Jupiter: Are high energy costs squeezing growth in core Europe?

Niall Gallagher examines Europe’s donut economy – where growth in periphery countries outpaces the core – and how disparity in energy prices could be driving this.

I’ve talked to clients recently about Europe being a ‘donut’ economy, with stronger economic growth in the outer countries such as the Nordics, Ireland, Portugal & Spain, Greece and eastern Europe, and weaker conditions in the core countries - including Germany, France and the UK. 

The economic forecasts (figure 3, below) show the extent to which the ‘donut’ economies are growing more quickly and in line or ahead of the US.

We think that differences in energy costs, and in particular electricity costs, explain a part, maybe even a big part, of these differential growth rates. Higher-than-average energy costs are creating significant economic challenges for countries like the UK and Germany.

What are the investment implications?

1. We think a significant wedge is opening up in the competitiveness between different European countries based on diverging electricity costs  
2. Clients should not think of Europe as one amorphous economic blob but a region of 30 countries with differing prospects
   1. We are cautious on companies exposed to domestic industries and mass-market domestic consumers in the UK, Germany and certain other European countries due to very high embedded energy costs
   2. We are more positive on companies exposed to domestic industries and consumers in the Nordics, Spain, Portugal, and eastern Europe due to lower embedded energy costs (and Ireland and Greece for different reasons)
3. The US is very competitively advantaged due to cheap energy versus other developed markets, but electricity costs in some European countries are comparable with the US and economic growth rates in these countries are in general on par or stronger than those of the US
4. We must not lose sight of the fact that more than 50% of the revenues of the European equity market are derived from outside of Europe, and many of the European companies we invest in are global companies based in Europe.            
5. Within European equity market sectors, we are particularly positive on the suppliers of electrical equipment and utilities with acceptable ROCE and expanding assets. Many of these companies are heavily exposed to the US economy. 

Figure 1. Mind the gap: US, UK, and Germany electricity prices since 2000

Household electricity prices in the UK, Germany and the US

Non-household electricity prices in the UK, Germany and the US

Source: UK Dept for Energy Security, International Energy Association (IEA) at 30.9.25. In pence per kWh. Prices converted to pounds sterling using annual avg exchange rates. Prices include all taxes where not refundable on purchase.

Figure 2. UK has highest prices: Industrial electricity prices in the IEA in 2023 in pence per kWh including taxes 

Source: IEA, as at 8.1.26. Prices converted to pounds sterling using annual avg exchange rates. Prices include all taxes where not refundable on purchase.

Figure 3. Donut economy? A sampling of European growth estimates

Jupiter data as at 3.1.26. Source: European Commission

Our European equities strategy is exposed to electrification and the energy transition through ownership of a range of leading global companies providing enabling products, such as cabling, electronic equipment, semi capex production equipment and gas turbines. We also own some utilities that are investing and expanding their asset bases to make the energy transition happen.

Electricity demand is growing for the first time in decades, driven by the adoption of electric vehicles, electrification of industry and the early adoption of heat pumps, whilst the explosive growth of AI and hyperscaler capex has lit a fire under the demand for the products provided by these companies.  This is  positive, but sadly there are still issues related to differences in national energy policies and how the energy transition is being implemented across countries. This feeds into the idea of a ‘donut’ European economy.   

Energy costs and growth

I’ve written before about the crucial importance of energy prices to economic growth and the suboptimal (if not irrational) way that the energy transition is being implemented across many European counties including the UK.  To be clear, we are not questioning the science of anthropogenic climate change or the need to decarbonise. Rather, our concern is the way decarbonisation  is being done and the lack of  an engineering mindset in the implementation, which often comes across as ideological. The long-run evidence, covered extensively by the scientist and academic Vaclav Smil in his book “Energy and Civilisation,’’ and by others, is clear:  cheap and abundant energy is among the most important factors for economic growth and development. I’ve long believed that economists and economic policymakers, in particular, don’t pay enough attention to energy costs, and the impact of changing energy costs on a country’s competitiveness and growth prospects. In this context Figures 1 and 2 (above) are especially important.  

Figure 1 shows how electricity prices have trended for household and business/industrial consumers in the US, UK, and Germany. This is a dramatic chart, in my view. If we go back, electricity prices were broadly comparable across these three countries, but a large divergence has opened up, such that industrial/business electricity costs in the UK and Germany are now 4x to 5x US levels whilst household electricity prices are 2x to 3x US levels. Why/how has this happened? 

Politicians and policymakers in the UK often suggest that rising electricity costs are a function of high internationally traded gas prices (LNG) and the impact of the Russian invasion of Ukraine. This is not correct.

Whilst it is the case that gas prices spiked in 2021 and 2022 (for numerous reasons), internationally traded gas prices have now reverted back to the more normal levels seen of the last 15 years (see Figure 4, below), yet electricity prices have not reverted – they have hardly budged at all! More importantly – and contrary to what some politicians have claimed – the rise in UK and German electricity prices has little to do with internationally traded gas prices. They are instead the result of the large additional total system costs added to the electricity system. These costs include  the buildout of intermittent renewables and the associated subsidy, curtailment, backup/storage and network costs.

In our view, this is an attempt to decarbonise electricity provision with energy generation technologies that are less reliable and very expensive.

No sugar coating

One thing more than anything else that has driven the huge increase in electricity system costs, is the series of decisions by UK and German policymakers to decarbonise their electricity systems through the use of offshore wind, which is an expensive technology at a total system level.  It is arguably 5x to 10x more expensive than traditional unabated coal and gas electricity generation, when costed properly.  Costed properly means taking all the additional grid and backup/storage requirements into account and not just the cost of generation, at the point of generation.

Research  by energy consultant Kathryn Porter at Watt-Logic¹ breaks down the total costs of renewables into granular detail for anyone who wants to understand how this works and how this has happened.  In fact, if internationally traded gas costs were to halve from here and fall close to US domestic gas prices, electricity costs in the UK would fall by only about 10% - a drop in the bucket compared to the actual difference in electricity costs between the UK and the US.

There is no way to sugar coat this: the longer term economic consequences of very high electricity costs in the UK and Germany are bad and will severely hamper competitiveness for any energy-intensive business in these countries. 

Unfortunately, we see no way out of this predicament as subsidy contracts to renewable electricity generators are struck for 15-20 years and new capital equipment is depreciated over 40-60 years;  thus we appear to be stuck with high electricity prices for decades to come.

We would expect energy-intensive industries to relocate or shut down altogether, accelerating deindustrialisation. At the same time, industries of the future - such as AI data centres, which depend on cheap and abundant energy - are likely to locate elsewhere. The economic costs of this goes further: consumers in the UK and Germany are paying far more for their utility bills than they need to, and far more than consumers in the US. This diverts money away from other spending and represents a deadweight cost to the economy.

Divergence in policy

We think it is likely that the UK and German governments, under pressure from businesses and consumers, will look to take some of the total system costs onto the general ledger  i.e., central government spending. This will not make the costs go away, it just reallocates them and may require substantial tax increases in those countries, in our view.      

However, there is more to it than this, as illustrated by Figure 2.  What is important in this chart are the differences between the countries, especially the European countries.  At the top of the chart for industrial electricity prices in 2023 was the UK and at the bottom was the US.  Finland, Norway and Sweden are at US levels, Portugal and Spain are somewhere higher but much lower than the UK, whilst Germany and France are higher but not at the extreme levels. Why is this?

The German case is easy to explain as the  government already subsidises industrial electricity prices – but not household electricity prices – shifting the costs elsewhere and leaving citizens on the hook through higher taxes.  Nordic and Spain/Portugal prices  interest us most as these reveal  important infrastructure and policy differences with  the UK/Germany (as well as smaller northern European countries ) that really matter for economic growth and that have investment implications. Specifically:

• Norway, Sweden, and Finland are blessed with vast hydro generation resources and infrastructures that were built decades ago and are largely depreciated (i.e., paid for).  This is ultra-cheap electricity generation. These countries have also been far more pragmatic on nuclear generation – they didn’t shut it down and have even built more. They also   have large landmasses with low population density at northern latitudes where they can build cheap onshore windfarms, which have completely different economics from building offshore windfarms in the middle of the sea.  Therefore we believe that the electricity price gap between the Nordic countries and offshore wind–focused northern European economies is likely to widen, strengthening the Nordics’ competitive advantage.

• Spain and Portugal are interesting too for different reasons, and we think their structural advantage with lower electricity prices will also be sustained.  Spanish policy has been more pragmatic than northern European policy about retaining nuclear and having a long-standing and well-worked out approach to gas,  with multiple sources that are often cheaper than international gas. Spain has hydro and a large, low-population land mass that is suitable for cheap onshore wind. But the key difference looking forward is that Spain is leveraged into solar at both a distributed level (rooftop) and a utility level. Spain has abundant solar resources and the economics of solar are diametrically opposed to offshore wind; solar is a deflationary technology and is far cheaper than offshore wind, which is an inflationary technology. On most properly constructed cost curves, the full system cost of offshore wind is multiples (c.5x) higher than that of  solar, and this total cost difference is growing.  We think Spain and Portugal provide a great example of where other southern European countries such as Greece and Italy could go.

The longer term consequences of these electricity cost differences between nations are important: much economic commentary has focused on the lack of GDP per capita and productivity growth since 2008 in large European economies (UK, Germany) blaming the consequences of the GFC, or Brexit. We think a fair amount of this lack of growth and productivity can be explained by the slow economic strangulation from very high electricity costs. This also is a very plausible explanation for why the UK and Germany have grown more slowly than the US on a per capita basis. Going forward we think these economic differentials will continue to compound, providing the peripheral ‘donut’ economies with a growing competitive advantage.  If you were running an energy-intensive business, would you choose to locate it in Germany or in the Nordics/Spain? 

The economic forecasts in Figure 3 are for two years only, and forecasts will differ, but the general point that we would make is that the peripheral ‘donut’ economies are seeing growth more akin to the US, the core, northern European economies of the UK, Germany and France (for different reasons) are the low-growth cases.  We think this speaks to the crucial importance of cheap and abundant energy to economic growth, and for us it has clear investment implications, as noted above.

Figure 4. Back to normal? UK LNG import prices

Last Price

Source: Bloomberg as at 8.1.26

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Niall Gallagher

Investment Manager, European Equities