In a major shift of energy policy, the European Commission is looking to drastically reduce Europe's imports of fossil fuel from Russia following Russia's military actions in Ukraine. S&P Global Ratings believes this is unlikely to end well for European gas players, mainly because other gas sources cannot replace the large volumes from Russia. What's more, we believe some energy-intensive industrial sectors like fertilizers, steel, and paper could face temporary plant closures, hampering the eurozone's GDP growth, with a potential knock-on effect on utilities.

The Commission unveiled the outline of its plan to make Europe independent from Russian oil and gas on March 8. The proposal--REPowerEU--will seek to diversify gas supplies, speed up the rollout of renewable gases, and replace gas in heating and power generation, thereby reducing EU demand for Russian gas as soon as possible, with the target initially set at two-thirds before the end of the year. As essential as such a plan is for Europe's energy security, it may not be easy to implement. Gas production in Europe has been in structural decline for years. In addition, there are limited sources of gas globally and supply lags due to underinvestment, while expanding regasification capacity will take time. Also, most of the world's liquefied natural gas (LNG) production is currently locked into long-term contracts not destined for Europe, and large supply increments are unlikely before 2025-2026.

How Dependent Is Europe On Russian Gas?

The EU imports 90% of the gas it consumes and, on average, about 40% of that comes from Russia (45% in 2021). This represents about 140 billion cubic meters (bcm) per year. In the U.K., the situation is very different, since Britain imports only 5% of its total gas needs from Russia.

Chart 1

We believe that, in the best case, all else being equal, Europe can find about 50 bcm of gas elsewhere, leaving a shortfall of about 90 bcm. According to S&P Global Platts Analytics, the most likely sources this year would be, in order of likelihood: international imports of LNG (25 bcm), Italy's strategic reserve (4.6 bcm), a potential increase in Norwegian production (10 bcm), additional flows to Italy from Algeria and Libya (10 bcm and 4 bcm respectively), and increased production in the Netherlands by expanding the Groningen permit (2 bcm).

Chart 2

We see additional LNG imports beyond these levels as challenging. Notably, this is because it takes two to three years to build an LNG terminal, so an immediate increase in Europe's regasification capacity is not possible. In addition, most LNG cargoes are already under long-term contracts and will go mainly to Asian markets. Potential extensions or restarts of coal- and lignite-fired generation could serve as a backup but recommissioning plants would take time and sourcing coal would not reduce reliance on Russia. Also, we understand that shutdowns of nuclear plants, which have already begun for example in Germany and are about to start in Belgium, may be difficult to reverse for technical reasons.

Is Timing An Important Factor?

Timing is crucial when it comes to the flow of gas from Russia to Europe. As winter comes to an end and temperatures remain milder than usual, short-term risks are reducing. However, summer is usually when countries replenish their gas stocks to meet the next winter, and gas storage across Europe is currently slightly less than 30% full. We understand the European Commission will propose legislation in April mandating a minimum storage level of 90% by Oct. 1, 2022. But the big question is where Europe will get the gas to refill its stocks.

As of now, both Gazprom PJSC and its European customers have said that Gazprom is meeting its gas supply obligations. However, this is limited to amounts stated in contractual agreements and no higher, which means gas imports are already below historical averages. The continuing military conflict elevates the risk of a gas supply interruption, either due to damage to gas infrastructure in Ukraine, a ban by the Russian government, or strengthening of European sanctions. In March 2022, the transfer and convertibility assessment (T&C) on Russia was revised down to 'CCC-' alongside the sovereign downgrade. Severe sanctions from the U.S., EU, and other countries in response to Russia's actions in Ukraine have made a large portion of the Russian Central Bank's reserves inaccessible, triggering strict foreign currency exchange controls in Russia. Although Gazprom has reportedly repaid its $1.3 billion Eurobond, which matured on March 7, 2022, T&C restrictions (including on repatriation of 80% of export revenue, repayment of foreign currency denominated debt in rubles, and prohibition of foreign currency transfers to jurisdictions the Russian government has labeled "unfriendly") make it increasingly difficult for Russian issuers to service their debt. In the event of a default, it is uncertain what will happen to gas deliveries to Europe.

How Will Cutting The Gas Flow Affect Gas And Power Prices?

We anticipate a gas price surge in Europe (see chart 3), given that there is unlikely to be a replacement for Russian gas in the short term. Because gas remains the price setter for European power prices, the direct consequence is an increase in spot and forward power prices that goes far beyond our assumptions as of February.

Chart 3

We had already expected a price hike because of the accelerated closure of coal and lignite plants, and planned decommissioning of nuclear power plants, which would not be compensated by a timely ramp-up of renewables generation. In that context, we anticipated that gas plants would be a clear winner, with rising load factors over the next three years giving them a more prominent role in European power prices. Yet even if the outright capacity of coal and nuclear power plants could be extended, this is unlikely to sufficiently curb the rise in power prices.

The TTF, Europe's main gas index, is currently trading 10x higher than the 2020 average and above the peak in December 2021, which at that time led to heavy margin calls and the main players having to draw billions in cash. While still difficult to quantify in the currently uncertain and extremely volatile environment, we now anticipate higher forward gas prices in 2023 and 2024 than we assumed. The most recent market indicators suggest power prices in 2023 will be 2x or 3x higher than in our base case. We believe such high prices are unsustainable for the European economy. The EU's plan outlines a series of measures--including price regulation, state aid, and tax measures--to protect European households and businesses from the impact of rising energy prices, however.

Will The Cost Of The Energy Crisis Fall Back On Utilities?

We understand that the Commission will explore all possible options for a contingency plan to limit the impact of rising gas prices on electricity prices, including for example imposing temporary price limits. It has also outlined potential steps member states can take, such as offering energy subsidies and vouchers and tax reductions. In the current exceptional circumstances, member states can set regulated prices for vulnerable consumers, households, and micro-enterprises to help protect consumers and the economy. They can also impose temporary tax measures on utility companies' windfall profits.

What this means for utilities is that, although most of their operations are hedged for 2022 with hardly any benefit from the elevated prices, next year they may not enjoy higher profits because governments could impose special taxes. We may however see some players benefiting more from the current situation than others, when production is pilotable and unhedged, such as for hydropower plants.

Another potential critical longer-term development could come from the European Commission's consideration of options to optimize the electricity market's design. With the aim of accelerating renewable energy generation at low marginal cost and the transition from gas and coal, while fostering green investments, the Commission now seems ready to envisage alternative pricing mechanisms to keep electricity affordable without disrupting supply. We believe this could reshape the European energy market including possibly a move away from the merit order mechanism.

Chart 4

What Factors Could Push Down Demand For Gas?

High energy prices could make some Europe-based industrial companies less competitive than their non-European rivals. We believe that inability to pass energy price increases to customers may lead to temporary shutdowns, thereby removing a large chunk of gas and power demand from the market. For instance, the French industry association has pledged to implement rationing of gas to manage disruption risk. For instance, fertilizer company Yara announced it is reducing its ammonia production in France and Italy as a result of the high gas prices.

Beyond business continuity decisions, we believe a gas supply shortage could also trigger temporary industrial plant closures. For example, this could stem from contractual arrangements with a system operator, where in such a scenario some units are remunerated for being interrupted in priority. Alternatively, the gas system operator could manage disruption risk through partial shutdowns in specific service areas.

Demand from households could also reduce if heating needs go down (also because of higher bills). In the longer term, this could result from the faster replacement of gas-fired home heating systems with electric heat pumps, supported by government incentives. However, the success of this hinges on Europe's ability to significantly expand its green power generation capacity. At the moment, the use of electric heat pumps remains quite low, but if this trend were to accelerate, we believe it could help tighten the European power supply-and-demand balance.

What Could Be The Economic Fallout For Europe And Its Utilities?

In light of the Russia-Ukraine conflict, Europe's exposure to Russian imports, and surge in energy prices, we now forecast a GDP decline in Europe of about 1.2% this year (see "Global Macro Update: Preliminary Forecasts Reflecting The Russia-Ukraine Conflict," published March 8, on RatingsDirect). We expect the growth rate will be largely unchanged in 2023-2024, and inflation to jump 2%.

Against this backdrop, gas and power utilities will be expected to advance their renewables agendas. We believe they could find it difficult to balance the need for more renewables, more biofuels, and increased investment with the reality of less gas. Added to this, we see increasing risks to our baseline macroeconomic forecasts, mainly related to a potential escalation of the situation in Ukraine. That could include the intensity of the military conflict, its expansion across a wider geographic area, or broadening of sanctions that restrict Russia's ability to export energy to key trading partners.

Can Utilities Cope With Hedging And Margin Calls In Such Volatile Energy Markets?

A key strength of large European utilities we rate is their management of supply and trading risk. They do this by securing prices on both the procurement and sale of commodities, which allows them to make a margin without being significantly exposed to volume or price risk. On power generation, we note that companies' hedging strategies provide increased visibility on future revenue. At the same time, we recognize that the gas procurement market and gas supply contracts remain generally opaque, with little public information available on the terms and conditions, including the price formulas. In the current exceptional circumstances, we believe this may add a layer of credit risk.

Yet since the end of 2021 and a first sudden spike in gas prices, energy markets have become even more volatile. We expected some fluctuations as part of the energy transition, especially due to the impact of weather patterns on power supply and demand, but did not expect them to be so wide. In December, energy companies faced a surge in margin calls through their hedging contracts, which resulted in billions of cash outflows.

We see such risk arising again amid the persistent volatility. However, we believe some key commodity market players have rapidly improved their situation in the first quarter of 2022, by renegotiating contracts, limiting margin calls with key counterparties, using letters of credit to manage related cash risk with key core banks, and securing additional credit lines to manage liquidity. We see these measures as supporting utility companies' credit quality. Another positive factor is that, as winter ends in Europe, hedging positions are unwinding and the related collateral is being returned to the utilities. Nevertheless, we see continuous strain from these activities, with large working capital swings likely to continue. In addition, most purchase agreements include a provision that sets the price one month or quarter ahead of the delivery, which creates short-term price exposure. This means hedging contracts in gas purchase agreements don't protect against price increases in the short period before delivery. These price hikes need to be passed through to end customers as early as now, in some cases.

At the same time, a drop in Russian gas flows may limit the volume of deliveries and hence utilities' ability to honor sales contracts. Details of trading arrangements are typically confidential and the contract terms very diverse. However, we understand that large gas supply contracts could benefit from force majeure clauses, since they would allow a retailer to step away from its commitment. Nevertheless, we understand that such clauses may not be easy to trigger in certain circumstances, notably because sales contracts are generally not linked directly to the source of the gas. What's more, triggering a force majeure clause on such a large scale has not happened before, so it's unclear whether mitigating factors would be effective.

On other contracts, the potential lack of physical delivery may lead to greater consequences. Some companies may need to buy gas from alternative sources--and at very high prices--to meet their delivery commitments, which could result in massive losses. We understand that, in such a scenario, the state could intervene to support the utility company and, in doing so, manage the scarcity of gas, as is the case in Germany by law. EU state aid rules can also offer member states options to provide short-term support to companies affected by high energy prices and help reduce their exposure to energy price volatility in the medium to long term. Although the mechanism for this has not yet been defined, we believe this is particularly important to manage gas distribution contracts that may not be fulfilled, as well as for utilities that may have to end their contracts with Russia/Gazprom prematurely.

How Might A Lack Of Russian Gas Affect Europe's Decarbonization Efforts?

The EU's accelerated timeline to expand renewable energy capacity by 2030, alongside diversification to new gas routes, underlies the Commission's decision to reduce Europe's dependence on Russian gas. This development is positive for utility companies' growth prospects, even though it may mean increasing capital expenditure beyond what is currently planned. Yet we still have doubts about whether Europe can deliver on this target.

After the EU proposed its Fit for 55 package, we stated our view that national targets will be difficult to achieve by 2030 (see "Fit for 55: The Gains (And Pains) For European Utilities," published Sept. 29, 2021). Europe's renewables ambitions face several hurdles, including long and burdensome processes to obtain permits, land availability, and supply chain disruptions, since a large proportion of components comes from China. Consequently, we remain cautious about how Europe plans to substitute for Russian gas; a supply-demand imbalance could keep pushing up prices beyond 2025.

The other more immediate consequence is that Europe will likely prioritize security of supply over decarbonization. This implies greater use of coal and lignite plants to make up for the gas-supply shortfall. Germany, for example, is already considering reopening certain coal-fired power plants. This will likely support earnings for those generation companies, even though there might be clawbacks of some of their earnings in the current environment, notably because they are by definition from unhedged volumes that fully benefit from the currently high prices.

For nuclear generation, the outcome may also be favorable. As the race to net zero intensifies and energy prices continue to surge across the continent, Europe appears to be changing its stance about nuclear energy. Nuclear generation provides a viable, low-carbon supply of energy, and extending the lifespan of existing plants could buy renewables projects valuable time to expand and contribute to Europe's energy independence. Recently announced updates to the EU's Green Taxonomy--which seeks to encourage sustainable investment--will include nuclear for the first time, but under certain conditions. At the same time, concerns on nuclear plant security remains high, particularly in view of concerns regarding Europe's largest nuclear power plant, Zaporizhzhia, in Ukraine, and Chernobyl (now non-operational) after Russian troops entered the country. Also, Europe has built few nuclear power plants over the past decades and faces limitations regarding supply chains and skilled personnel (see "Nuclear In Europe: Lessons Learned And Ways Ahead," published Dec. 16, 2021).

How Will Regulated Power And Gas Networks Fare In This Situation?

Regulation is generally protective, leaving operators largely immune to volume and price risks. This is one of the factors we examine when assessing the strength of a regulatory framework and, ultimately, the strengths of a utility company's business risk profile.

Concern about the affordability of energy is mounting, raising questions on whether (and how) power and gas networks could share the burden, alongside the state and consumers. In this context, we see an increasing risk of political intervention to reduce network operators' profitability in a stressed environment. Yet, given the small share of network costs in energy bills, and legal hurdles to implement clawbacks on regulated activities, we believe that--for now--regulated network revenue will not be subject to negative political intervention in the short term. What's more, given the investment needs to accommodate the energy transition, we believe such intervention could bring more downside than upside, since it would blur utility companies' visibility on earnings.

Nevertheless, we think government intervention will be essential to avoid payment risks due to increasing insolvency, fuel poverty, or households refusing to pay exorbitant energy bills, as was the case in Greece during the sovereign debt crisis. Amid such elevated energy prices, social risks linked to affordability are rising, especially in markets where energy bills represented a large share of households' disposable income even before the crisis. Such a situation would increase pressure on network operators' cash flows, even though regulation generally allows for cost recovery in such a scenario.

We also expect inflation to rise faster over the next two years as the price of other commodities and food products also increases. This could penalize networks whose regulatory remuneration is not linked to inflation, like those in Spain. We believe this could eventually pressure cash flows further.

What Lies Ahead For Europe's Gas Infrastructure?

The Commission's REPowerEU proposal will seek to diversify gas supplies, speed up the roll out of renewable gases, and replace gas in heating and power generation. The move away from Russian gas implies a sharp reduction of gas usage over the coming decade, whereas we previously expected gas volumes would remain flat or decline slightly over that period compared with 2019 levels.

With lower gas volumes and the EU's willingness to accelerate the shift to electric heating, we believe the business models of some gas infrastructure networks may need to evolve. More important, if Russian gas no longer flows to Europe, some gas infrastructure for transit routes will likely be less utilized. Infrastructure owners, such as EPIF, which operates Eustream, may therefore be at risk.

At the same time, we believe the EU will push ahead with projects on decarbonized gas, such as hydrogen and biomethane, which may stimulate investments in new infrastructure faster than currently anticipated. Europe now aims to double its ambition for biomethane, to produce 35 bcm per year by 2030; and to add 10 mt of imported renewable hydrogen from diverse sources and 5 mt of domestic renewable hydrogen. This could benefit gas network operators, to the extent that these investments are effectively developed and there's a favorable regulatory framework. Another key factor for gas operators' credit quality is their ability to address balance-sheet headroom while managing an investment peak in the coming years.

At this stage, we still see more downside than upside for rated gas infrastructure networks and--in all cases--increasing uncertainty regarding the long-term sustainability of their business models.

Related Research

• Economic Research: Moving The Russia-Ukraine Scenario Needle: European Output At Risk, March 16, 2022
• Global Macro Update: Preliminary Forecasts Reflecting The Russia-Ukraine Conflict, March 8, 2022
• Nuclear In Europe: Lessons Learned And Ways Ahead, Dec. 16, 2021
• Fit for 55: The Gains (And Pains) For European Utilities, Sept. 29, 2021

Editor: Bernadette Stroeder