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01 July 2022

Germany's first gas domino falls

In our main story, we discuss Uniper’s financial difficulties, and repercussions for Germany’s energy markets; we also have stories on Spain’s difficult road to reach its Nato commitment on defence spending; on the ECB’s new plans for reinvesting its sovereign debt portfolio; on shortages of lithium, a crucial natural resource for the energy transition; on a French push to save energy; and, below, on Erdogan’s vacillation over Swedish and Finnish Nato membership.

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Erdogan's yes, but moment

Accession of Sweden and Finland to Nato is not a done deal yet, warns Recep Tayyip Erdogan. Turkey withdrew its veto against accession talks to start with the Nordic countries in return for extensive anti-terrorism assurances that require changes in domestic legislation, and the extradition of suspected terrorists.

What matters are not the pledges they gave but the delivery of those pledges, Erdogan insisted. Both governments bent over backwards to give Turkey its anti-terrorism assurances. One of the pledges is facilitating the extradition of 76 Kurds, deemed as terrorists by Turkey. But this is not so easy. The question is whether the courts in Finland and Sweden have the same definition of a terrorist as Ankara does.

Theoretically, their Nato membership could still be stopped or delayed if the Turkish parliament votes against it. So, indeed, their membership is not a done deal. We also know that Joe Biden’s call to and his meeting with Erdogan played a role in what looked before like a deadlocked situation. Some argued that this is less about the F-16 fighter jet programme than about Erdogan having his meeting with the US President. Jens Stoltenberg was also instrumental in forging a compromise. But Erdogan’s warning and rumblings on the left in Sweden are a reminder that those deals may be easier announced than implemented.

30 June 2022

Where 'don't know' is the correct answer

In our irregular series on scenarios that are not our base case but plausible nevertheless, we will focus today on the impact of a Russian gas embargo on Germany. Our base case sits somewhere between the most extreme estimates of German economic institutes, as juxtaposed by Handelsblatt. But it is worth looking at those extreme scenarios in some detail. It is not what they predict that is revealing but how they think about the evolving situation.

Prognos predicts a drop in GDP by 12.7% in the second half of this year, around €200bn, if the gas stops flowing. The premise is that once the Nord Stream 1 pipeline gets serviced on July 11, and the gas flows stop during the maintenance period, it will not come back afterwards. Prognos writes that an abrupt stop would mean that half of German demand would not be met by supply. The main economic impact is through a domino effect, the kind of which Robert Habeck talked about recently. Prognos has taken a detailed look at industry supply chains to come to this conclusion. A steel company does not use much gas, and in any case is likely to be exempted from rationing. But a rolling mill needs a lot more energy, and is not exempted. The secondary effects outweigh the primary by 3 to 1 in their calculation. This is why their forecast is so pessimistic.

During acute crises, we think it is a good idea for economic analysts to try to gain a deeper understanding of dynamic effects, rather than stare at useless models. We think Prognos's method is quite good, but are moderately more optimistic because dynamic effects work in both directions. There will be offsetting trends, in terms of energy efficiency, and alternative supplies, some of which could kick in immediately.

The other study cited in Handelsblatt comes to a diametrically opposite conclusion. A joint prognosis by Germany’s leading economic institutes says the governments' efforts to diversify energy supplies were already bearing fruit, and that the effect of an embargo would be minimal. In their most probable scenario, there would be no shortages whatsoever during the winter even if Putin were to cuts the gas. They argue that the improved gas storage is the main reason. In April the gas tanks were 30% full. Now this is up to 58%. They put the probability of a shortfall of supply at only 20%. In that scenario, they arrive at a similar direct economic impact as the Prognos Institute, but they don’t go into the domino doomsday scenarios. In that scenario we are looking at a normal recession. Their most pessimistic scenario, very improbable in their view, would see output slashed at 9%.

We never cease to be amazed by how economists, and professional investors too, fool themselves by attaching precise percentages to future scenarios. There is, of course, no valid statistical or probabilistic basis behind this practice, but it is very common nevertheless.

When it comes to the future, we can rank our scenarios, and express subjective views, but that is about it. In our own subject base case, Russia will continue to supply gas at reduced volumes until the autumn. Depending on the war, and the size of their current account surplus, they might at this point take a decision to cut supplies altogether. A total cut-off in July, followed by an acute shortage in the winter and an industrial domino effect, is, however, not an improbable scenario.

What we find most useful about these extreme scenarios is not what any of them predict, but the sheer range of expectations between the two. That is telling us that we are dealing with real, raw uncertainty.

29 June 2022

Why they hate Scholz

Armin Laschet’s bid to become German chancellor ended the day he was caught giggling on stage during a meeting with victims of the 2021 floods. Olaf Scholz had such a moment yesterday at the end of the G7 summit. A journalist from Deutsche Welle asked him the following question:

“Could you say what security guarantees the G7 has agreed on for Ukraine for the period after the war?”

Scholz's response consisted of three words only:

“Yes, I could.”

The men’s arrogance, and his coldness, has to be seen to believed. We have seen milder versions of this before. Scholz is the most dangerous sort of politician: a man with an inferiority complex. 

The journalist, Rosalia Romaniec, put it well in her tweet following this incident.

“What a pity, Herr Bundeskanzler. When I learned German, I was taught to use polite questions during press conferences. This was meant as a serious question.”

28 June 2022

A Rubicon, crossed

One of the lessons during the global financial crisis was the need to avoid binary outcomes, as in defaulting on all of your debt. The Romans, of course, have known this for much longer. When Julius Caesar and his army crossed the northern Italian river Rubicon into Roman territory, he could not go back.

Russia’s default, together with the freezing of central bank assets, is the financial market equivalent of a modern Rubicon crossing. There is no way back now. Or to put this into modern geopolitical jargon: there is no off-ramp for Russian finance.

Russia’s default is not a matter of can’t pay or won’t pay. They have the money, and they want to pay. What happened is that western sanctions have made it impossible for western bondholders to receive payments through the banks. Joe Biden hailed Russia’s default a sign that western sanctions are working. This statement is absolutely correct. If you cut off the financial flows, then surely a default is an inevitable, almost minor consequence.

The default relates to interest payments of $100m on two bonds. In normal times, a default cuts you off from the financial markets, but Russia is cut off anyway. That Rubicon has been crossed with the financial sanctions. The default has therefore no further short-term consequences. But it might become a problem later. If the west ever agreed to lift the sanctions, for example as part of a Russia/Ukraine peace agreement, the default cannot be reversed. You can unfreeze assets. But you can’t un-default. In warfare, diplomacy, and financial regulation, Rubicons are to be avoided if possible because they narrow your choices afterwards. Sometimes, of course, you have no choice.

The problem with crossing the Rubicon is not only that you can’t go back. It is that the best option at that point is often to double down and go forward. This is what Caesar did. If you default on one part of your debt, you might as well default on the rest. As a direct result of financial sanctions, Russia has started to diversify its foreign reserves, and is working on a parallel payments system infrastructure. We are entering a period in which the US may lose its global financial monopoly, which is at least in part due to a lack of alternative infrastructure. The dollar won’t be easily displaced as a global currency, but there is no reason why the countries known as the Brics should transact among each other by channelling flows through the US jurisdiction.

Yesterday, Russia crossed another Rubicon with the bombing of a central Ukrainian shopping centre. The timing is probably no coincidence as G7 leaders met in the surreal picturesque setting of Elmau in the German Alps. The only meaningful agreement struck in the lush surroundings of one of Europe’s most exclusive resorts is an increase in the number of troops on Nato’s front line states to brigade level, which in most cases involves a doubling or trebling of existing numbers to about 3000 and 5000. There will also be an increase in the numbers of troops on high alert. What is less reported in the media this morning is the total failure by Jens Stoltenberg, director general of Nato, to persuade Turkey to drop its veto on Swedish and Finnish Nato accession. We recall Stoltenberg boasting at one point that Nato enlargement could be get done with in an hour after Sweden and Finland applied. This is a very long hour.

From our admittedly skewed perspective another Rubicon has been crossed since the start of the Ukraine war: the de facto abandonment of European strategic autonomy. The chronic lack of defence spending combined with naiveness about what strategic autonomy would involve, may have left Europeans with no alternative. We recall Angela Merkel’s words after the US presidential elections that Joe Biden’s victory, while welcome, should be no excuse to abandon strategic autonomy. She said the narrow election result in the US demonstrated a lack of consensus in favour of continued support for Europe. The mid-terms will probably serve as a reminder to complacent Europeans that Trumpism is not defeated.

The things about Rubicons is you can’t go back later when you want to. We are crossing a lot of them right now with consequences that will outlast the war in Ukraine.

27 June 2022

Hydrogen for dummies

As the EU is struggling to meet its own deadline to phase out fuel-driven cars, we are wondering whether the EU should actively consider, and support, hydrogen as an additional source of fuel.

One of the reasons we are interested in hydrogen is because we see a need for more diversification, the lack of which would put the EU’s ambitious emissions reductions targets at risk. For example, we see big problems for some industries such as aviation and cargo, for which hydrogen might be more suitable.

Hydrogen is not necessarily the better technology, but it might be a useful additional source of power for the next generation of electric vehicles, if we think beyond just passenger cars. Hydrogen has several advantages.

Hydrogen cars are electric. Their fuel cells convert hydrogen and oxygen to water and electricity to power the engine. That is why they are called hydrogen electric vehicles (HEV).

Batteries are a suitable technology for cars, or urban buses, but not for long-distance lorries, shipping, and aviation. Hydrogen offers a higher driving range than batteries and faster refuelling.

The first stage of the process is the production of hydrogen. Virtually all of hydrogen production currently is through methane, which has an efficiency of 70 to 85%. The remaining hydrogen is produced via electrolysis, which involves breaking down water with electricity into hydrogen and oxygen. This process has an efficiency of 60-80%. The methane process is economically efficient, but results in large amounts of CO2 emissions.

In the second stage hydrogen needs to be converted to power. This takes place in a fuel cell where oxygen and hydrogen are combined to create electricity, heat and water. The efficiency of a hydrogen fuel cell is between 40 and 60%. Taking together, this means that around one half of the energy is lost in the entire process.

Right now, hydrogen accounts for less than 2% of Europe’s present energy consumption, and is primarily used to produce chemical products. There are only 144 hydrogen recharging stations for HEVs across Europe. The UK government has committed only £240m for low-carbon hydrogen funds. There are only around 5000 km of hydrogen pipelines today, most of them in the US (2600 km), Belgium (600 km) and Germany (400 km), compared with some 3m km of natural gas pipelines.

It is possible to channel hydrogen into the gas grid. This is a potentially interesting option because the gas pipelines may soon be running empty as a direct consequence of the war in Ukraine. This would also reduce the upfront capital costs of hydrogen projects.

But there are potential problems. Renewable hydrogen could increase the operating cost. Domestic production of renewable hydrogen in the EU will probably not be enough to meet demand. Also, if pipeline transport is not possible, hydrogen must be liquefied for transport. Here are some obvious parallels to gas.

The EU has a two-stage plan for hydrogen investments. The first is increasing manufacturing capacity. In the second phase, which will run from 2024 until 2030, the focus is on infrastructure, starting with local networks on islands and remote areas where hydrogen would be used not only for renewable energy but also in industry, transport, and for heating. In this phase, the EU is planning a pan-European hydrogen network. The goal is to get at least 6 GW of hydrogen electrolysers rising to 40 GW in 2030.

An interesting part of the strategy involved Ukraine. The total plan had been for 40 GW capacity in the EU, and another 40 GW in Ukraine and North Africa. But that was before the war. A large portion of the country’s installed renewables capacity lies in war zones, including most of the wind farms. The EU will need a plan B.

24 June 2022

A historic moment for the EU - or not

Beware when politicians refer to their own decisions as historic. Awarding candidacy status comes cheap. Waving blue and yellow flags also comes cheap. Tweets cost nothing.

But nothing is quite as cheap as EU candidacy status. Turkey has had it since 1999. North Macedonia has had candidacy status since 2005, Montenegro since 2008. What really matters is the start of negotiations. And from there a long road still waits ahead, paved with good intentions mostly.

The deal reached in the European Council is a classic EU fudge, high on symbolism with the purpose of allowing EU leaders to indulge in fantasies about their own historic role.

Kid yourself not. Ukraine will not be in the EU for a long time, if ever. The biggest obstacle to Ukrainian membership is probably not even Ukraine's readiness, but the EU itself. Ukraine, a large country, would become a significant net recipient of EU funds, at the expense of other net recipients, like Poland. Under the so-called Copenhagen criteria from 1993, enlargement also goes hand in hand with reforms in the way the EU operates. Voting rights and the number of MEPs would have to change, as we reported yesterday. Voting rights are a zero sum game. This is not just about the number of raw votes in the EU’s qualified majority voting system, but also the ability of countries to form coalitions. How many small countries does it take for coalitions to form that have the power to outvote Germany and France? With the accession of so many smaller countries, we would be getting close to this point. Germany already staked a claim for more proportional representation to reduce the probability of being outvoted.

Together with Ukraine and Moldova, there are now seven countries that have candidate status, all of them in the east and the south east of Europe. Bosnia and Georgia have made applications, and Kosovo is another potential candidate.

The accession of so many countries, combined with the departure of a large western country, is shifting the balance. There is no way that France and Germany can maintain their current power in an enlarged EU, or even their informal role as agenda setters. The geographical centre of an EU that includes Ukraine would be somewhere to the east of the German border. With a population of 44m, Ukraine is larger than Poland, and just behind Spain. Ukraine and Poland together would be bigger than Germany. The total population of all candidates and applicants is close to 80m, without Turkey, with whom membership talks are frozen. If you include Turkey, the total would rise to 150m.

EU membership is a binary option. You are in or out. Norway and Switzerland have their deals, and so does the UK. But these deals have mostly not given rise to happiness. One route forward for the EU would be differentiated integration, a term we prefer to variable geometry, where the emphasis is not so much on opt-outs as opt-ins. Amid all the mutual backslapping and self-congratulation in Brussels yesterday, we heard the voice of Alexander Schallenberg, Austria’s foreign minister, who suggested that Ukraine should join the single market as a first step, as he said, to avoid disappointment. We think this is a sensible proposal, for disappointment is otherwise guaranteed.

Behind the decision to award immediate candidacy status to Ukraine was a bitter fight over the beginning of accession talks with North Macedonia and Albania, the two countries that have lingered in the EU’s antechamber for years. Accession talks with North Macedonia and Albania are blocked by Bulgaria, but we read in Euractiv this morning that the Bulgarian parliament could unblock its veto today in time for the Council to save itself the embarrassment of having to say no to those two countries once again.

Austria wanted the EU to grant candidacy status to Bosnia, but was promised that the Council would deal with this issue on another occasion.

23 June 2022

Ionesco would have been proud

The theatre of the absurd has a long European tradition. But even the famous dramatists in this genre would have struggled to come up with anything quite as absurd as the story of Germany and gas sanctions.

The priority at the beginning of the war was clearly to keep the gas flowing. So the German government and the EU agreed to sanction coal and oil, and then flouted their own sanctions by paying Gazprom in roubles. As a result, Vladimir Putin is now so awash in cash that he can afford to use gas sanctions against the EU.

Norbert Röttgen, the former chairman of the Bundestag’s foreign affairs committee, made the point that it would have been better to have embargoed gas immediately. The situation Germany finds itself in today was not only foreseeable. It was foreseen. He asks why has Robert Habeck, the economics minister, did not make preparations when the war started, and avoided immediately taking measures to reduce gas consumption. Habeck kept on saying that a gas embargo would lead to mass unemployment and recession. Did he think that Vladimir Putin would not hear this? As so often in politics, we are once again in a situation in which complacency gives rises to panic. We are more vulnerable now than if we had imposed the gas sanctions ourselves, on our own terms. Another story in our ongoing series of complacency giving rise to panic.

22 June 2022

The long road to Nato enlargement

The talks between Turkey, Finland and Sweden to clear the way for their Nato accession ended inconclusively in Brussels yesterday. Don’t hold your breath, Turkey won’t be pressured to nod through the accession at the Nato summit next week. Their negotiators referred to Greece’s resistance against Macedonia’s accession that lasted ten years and happened only after they changed their official name and constitutional references to North Macedonia. It is a good reminder that those hold-ups can last, even if the rest of the community finds it impossible to understand the nature of the conflict. Though the situation is different today with the war in Ukraine at Europe’s doorsteps, Turkey will be insisting that both nations are to address Turkey’s security concerns and take effective steps to combat terrorism.

The matter is more of an issue for Sweden than Finland. Both countries support the Syrian Kurdish People’s Protection Units (YPG), which Turkey accuses of having direct links to the PKK, a terrorist group that has been waging an armed campaign against the Turkish state since 1984. But Sweden has more clout in this. They have a larger Kurdish community and more political ties than Finland. Turkey is furious that Swedish government still receives senior figures from the Kurdish-led autonomous administration in Northeast Syria, as well as military commanders.  Turkey wants Sweden to cut all ties and shut down their representative office in Sweden. Turkey is also demanding that Sweden and Finland lift arms embargoes imposed on Turkey for its military incursions into Syria to battle Kurdish fighters.

How can they move forward? Sanna Marin, Finland’s prime minister, has expressed concern that there is a risk of the situation freezing. This may well be what it is about to happen. Turkish demands run counter to the value-based tenets of the two Scandinavian democracies. There is no way they can give into Turkish demands on face value. The Swedes say a beefed-up anti-terror law will address many of Turkey’s concerns when it comes into force on July 1, Al Monitor reports. But it not convince the Turkish delegation. They want a real sacrifice.

Turkey’s tough negotiation stance is also to be understood in the wider geopolitical game. Turkey is still holding out to mediate with Russia and hopes to be the big Nato player in the Middle East. The price for Turkey’s nod will probably have to be settled not only with Sweden and Finland but elsewhere in Nato too. If the US deal over F-16 fighters fails, could Eurofighter Typhoons be a sweetener the Europeans ship in?

Given the rivalry between Turkey and Greece, anything less than 10 years to allow Nato accession to proceed would be a success. Until then, they are haggling over the price.

21 June 2022

Beware of blockades

What we know from international law is that blockades constitute an act of war. What international law does not tell us with the same clarity is whether a particular action falls into this category. If Russia blocks Ukrainian wheat exports, this would in our naive view constitute a blockade because this is literally what is happening: shipments are being blocked. Economic sanctions that cut vital supplies to an island, an enclave or an exclave fall into the same category. What we do know is that blockades are bloody dangerous. The Middle East has seen many blockades in the last 50 years. The German blockade of Leningrad was a famous European example, as was the Soviet blockade of Berlin.

The Kaliningrad exclave on the south-eastern corner of the Baltic Sea is Russian, but fully surrounded by Poland and Lithuania, both members of the EU and Nato. It is the area of Russia most vulnerable to a blockade. Lithuania has implemented the latest round of EU sanctions and stopped rail transports of certain goods, like steel, into the Kaliningrad oblast. Russia responded with unbridled fury. The Kremlin’s spokesman, clearly lost for words, called it a violation of everything.

We would pose the question of whether this particular decision has been coordinated with the EU and Nato. It’s seem that the answer is yes and no, respectively. Lithuania’s president, Gabrielus Landsbergis, said the decision was done with consultation with the European Commission, and followed Commission guidelines. We have no reason to disbelieve him. The first reactions from the Commissions seems to support that narrative.

Steel transports are fair game during an international dispute. The EU sanctions against Russia clearly do not qualify as a blockade. If anything, we have criticised them as ineffective. But enclaves are complicated. The question is whether we have a strategy in place to deal with possible Russian counter-measures directed at Lithuania and whether that strategy is consistent with our declared preference not to get dragged into a direct confrontation with Russia. We doubt that such a strategy exists.

20 June 2022

Let's blow up a pipeline

1967 was a fateful year for the German left. It had been in opposition for almost 20 years, since the start of the Federal Republic. In that year, the SPD joined the first grand coalition, and held important offices of state. That was the moment when the left split into those who relished power after more than one generation in the political wilderness, and those who sought to continue the fight against the bourgeois establishment.

The latter group organised itself in what was known at the time the extra-parliamentary opposition. Out of this grew the Baader-Meinhof terrorist group. The core members of the group had been well-known members of the left, mostly with an upper-middle class background. Ukrike Meinhoff had been a television journalist. In 1977, the wave of terror hit a peak when one of the terrorists, Susanne Albrecht, assassinated her uncle, the chairman of Dresdner Bank, and when the group abducted, and later assassinated, Hans-Martin Schleier, the head of the federation of German industry.

We are re-telling the story because we may be at the start of a similar development in the environmental movement. We recall Robert Habeck’s statement that the Green Party was not the political arm of that movement. And the German Green movements reserve most of their criticism these days for the Green party. The best known representative of the environmental movement in Germany is Luisa Neubauer, a young climate activist who has been heading the German arm of the Fridays for Future movement. While Greta Thunberg is fading from public consciousness, Neubauer is right up there, and is a regular guest at talk shows, in which she often clashes with members of the coalition. Hated by the old white men she constantly criticises, she has become a formidable presence in the German political scene. Now that the Greens are restarting coal production, they are creating fertile ground for an extra-parliamentary opposition.

Recently, Neubauer tweeted we are planning to blow up a pipeline. This is not a reference to Nord Stream, but an east African oil pipeline that does not even exist yet. And it’s not even her own idea, but a reference to a book by Swedish academic and climate activist, Andreas Malm, who wrote an instruction manual entitled “How to blow up a pipeline”.

Her own invocation of that expression spooked the German media. When they read the book, they got spooked even more. Its most important message was a battle cry for climate activists to burn and destroy all CO2-emitting machinery. It also invoked Meinhoff’s most famous statement: that it was time for a transition from opposition to resistance. Bild confronted Neubauer on whether she supported those statements, but she refused to comment.

What happened to the climate movement is that events intruded, namely the pandemic and the war in Ukraine, and their agenda has fallen down the priority list of governments. We see very little chance that western democratic systems will deliver on their climate change targets and policy promises. Thunberg has been talking for quite some time about the big gap between what governments, and especially European institutions, say and what they do. We have been making similar observations in our field. The environmental movement will be where the German left was in 1967, at the point where realpolitik of the Greens leads to a split into a Green establishment and an extra-parliamentary opposition, dedicated to resistance.