A Stress Test for E.U. Energy Supplies

Europe is conducting two stress tests. One is on its energy suppliers, to see how badly they would fare if flows of Russian natural gas were disrupted. The other is on eurozone banks to ensure they are strong enough to finance economic recovery.

It is hard to know which of the two stress tests is more important. But it is clear that an effective system of energy security requires many of the same elements as financial stability.

One is the need for credible stress tests. Europe flunked its original bank tests by modeling conditions that were not sufficiently stressful. The new test being conducted by the European Central Bank looks more credible.

The European Union is only now conducting its first gas test. Member states submitted their results last month to the European Commission, which is now reviewing them before coming up with recommendations next month. It should not pull its punches.

Part of the gas test involves checking whether countries have done what they are already supposed to have done to improve security. After gas via the Ukraine was disrupted in 2009, companies were told they needed to ensure supplies in the event of a 30-day disruption.

But a 30-day buffer is not enough. Although Ukraine has agreed to a cease-fire with rebels, peace on the bloc’s eastern frontier is far from guaranteed. And the Union’s ability to confront Vladimir V. Putin’s revanchism will be compromised as long as it is worried about running out of gas. Policy makers bolstered capital buffers after the financial crisis; they should now increase minimum gas buffers after the Ukrainian crisis.

Banks do not just undergo stress tests. They also have to produce “recovery plans” to make sure they can continue operating if they suffer a shock. Similarly, the gas tests are supposed to be accompanied by contingency plans. Bank recovery plans involve things like raising more capital and shrinking balance sheets. Gas contingency plans need to include increasing storage facilities, switching to alternative fuels and rationing supplies. They need to be robust.

One way of trying to stop banks from getting into trouble is to forbid them to put all their eggs in one basket. There are “large exposure limits,” which prevent their lending more than a quarter of their capital to a single party.

What makes the European Union vulnerable in the gas arena is that 27 percent of its consumption comes from Russia. Six member states get all their gas imports from Russia. It will take time to diversify supply to other fuels (like nuclear energy and renewables) or other sources of gas (like shale and liquefied natural gas). But eventually there should be an equivalent of “large exposure limits” to ensure energy security.

Another way of preventing a financial crisis is to engage in “macroprudential” policy. The basic idea is that it is not enough to look at individual banks, because of the cat’s cradle of linkages between lenders. Regulators need to examine the system as a whole.

There is the same imperative in the gas world. The European Union already has a body called the Gas Coordination Group, which exchanges information and coordinates action. Meanwhile, member states are required to inform the commission before signing any intergovernmental agreements in the energy field so it can check that what may be a good deal for one country does not undermine another’s security.

Donald Tusk, the Polish prime minister, who has just been chosen as the next president of the European Council, has advocated going one step further: involving the commission in all energy negotiations in the bloc. Although this would clearly increase its bargaining power vis-à-vis Russia, it would also contravene trade and antitrust policy.

A more modest idea, though, is worth considering: Get the commission to co-sign all gas deals but give it the power to object only if it believes energy security is being compromised. The Euratom Supply Agency already does this with uranium supplies.

There is, though, one big difference between gas and banking. You cannot print gas in the same way that you can print money, so there cannot be a lender of last resort in quite the same way. But two things can be done that would have a somewhat similar effect.

The most important is to complete the single market in gas. This means ensuring there are enough gas pipelines connecting different national markets. If one country lost access to gas, it could then import it from another. Although the European Union as a whole might still face a shortage, the hit would be shared among all 28 countries, rather than absorbed by a few vulnerable states.

In the past few years, a lot of interconnectors have been built. But the Commission estimates that 17 billion euros, or about $22 billion, still needs to be spent. This is a top priority for the next few years.

Another way of protecting vulnerable countries would be for the bloc to set up a fund to help them pay for liquefied natural gas in the event that Russian gas was cut off, as suggested by Matthew Bryza, director of the International Center for Defense Studies in Estonia. Given that L.N.G. is more expensive than piped gas, the fund could finance the extra cost.

The analogy between gas and finance is not exact. But, as Europe takes action to improve its energy security, it can learn the lessons from banking — from its failures as well as its successes.

NY Times