification terminals, some of which are already operational.

The single most important factor in helping to attract additional supplies was the ability of Europe’s markets to react freely to the severe imbalances in demand and supply.

…to the other extreme

While 2022 inflicted significant shocks, plummeting global demand caused by Covid lockdown-related restrictions in 2020 also tested the resilience of the EU gas market.

With global gas demand falling some 4% year on year in 2020, supply exceeded consumption, and excess LNG was pushed to Europe which absorbed two-thirds of incremental global supply in the first half of the year.

Europe’s was able to mop up the global supply overhang due to the flexibility of its markets, its storage facilities and the availability of vast storage capacity in its immediate neighbourhood, in Ukraine.

Data collated by ICIS shows volume traded on the Dutch TTF hub, Europe’s most liquid gas market, reached its highest level in 2020 as prices collapsed and a share of the gas produced globally was absorbed by Europe.

Both examples – the demand collapse induced by global covid restrictions in 2020 as well as the supply crunch caused by Russia in 2022 – prove the resilience of the European gas market in the face of extreme shocks.

3. WHAT NEXT?

More than three decades ago liberal markets were seen as a cure to the inefficiencies of centralised economies.

However, there is no doubt that the political and economic shocks experienced in the aftermath of the Covid pandemic and Russia’s invasion of Ukraine have lashed markets, contributing to rising inflation and higher living costs.

There have also been questions about the vulnerability of markets to malign speculative activity, including reports that large hedge funds armed with new technology such as algorithmic models may have contributed to abnormal bouts of volatility in the gas market at the height of the 2022 price spikes.

To mitigate the impact of the rising risks and to stave off social discontent, many member states resorted to a vast array of interventionist measures.

As the debate between free markets or intervention continues, the EU is facing two dilemmas that will determine the direction its market arrangements should take in the years to come.

Safe or wealthy?

The first relates to a choice the EU will make as it faces the challenge of tackling security alongside its quest for prosperity. Although security risks are real, there are prevailing arguments to refrain from further regulating the EU’s internal gas market.

The market proved its resilience to extreme stress both in times of supply shocks and exceptionally low demand, sending reliable price signals that enabled a prompt reaction to unforeseen challenges. The ability of the market to react provided the necessary safeguards in times of extreme threat.

Energy market liberalisation and the need to guarantee supply security have therefore not been mutually exclusive, but thoroughly compatible.

The liberal norms that brought fair competition, transparency, good governance and the rule-of-law shielded the EU from the malign influence of rogue actors such as Russia which weaponised gas supplies. The establishment and consolidation of the internal gas market allowed the EU to remain the rule setter and Russia the rule taker.

National or international?

Despite the growing collection of regulations adopted by the EU to integrate member states, the construction of the internal liberal market has been fuzzy at times, reflecting a patchwork of disjointed regulatory regimes.

One example is the process of market liberalisation itself. Over the years markets such as the Dutch TTF gas hub, which was fully committed to liberalisation, reached a high level of liquidity and maturity while others have struggled to open.

This has often led to clashes between national regulatory regimes and policies adopted at EU level. In many cases, the EU had to intervene, triggering infringement procedures against national governments and forcing member states to step back in line.

The events of 2022 laid bare such fault lines as many member states adopted regulations such as capping retail and wholesale prices, ladling out generous subsidies or introducing hefty taxation that had been frowned on by the EU.

Despite the clear clash, the EU adopted a more lenient stance towards national policies and even took a leaf out of the member states’ book, seeking to regulate wholesale gas prices.

In the longer-term such compromises could prove harmful not only to the internal gas market but to the wider EU project as member states would feel empowered to stray away from the bloc’s common objectives. What is needed is more nationally-aligned, long-term planning at EU level to address the challenges that will face the bloc in the future.

The answer

Unity of purpose and action is vital as the EU faces not only geopolitical threats but also challenges of historic importance such as climate change and the low-carbon energy transition.

Supply security will hinge on the large-scale deployment of renewable forms of generation, which means energy markets will need to be flexible, nimble and integrated to guarantee reliable supplies at affordable prices.

The answer to the EU’s multiple challenges, therefore, is further deepening the integration of its markets and allowing them to operate along the original, guiding principles. Europe’s best hope for success is as it has always been: Free trade, fair competition and deeper integration.