Natural gas prices in Europe have not enjoyed anything like the recovery that has driven power, coal, and carbon back up to pre-COVID levels. A long-term glut of gas supply hangs over the market, despite recent cutbacks in US production, and the outlook remains as gloomy as it did before the CODIV-19 pandemic swept around the world.

Despite US liquefied natural gas (LNG) exports being nearly halved during the last three months, supply remains strong as other producers appear ready to fill the gap, and new sources of pipeline supply to Europe will further marginalise US LNG.

A quick look at how energy prices have performed in Europe this year shows that crude oil and natural gas are the two laggards. German baseload power and API2 coal are within touching distance of their January 1 levels, while carbon has streaked ahead and has gained more than 20% since the start of the year.

TTF natural gas prices are down by just over 20% for the year, while front-month Brent is about 35% off from its January 1 price.

To be fair, all the main energy markets endured a rough start to 2020, with all five of the benchmarks falling over the first two months. And after the initial shock of Covid-related lockdowns in Europe, prices dipped very sharply – as much as 70% in the case of crude oil – before starting to recover in May.

As demand for natural gas ebbed, US shale producers started to shut in production. Daily feed gas supply to the six US liquefaction plants fell from 8.41 billion cubic feet on January 3 to as little as 2.82 billion cubic feet on July 9, data show.

The US briefly topped the list of export suppliers to Europe early this year, as a flotilla of 74 cargoes sailed to European ports in January, according to the US Energy Information Administration. By June and July, however, 70 shipments were cancelled. The US Energy Information Administration predicts third quarter exports will equate to about 3.7 billion cu ft/day of feed gas production.

But the curtailment of US exports has done little to boost European prices. The front-month and front-year contracts were largely unchanged as the market rolled into July, though the front-quarter contract rose sharply as traders focused on higher demand in the fourth quarter.

There have also been regional developments in Europe, particularly the news that Russia is preparing to resume work on the Nord Stream 2 pipeline to Germany. Danish regulators gave clearance for Russian vessels to restart pipe-laying activities last month, and the project could be completed by as soon as early 2021.

The prospect of additional supply into the region has not materially impacted prices to date, but it does damp the outlook for LNG from the US. Shipments will need to look further afield for buyers once the pipeline is up and running. This loss of nearby market share may be one of the motivations behind new sanctions being prepared in the US Congress against the project.

Nord Stream 2 is likely to ship as much as 1.5 billion cu ft/day to Germany, which would help maintain high storage levels in the region, even after gas shipments along a southern route through Ukraine are reduced.

Whether Nord Stream has any impact on other LNG suppliers to Europe remains to be seen. Qatar continues to dominate supply to the region, and the Middle Eastern country’s determination to remain a leading exporter to Europe will likely force other sellers to consider Asia as a longer-term outlet.

The steep drop in crude oil prices between March and April came as nations representing the bulk of demand went into lockdown, bringing industrial production to a near-halt and driving road traffic down to levels not seen in decades.

Passenger car traffic in the UK dropped like a stone, falling by two-thirds from normal levels in April, while light commercial traffic dropped around 60% and heavy goods traffic fell nearly 40% as distribution systems struggled to maintain supplies.

Oil prices also went into free-fall as lockdown started, with front-month Brent dropping from $50/barrel on March 5 to a low of $19.33 on April 21.

More recently however, UK road use has increased to around 60% of normal pre-Covid levels for cars, more than 70% for light commercial and more than 80% for heavy goods vehicles, according to UK government data.

This recovery has been mirrored in other countries as well and as if in sympathy, oil prices have climbed to the point where they are now just 20% below their pre-Covid levels.

It’s a common complaint among drivers that gasoline prices are very quick to reflect an increase in oil prices, but far too slow to respond when crude falls. And with crude having dropped by more than 50% in April, drivers might be forgiven for having expected a significant fall in retail gasoline prices.

We’ve decided to look at this complaint in light of the recent collapse in oil prices. We’ll compare prices in the US as well as three European countries: the Netherlands, which has the highest fuel duties according to the European Environment Agency (EEA), Lithuania, which has one of the lowest, and the UK.

CHART 1 – Gross fuel prices index

Source: Automobile Association UK, ICE Futures, fuel duty data from European Environment Agency, US data from various sources

All European gasoline retail prices include both a national fuel duty and value-added tax (VAT). Fuel duty is normally a fixed amount per liter, while VAT is assessed as a percentage of the net total.

The Netherlands levies a duty of nearly €0.79/liter on gasoline, while Lithuania’s government takes less than €0.44/liter. The UK comes in at the higher end of the scale at around €0.65/liter, according to the EEA data.

In the US, gasoline is subject to a federal tax of 18.4 cents/gallon, while every state also levies its own fuel and sales taxes; these range from 14.66 cents/gallon in Alaska to 61.2 cents/gallon in California. We’ve applied a mean of 31.3 cents/gallon for our calculations.

The VAT on fuels varies across EU countries, but in the cases we’re examining, the rate is 21% in both the Netherlands and Lithuania, and 20% in the UK.

Stripping both those costs away gives us the net cost of gasoline as shown below:

CHART 2 – Net fuel prices

Source: Automobile Association UK, ICE Futures, fuel duty data from European Environment Agency, US data from various sources

As the data show, there is an overall trend, but differences in how quickly the costs are passed through the distribution chain, and different wholesale prices across countries can cloud the picture.

And it’s also clear that once taxes and duties are removed from the cost of gasoline, that fuel prices correlate much more closely to the crude oil price. Indeed, it could be argued that gasoline, net of duties and taxes, reflected pretty closely Brent’s decline in March and April.

So what we can suggest from this study is that the bulk cost of gasoline as a product does in fact correlate much more closely with crude oil, while the retail price of gasoline is unfortunately inflated by regressive taxes.

Over the last few weeks, two utilities – SSE and RWE – closed their last working coal-fired power stations in the UK, leaving the country with just four coal-based plants supplying electricity to the grid.

By the end of 2019, coal’s contribution to the country’s power supply had slipped from 70% in 1990 to less than 3%. By 2025 that share will have dropped to zero.

Europe’s largest economy, Germany, is headed in the same direction. A law passed last year will see the country quit all forms of coal-fired power by 2038 at the latest, and analysts believe the end will come well before then.

The coal exit may not be felt by industry or consumers directly if renewable energy, natural gas and nuclear power are able to fill the gap. Indications point towards continued growth for wind and solar power and the potential for back up through grid-scale batteries should they be built in scale.

One area where the loss of coal power will be felt, however, is the climate. In 2010, German power plants belched 369 million tonnes of carbon dioxide into the atmosphere. By 2019, this number fell to 311 million tonnes, helped chiefly by some plant closures but mainly from the shift to natural gas and renewables.

Coal’s share of Germany’s total was 244 million tonnes in 2010, falling to around 165 million in 2019. The coal sector is still the single largest emitter in the country.

An unintended consequence of the German and UK exits from coal, together with government pledges in 11 other EU countries, will therefore be to remove that largest source of demand for EU emissions allowances, and this threatens to undermine the effectiveness of the EU Emissions Trading System.

At present, the vast majority of EU industrial installations receive a large handout of free EU allowances (EUAs). This is to protect them from additional costs that would make them uncompetitive in world markets.

But there is no such protection for the power sector: generators are required to buy every EUA they need, either through daily auctions organised by the EU, or in the secondary market, where prices are currently around €18/tonne CO2 equivalent.

Each EU state has a reserve of EUAs for auction, and we can use this figure as a rough estimate of the power sector’s demand. To be clear, many industrial plants don’t receive 100% of what they need free of charge, and so they also need to buy some EUAs in the market or at auction.

Let’s take the UK as an example. In 2013, CO2 from UK coal and gas-fired power plants totaled 142 million tonnes, while the country’s auction reserve of EUAs was just 107 million tonnes.

By 2018, however, coal and gas emissions had tumbled to 39 million tonnes, while the auction reserve was still 101 million tonnes.

Even allowing for the demand from industrial plants, this represents a significant surplus. And when the last four UK power plants shut over the next few years, the auction, together with the free handouts to industry, would dwarf the market demand.

Germany and the eleven other countries committed to phasing out coal face the same problem. The gradual decline in demand will leave a growing glut of allowances that could push EUA prices back to levels below €10/tonne not seen since late 2017.

The EU has a solution, but it has so far failed to make much of a dent in the existing surplus.

The Market Stability Reserve (MSR) automatically removes 24% of the total market surplus each year, by reducing the number of EUAs each country has in its auction reserve. In 2019, the MSR’s first year of operation, it took 400 million EUAs from the market and according to analysts it may take a similar volume in 2020.

According to a study by Carbon Market Watch published last year, the closure of coal plants across Europe over the next ten years could wipe out an average of 240 million tonnes of demand for EUAs each year. The MSR would find it hard to keep up.

Market observers and lobby groups are calling for reforms to the MSR that would enable it to take a greater volume of surplus EUAs from the market each year, thereby tightening supply, boosting the price and increasing the incentive to cut emissions in other sectors.

Quitting coal is generally seen as a positive move for the climate, but the impact of so-called “overlapping” policies risks the integrity of the EU ETS and calls into question the willingness of policymakers to let the market take the lead in driving Europe’s decarbonization.