With Russian gas flows to Europe severely diminished, energy analyst David Maccarrone and utilities analyst Fred Barasi assess the impact on Europe’s energy and utilities sectors amid the ongoing energy transition.
Addressing the Russian gas threat
Replacing Russian oil and gas is a challenge for European governments, but provided that this winter is mild, it is one that they are likely to be able to meet with imports of liquefied natural gas (LNG), increased oil-fired power generation, and cuts in both residential and industrial gas demand. In the longer term, energy supply should be further boosted as planned renewable energy projects start to come on stream.
However, while the immediate threat of energy shortages may be manageable, energy prices remain extremely high relative to history. The link between gas prices and electricity prices is another problem. While renewables and nuclear power may currently be significantly cheaper, gas-fired power stations remain the marginal source of electricity generation in most European countries, and this fact is keeping electricity prices high.
Breaking the link will not be easy, or quick. The electricity market is long established, and companies have made significant investments into new power stations with an assumption that the current model will continue. Nevertheless, some governments are attempting to renegotiate contracts with wind, solar and nuclear operators at a fixed price well below the prevailing forward price, in order to reduce wholesale energy costs. Many large renewable projects that are being built now, or are being planned, will also be contracted at fixed energy prices far below today’s prices.
The attraction of windfall taxes
The decoupling of electricity prices from gas prices should make a difference in the long term, especially if the crisis leads to a more rapid move to renewables, but it will take time for new lower priced projects to come on stream. In the meantime, the unprecedented rise in energy costs threatens to undermine business confidence, hit consumer spending and push many households into fuel poverty.
Given the potential economic and social impact, we expect further action from governments across Europe to help shield households and businesses from the worst of the energy price rise. At the same time, allowing utility companies to reap large windfall profits from electricity prices that are up to 10 times higher than the long-run average, or allowing oil and gas producers to rake in profits from soaring fossil fuel prices, is not socially acceptable in the midst of a cost-of-living crisis. Hence, the attractiveness of windfall taxes to governments looking to fund energy price caps for consumers.
However, taxing Europe’s utility providers and energy companies may not provide all of the cash that governments need. With the cost of capping energy bills running to hundreds of billions of euros, governments will ultimately need to work out how much of the price increases they can allocate to consumers and how much they are prepared (or able) to absorb themselves. The recent market reaction to the UK government’s spending plans highlights the risks posed by fiscal stimulus that is perceived as unsustainable.
Utilities and renewables: A differentiated impact
Most European electricity and gas suppliers hedge their power production up to two years in advance, so their earnings won’t fully reflect today’s prices until around 2024. While earnings therefore look likely to be capped in future by windfall taxes, cash flow is a more immediate concern, with several traditional power utilities tapping emergency credit lines in recent months to raise the cash collateral required to hedge against surging wholesale electricity and gas prices.
The situation is more positive for utility providers with major renewables arms. While the profits made by renewable energy suppliers are also being kept in check by long-term fixed contracts that are based on electricity prices well below today’s level, contracted prices for wind and solar are likely to rise in the next round of auctions. Given governments want to encourage investment in renewables as part of the energy transition, the impact of windfall taxes on earnings from renewables should also be less than for traditional energy companies. As a result, we believe the outlook is positive for earnings across the renewables sector over the medium term.
Oil and gas: Diversified revenue streams
Governments also have their eyes on the extra profits that are being earned by oil and gas producers as a result of surging gas prices. Further taxes on the energy sector are therefore to be expected. However, the oil and gas companies can only contribute so much more to government coffers, given already high marginal tax rates on oil and gas production in many European countries and that many earnings sources are generated outside of Europe.
Furthermore, the risk to earnings posed by a fossil-fuel related windfall tax is mitigated to some degree by the fact that Europe’s integrated oil and gas companies have been diversifying their revenue streams away from fossil fuels and towards low-carbon energy production. While there has been a reluctance to invest in new oil and gas production because of expectations of a sharp drop in demand over the next 10 years, the oil majors have instead been shifting the balance of their energy production towards renewables.
The broad strategy is to leverage their traditional strengths in oil and gas extraction by providing a gas backstop to deal with the intermittency of renewable power generation, complemented by new sources of revenue from battery storage and clean hydrogen solutions, and a commitment to low carbon energy generation.
Accelerated energy transition
While oil and gas companies are embracing the energy transition, renewables are also at the core of the European Union’s response to the crisis, thanks to their ability to provide secure, cheap and low carbon sources of energy. If planning processes can be expedited, governments have the opportunity to bring forward existing projects and kick-start new ones, significantly increasing the role of renewables in the energy mix.
With the need to find cheap alternatives to gas accelerating the move to renewables, it’s the shift in Europe’s energy mix that may end up being the most significant long-term consequence of the current crisis for the European economy. For investors in utilities and energy stocks, while government price caps and windfall taxes may impact earnings, the energy transition tailwind should benefit companies in both sectors that have a high exposure to renewables and other low-carbon energy sources.