Affordability and supply security are regularly put forward as reasons not to decarbonize the power system. However, if “green is expensive and unstable vs brown is cheap and secure” may be an appealing slogan for some energy companies, it simply does not hold up in the face of the facts. Exploring European inflation and energy data from 2021 to 2023, Reclaim Finance – with support from the energy think tank Ember – shows how EU gas dependency contributed to higher inflation and price volatility. It evidences the need to cut fossil fuel power to maintain price stability, providing a clear justification for the European Central Bank (ECB) and Eurosystem central banks to support renewable energy and energy efficiency deployment in the Union.
Gas-driven electricity prices… and the way out
In the EU, all electricity producers get the same price for the power they are selling at a given moment. Concretely:
- Electricity producers bid into the market at a price based on their production cost.
- The bidding goes from the cheapest to the most expensive energy source.
- Once the full demand is satisfied, everybody obtains the price of the last producer (“marginal generator”) from which electricity was bought (1).
While renewables are the cheapest source of power and are therefore bought first, the capacity remains too low to meet the whole EU electricity demand, letting costlier production fill the gap. Most of the time, gas is therefore the price-setting generator: it was the case 55% of the time in 2022 (2). And, as the production costs for gas power are significantly higher than those for renewables and as they are much more volatile, this reliance on gas power drives electricity prices up and exposes Europeans to shocks. To summarize, the higher the gap between renewable production and electricity demand, the more demand for gas power increases and the more costly electricity becomes.
Correlation between gas prices and electricity prices
This can largely explain the fact that gas power demand remains insensitive to price variations. High prices do not trigger any reduction in gas power consumption because gas is still needed to meet total demand.
Correlation between Title Transfer Facility (TTF) gas price and gas demand for power
Therefore, reducing the “renewable to demand” gap provides an avenue to lower electricity prices and avoid undue volatility. This can be done by increasing renewable energy capacity and reducing electricity demand through increased efficiency (3). Unsurprisingly both these options were put forward to lower the EU Russian gas dependency after Russia attacked Ukraine in 2022 (4). However, this is not the direction that the EU has taken with its massive build-up of Liquified Natural Gas (LNG) infrastructures (5). Indeed, LNG is generally costlier than gas delivered by pipeline and a large share of it is traded on volatile spot markets. It therefore increases the EU exposure to changes in gas demand in other parts of the world and to other sorts of supply disruptions. For example, in the week of October 13th, 2023, European gas futures jumped almost 23% despite no major change in consumption due to geopolitical unrest in the Middle East and fears of strikes in Australian LNG infrastructures (6).
Gas power and inflation
Largely dependent on gas prices, electricity prices have a large impact on EU energy inflation. Looking at EU data from 2021-2023:
- When electricity prices stay below 150€/MWh, energy inflation (Harmonised Indices of Consumer Prices Energy – HICP energy) does not rise more than 20% above the previous year. In most cases observed in the 2021-2023 period, it is below 15% (and in some instances negative).
- Above 150€/MWh, energy inflation (HICP energy) climbs up between 20% and 45% above the previous year.
This direct contribution to energy inflation comes on top of a broader but more difficult to quantify contribution to inflation. Indeed, our economy is energy-intensive and the shift in energy prices at least partially reverberates in the price of goods and services (7). Furthermore, additional impact comes from the contribution of gas to global warming (8).
Correlation between electricity price and HCIP Energy index inflation
Furthermore, it is likely that the effect of electricity prices on HICP Energy and overall HICP was reduced due to the exceptional measures taken by European states in 2022. Indeed, according to the European Commission, the total amount of energy subsidies in the EU increased to an exceptional 216 billion euros by 2021 and 390 billion in 2022 (including a surge in fossil fuel subsidies from 56 billion euros in 2021 to 123 billion in 2022) (9). ECB calculations suggest this contributed to contain inflation by 0.9 percentage points over the period 2022-2023. By its own admission, the ECB indirectly supported these public subsidies by creating the Transmission Protection Instrument (TPI) during the crisis (10).
The analysis of European inflation and energy data from 2021 to 2023 provides a clear warning: without a sustainable energy transition, the EU will remain vulnerable to gas prices shocks and could struggle to maintain price stability. For the ECB and Eurosystem central banks, these elements provide a compelling argument to explore the connection between fossil fuels and inflation and to contribute to lower gas demand through renewable energy and energy efficiency deployment (11). While higher interest rates are already negatively impacting renewable energy deployment (12) and building renovation (13), the central bank should consider any lever available to mitigate this effect. As tens of thousands of Europeans are asking, it should start by providing lower rates for funding these essential activities (14).
