Denmark risks a period of energy price fluctuations, impacting inflation and monetary policy

Changes in energy prices affect inflation. This became clear after the Russian invasion of Ukraine, where a partial cut-off in the supply of Russian natural gas to the EU – together with underlying demand pressures – caused significant consumer price increases in 2022.¹

Higher energy prices contribute directly to inflation through household energy purchases, and indirectly through increased costs for firms

More expensive energy drives up consumer prices through household purchases of energy for e.g. electrical appliances, heating and transport, which directly affect the consumer price index, see chart 1.² At the same time, companies buy energy for e.g. industrial processes, heating, cooling and transportation. This means that changes in energy prices affect production costs and thus consumer prices for other goods and services apart from energy products.

Due to the indirect effects on consumer prices, the higher energy prices in 2022 led to an increase in core inflation, which is a measure of consumer price increases excluding the direct effects of energy and unprocessed food. Calculations show that the indirect energy price effects accounted for approx. 4 percentage points of total Danish core inflation of 6.6 per cent in Q4 2022. The calculations also indicate that the pass-through from higher energy prices to domestic inflation has been faster and stronger than in the past. The relatively strong pass-through compared to previously could suggest that large energy price shocks affect core inflation relatively more than smaller shocks.³

Energy price increases risk affecting inflation expectations

Increases in energy prices potentially have two rounds of consequences for price setting. In the first round, energy prices increase inflation directly and indirectly through more expensive energy purchases for households and firms. The second round of consequences occurs if sustained increases in energy prices raise household and business expectations for future inflation.

At worst, higher inflation expectations risk creating a wage-price spiral in which employees seek higher wages in anticipation of higher consumer prices, while firms increase their prices in anticipation of higher labour costs. The expectations then become self-fulfilling and increase inflation over time. A wage-price spiral was evident after the two oil crises in the 1970s, when Denmark experienced an uptick in inflation expectations.

Central banks respond to energy price increases that raise inflation expectations by increasing monetary policy interest rates

Central banks with price stability objectives will typically raise monetary policy interest rates to prevent a wage-price spiral if they fear increased inflation expectations due to sustained increases in energy prices.⁴ The objective is thus to reduce demand in the economy and thereby lower inflation. In contrast, it is not relevant for central banks to raise interest rates following short-lived fluctuations in energy prices, if these fluctuations are not expected to affect inflation expectations.⁵

Whether and when fluctuations in energy prices affect inflation expectations is ultimately an empirical question.⁶ Several studies indicate that large energy price increases, in particular, affect inflation expectations among households and firms. This effect on inflation expectations is due to increases in the price of e.g. petrol and heating being particularly salient to households because these items are homogenous, purchased frequently and account for a large proportion of certain households' expenditures. In the same way, price increases on e.g. process energy are an obvious additional cost for firms. As a result, households and firms are more likely to notice large increases in the price of energy products than other price changes.⁷

Increased risk of price fluctuations on the energy markets demands more of central banks’ analyses and communication

The European energy markets are currently undergoing large transformations due to the transition away from Russian natural gas and oil products towards more renewable energy. In the absence of mitigating measures the development of solar and wind energy makes the electricity supply more weather dependent. This increases the risk of electricity price increases during periods of adverse weather conditions, i.e. especially cold weather, where the sun does not shine and the wind does not blow, and where electricity consumption for heating is high.⁸ Overall, these changes could lead to a period with greater and more frequent fluctuations in energy prices, which in turn increase the demands on central banks’ analysis and communication. It is imperative that the central banks can assess, also in future, whether a given change in the energy price will shift inflation expectations or not, so they can adjust monetary policy and any fiscal policy recommendations correctly. At the same time, it is vital that the central banks communicate about inflation so that households, firms and the financial markets do not misinterpret the central banks’ monetary policy.

Since the 1980s, the temporary shocks to price setting in the EU have generally been sufficiently small that price stability in the medium term (ensured through price-stabilising monetary policy) resulted in short-term price stability. The changes in the energy markets towards greater energy price fluctuations could weaken this conjunction. Even if inflation expectations are not affected by large temporary fluctuations in prices, these fluctuations will mean that the average stability of consumer prices over a number of years does not necessarily lead to price stability from one quarter or year to the next.⁹

Electricity is produced in power plants through the firing of fossil primary energy sources, for example coal, oil and natural gas, and also from renewable primary energy sources such as solar and wind energy. As primary energy sources are traded across borders in Europe, and because it is possible to substitute between energy inputs in electricity production, the electricity price in Denmark is affected by the price of primary energy sources in Europe.

The last matched electricity producer sets the price at a given time, resulting in incrementally higher electricity prices

Electricity supply differs from other forms of energy supply because electricity must be consumed the moment it is produced. It is therefore necessary to continuously adjust electricity production to ensure balance in the market.

Electricity prices in Denmark are set at auctions on the Nord Pool Spot exchange, where electricity producers and suppliers report production capacity and consumption. The market works by the producers with the lowest variable costs bidding first to produce electricity. When the available supply is large enough to match the demand for a given hourly interval, no more producers are matched. In this way, the last matched producer (marginal producer) will at any given time determine the price of all the electricity being offered for the hour in question in the market in question.¹⁰

The stepwise supply of electricity can cause large increases in electricity prices if the market shifts from one primary source to another and significantly more expensive source. Even minor increases in demand for or decreases in the supply of electricity can significantly increase the electricity price. Conversely, higher production costs for primary sources that are not the last matched producer will not affect the electricity price as long as the last necessary producer does not switch.

The mix of primary sources in electricity supply is determined by production costs

As long as free competition exists in the electricity market, the mix of generation technologies in the electricity supply will depend on the variable and fixed costs of the technologies.¹¹ This is illustrated in chart 2, which illustrates electricity consumption in the EU in 2021 ranked by the levelized cost of production for the different technologies.¹² On average, solar, wind and hydro provide cheaper electricity than nuclear power and natural gas, mainly due to the low variable costs of renewable technologies.

Power plants balance supply and demand in the electricity grid

Coal, oil and gas power plants basically provide a more stable and adjustable power supply than solar and wind energy, which are both dependent on the prevailing weather conditions. Provided there is enough energy, power plant activity can thus be adjusted, unlike solar and wind energy.¹³ The Danish electricity grid is divided into two zones: DK1 west of the Great Belt, and DK2 east of the Great Belt.¹⁴ Table 1 shows how electricity generation by power plants co-varies with electricity production from offshore wind turbines and the total demand for electricity within the two zones. A decrease in offshore wind power production leads to an almost corresponding increase in electricity production from the power plants in DK1 and a significant increase in DK2. An increased demand for electricity also leads to an almost corresponding increase in power plant electricity production in the two zones.

Natural gas power plants determine the electricity price when the rest of the electricity supply is low or demand is high

Coal power is used (like nuclear power) to power steam turbines in baseload power plants. Steam turbines typically have a long ramp-up time, which results in slow demand-response characteristics. Baseload plants are therefore used to provide a continuous supply of electricity throughout the year and will typically only be switched off for maintenance. This helps to reduce the levelized price of coal power in chart 2.¹⁵

In contrast, natural gas is used to power gas turbines in peak power plants, which are only active when the demand for electricity is particularly high, or when electricity supplies from other sources are low. Natural gas is therefore often the last matched electricity producer. Power plants with gas turbines have a shorter ramp-up time because the turbines are driven directly by the gases produced by combustion. It is therefore easier to regulate gas turbines than steam turbines, which makes it easier to balance the electricity market. However, gas turbine plants are less efficient, which increases the unit cost of electricity when generated using natural gas.¹⁶

Due to the regular role of gas turbines as last matched electricity producers, electricity prices have historically been strongly correlated with the price of natural gas.¹⁷ For example, the correlation was 73 per cent in the period 2015-2021, since when the correlation has been even higher, see chart 3. The gas market therefore plays a key role in determining the price of electricity, and the record high gas prices in 2022 were one of the main reasons behind the high electricity prices.¹⁸

The prices of primary energy sources in Denmark are to a large extent determined by supply and demand in Europe, as the primary sources are traded across European national borders. Thus, the price of energy that is not produced in Denmark affects energy prices in Denmark.

Since the 1990s, European energy supplies have become greener – and increasingly dependent on imported natural gas

In the early 1990s, energy production within the EU was mainly based on coal, natural gas and nuclear power, see chart 4. Since then, internal production has shifted away from energy types with a high greenhouse gas (GHG) content. This is due to a political desire to expand the green energy infrastructure and reduce coal and natural gas extraction in Europe.¹⁹

The expansion of green energy infrastructure has not been sufficient to compensate for lower coal and natural gas extraction. Total internal production has decreased from approx. 30 exajoules in the early 1990s to 25 exajoules in 2021, and the EU has thus become less energy self-sufficient, as consumption has not fallen to the same extent. Instead, the EU has compensated by increasing imports of natural gas in particular, which in 2021 accounted for a quarter of total energy imports, see chart 5.

Increased natural gas imports made the EU dependent on Russia and Norway in particular

Oil can be transported at relatively low marginal cost in liquid form via pipelines, tankers and rail. This makes it possible to have a global oil market where buyers can substitute between different suppliers relatively easily.²⁰ Natural gas can also be transported at low marginal cost via pipelines. In contrast, maritime transport of natural gas requires the gas to be converted into liquefied natural gas (LNG). Due to the additional costs of LNG transport, diversifying natural gas imports is more costly than oil imports, and gas buyers are therefore more dependent on regular suppliers.²¹ The EU’s dependence on natural gas is thus a greater source of geopolitical risk than being dependent on oil, even though, overall, oil imports account for more than natural gas imports in the EU’s total energy supply.²²

Natural gas supply in the EU has historically remained largely constant throughout the year, whereas demand is higher in the winter (due to heating needs) and lower in the summer, see chart 6. Therefore, a stable development in gas prices relies heavily on storage facilities being filled during the summer half-year with gas which can then be used to meet higher winter demand.

Russia’s invasion of Ukraine in 2022 led to a significant decrease in imports of Russian gas

Russia’s invasion of Ukraine and the cut-off in the supply of Russian natural gas meant that Russia’s share of EU gas imports fell from 41 per cent in 2021 to 9 per cent in 2022. The sharp decrease in the supply of natural gas combined with fears of further shortages contributed significantly to driving up gas prices, see chart 3. Subsequently, the supply cut-off has been partially offset by increased LNG imports from, in particular, Qatar and the US. At the same time, the EU has decided that member states should try to reduce their gas consumption by 15 per cent,²³ something that the unusually warm winter of 2022/2023 has aided the member states in achieving.²⁴ Overall, the measures have caused the gas price to fall. However, the average gas price in 2023 is still almost twice that of the level in 2016-2021, see chart 3.²⁵

No guarantee that the EU will have such a favourable starting point in future for refilling its gas storage facilities in the summer half-year as it did in 2023

In order to ensure sufficient natural gas stocks for the winter season, the EU has adopted a target whereby, in future, its gas storage facilities must be 90 per cent full by 1 November.²⁶ As of 2 October 2023, gas storage facilities in the EU were 96 per cent full, and the EU has thus succeeded in achieving its 90 per cent gas storage target for 2023, see chart 7. However, filled gas storage facilities are no guarantee against price fluctuations in the gas market. If gas storage facilities are 90 per cent full, stocks are sufficient to cover about two months of average winter consumption.²⁷ In addition, the risk of more volatile gas prices increases when gas stocks fall below 30 per cent. According to the IEA, a cold winter combined with low natural gas supplies to the EU could push gas stocks below this limit in 2024 despite the high gas storage levels at the beginning of the winter.²⁸

Colder winters or reduced gas supplies will lead to more depleted stocks and potentially prevent the EU countries from achieving their target of filling gas storage facilities to 90 per cent of capacity during the summer half-year the following year. Whether a possible mismatch between natural gas supply and demand leads to higher gas prices will ultimately depend on whether priority is given to refilling the gas storage facilities. If less priority is given to refilling gas storage facilities during the summer half-year, lower filling levels will increase the risk of price increases due to market turmoil and actual shortages during the winter season. Against this background, this section studies the extent to which gas demand will exceed natural gas supplies during the summer half-year if priority is given to storing enough natural gas to achieve the 90 per cent gas storage target by the end of October. The study makes various assumptions about future supply and demand.²⁹ The calculations show that the European gas market remains sensitive to changes in supply and demand, see chart 8.

If gas supplies remain at 2022 levels, total gas demand will be 12 per cent higher than supply

The calculations in chart 8 show that total gas demand in the summer half-year will exceed the supply of gas by 12 per cent if initial storage levels are assumed to be at the average level for 2017-2021 and supply is at the same level as in 2022.³⁰ This means that gas consumption by European households and firms must be reduced by 17 per cent. If the EU countries meet the target of reducing consumption by 15 per cent, it will only be necessary to reduce consumption by a further 2 per cent in future years to achieve the 90 per cent gas storage target by November.

If imports of LNG or Russian natural gas are further restricted, this may challenge the possibilities for reaching the 90 per cent gas storage target

There is still a risk that Russia will stop its remaining gas exports through pipelines in Ukraine and the Black Sea. Likewise, there is political pressure for the EU to stop all imports of Russian gas. If all Russian gas imports cease, demand would exceed supply by 19 per cent if initial gas stocks were at average levels. In this situation, EU countries would have to reduce their gas consumption by 26 per cent.

In addition, the EU’s dependence on imported LNG is a possible risk factor. LNG is mainly traded in spot markets, where prices are more volatile compared to the long-term contracts that dominated gas supply in the past. Prices are therefore sensitive to changes in demand. In particular, China’s LNG demand may increase, which may reduce the EU’s access to LNG imports. If the EU’s LNG imports are restricted by 10 per cent concurrently with Russian gas imports being cut-off, demand will exceed supply by 23 per cent, and EU consumption would have to be reduced by 32 per cent.³¹

Colder winters increase the demand for natural gas in winter, necessitating greater reductions in gas consumption during the summer half-year

As previously described, extraordinarily cold winters can lead to very low gas stocks by the end of the winter season. For example, in May 2018 gas storage levels were as low as 31 per cent.³² Winter 2023/2024 risks being particularly cold, as the El Niño weather phenomenon currently unfolding in the Pacific Ocean could mean colder winter temperatures in Europe.³³ If gas storage levels are at 31 per cent of capacity at the beginning of May, demand will be 18 per cent higher than supply after taking gas storage refilling requirements into account. If, at the same time, remaining imports of Russian natural gas to the EU are interrupted and LNG imports are reduced, demand will outstrip supply by as much as 28 per cent.

The Danish Climate Act (Klimaloven) sets targets for Denmark to reduce its GHG emissions by 50-54 per cent by 2025 and 70 per cent by 2030 compared to 1990 levels and to achieve climate neutrality by 2050.³⁴ In order to achieve these goals, Denmark is currently converting its energy consumption and production to reduce its CO₂e emissions, see chart 9.³⁵ In spite of lower CO₂e emissions from electricity and district heating generation by power plants, utilities still accounted for 18 per cent of total domestic emissions in 2022. If emissions from Danish foreign transport activities are included, Denmark’s CO₂e emissions have been roughly constant since 1990. The green transition therefore depends on the continued transformation of the energy supply system.

The design of energy supply systems has traditionally traded off two objectives: low costs vs energy security. The climate targets add a third objective for energy supply: climate neutrality. This additional objective could, in principle, lead to higher and more volatile energy prices if the two traditional objectives are compromised. Higher energy prices may thus be necessary to ensure a sufficient reduction in consumption during the green transition. The trade-off between costs, security of supply and climate neutrality is referred to as the ‘energy trilemma’ in energy economics.³⁶ Against this background, this section discusses the importance of the energy transition for price setting of energy products.³⁷

The development presupposes a general electrification of the Danish society

The plans for the Danish energy supply in the coming years point to increased electrification of the Danish economy.³⁸ The increased power capacity will primarily come from solar and wind power, see chart 10. Thus, solar energy capacity will increase more than sixfold, while wind capacity will triple by 2035. In contrast, the capacity of coal and natural gas-fired power plants, for example, will decrease, so that capacity in 2035 is half that compared to 2022. At the same time, large increases in electricity consumption are expected, see chart 11. The increase in Danish electricity consumption is primarily driven by Power-to-X (PtX), which is explained below. At the EU level, a similar trend is expected, with fossil fuels being replaced by renewable energy sources between now and 2050. The EU also plans to reduce its energy consumption by about a third by 2050.³⁹

Fewer power plants and more renewable energy will make electricity prices more weather-dependent, which may increase the risk of fluctuating electricity prices during a transition period

As mentioned previously, power plants provide a more stable and adjustable power supply than solar and wind energy, which are both dependent on the prevailing weather conditions. Relying on solar and wind energy to a greater extent therefore makes electricity supplies more volatile and inelastic.⁴⁰ The challenges associated with a more fluctuating and inelastic supply are illustrated in Energinet’s model simulations of future electricity prices, see chart 12. According to the simulations, seen over a whole year, the weather has virtually no impact on the average annual electricity price with energy supplies as they were in 2023. However, this will change given the plans to roll out renewable energy in Denmark. The average electricity price in 2030 will be almost three times as high in unfavourable weather years compared to favourable weather years. By comparison, the price increased by a factor of 3.6 from 2021 to 2022, see chart 3.⁴¹

Electricity prices in chart 12 are average annual prices. In practice, fluctuations within the years will be greater than shown in the chart, as annual averages smooth variations within a year. Very large fluctuations in electricity prices can result in controlled shutdowns of parts of the electricity grid. The Danish Council on Climate Change expects that, in 2030, Denmark may experience up to 59 hours of power shortages in difficult weather years. By comparison, Danish consumers have experienced power shortages lasting an average of 20 minutes a year for the past many years.⁴²

Solar and wind power is, on average, cheaper than electricity from coal and gas power plants. The expansion of solar and wind energy in combination with the scaling-down of power plants is therefore expected to reduce the average electricity price by about a third from 2023 to 2035, see chart 12.

In a Danish context, Power-to-X has been proposed as a way of ensuring flexible electricity consumption and thus mitigate fluctuating electricity prices

The challenges of fluctuating electricity prices and possible power shortages can, in principle, be mitigated through three types of solutions: adjustable power capacity, electricity storage and flexible electricity consumption.⁴³ In a Danish context, PtX has been proposed as a way of ensuring a robust electricity supply.

PtX describes technologies that use electricity from renewable solar and wind energy to convert water into hydrogen by electrolysis. The hydrogen can then either be used as a fuel or converted into other synthetic fuels (‘electrofuels’ or ‘e-fuels’). Unlike electricity, the synthetic fuels from the PtX processes can be stored and transported. The fuels can thus replace oil products in transport and contribute to reducing CO₂e emissions from Danish transport activities at home and abroad. The electrolysis process in PtX plants also gives off heat which can be used in the district heating network.⁴⁴

Access to large amounts of cheap electricity is necessary to power PtX processes, see chart 11. In the Danish strategies for a green transition, PtX is highlighted as a method for creating flexible electricity consumption, as PtX plants can be switched off at times of expensive electricity.⁴⁵ Energinet expects electricity price fluctuations to be smaller after 2030 as renewable energy and PtX technologies expand, see chart 12.

Challenges with fluctuating electricity prices can be mitigated in several ways

However, the Danish Council on Climate Change points out that flexible consumption – possibly combined with increased electricity storage – is not enough to mitigate problems with fluctuating electricity prices and power shortages.⁴⁶ The Danish Council on Climate Change has therefore suggested that PtX – in addition to contributing to flexible electricity consumption – must also ensure adjustable power capacity. This can be achieved by burning synthetic fuels at peaking power plants when the supply from solar and wind energy is insufficient to meet demand.⁴⁷

The feasibility of ensuring a renewable and robust electricity supply in Denmark and Europe in the coming years depends on the technical potential of the green solutions and geopolitical tensions. If the expansion of adjustable infrastructure is slowed and the climate targets are still maintained, this could spread to the electricity grid in the form of greater electricity price fluctuations and, in the worst case, power shortages. At the same time, the direct impact of climate change on the electricity price can come to play a bigger role in the energy markets. 

There are risks associated with PtX as a solution to the challenge of electricity storage, as the technology is unproven at larger scale 

PtX plants have not been used in large-scale public utilities.⁴⁸ Therefore, PtX is associated with some technology risk, given that the technologies, when scaled up from pilot plants, may not be as efficient and competitive as assumed in the energy planning.

PtX plants are less energy-efficient compared to using electricity directly from renewable sources, as energy is lost during the conversion from electricity to synthetic fuels. In addition, PtX plants have higher capital costs per unit produced compared to traditional plants for fuel production, since the PtX plants do not operate at times of expensive electricity, which reduces their utilisation rate.⁴⁹

The lower energy efficiency – combined with high capital costs – necessitates close integration between different industries to ensure sufficient excess energy and enough demand for residual products to use PtX technologies competitively. The plans for PtX in Denmark are therefore based on coordination between energy utilities, the plastics and chemical industry, maritime and air traffic, road haulage and agriculture, etc., driven by the public sector.⁵⁰ A risk with this type of planning is that the plans may prove to be unfeasible if, for example, industry-specific market conditions are less favourable than expected. If this is the case, the roll-out of renewable energy infrastructure could be slowed down.

Access to key minerals and metals is vulnerable to geopolitical tensions and bottlenecks

An energy supply based on renewable energy sources requires significantly larger volumes of minerals and metals compared to a fossil fuel-based energy supply.⁵¹ Manufacturing a typical electric car, for example, requires six times as many minerals as a conventional car, and an onshore wind farm requires nine times more mineral resources than a gas-fired power plant. The IEA expects demand for minerals and metals needed for the green transition to double if current global developments continue. The IEA also estimates that demand will quadruple if the world is to achieve the 2°C target of the Paris Agreement.⁵²

The increased demand for key minerals and metals risks creating supply bottlenecks. The supply of minerals and metals has historically had difficulty adjusting to demand in the short term, as mining is typically a lengthy process.⁵³ In addition, supply is vulnerable to trade restrictions, supply chain disruptions and geopolitical tensions as it is highly concentrated in a few countries. For example, China is among the three largest producers of copper, graphite and rare earth elements, and is also responsible for much of the processing and refining.⁵⁴ Lack of access to minerals and metals or large price fluctuations can slow down the deployment of renewable energy infrastructure.⁵⁵

More extreme weather can result in greater fluctuations in energy prices

Climate change – causing more extreme changes in weather – also has a direct impact on price setting in energy markets. Extreme weather affects both the supply of and the demand for energy, and thus climate change does not just affect energy markets indirectly through the need for a green transition of the energy supply.

The impact of climate change on the energy supply was evident in the 2022 summer, which was unusually hot and dry in Europe, see chart 13.⁵⁶ Low water levels in European rivers presented challenges for, among other things, the cooling of French nuclear power plants, which resulted in a low production of electricity and district heating.⁵⁷ At the same time, the low water levels prevented the maritime transport of fuel to German power plants, thereby reducing their capacity. Finally, low water reservoir levels reduced the capacity of hydroelectric power plants in Norway, Italy and Spain, among others.⁵⁸

The climate can also affect the demand for energy for heating in the winter and for cooling in the summer.⁵⁹ As an example, heatwaves have been seen to increase electricity demand by up to 11 per cent in southern Europe.⁶⁰ The number of periods when the electricity demand in Europe increases due to extreme cold or hot spells is expected to grow if global temperatures rise by 2°C as in the Paris Agreement.⁶¹

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