Streetwise Professor

September 11, 2022

If You Don’t Like the Message the Price Sends, Ignoring It Only Makes Things Worse

Filed under: Commodities,Economics,Energy,LNG,Regulation — cpirrong @ 2:50 pm

European politicians are desperate, and desperate politicians thrash around and grab stupid ideas–any idea–that they think will alleviate the source of their desperation.

The cost of energy is extremely high now in Europe, and that is stoking political desperation. The politicians don’t like the price signals that the market is sending, and so they are exploring myriad ways of interfering with the price system. These policies (e.g., price controls) cannot solve the underlying problem: Europe is structurally short energy. Moreover, they will create their own problems, which will result in panicked reactions that will create new problems. Wash, rinse, repeat. The whole thing is doomed to collapse. In tears.

There is no better illustration of the European failure to come to grips with their real problems than some of the recent proposals surrounding LNG. One is to cap the price of imported LNG.

Brilliant! That way you’ll have even less gas, and the marginal value of power will go up! Yay!

Er, the LNG market is a world market. Yes, Europe collectively is large enough to have some monopsony power and thus can reduce price: but one exercises monopsony power by cutting purchases. That is, less gas will flow to Europe. Europeans will consume less electricity, and they will substitute higher cost ways of generating it. The shadow price (the opportunity cost, i.e., the real cost) of electricity and gas will increase, not fall.

Another proposal is in some ways even whackier: to replace the Dutch Title Transfer Facility (TTF) price with the Japan-Korea Marker (JKM) as the benchmark price for gas in Europe. Because the JKM price is lower. Or something:

As a last resort in case of supply disruption in Europe the EU could also explore temporarily pegging the TTF to the JKM Asian benchmark as a dynamic cap. Yet that would require the use of other hubs or mechanisms to allocate gas inside Europe, the commission said in the document on benchmarks for the wholesale gas market. “In this situation, JKM would become the world price for international gas for some time,” the commission said. “The wholesale market would be therefore determined by LNG supply/demand, and not by the EU’s internal bottlenecks. LNG would still be attracted by the fact transport costs are lower to the EU.”

In other words, the EC doesn’t like the basis between the price of pipeline gas in Europe (as measured by the TTF price in the Netherlands) and JKM. So, voilà! Make JKM the benchmark and tie the TTF price to the JKM price.

This begs the question of why the basis is what it is. The basis–the spread–reflects bottlenecks as well as shipping costs. If TTF is at a premium to JKM (which it is) even though shipping costs to Europe are lower, that means that there is some bottleneck to transform LNG on the European coast into gas in a pipeline on the continent. The most likely bottlenecks is gasification capacity. The Europeans are scrambling to get floating LNG gasification facilities operating, but the basis/spread is saying that a lot more capacity is needed.

The EC concedes that TTF is at a premium, and that the premium has increased: ““The price premium between the TTF and Europe’s LNG delivered ex-ship indices has widened significantly bringing up questions about its representativeness as an index for linking the contracts in the whole EU-27.”

It only brings up questions to fools. Non-fools get it.

If by “pegging” the Europeans impose some spread between TTF and JKM (adjusted for shipping cost differentials) that does not reflect these EU bottlenecks and their associated costs, the supply of LNG to Europe will be reduced. The only way to incentivize the flow of gas from overseas into European pipes is to have a price that covers the cost of that transformation. If there are bottlenecks, that transformation is expensive.

Thus, it is utterly delusional to think that a price that does not reflect “the EU’s internal bottlenecks” is a good thing: you want a price that does reflect them. The bottlenecks don’t go away because you don’t let the market price reflect them. If you don’t let the market price reflect them, the gas will go away. (Asia will send its regards, by the way.)

You may not like the message the price sends, but you cannot wish it away. And if you try, the message will be sent in an even more painful way. The Europeans (and the UK) seem hell bent on proving this very basic point the hard way, rather than learning from the hard experience of others dating back millennia.

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  1. You can ignore reality but you can’t ignore the consequences of doing so.

    Comment by The Pilot — September 12, 2022 @ 1:31 pm

  2. UK economics. Spend 150 billion quid of taxpayers’ money to keep taxpayers’ energy bills down.
    Anyone see the flaw in this strategy? No one in government, it seems.
    Vova’s defeat on the battlefield shows that the Russian chain of command is FUBAR. So I don’t suppose anyone will obey an order to launch the nukes.
    OTOH, they’ll be happy to shut down all the pipes.
    And that will mean no energy at all, intermittently.
    So when the lights come on… the freezer starts automatically, and we’ll celebrate by having a cup of tea. Then…
    Oh, the British. Pity us, we have been governed by fools with Oxford PPE degrees for so long.

    Comment by philip — September 12, 2022 @ 4:22 pm

  3. @2 Liz must be thanking her lucky stars that Her Maj croaked a day before she was due to unveil her cunning plan to save us all from economic oblivion. Gives her an extra week or two to fine tune it.

    How many Hinckley C’s or Sizewell 3’s could we get for £150 billion? At least one surely. Do EDF offer bulk discounts?

    Actually a cheaper, simpler & quicker option maybe to buy every household a generator plus a bowser of diesel.

    Comment by David Mercer — September 13, 2022 @ 4:59 am

  4. My concern is that this is all a shuffling of deck-chairs on the Titanic.

    While bureaucrats are seeking to placate clueless ministers with these word-games, Europe’s businesses are one-by-one closing down. And not just Herr Strüdel’s picklewurst shop – their heavy industry is winding down, because energy costs make continuing to operate impossible.

    The thought that a ‘European economic collapse’ scenario now has a non-zero probability attached to it should be terrifying everyone. As an ancestor of men who twice had to sail around the world to sort out angry starving Germans I really don’t want the Germans angry and starving again.

    Comment by Ex-Global Super-Regulator on Lunch Break — September 13, 2022 @ 5:09 am

  5. @ David Mercer

    The problem is easily solved by abandoning watermelon targets, removing their subsidies (25% of energy bills is what I have heard), and going for fracking. Back of an envelope calculation is that you need 6 to 7 tcf of gas to pay for a liquefaction plant. UK estimates shale reserves are 200 times that – about 1,300 tcf.

    Ecofascism has enabled Putin by making people reliant on his energy who shouldn’t be. Far more people are being killed by environmentalism now than will ever suffer from climate change in the future.

    @ E-GS-RROLB

    A descendant of such surely?

    Comment by Green as Grass — September 13, 2022 @ 8:43 am

  6. Yep. We’re in the first half of September and it ain’t even cold yet.

    And still the politicians are in a panic clutching at the most ludicrous straws possible.
    Well, you’ve fallen into the mire, the quicksand is suck, suck, sucking you under … of course, you’ll clutch at the most ludicrous straws, anything to save you from being sucked into oblivion.

    Expect torches and pitchforks when it turns really cold and multiple enterprises close their factories and there ain’t no central heating or hot showers …

    Comment by Simple Simon — September 13, 2022 @ 11:17 am

  7. Well, seems I’m not smart enough to get it. Germany e.g. did not have really LNG infrastructure. Something is there and they are about to create more, decided laws in Mai 2022 that make it easy, no environmental concerns etc and the state invests 3 Billion, which is not much of course. So the price is saying this is not enough? So, what follows from this? If there is a certain capacity, then more LNG cannot be processed. Why should the price for the LNG within capacity be higher then? Within capacity there are no constraints. Above capacity nothing can be handled. Without the state intervening no increase in capacity. Why don’t they build more capacity? Because they are ignorant, because they want the economy to go down in Germany anyway, they are just doing some window dressing? I’d say: see, your price signal, your market mechanism isn’t working, isn’t helping. And if the price would double, there is no automatism that more capacity will be build. The ‘invisible hand’ isn’t doing anything. F*** Adam Smith. Now, Europe seems to be f***** anyway…that’s what not just this signal is saying, or?

    Comment by A-w-n — September 13, 2022 @ 11:35 am

  8. Never mind. We can always restart the coal fired generators…

    Comment by philip — September 13, 2022 @ 2:46 pm

  9. @ Green as Grass yes, apologies, well spotted; my only excuse is that ‘it was late’.

    Comment by Ex-Global Super-Regulator on Lunch Break — September 13, 2022 @ 5:51 pm

  10. Some evidence that Germany at least is getting in position to pull the rug from under Ukraine:

    Germany’s top military chief has been criticised for a “stunningly poor analysis” of the Ukraine war, after he claimed that Russia was capable of opening a second front against Nato.

    General Eberhard Zorn cited the threat of a second Russian front as the reason for Germany’s reluctance to send more weapons to Kyiv.

    “[Vladimir] Putin is capable of” opening a second front, Germany’s most senior military commander told Focus magazine, saying that Kaliningrad, the Baltic Sea, and the Finnish border were all possible points of attack.

    He added that, “even though 60 per cent of Russian army forces are tied up in Ukraine, they still have uncommitted capacity.

    “If Putin ordered a general mobilisation, he would not have personnel problems either,” he said.

    General Zorn further insisted that the German army could not give more weapons to Ukraine, saying that “all that we have given, we need it back”.

    “For effective deterrence, we need the appropriate forces. Our partners are counting on us,” he insisted.

    Comment by Green as Grass — September 16, 2022 @ 6:26 am

  11. My comment here is waiting for moderation for some days now, I’ve questioned whether the market mechanism really works here and also, whether the Germsn gov really intends to get the prices lower. Yanis Varoufakis said in an interview on the 13th, there shouldn’t be an energy market with a market price, because it’s a natural monopoly with gov orchestration and intervention. Also, Europe would not just have decided to switch to LNG, but pushes the prices uo, because Europe can afford it, but Africa, Latin America and big parts of Asia can’t and so Europe is securing the supply to Europe and export misrery to the other regions…makes sense together with the EU decision to keep prices up, but tax access profits…

    Comment by Mike — September 16, 2022 @ 10:21 am

  12. Meant were ‘excess profits’ of course…

    Comment by Mike — September 16, 2022 @ 10:27 am

  13. @Mike–Didn’t know you were in limbo. Do you have any other comments that are missing?

    Comment by cpirrong — September 17, 2022 @ 3:33 pm

  14. @Mike. Varoufakis doesn’t like markets. Who knew? Natural monopoly in generation? No. Perhaps in transmission. But that’s not the issue now.

    The commodity goes to whoever has the highest willingness to pay at the margin. Yes, that is a function of income. If you don’t want the world to work that way, well, no alternative has been found to work better.

    Also, greater investment in European infrastructure to take LNG, and a reduction in use of Russian gas, would have increased the demand for LNG liquefaction capacity and the upstream resource base to support it. Your analysis ignores these supply side effects.

    The Europeans’ problem is that the market is working all too well, as the title of the post indicates. They don’t like the message it is sending.

    Comment by cpirrong — September 17, 2022 @ 3:39 pm

  15. @Green as Grass. “At your feet or at your throat.” Some things never change.

    Comment by cpirrong — September 17, 2022 @ 3:39 pm

  16. @philip. If you could turn one on for even a few days this winter you’d make large bank. See my post on sparks and darks.

    Comment by cpirrong — September 17, 2022 @ 3:41 pm

  17. @Ex-Global Super-Regulator on Lunch Break. On a podcast I said it was like playing musical chairs, except that there are 30 more people than chairs, not 1. So to combine our metaphors, it’s like playing musical chairs on the deck of the Titanic.

    Yes the prospect for an economic collapse is very real. Surprisingly, even though you would expect that to have severe impacts on the banking sector, European bank stocks have held up pretty well through all this. Presumably everybody assumes a bailout will occur in the event.

    Comment by cpirrong — September 17, 2022 @ 3:47 pm

  18. @cpirrong: all comments here now, thank you, had used A-w-n accidentally, that I use elsewhere instead of my name. Well, ‘has no alternative been found to work better?’ Long-term gas contracts with Russia has worked better and would also work better now and getting Nord Stream 2 into use. The constraint is common sense, that’s what the price signal is saying…

    …as is true for other topics, like eletricity: light pollution is a problem for years, TV, bakery ovens running on electricity, microwave, electrical garage door openers, an e-car policy, digitalization and blockchain, it’s idiocy that feeds on electricity. And we don’t need industrial farming etc.

    Labour for example also is not organized in market with an exchange, where highest paid and most constraint type of job/profession sets the daily price for all labour. So, the article is about a price signal in the ‘market’, but politicians are supposed to ‘get the meaning’, but then the market needs politics; but politicians created the problem in the first place, yet they normally don’t decide for themselves, esp. not in Germany and the EU, so I suppose somebody knew what certain policies ‘guiding’ politicians cause together with ‘market mechanisms’ and on a geo-political world map within a geo-political power game.

    Comment by Mike — September 18, 2022 @ 2:38 am

  19. Update: Dear Prof. Somebody now sabotaged Nord Stream 2 and Nord Stream 1, as Biden has promised early February for the case that Russian tanks would cross the Ukrainian border…the price signal did not react, they say because nobody expected it to get in use (again). Looks just like geopolitics against Russia and Germany, then there is something on the side that some call a market sending signals.

    Comment by Mike — September 27, 2022 @ 5:16 am

  20. Update: in German media (un-)covered now is the role of the Energy Trading Hub Europe that acted as gov agency by order of the incompetent German Economics Minister with gov sponsored credit lines and caused a big part of the price upswings with their buying gas at any price in large quantities in mission to fill German gas tanks. Again, ‘the markets’ is a fictitious term and politics is shaping the conditions.

    Comment by Mike — October 19, 2022 @ 4:11 am

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