Can Europe Survive Without Russian Gas?

Summary

• New IMF research explores how disruptions to Russian gas supply could impact Europe’s economic outlook.
• For the most vulnerable countries, a sudden cease in Russian gas imports could significantly affect growth, shrinking GDP by up to 6% in Hungary, the Slovak Republic and Czechia.
• Under the best-case scenario, the EU could replace as much as 70% of its Russian gas imports by the end of 2022 if Russia fully shuts off supply. But it would still experience gas price rises of over 100% by June 2023.

Introduction

Winter is coming – for many EU cities, temperatures fall below 10 degrees Celsius in September. Household heating systems will start to kick in, which, alongside heavy industrial usage in some sectors like chemicals could burn through the EU’s surplus gas supplies by as early as November.

With Russian gas pipeline flows to Europe already 35% below 2021 levels, and fears imports could stop completely, regional shortages, very high prices and rationing could ensue. A series of IMF working papers^[1] is the first to discuss how the European gas market could evolve and fragment under a full gas shutoff while assessing the economic impact of such a scenario.

Their assessment is not overly disastrous. If Russian deliveries of gas continue at the current reduced level, Europe should be fine. Given a full disruption, however, it could replace only two-thirds of Russian gas. This would have a strong negative impact on GDP of up to 6%. And, even with access to the global LNG market, EU gas prices would still roughly double from their Q1 2022 levels.

Russian Overreliance

The EU relies heavily on external hydrocarbon sources, most notably Russia. The dependence varies dramatically across countries (Chart 1). But on average, 57.5% of total net imports and 40% of natural gas imports came from Russia in 2020.

Natural gas imports are the main concern. The European natural gas market is not fully integrated, making gas hard to replace. Russian pipelines enter Europe through Germany, (Nord Stream I), Poland (Yamal), Ukraine and Turkey. These pipelines account for 42% of EU gas imports.

Non-Russian pipelines make up 30% of imports and enter via Norway, the UK and Northern Africa. Currently, pipeline capacity utilisation from Norway stands at 81% and 50-60% from other non-Russian sources (capacity is never at 100% due to maintenance).

The last source of imported gas is LNG, making up the remaining 28%. Utilisation was at 39% in 2021, which increased to 66% in April 2022. The map below gives a detailed overview of Europe’s existing gas infrastructure.

Short-Term Supply Fixes

Russia has already stopped gas deliveries to Poland, Bulgaria, Finland, Denmark, and the Netherlands. And it has reduced them to Germany, Italy, France and others. In 2021, the EU imported 155 bcm of gas from Russia. So, if the taps turn off, Europe will need to replace roughly 39% of its annual gas consumption (400 bcm).

LNG Terminals

So far, LNG terminals have plugged most of the shortfalls, especially in Poland. Finland also expects a newly leased floating LNG terminal to fully replace Russian imports by the end of the year. And new agreements with Israel, Egypt, the US, Qatar and Australia could further increase LNG imports this year and the next.

According to the papers’ calculations, higher LNG imports will provide around 55 bcm more in gas to Europe in 2022. For context, the EU imported around 155 bcm of gas from Russia in 2021 (total EU gas imports were 285 bcm). So, expanding LNG imports could plug around a third of any Russian gas cut-off.

One key challenge with LNG terminals, however, is transmitting newly acquired LNG imports within Europe. For example, Spain, the EU’s largest LNG hub, can only export 10% of its import capacity to France. France, in turn, cannot transmit to most neighbouring gas systems given bottlenecks. Similar constraints between Germany and Italy mean transmitting imports into Central and Eastern Europe may require rerouting through North Africa.

Also, the full 55 bcm is unlikely to be utilised as mandates will require storages to be refilled. According to the authors, there are also uncertainties around competition from Asia, summer maintenance, and the timing of US exports. So, while LNG will help Russian gas replacement, more is needed.

Maximising Capacity From Non-Russian Pipelines

There is substantial excess capacity in non-Russian pipelines. Currently, the Azerbaijan and North African pipelines are running at 62% and 51% utilisation rates, respectively. The authors anticipate this can be increased by about 10 bcm this year, up from 48 bcm in 2021. The scheduled completion and early operation of The Baltic Pipe linking Norway and Poland in Q4 2022 should bring an additional 10 bcm in 2023.

Domestic Production

The EU produces roughly 45 bcm annually, just over 10% of its annual consumption. The authors believe nuclear power could provide the equivalent of an additional 7 bcm in gas in 2022, reflecting a new nuclear plant in Finland. Renewable energy can also add an equivalent of 17 bcm, with potentially another 6 bcm from new solar and power facilities.

Substitution by other hydrocarbon energy sources is also an option. Gas-to-coal switching is already underway in Europe, led primarily by Germany and the Netherlands. The authors estimate this switching can reduce gas demand by 9 bcm, while gas-to-oil switching can reduce gas demand by a further 3 bcm.

Realistically, the authors expect the domestic EU power sector and fuel switching to replace an equivalent of around 22 bcm of gas by the end of 2022. This represents 14% of Russian gas imports, alongside the 35% from LNG and 10% from non-Russian gas imports.

Storage

Storage may help with the roughly 40% shortfall if Russia turns the taps off. According to the authors, a maximum of 40bcm (25% of annual Russian imports) could be available to cover temporary supply shortfalls over the next 12 months.

However, capacity is unevenly distributed across the EU (Chart 3). This will increase the prevalence of bottlenecks, making transmission difficult, if not impossible, for some countries. Germany and Ukraine make up 40% of the EU’s storage capacity (Chart 3), with Gazprom owning most of the storage facilities. By the end of June, EU storage facilities were at 58% of capacity – only near its average level over the past decade.

Short-Term Demand Fixes

With supply unable to fully replace Russian imports, households will also need to compress demand in the short run. However, a lack of incentives to reduce consumption and highly inelastic demand means only some household reduction is likely – roughly 4 bcm for the remainder of the year.

A more significant reduction will be required from the industrial sector, and there are examples of this happening. Norwegian fertiliser company Yara has temporarily reduced its production, as have European aluminium and zinc smelters. Meanwhile, ArcelorMittal is using all its electric arc furnaces to reduce gas consumption.

Using the IMF’s World Economic Outlook natural gas price forecasts, alongside estimated elasticities, the authors expect a 13 bcm reduction in industrial demand for the rest of 2022. Tallying everything together, and excluding storage, roughly 70% of Russia’s gas imports are likely to be replaced by the end of 2022 (Table 1).

Gas Shortages and Price Rises

Under a full shutoff, there is a 30% shortfall in gas. Even if storage reached 65% of capacity (was 58% in June 2022), the reserves would not be enough to meet demand in all countries. And by drawing down these reserves, storage levels by 2023 would be near zero, meaning the problem would continue through 2023/4 (Chart 4).

Under an average winter, the shortfall in gas would need consumption to drop 12% (or 36 bcm). But under a particularly cold one, the authors estimate an additional 30 bcm of demand compression would be needed. This would mean significantly higher gas prices – estimated to be around 111%. This is a lower bound price rise under a full shutoff, while an upper bound is estimated to be 367% if none of the 155 bcm was replaced.

By country, shortages will impact UK, Ireland, Spain, Portugal, Sweden, and Denmark least, followed by France, the Netherlands and Belgium. Finland, Latvia, Lithuania, Estonia depend highly on Russian gas but could avoid physical shortages given soon-to-be-launched alternatives. Turkey should also meet most of its shortfall.

The only countries that could really suffer from gas shortages would be Germany, Austria, Italy, Czechia, Slovakia and Hungary. Their shortfall could be anywhere between 15-40%, requiring a significant reduction in gas consumption.

The Economic Impact of Gas Shortages

Next, the authors build a model to estimate the economic impact of a full and prolonged Russian gas shutoff. They consider the inputs of various industries, the substitutability of gas, downstream linkages, market structures and time horizons, as well as reduced private demand and likely policy responses.

They start with the least-affected countries, i.e., the ones that will face no physical shortage but large price rises. Under a scenario in which the government provides no protection to households and services against the large estimated price rises (more likely they will), these countries will face GDP reductions of around 0.4-1.4% (Chart 5).

The next severely affected countries would be Germany and Austria. These countries are estimated to experience 2.0% and 1.9% declines to GDP from June 2022 to June 2023, respectively. Meanwhile, the worst-affected countries – Italy, Czechia, Slovakia and Hungary – could see GDP drop as much as 3.7-4.2%. The EU average is -1.8%.

Even under alternative scenarios, Hungary, Slovakia, and Italy always come out worst. Other countries at risk are Croatia, Lithuania, Belgium and the Netherlands. These countries have some reliance on Russian gas and could experience supply bottlenecks based on existing infrastructure.

Lastly, if governments provide insurance against gas price rises, which they likely will, the authors estimate the GDP impacts to be about 50% larger.

Bottom Line

The paper offers a comprehensive insight into the worst-case scenario for Europe this winter – a full Russian gas shutoff. The good news is most countries will probably not run out of gas thanks to supply- and demand-side fixes. However, a conservative estimate of gas prices is that they will double – this is what will impact GDP most.

European governments may even still be able to combat this. Increasing storage, minimising infrastructure bottlenecks, and improving gas sharing among members could further limit the pain. In the best-case scenario, the paper estimates an average GDP reduction across member states of only -0.4% – a price I am sure they would be willing to pay to remove Russian gas dependence.

[1] Natural Gas in Europe: The Potential Impact of Disruptions to Supply; The Economic Impacts on Germany of a Potential Russian Gas Shutoff; Market Size and Supply Disruptions: Sharing the Pain of a Potential Russian Gas Shut-off to the European Union.