If we were to hazard a guess about which single word best sums up UK and European consumers’ feelings right now, that word would be: Ouch. Or perhaps: Oof. Either would be an entirely logical reaction to electricity prices’ astronomical spike this month, which smacked households across Britain and the Continent. Governments across Europe are racing to try and relieve the pressure, and their efforts thus far are largely a mixed bag. Unsurprisingly, financial commentators we follow on both sides of the Atlantic warn this will drive even faster inflation, creating headaches for monetary policymakers at the Bank of England (BoE), European Central Bank (ECB) and equity market. We think it indeed fair to presume this spike will likely show up in eurozone September inflation when the preliminary report hits Friday, but we think it would be folly to extrapolate that into something bigger—or presume monetary policymakers can do anything about it. Our research shows electricity prices in Europe these days stem largely from structural and political factors, not monetary ones, and we think their impact probably is a lot milder than commentators allege.
Not that we are dismissing the pain for households and businesses, which is real. The UK, which has taken the worst of it, saw wholesale power prices hit £475 per megawatt-hour intraday on Wednesday, according to Reuters.[i] FactSet data show they settled by closing to about £415—still over 9 times their pre-pandemic average.[ii] They are lower across the Continent, but not by much, leaving politicians scrambling.[iii] Italy’s government is reportedly planning to use public funds to curb households’ energy costs, according to Bloomberg.[iv] Spain’s government announced a suite of electricity tax cuts, which we think should likely help somewhat, as well as measures to promote clean energy (which makes zero sense as a solution to the current issues, as we will discuss momentarily) and plans to cap utilities’ profits through special taxes, which we think probably do more harm than good in the long run as they dissuade investment.[v] Meanwhile, we think the UK is already proving the proverbial law of unintended consequences, as price caps enacted in 2017 have forced providers out of business—including two that fell last week as prices spiked.[vi] In general, basic economic theory holds that fewer producers mean less competition and, you guessed it, higher prices.
In our view, none of the measures announced thus far address the root cause of today’s high prices: Power supply. Whether you think this push is spot-on or not, European governments are major proponents of lower-emissions energy generation, which has generally meant switching domestic energy production from coal to renewables in recent years.
In Germany and other key nations, the renewable category doesn’t include nuclear, tied to the political push to phase out reactors following Japan’s Fukushima disaster a decade ago. That leaves wind and solar—intermittent sources of energy that produce well when the wind blows and the sun shines, but not otherwise, and which industry analysts agree lack effective storage. Hence, European nations depend heavily on natural gas, which burns cleaner than coal. But that natural gas comes chiefly from Russian pipelines and other nations’ tankers, not domestic sources, leaving supply and prices vulnerable to Russian President Vladimir Putin’s whims and seaborne freight prices, which are up.[vii]
European wind power output was already tepid this year entering last week, when the wind stopped blowing in the North Sea. Wind-based electricity generation tumbled. Much of Europe took a hit, but the UK bore the brunt because its imported electricity comes via undersea cables from France. UK prices were already significantly higher than Continental prices when one of those cables caught fire Wednesday, which the National Grid estimates will put it out of commission for half a year. Filling the shortfall are the country’s four remaining coal-fired plants.[viii] Ultimately, however, we think the real solution will likely be for the wind to start blowing again.
This isn’t the first time the shift to wind and solar has had a similar effect. South Australia dealt with spiking prices and rolling blackouts back in 2017, and Californians are quite familiar with them. They are a headache, but only a temporary one—and one our analysis finds economies are pretty adept at overcoming. Which is good, because we don’t think there is a lot governments can do to turn the lights back on instantly. No matter how many wind turbines the Spanish government promotes, for example, they are all for naught if the wind doesn’t blow. Politicians can’t make the sun shine day and night all year long either. The ECB and BoE can’t build pipelines, approve nuclear reactors, enter the hydraulic fracturing business (which governments on the Continent largely haven’t permitted anyway) or spearhead new technologies. About the only manmade solution we can think of is to put all of Europe’s politicians on a barge in the North Sea and let them blow all their hot air at the turbines—and even then, it probably wouldn’t help Southern Europe.[ix]
That is the bad news. The good news: This likely isn’t as big of an inflation driver as you might think. In the eurozone, energy’s weighting in the Harmonised Index of Consumer Prices (a broad measure of prices in goods and services across the economy) is 9.5%.[x] In August, energy prices’ 15.4% year-over-year increase contributed less than half of the eurozone’s 3.0% inflation rate—excluding energy, prices rose 1.7%.[xi] So, it had an impact, but not a gigantic one. In the UK, total utilities—water, electricity, gas and other fuels—are 14.3% of the Consumer Price Index (CPI) basket.[xii] In August, CPI rose 3.0% overall and 2.8% excluding energy—even as energy prices rose 9.5% y/y.[xiii] So even if this were something monetary policymakers alone could fix, we think there is little to suggest that would actually be necessary.
Lastly, we would be remiss not to address the elephant in the room: Utilities shares. We haven’t seen any financial commentators argue this is a boon for them, which we think is correct. Wholesale and retail prices alike are up, so none of this points to soaring profits, outside maybe a few isolated scenarios in Spain, which the government is planning to “fix” with excise taxes. So we aren’t at all surprised Utilities shares aren’t outperforming right now. They had a very brief burst in mid-August but are largely in line with the MSCI World Index over the past month—and remain one of the worst-performing sectors year to date.[xiv] We don’t think that is likely to change any time soon, given our research indicates market fundamentals most favour companies capitalising on long-term technological trends (e.g., Information Technology and Internet-related companies in Consumer Discretionary and Communication Services).
[i] “Fire Cuts British Power Imports Adding to Supply Squeeze, Soaring Prices,” Susanna Twidale and Nina Chestney, Reuters, 15/9/2021. Accessed via MSN.com.
[ii] Source: FactSet, as of 15/9/2021. NORX UK Power Day Ahead Daily Average, GBP/MWh, 11/10/2013 – 15/9/2021.
[iii] “Analysis – Expensive Winter Ahead as Europe’s Power Prices Surge,” Vera Eckert, Susanna Twidale and Forrest Crellin, Reuters, 10/9/2021. Accessed via MSN.com.
[iv] “Draghi Ready to Intervene Again as Italy’s Power Prices Soar,” Chiara Albanese and Alessandra Migliacco, Bloomberg, 14/9/2021. Accessed via Financial Post.
[v] “Spain Announces New Measures to Bring Down Soaring Energy Bills,” Miguel Àngel Noceda, El País, 14/9/2021.
[vi] “Half a Million Homes to Be Given New Energy Supplier After Two More Go Bust,” Jillian Ambrose, The Guardian, 14/9/2021.
[vii] Source: FactSet, as of 15/9/2021.
[viii] “Fire Shuts Off One of UK’s Most Important Power Cables in Midst of Supply Crunch,” Jillian Ambrose, The Guardian, 15/9/2021.
[ix] Statement is a joke about politicians’ rhetoric.
[x] Source: Eurostat, as of 15/9/2021.
[xii] Source: Office for National Statistics, as of 15/9/2021.
[xiv] Source: FactSet, as of 15/9/2021. Statement based on MSCI World Index and its constituent sectors’ returns with net dividends in GBP.
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