European gas-to-power: 5-year low in gas prices insufficient to power gas renaissance

August 2015 | Daniel Cramer, Peter Lambert


In the past five years the European power market has seen a sharp drop in the utilization of gas-fired capacity, with renewables and coal taking market share, against a background of shrinking demand. In 2015, as gas prices fell to five year lows, some observers anticipated an imminent gas-to-power renaissance. Our analysis on market fundamentals shows this is highly unlikely: for gas-to-power to outperform increasingly cheap coal, gas prices would need to drop another 50% – to levels not seen since the economic crisis in 2009. Unless regulators change the underlying fundamentals, European players should get ready to navigate the continued tough times ahead.

So far, the decline in gas use has come against a background of weak European economic growth, which caused demand to soften as industrial activity slumped and consumers tightened their belts. On the regulatory side, ambitious subsidies and obligatory offtake for renewable energy sources (RES) helped drive more than EUR 80 billion of annual investment in competing capacity, and resulted in power price falls and reduced market share for merchant producers.

Gas also lost out to coal, which saw prices almost half between 2011 and 2015, mainly driven by the lack in U.S. imports as a result of the recent shale gas boom. Gas in Europe, however, saw domestic reserves shrink and prices rise, at least until recently. Add to this a substantial fall in the price of European carbon credits, and coal quickly became a cheaper power generation option than gas. As a result, gas is often running at a minimum: either only during peak hours (as a result of superior operational flexibility and increased need for ancillary services) or because it is required to run (for instance due to heat commitments to nearby residential customers).

Window of opportunity?

Recently European gas prices have been falling to around EUR 15-20/MWh – representing a five-year low. But even with this price, which comes as a result of lower oil prices, a relatively mild winter weather and renewed LNG inflows, the underlying fundamentals suggest that in most cases coal is still set to outcompete gas.

As well as influencing sentiment in related energy markets, lower oil prices have driven down gas import prices directly. During the last quarter of 2014, oil prices declined by roughly 30 percent compared to the first half of 2014, and at times have traded at less than half the price of July 2014. Major long-term pipeline imports from countries such as Russia, Norway and Algeria are still partly oil-linked – driving down gas prices in Europe.

In addition, a mild winter reduced the demand for gas heating in Europe, especially in the residential and commercial sectors, leaving spring gas storage levels much higher than in previous years, and adding to downward pressure on prices.

While a slight resurgence in economic growth this summer could help demand rebound, it is likely to be offset by increased LNG supply in the next few years, which could help stabilize gas prices at a lower level. Globally, an additional 158 bcm of LNG capacity is expected to be added between 2015 and 2020 – much of it in North America and Australia – compared to just 87 bcm between 2010 and 2015. Given that new LNG supplies are expected to outstrip demand growth in the large Asian market, volume previously diverted to Asia are likely to flow back into the European market. These flows will compete directly with Russian piped supplies for market share – potentially driving down prices further.

These factors combined may be enough to reinvigorate the European gas-to-power market, according to some observers. But even now, our analysis of underlying fundamentals, comparing coal and gas prices together with average power plant efficiency levels (see graph), shows that in most cases gas-fired capacity remains at a commercial disadvantage to coal, and conditions look set to worsen. As a result of ample coal supply and anticipated weak global demand, forward prices have dropped to 9-year lows – or almost 60 percent below their peak in 2011. With several main producers of coal still making cash at this price level, this lower price level could sustain for years to come.


Given this outlook for coal prices, gas would need to drop to 10 EUR/MWh – or 50% below current levels – in order to compete widely with coal. Alternatively, carbon prices would have to rise to 40 EUR/t (an increase of more than 400% from current European Emissions Trading System (ETS) price levels); or regulatory changes, such as major rewards for generation flexibility in power markets – for which gas would qualify – would need to be introduced. Few market observers expect this to happen.

Therefore, unless regulators alter the fundamentals of the European market, gas-to-power players will be forced to navigate a continuously challenging market. Two main areas of relief remain. On the one hand, operators can increase the reliance on by-products (such as ancillary services or heat generation). On the other, power players can wait for further mothballing in the short to medium term, which might enable higher wholesale prices especially for peak power generation. In spite of their value potential, both options reveal an inconvenient truth: a renewed gas-to-power renaissance seems a distant future.

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About the authors

Daniel Cramer is a Senior Analyst in Energy Insights' London office.
Peter Lambert Senior Expert in McKinsey's Sydney office.