The EU needs a grand bargain that reduces demand, increases supply, and keeps energy markets open

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Europe’s energy system faces an unprecedented crisis. Supplies of Russian gas—critical for heating, industrial processes, and power—have been cut by more than 80 percent this year. Wholesale prices of electricity and gas have surged as much as 15-fold since early 2021, with severe effects for households and businesses. The problem could well worsen. Europe may be about to experience its first winter without Russian gas, risking even higher prices, gas shortages, and a major recession.

European governments have started to implement a range of policy responses. One class of policies aims to mitigate the impact of higher costs on consumers and businesses. These include retail price caps, regulated tariffs, support programs for energy-intensive companies, and liquidity or capital backing for energy companies, including even nationalization. Another class of measures seeks to stabilize and reduce wholesale prices and ensure energy security. This includes policies to encourage energy savings and increase supply but also to cap energy costs, particularly wholesale gas prices.

Such measures don’t offer clean solutions, for two reasons. First, conflicting objectives: subsidies or capping prices can make the underlying problem worse by increasing demand. Second, cross-border spillovers: subsidizing energy consumption may benefit consumers in one country but would also raise consumption, leading to higher wholesale prices across the European Union and hurting consumers in other countries.

An assessment of the available policy options leads to a clear conclusion. The approach that best addresses both problems is a coordinated effort by governments to reduce energy demand and increase supply while keeping internal energy markets open and protecting vulnerable consumers.

High, volatile prices

The primary cause of the massive increase in European gas prices is the reduction of Russian supply. Liquefied natural gas (LNG) is the primary replacement option. The cost of LNG has more than doubled since Russia’s February invasion of Ukraine.

The increase in wholesale electricity prices reflects the surge in natural gas prices and shortfalls in nuclear and hydroelectric generation, which have had to be supplemented with power from more expensive coal and gas plants. As a result, the most expensive energy source to meet demand in most European power markets is now gas. This implies that most lower-cost power producers are making extremely high profits (unless they have locked in lower prices by selling forward).

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