Russia's invasion of Ukraine has triggered a shift in European power production sources and forced the governments to rethink their long-term energy policies.
The European Union is now on track to reduce reliance on Russian gas sharply before eliminating it entirely. Yet, with coal and nuclear phaseouts taking place across Europe – Germany will close its remaining reactors in December and will get rid of all coal by 2030 – natural gas was expected to play a key role in energy transition.
Russian gas flows account for about 40% of all European imports. And there are doubts on whether gas has a future as bridge generation fuel between high-carbon intensity fuels and green energy.
In recent months, coal – the most carbon-intensive fuel – has been having a so-called "renaissance" period to address reduced gas availability. The European Commission said coal burn could rise some 5% above previous expectations over the next five to 10 years. Yet this could only be a short-term solution.
Glenn Rickson, head of European Power Analysis at S&P Global Commodity Insights, expects gas generation to play "a leading role and a leading price setting role in European power markets for many years to come".
That said, the events of the last few months will inevitably have a profound impact on Europe's energy sector.
LNG has proved to be an efficient replacement for the missing Gazprom's volumes even before the Ukraine's invasion started, as Russian imports to Europe already have been well below historical averages in January and most of February.
Deliveries of LNG in April hit a record high for any single month, with aggregated imports into Europe and Turkey equating to 15.995 Bcm of natural gas, S&P Global data showed.
It is likely that LNG supply will help to meet European demand short-term, especially to fill gas storages that have remained well below historical averages so far this year.
Europe has been sourcing LNG supplies from multiple markets, with the majority coming from the US. Qatar, Algeria, Nigeria and Russia were also among the biggest suppliers so far this year.
But sourcing LNG in the spot market is hardly a mid- and especially not a long-term solution. Europe was able to secure supplies in part because Asian demand is typically subdued around this time of the year, and is expected to jump in July before peaking throughout all of winter.
For LNG to become a key part of a solution to phase out Russian gas, Europe needs to agree on long-term contracts. This could be challenging as European buyers are more constrained – as opposed to their Asian counterparts – and can only offer deals for a limited period because of local energy transition regulations.
However, Europe is certainly counting on more LNG to come long-term and is investing heavily in new infrastructure. Germany, for instance, in early May approved speeding up construction of two LNG terminals. Unlike France, the Netherlands and Italy, Germany does not have any LNG terminals.
Russia sending more pipeline gas eastward, when the west stops buying, could leave more LNG available to be directed to Europe, but where exactly the supply will ship will of course also depend on price arbitrage.
Hypothetically, Russian volumes currently sold via TurkStream-2 pipeline to Europe – currently at 16 Bcm/y – could be delivered to Turkey for re-export to Europe and elsewhere, according to Nadia Kazakova, Russia oil and gas strategist at Renaissance Energy Advisors. Higher Russian exports to Turkey could free up some LNG cargoes, which Ankara buys in the spot market.
Russian gas exports to China are expected to increase to around 16 Bcm in 2022 from 10 Bcm in 2021. By 2025 exports will rise to 38 Bcm under a 30-year contract with China's CNPC.
Moreover, in February Russia signed an extra 10 Bcm/y contract to deliver gas from its Sakhalin gas fields to China, although the pipeline extension is still to be built and commissioned.
Also, Russia could potentially deliver 30 Bcm/y of gas from West Siberian fields to China via Mongolia.
"However, this project would require a new 4,000 km pipeline. Russia and China are yet to agree on pricing. In addition, a transit agreement would need to be signed between Russia and Mongolia," Kazakova said.
In any case, while Russian gas will replace – and displace – some LNG deliveries, the Chinese government might want to limit Russia's share in total gas imports to maintain a diversified portfolio of gas suppliers, Kazakova added.
New world scenario
Russia's invasion of Ukraine forced the European Union to make considerable changes its energy strategy, with S&P Global amending its long-term forecasts accordingly. Analysts expect green hydrogen – domestically produced and imported – to play a key role in reducing gas demand in the European power sector.
"It's notable the European Commission doubled down on its climate ambition through its REPower EU strategy, which is focused on reducing Europe's dependency on Russian gas, but inevitably also has wider implications for natural gas in the power sector overall, regardless of the origin country," S&P Global's Rickson said.
Previously, the phasing out of fossil fuels from power generation had ticked the decarbonization box. Now Russia-Ukraine war and subsequent gas flows disruption concerns also mean that a move from gas is also ticking the security supply and affordability boxes.
In the European long-term electricity forecast published in March S&P Global analysts ran two scenarios for Europe's power markets out to 2050. A reference case, which is essentially the "pre-Ukraine invasion outlook" and "a New World case", where the analysts considered the implications of Europe's transition away from gas.
In "the New World case" analysts saw a greater renewables rollout, as well as an accelerated push for hydrogen-fuelled power plants to replace gas units as a backup capacity. This is expected to take place faster and to a greater extent, as opposed to "the pre-invasion" outlook.
In this new scenario, western European unabated gas capacity falls from about 160 GW installed now to about 80 GW by 2035 and to 12 GW by 2050. This is about 22 GW and 4 GW below our reference case, respectively.
S&P Global analysts previously expected gas for power demand to rise until 2027 on the back of nuclear and coal closures. The new assumption is that gas for power demand in Western Europe will fall 10 Bcm/year by 2027 from 2021 level, and further drop to around 25 Bcm/year by 2050.
Gas and power prices have already been way above levels seen in previous years on the back of lower French nuclear availability and low gas stocks across Europe. The invasion of Ukraine only exacerbated the already tight situation.
As one of the outcomes, the market started to pay closer to attention to spark spreads – a margin for power plants that use gas as a fuel to produce electricity. Clean spark spread is a margin that includes costs of carbon emission allowances.
"Sparks spreads are a hot topic right now, since the focus is very much on gas power plants profitability," an Italy-based power trader said.
Indeed, sharp and frequent price swings result in extreme margin changes, even on a daily basis. For instance in Germany, which is particularly dependent on Russian gas and hence more vulnerable to price spikes, spark spreads were seen changing from positive to negative multiple times throughout a month.
To provide the market with a better insight, S&P Global will launch new peakload spark spread calculations for German and UK power markets, and baseload and peakload spark spread calculations for France and the Netherlands June 1. The spreads will be calculated for gas plants with efficiencies of 45%, 50% and 60%.
Multiple market sources highlighted the need for peakload margins visibility in addition to baseload.
"Not loads of the CCGT fleet run during baseload hours, lots will just run peaks because of their lower efficiency as they get older… Overnight prices are very cheap due to lower demand. Overnight demand is not massively important. Overnights dilute the price," a UK-based power trader said.
Spread trading is generally becoming more important to market players, whether these are cross-commodity spreads such as power and gas or location spread, according to Tim Greenwood, sales director for power derivatives at the European Energy Exchange.
"The spreads are very important for the development of both our power and gas markets. This is actually quite logical. In some markets, it is the same trader who has the mandate to hedge gas purchases, hedge power generation and hedge the carbon offset," Greenwood said, adding that price swings resulted in most trading moving to the cleared markets and away from bilateral uncleared trading.
"In addition, trading participants are a lot more sensitive to their cash and collateral management and are appreciating, for example, the ability of cross-margin between our power and gas futures," Greenwood said.
It is fair to say that gas trading will also be important in the long run, even as the key focus is on sustainable energy, including hydrogen, Greenwood added.
While clean energy will certainly displace carbon-intensive fuels in the long term, Europe inevitably has to stick to the "old school" natural gas for now, as long as it remains committed to hitting its ambitious climate targets.