What to Make of the European Commission’s Winter Plan

The western United States may be enduring an epic heatwave right now, but winter is front and center on many investors’ minds—specifically the European winter, now that Russian gas provider Gazprom has ceased supplying the EU through the Nord Stream 1 pipeline. European Commission President Ursula von der Leyen laid out a potential response plan ahead of an emergency summit to tackle the issue Friday, but her package of windfall taxes, price caps and mandatory conservation left most observers underwhelmed. In our view, that dour reaction is probably a good thing. Rationing, of course, adds to widespread worries of a forthcoming European recession. If this becomes the baseline expectation, which doesn’t seem too distant, then it should help stocks price the economic impact quickly and move on.

The European Commission doesn’t get the final say-so on the EU’s collective response. That honor goes to the European Council, which is composed of heads of state and government from every EU member state. Its decisions are typically unanimous, and they usually include exemptions for some nations in order to win approval. So von der Leyen’s statement—and the policy proposals leaked to The Guardian Wednesday—isn’t necessarily a blueprint of what EU leaders will agree to. But as the likely starting point for talks, it is worth a look.

The provision gaining the most attention: a revenue cap on electricity providers that use low-carbon power sources, including wind, solar and nuclear. EU energy regulations tie electricity prices not to input costs, but to the price of the most expensive source. Right now, that is natural gas, delivering a big revenue windfall to providers that use cheaper inputs. While she didn’t specify a cap, The Guardian reported the European Commission will propose a ceiling of €200 per megawatt hour for low-carbon sources, which their research claims is what the market price of electricity would be absent sanctions and supply hiccups, with a windfall tax running parallel.^[i] There is also a proposed windfall tax for oil and gas companies, mandatory energy reduction of 5% during peak hours and a cap on Russian gas prices and measures to support the functioning of energy derivatives markets. Proceeds of the windfall tax would go to member states to help households and businesses cope with energy costs.

In our view, this is a mixed bag. Ensuring liquidity in energy futures markets is probably the most beneficial part, as collateral requirements have increased dramatically with higher gas and electricity prices, sticking power companies with astronomical margin calls. Some estimates put the cash shortage at $1.5 trillion, leading to fears that a lack of liquidity will drive suppliers into bankruptcy and destabilize markets, driving futures prices even higher—and leading to even higher retail energy bills. The European Commission proposes to “facilitate the liquidity support by Member States for energy companies,” which seems to be basically a cousin of central banks providing emergency funding to banks that are illiquid but otherwise solvent.^[ii] If it works as intended, it could help.

Other aspects of the plan may be more politically appealing but likely less beneficial. Capping Russian gas prices won’t help on the supply front, as it would likely encourage Moscow to cease the remaining flows, which Russian President Vladimir Putin nodded to earlier today. Capping all non-EU gas, which Poland suggested, would discourage non-Russian suppliers from entering the market. Windfall taxes have a tendency to discourage investment—preventing long-term supply solutions—and redirecting the proceeds to households and businesses reduces the incentive to conserve power above and beyond mandatory measures. That could very well increase the risk of blackouts and energy rationing this winter, which would worsen the economic impact. Same goes for new UK Prime Minister Liz Truss’s proposal to cap energy prices through next winter.

So, at risk of stating the obvious, Friday’s summit bears watching. But not in the sense that it will be make or break for the EU economy or stocks. Rather, getting clarity on the EU’s approach will help investors determine the probable economic outcome over the next few quarters, which helps markets pre-price it. Fears of energy shortages have played a big role in EU market weakness this year, suggesting they already do reflect these worries to an extent. Already, we are seeing reports of factories going offline due to prohibitive power prices, and these closures are starting to show up in economic data. It won’t take long for markets to weigh the big picture—if they haven’t already—much as stocks priced the eventual damage from COVID lockdowns well before economic data revealed the full tally.

Plus, while the EU is a big piece of the global economy, a prolonged European recession isn’t necessarily a trigger for a global recession. The eurozone recession that accompanied the sovereign debt crisis lasted two years, but it didn’t cause a global recession, and global stocks recovered from 2011’s deep correction (a sentiment-fueled drop of around -10% to -20%) long before eurozone GDP hit bottom in Q1 2013. Similarly, the Asia/Pacific region’s late-1990s recession and Europe’s early-1990s recessions didn’t cause global downturns. So even if Europe is in for some very tough economic times from here, it doesn’t necessarily mean the global economy and stocks outside Europe are due for a pounding.

Approaching these issues like markets do isn’t easy for many investors, especially when stocks are enduring tough times again. Emotion often takes center stage, and thinking through the next 3 – 30 months can seem more like wishful thinking than informed theory when fearful headlines abound. But we think it is a necessary tactic, as it can reduce the temptation to react to bad news and increase the likelihood of participating in a recovery whenever it arrives.