European governments have a tremendous gas problem. Soaring prices of the fossil fuel have inflated the cost of electricity. UK power for delivery in November now exceeds 300 pounds per megawatt hour, an all-time high. There’s a near-term fix, but it requires politicians with a taste for market risk.
Leaders like British Prime Minister Boris Johnson have few good ways to rapidly lower prices. The UK is phasing out coal power stations and investing in renewables, but adequate storage to offset the fact that the wind doesn’t always blow is some way off. New nuclear, meanwhile, wouldn’t supply low-carbon power until after 2030. Unless winters in the 2020s are unusually warm, the UK will rely heavily on expensive imported gas for years to come.
Johnson and his peers can’t do much about the next year or two. But if they wanted to lock in cheaper prices after that, states could ask a bunch of banks to draw up a hedging contract. A government might acquire a call option, locking in the right to buy gas at a set price in 2023.
Such a move would not be unprecedented. Egypt employed JPMorgan and Citigroup to write such options on its oil imports. More importantly, natural gas for delivery in late 2023 trades under 30 euros per megawatt hour, way below the 117 euros the cost of delivery next month spiked to on Tuesday.
In 2019 the UK used 876 million MWh of gas. Call options quoted on the CME Exchange cost about 7 euros per MWh. If someone was prepared to take the other side of the trade, it could cost Johnson about 5 billion pounds to guarantee sub-30 euros per MWh gas two years hence, Breakingviews calculations suggest.
Sounds good, but in practice meddling with derivatives is a recipe for trouble. One reason 2023 gas options are cheaper is because it might just take a few warm winters for the current inflation to subside. If prices dropped below 30 euros per MWh, as they did last year, hedging would have been a waste of public money.
Still, a populist backlash in response to spiking electricity costs today could torpedo the transition to a low-carbon future. During the pandemic, many states paid private employees’ wages. Far-out solutions may still be in vogue.
CONTEXT NEWS
– European wholesale gas prices surged to record highs in several contracts on Oct. 5, with gas for November delivery at the Dutch TTF hub, a European benchmark, trading at a record 120.80 euros per megawatt hour, up 26% from the previous day’s close. On Oct. 6 the contract rose another 21% to 143 euros per MWh.
– As recently as April similar contracts traded below 20 euros per MWh.
– The price of power for next-day delivery in the UK market rose 44% to 260 pounds per MWh on Oct. 5. It traded at 270 pounds per MWh on Oct. 6.
Source: Reuters (Reporting by George Hay; Editing by Rob Cox and Oliver Taslic)