2027, Europe's next energy crisis
Emerging macro and political risks could derail EU ETS reforms, revenue redistribution might be the answer
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Europe's natural gas market is giving off late 2021 vibes.
That the view of Anne-Sophie Corbeau, research scholar at the Center on Global Energy Policy. Corbeau believes that four factors are particular relevant to Europe right now: a) the Strait of Hormuz remains essentially closed, with only the occasional LNG cargo getting through, b) Europe is experiencing heightened competition for spot cargoes with Asia, c) low European gas inventories (20% below the 5-year average), and d) Norwegian maintenance and low Algerian LNG deliveries to Italy.
TTF, the European natural gas price benchmark has responded, surging by more than 50% since the start of August to over €80 per MWh. For the natural gas market, the uncomfortable truth is that unlike in 2022 there are no alternative sources of LNG supply waiting in the wings to bail Europe out this time. Arguably the potential for a crisis across the energy spectrum is even greater going into 2027 than it was in 2022.
Back in 2022 geopolitical conflict to the east coincided with an extremely hot and dry summer to the west, curbing nuclear and hydroelectric power generation. That boosted demand for fossil fuels and led to a spike in European power prices. Coming off the back of another very hot summer in 2026, the UN has warned that a combination of climate change and a further strengthening in the El Niño weather phenomenon means that next year is almost certain to be the hottest year ever recorded.
Across the continent, hydropower generation dropped to the lowest level in at least seven years in 2026 (6% below 2022 levels) as reservoirs ran low. In Norway, often termed Europe's battery because of the power cables that stretch from the country's hydroelectric plants into northern Europe, reservoirs levels have fallen to record lows. This year high temperatures and low water levels also led several countries to curb output from their nuclear reactors, or forced them to shutdown entirely. If reservoir levels don't replenish in time this winter then Europe may need to radically increase its demand for fossil fuels.
Most European households are only used to a few night of uncomfortable nights sleep each summer. Not so in 2026. Several weeks of high temperatures increased demand for cooling. As more people respond by purchasing AC units demand for power during periods of extreme high temperatures could be significantly higher next year. The high cost of installation in older buildings means that many are turning to less expensive, but more energy inefficient, portable AC units.
European industry also needs to contend with drought conditions. Record low water levels also constricted the transportation of goods along the Rhine and the Danube, two rivers that act as arteries for much of Europe's heavy industry. In 2018, the last period of extreme low water levels, German real GDP growth was curbed by 0.3 to 0.4 percentage points as transport along the Rhine was disrupted.
Finally, diesel looks set join the cast of villains in the next European energy crisis. During the past week, the crack spread - the price premium between the cost of crude and the wholesale price of diesel - jumped to more than $100 per barrel, a record high. Rising diesel prices feed into higher freight and manufacturing costs, slowing economic growth while also driving up inflation.
Europe responded to the last energy crisis by pivoting away from Russian gas and improving energy efficiency. While that may suggest that Europe is better prepared this time when another energy crisis hits, the options for mitigating the impact are probably much more limited this time around. For example, the relatively low cost opportunities for lowering energy intensity much further may have already been exploited, while governments are not in a position to offer the kind of generous energy subsidies they dolled out to businesses and households back in 2022/23.
A cold front and the political fallout is hotting up
Another energy crisis could not come at a worse time. Last weekend Europe was rocked by the news that the far-right Alternative for Germany (AfD) party scored its first state election victory, albeit narrowly failing to secure an absolute majority.
Home to around 2.1 million people, Saxony-Anhalt is the poorest of Germany's 16 states, and the location for several energy intensive manufacturers. Bloomberg reports that the rising cost of energy was a big issue in the runup to the election with some employers, including operators of the regions petrochemical industry, recently announcing that plants face imminent closure.
The Euro and climate sceptic AfD campaigned on the promise of pulling support for renewables and lifting the ban on Russian energy imports. Thankfully most of the laws that shape energy and climate policy are decided at the federal level, meaning that the AfD has little power. Nonetheless, they could still shift the narrative and frame climate policies and green investment as bad for energy prices and employment.
It may be one German state election but the signal it sends is being heard loud and clear elsewhere in Europe. None more so than in those member states that have general elections taking place in 2027. France, Poland, Italy, and Spain are among the largest states where voters will head to the ballot box next year. The outcome of the French and Polish elections are the most relevant to the EU carbon market.
The next French Presidential election takes place on 18th April 2027. Two weeks later on 2nd May a runoff takes place between the two leading candidates. Opinion polls indicate that Marine Le Pen, the leader of the far-right National Rally party will defeat all known candidates in the second round. The party have long been hostile to EU climate policy. In early 2025 senior party members called for the EU Green Deal, the 2019 plan which details how Europe will slash emissions by 2050, to be suspended.
Later in the year, the Polish parliamentary election will be held on 11th November. The opposition Law and Justice party (PiS) is blaming the high cost of transport and heating fuels and the price of electricity on EU climate policies, complicating efforts by the incumbent government to stay in power. Nearer term risks include a bill introduced by PiS that would if put to a vote later this autumn see Poland leave withdraw from the EU ETS. While the bill is very unlikely to be passed the negative sentiment surrounding it could still influence Polish attitudes to EU climate policy.
Escalating macro and political risks could undermine reforms
The prospect that EU climate policy is very likely to get drawn into domestic election debates means that the timetable for the reforms to be agreed upon is very tight. The European Commission published its EU ETS reform proposal just under two months ago on 17th July. Ireland (who currently holds the European Council presidency) has indicated that environment ministers from member states will need to agree on a joint position at a meeting on 11th December. The so-called "trilogue" negotiations between the Parliament, Council and the Commission will then begin in early 2027 and come to a conclusion by the end of the first quarter.
This is going to be extremely challenging, especially so given the scale and importance of the reforms. Remember, this will dictate the direction for EU climate policy through to 2040 and beyond. By trying to cram so much into barley a few months there's a risk that decisions will be made that are suboptimal given the cold light of day. A more realistic timetable according to E3G given past trilogue negotiations is for it all to come to a conclusion by the end of 2027. However, the longer the process takes, the higher the chances that events - political, economic or otherwise - intervene and scupper the reforms.
The market correctly priced the reforms included within the Commission's proposals. Forever forward looking there's a risk now that the market is failing to price in the economic and political factors that could undermine the negotiations. Right now the EU carbon price has broken through the €82-83 level that I've noted before as something of a line in the sand; the level at which political risk erupted in February 2027.
But as I noted in EUAs reaching critical turning point, if the EU carbon price continues to march higher, it increases the likelihood that there will be a political backlash. And so calls for EU ETS reforms to be loosened will gather pace – particularly so in an environment when energy prices are also high:
"Investors should note the EUA market exhibits significant reflexivity. If prices push higher as reform is debated then policymakers may be moved towards more extreme measures that seek to reduce the carbon price, or at least soften the blow to industry. Furthermore, short-term macro pain (for example, should high energy prices return later in the summer) could push those Member States and MEPs that are wavering to come down more forcefully towards relief-leaning."
As I go on to discuss in the earlier article, price moves beyond this level (and approaching €100 specifically), have tended to beat a quick retreat:
"More fundamentally, I don't think people are paying the €100 level enough attention. Supply-demand balances and marginal abatement cost curves all point towards the need for much higher carbon prices. However, its been clear for a long time, and early 2026 has been a reminder, that €100 is, and continues to be, a psychologically important level.
Even the most hardened, must stay-the-course, EU climate policy advocate is aware that if the carbon price rises above that level for too long, then the political backlash risks undermining the entire policy altogether."
As a recent concludes, once carbon prices rise above $84 per tonne CO2 (€72), income inequality tends to worsens since the policy disproportionately affects low income households. The solution according to the paper, and one that the EU's climate policymakers and member states might now pursue more vigorously, is to redistribute revenues above this level. That way you keep the carbon price signal intact, but also offset some of the regressive effects (see Carbon pricing doesn't have to be taxing).
The German economist, Rudiger Dornbusch famously observed that in economics, "things take longer to happen than you think they will, and then they happen faster than you thought they could." He had financial crises in mind but the observation stands for other perils, whether economic, political, or geopolitical.
More than six months since the beginning of the conflict between the US and Iran, equity markets, economic activity, and politics have generally appeared sanguine on the surface, to all intents and purposes carrying on regardless. As energy markets resume their upward march the real test is yet to come. As Dornbusch correctly identified, when the winds change it often has a habit of breaking things.
Europe's next energy crisis is brewing, and with that the political backlash to climate policy and the EU ETS could be more severe than ever. Policymakers need to get ahead of the game.
Peter Sainsbury
