What is driving the record-high growth in gas and electricity prices in Europe?

(authors: Soňa Benecká, Jan Hošek)

Natural gas prices reached new highs almost worldwide in December 2021 (see Chart 1). This growth was driven by a number of factors. The first was a shortage of gas in Asia, where demand surged last year. Large importers such as Japan and South Korea replenished their stocks after a cold winter. To do so, they made maximum use of their long-term liquefied natural gas (LNG) import contracts, the prices of which were more favourable than on the spot market. This caused deliveries to the spot market to fall, and, despite increasing supplies from the USA, the spot price soared as a result of rapidly rising demand. This was due mainly to demand from China, whose economy recovered quickly from the pandemic and was hit by an energy crisis caused by a shortage, and high prices, of coal. However, demand for LNG also increased in Brazil, where the worst drought in a decade reduced hydropower generation. It was replaced by gas generation. Demand for natural gas is rising steadily in almost all the emerging economies of South-East Asia (such as India and Pakistan).

Chart 1 – The prices of natural gas in Europe reached a new historical high in December 2021
EUR/MWh; source Refinitiv Datastream

Chart 1 – The prices of natural gas in Europe reached a new historical high in December 2021

Note: Natural gas is transported via pipelines, while LNG is transported by ship.


The currently high natural gas prices in Europe also reflect a specific situation. European gas storage remained considerably depleted after last year’s long, cold winter. Low wind generation in the summer necessitated greater use of backup gas power stations in Germany (see below). This, together with high gas prices and a recovery in industrial activity due to the receding pandemic, slowed the replenishment of gas stocks during the summer. Demand for gas was also pushed up by rising prices of emission allowances. The European gas storage filling rate ahead of this year’s heating season therefore fell well below its long-term average (see Chart 2). Whether gas stocks will hit critical lows will depend mainly on the weather this winter. The low filling rates coupled with worsening political relations with Russia are giving rise to concerns of gas shortages not only this winter, but throughout 2022. LNG supplies from the USA were partially redirected from Asia to Europe at the end of December 2021, but that merely returned gas prices to their October and November levels. According to market expectations, the price of this commodity will remain elevated for some time and will be highly volatile at least until the end of the heating season. The high level and volatility of prices in Europe are partly due to the EU’s push for individual countries to purchase gas increasingly on exchanges, whereas long-term contracts linked mainly to the price of oil dominated the market in the past. The Russian gas supplier Gazprom continues to prefer supplies based on bilateral long-term contracts, which it is fulfilling, and is showing little interest in selling gas on exchange markets.

Chart 2 – The gas storage filling rate in Europe has fallen well below the average for the previous six years
%; source Bloomberg

Chart 2 – The gas storage filling rate in Europe has fallen well below the average for the previous six years

Electricity prices also reached record levels in December. Despite a subsequent correction, they are currently at historical highs. This is because the current mechanism for setting electricity prices in Europe results in them being closely linked to gas prices. EU energy policy supports electricity production from renewable sources, which account for an increasing share of total power generation. Germany is number one in this respect (see Chart 3). However, renewable sources are highly dependent on the weather and their output is therefore unstable. As electricity storage is still under development, gas power stations are used as a flexible backup in the event of outages of renewable sources and thus define the marginal price of electricity on the market.

Chart 3 – In Germany, renewable electricity sources are gradually replacing coal and nuclear energy
structure of power generation in Germany; %; source Bloomberg

Chart 3 – In Germany, renewable electricity sources are gradually replacing coal and nuclear energy

Besides gas, electricity prices are being driven up by surging prices of emission allowances. These are intended to channel firms’ investment into low-emission power generation technology in a market-based way. At present, emission allowances are also traded on exchanges, to which financial investors also have access. However, this fosters unpredictable changes in allowance prices and hence causes firms problems. Electricity prices can thus also be expected to be very volatile and stay high until early 2023.

It will be difficult to recalibrate Europe’s energy mix so that net greenhouse gas emissions are cut by 55% by 2030 as proposed by the Commission. Gas will therefore be a transition energy source. Support for gas will be temporary and conditional on it replacing fuels that are more harmful to the climate (coal). As traditional electricity sources are switched off and renewable sources come on line only gradually, gas and electricity prices may therefore remain susceptible to sudden swings.

Households and firms will gradually face higher energy bills. The longer the high prices persist on the market, the more they will be reflected in new contracts. We are already seeing unprecedented growth in energy prices in the euro area production sector. Substantially higher prices of gas and electricity – together with material and component shortages – were the main driver of the rise in foreign industrial producer inflation in the second half of last year. The effect of the high energy prices on producer and consumer price inflation in the euro area should dissipate in the course of this year, but the planned structural changes in the energy sector may cause further price volatility, with long-term impacts on euro area price stability. The ECB has so far repeated that the growth in inflation pressures caused by the energy crisis is temporary, but that the more lasting inflationary effect of the green transition poses a significant risk in the longer term.

Some EU countries have introduced short-term mitigation measures in response to the current energy crisis, as the October EU summit failed to reach agreement on an EU-wide solution. Many countries, led by Germany, regard the crisis as only temporary and not requiring any structural changes (such as reform of the wholesale electricity market and regulation of the emission allowance market). In their opinion, therefore, there is no need to introduce measures applicable in all EU Member States. Nonetheless, most EU countries have focused on providing support to at-risk groups of the population, but many of them have also put in place across-the-board reductions in energy taxes or VAT, or are considering such steps. For example, Poland will lower the rate of VAT on electricity and heating for households to 5% for four months starting in February, and Hungary has capped petrol and diesel prices. Spain and Romania have started to regulate retail and wholesale prices of electricity.