Modern Artificial Intelligence (AI) models often work as opaque decision-making engines (black boxes); reaching conclusions without much transparency or explanations on how a given result is obtained. In an era where AI has become an integral part of our lives, where recruiters, healthcare providers, and other fields, rely on this tool to make decisions impacting individuals, understanding the way AI works is essential.
Could Explainable Artificial Intelligence, or XAI, be a way forward, a potential solution? But, what is XAI, how does it work in practice? What are its benefits, but also its risks, its relationship with data protection? What impact may XAI have in the years to come?
These are some of the questions that our distinguished guest speakers and experts tackled during the EDPS’ Internet Privacy Engineering Network (IPEN) hybrid event, which I had the pleasure of chairing on 31st May.
IPEN, established almost 10 years ago by the EDPS, brings together data protection and technology experts, as well as other pertinent actors, to discuss relevant challenges of embedding data protection and privacy requirements into the development of technologies. The forum generates thought-provoking views, fascinating exchanges, which, like for many others, informs and feeds my own reflections about the narrow relationship between privacy and technology.
This IPEN event on XAI was no exception.
Why XAI?
XAI focuses on developing AI systems that can not only provide accurate predictions and decisions, like other AI systems, but can also offer explanations on how a certain decision or conclusion is reached. In other words, XAI should be able to explain what it has done, what will happen next, and what information has been used to make a decision. With this information, individuals using XAI would be able to understand the reasoning behind an automated decision, and to take the appropriate, and informed, course of action. With XAI, the dynamic changes: users would not simply rely on AI systems to make decisions for them, but would play an integral part in making, or verifying, a decision. To this end, XAI – coupled with human cognition – could play an important role in fostering trust in AI systems, as well as increasing transparency and accountability of AI systems.
XAI, accountability, transparency and data protection: how does it all add up?
How does this all work in practice? How can transparency and accountability really be achieved? It won’t be enough if explanations given by an AI system are very technical – only understandable by a handful of experts.
Effective transparency and accountability, and therefore trust in AI systems, can only really be achieved if information about the underlying behaviour of a system can be explained with truthful and sincere simplicity, and in a clear and concise manner, so that this knowledge can be passed on from the provider to the users of AI systems. Obtaining clear information about the behaviour of AI also has an impact on the ability for its users, such as data controllers and processors, to evaluate the risks that this tool may pose to individuals’ rights to data protection and privacy, to protect them and their personal data.
XAI and its risks
Is it easy to explain AI in a simple, clear and concise way? Well, not really. Making AI understandable and meaningful to everyone is challenging to achieve without compromising on the predictive accuracy of AI. Arguably, one of the risks is that explanations could become subjective, convincing rather than informative, or open to interpretation, context-dependent, some participants shared at the IPEN event. Cultural filters can also play a role. There is probably not one single way to explain what an AI system does, but there are certainly many wrong ways to do so.
Risks to individuals’ privacy and personal data should be considered seriously as well. With XAI, results produced by AI systems may reveal personal information about individuals.
Other risks, shared by our panellists, include the possibility that explanations of AI-assisted decisions may reveal commercially sensitive material about how AI models and systems work. Furthermore, AI models may be exploited by individuals if they know too much about the logic behind their decisions.
XAI needs humans
Now that we have examined some of XIA’s possibilities, its possible impact on data protection, and examples of its benefits, but also risks, how may this field progress?
To advance in the field of AI, Human-AI collaboration is important. Moreover, interdisciplinary collaboration is essential. Experts in computer science, cognitive psychology, human-computer interaction, and ethics must work together to develop robust methodologies, standards and safeguards that promotes a fair AI ecosystem, to empower individuals, giving them control over their information and respecting their privacy.
In this sense, XAI is more likely to succeed if researchers, experts and practitioners in relevant fields adopt, put into practice, and improve AI models with their unique and creative knowledge. Above all, evaluation of these models should focus on people more than on technology.
As highlighted by the European Data Protection Supervisor, Wojciech Wiewiórowski, during the Annual Privacy Forum following the IPEN event: when it comes to XAI and Artificial Intelligence in general, enforcement of appropriate rules and existing EU Regulations, such as the General Data Protection Regulation (GDPR), must be upheld. Protecting individuals’ fundamental rights must come first.
When confronted with powerful AI systems, all human beings, even the clever ones, become somehow vulnerable in relation to the power of the machine. Therefore, we must shape AI to our human. As provided in Recital 4 of the GDPR on data processing, AI should also be designed to serve humankind.
Author:

Lenoardo Cerverna Navas, Director, EUROPEAN DATA PROTECTION SUPERVISOR

Compliments of the European Commission, European Data Protection Supervisor.The post EDPS | Explainable Artificial Intelligence needs Human Intelligence first appeared on European American Chamber of Commerce New York [EACCNY] | Your Partner for Transatlantic Business Resources.

Can EU companies be both green and globally competitive?
Tradeable allowances for carbon emissions set important price incentives for companies to become greener. Unfortunately, evidence shows that many companies move carbon intensive production to other regions, meaning their emissions leak abroad. This ECB Blog post investigates how the EU can strike a balance between green goals and competitiveness.
One of the EU’s most powerful tools to fight climate change is the Emissions Trading System (ETS). It sets a cap on greenhouse gas emissions for a number of industries and provides tradeable emissions allowances to companies. As the EU progressively reduces this cap over time, this pushes up prices for the allowances and strengthens the incentives to avoid emissions. There is both good news and bad news about the ETS. It has contributed to reducing emissions in the EU. But we also find evidence that this came at the cost of a reduced competitiveness in Europe and higher emissions elsewhere in the world. We look at the benefits and costs of the trading system and discuss how to avoid the export of carbon intensive production – what the experts call “carbon leakage”.
The ETS does curb emissions
The trading system is helping to cut greenhouse gas (GHG) emissions in the EU. Our analysis shows that its contribution totals an emissions reduction of 2-2.5 percentage points per year.[1] The system is effective in two distinct ways. First, stricter emissions regulations to make production greener reduce emissions faster. As we cannot measure this stringency directly, we use a proxy: the ratio of traded allowances to the total amount of emissions allowances used by industry. In other words, we assume that a stricter ETS regulation that forces companies to emit fewer GHGs leads to more active trading. Emissions from regulated industries fell by about 2 percentage points for each 1 percentage point increase in our proxy before 2013, and somewhat more after the ETS was reformed in that year. The price mechanism was also effective as higher stringency and higher allowance prices led to faster reductions of emissions.
Second, the ETS has a powerful steering role for companies: regulated EU industries have reduced their greenhouse gas emissions more than those industries in the EU that are not subject to the ETS (Chart 1).

Chart 1
Changes in greenhouse gas emissions – ETS-regulated industries vs non-regulated industries in the EU and in other regions
Percentages
Sources: Tonnes of CO2 equivalent greenhouse gas emissions are from the WIOD environmental account providing it for 56 industries and 43 countries plus the rest of the world for the period 2000-2016.
Notes: The blue bar is the average decline in emissions since ETS inception across all countries and sectors (-4.6 percentage points). The red bar depicts the difference in GHG emissions in ETS sectors globally relative to the average decline. The yellow bar shows the difference in emissions in ETS sectors within the EU relative to average change in emissions of ETS industries.

However, these achievements came at a cost. Contrary to earlier research showing limited empirical evidence of carbon leakages[2], we have found substantial evidence that companies shift carbon-intensive activities with heavy emissions from inside Europe to outside the EU. This runs counter to the EU’s efforts to also help reduce emissions globally. Although global emissions by all industries in all regions have declined since 2005 (blue bar), the global emissions by regulated industries rose above their level until 2005 (yellow bar), and this despite the fact that emissions in the very same industries fell markedly within the EU.
Obviously, such carbon leakages are detrimental to the fight against climate change. One way to address this problem is a carbon border adjustment mechanism (CBAM) on imports.[3] This tool is designed to find the best possible trade-off between reducing carbon emissions and keeping Europe’s producers competitive. It aims to avoid businesses transferring production from countries with strict climate policies to ones with laxer policies, and to thereby minimise carbon leakage.[4]
The current revisions to the ETS include a CBAM on imports of carbon-intensive products that are heavily traded with non-EU Member States. These include cement, iron, steel, aluminium, fertilisers and electricity. This border regime will be phased in to protect EU producers from foreign competition operating in unregulated regions. It will force importers to buy emissions allowances in proportion to the emissions embedded in their imports, at the ETS market price. This means that products will face the same carbon pricing regardless of where they come from and where the relevant greenhouse gasses were emitted. By treating all companies equally when supplying the EU market, the CBAM mitigates possible competitiveness losses.
The effects of the trading system on competition vary depending on the location (inside or outside the EU) and ownership (domestic or multinational companies).[5] We found that companies in the EU which source carbon intensive inputs from within the EU face a competitive disadvantage. This disadvantage grows as the share of carbon intensive inputs sourced within the EU increases. In contrast, those companies which manage to source these inputs from elsewhere perform better, arguably owing to cheaper inputs. This improvement is proportional to the amount of outsourced emission-intensive inputs. In other words: the more those companies source carbon-intensive inputs abroad, the more they can produce as they gain market share.[6]
EU companies which are subject to the ETS regulations produce less when they source high-carbon inputs from within the EU, but their production increases when they source them from outside the region. For multinational companies, we see a similar correlation, but the impact of the shift to outside the EU increases rapidly as the price of emissions allowances rises and has topped that of EU domestic companies at current ETS prices (Chart 2).

Chart 2
The effect of shifting purchases of high-emissions inputs from inside to outside the EU
Percentage points
Sources: OECD-AMNE and authors’ estimates.
Notes: The chart depicts the effect on companies’ production of a one percentage point shift of high carbon footprint inputs, across sourcing regions, from inside to outside the EU. For a 10 percentage point shift across regions of high carbon footprint inputs, EU companies expand production by 1 percentage point, compared to a no-shift strategy. This is based on regression analysis (for details see “Benefits and costs of the ETS in the EU, a lesson learned for the CBAM design”). The log value of sectoral production is regressed on country-sector-ownership fixed effects, emission intensity (emissions per euro worth of production), log value of inputs and the four shares of high carbon footprint inputs sourced from Domestic and MNE companies. The coefficients on these four regressors capture the elasticity of sectoral production to emission-intensive inputs depending on the regions in which they originated, e.g. from inside or outside the EU, as well as company ownership. The specification also includes the interaction of these shares with the price paid on allowances in t-1, to capture nonlinearity of the price for allowances. Finally, the specification encompasses deterministic country and industry trends and control for unobserved time heterogeneity. Matching the AMNE and WIOD databases eventually yields 34 sectors and 44 countries (including RoW) spanning the period 2000-16. Regulated (ETS) industries are Coke and refined petroleum products (C19), Basic metals (C24), Other non-metallic mineral products (C23), Electricity, gas, water, waste and remediation (DTE), and Transport and storage (H).

The effectiveness of the ETS in curbing EU greenhouse gas emissions is undeniable. But it comes at the significant cost of making EU companies less competitive, especially those that are domestically owned, as well as triggering carbon leakages. The degree to which EU production is affected depends on a company’s ownership and where it sources emission-intensive inputs. This suggests that some business models with multinational production chains may have more leeway in reorganising and sourcing “dirtier” inputs from outside the EU. The details of the CBAM must be carefully considered to make sure that the new EU environmental legislation prevents this. Based on our analysis we advise that the CBAM be extended to all regulated productions. Our evidence is a call for regulators to carefully establish the terms for the tariff equivalent charged on emissions embedded in imports and for the CBAM industry’s coverage.
Authors:

Justus Böning, PhD Candidate, KU Leuven

Virginia Di Nino, Principal Economist, Economics, Business Cycle Analysis, ECB

Till Folger, Consulatant, TWS Partners

Compliments of the European Central Bank.
Footnotes:
1. See Boning J., Di Nino v., Folger T., 2023, “Benefits and costs of the ETS in the EU, a lesson learned for the CBAM design”, ECB Working Paper No 2764.
2. See Chan, H. S. R., S. Li, and F. Zhang (2013): “Firm competitiveness and the European Union emissions trading scheme”, Energy Policy, 63, 1056-1064; Jaraite, J. and C. Di Maria (2016): “Did the EU ETS Make a Difference? An Empirical Assessment Using Lithuanian Firm-Level Data”, The Energy Journal, 37, 1-23; Koch, N. and H. Basse Mama (2016): “European climate policy and industrial relocation: Evidence from German multinational firms”; Dechezleprétre, A., Gennaioli, R. Martin, M. Muûls, and T. Stoerk (2019):”Searching for Carbon Leaks in Multinational Companies,” CGR Working Paper Series; aus dem Moore, N., P. Grosskurth, and M. Themann (2019): “Multinational corporations and the EU Emissions Trading System: The specter of asset erosion and creeping deindustrialization”, Journal of Environmental Economics and Management, 94, 1-26.
3. See the relevant press release.
4. For a definition of carbon leakage see Climate EU trading emissions “Carbon leakage refers to the situation that may occur if, for reasons of costs related to climate policies, businesses were to transfer production to other countries with laxer emission constraints. This could lead to an increase in their total emissions. The risk of carbon leakage may be higher in certain energy-intensive industries”.
5. Data on gross output by country and sector, the share of emission-intensive inputs and imports in total were obtained from the OECD AMNE database, which categorises companies according to domestic and foreign ownership (see Cadestin, De Backer, Desnoyers-James, Miroudot, Rigo and Ye (2018)).
6. See Boning J., Di Nino v., Folger T., 2023.The post ECB | Stop carbon leakage at the border first appeared on European American Chamber of Commerce New York [EACCNY] | Your Partner for Transatlantic Business Resources.

Tighter financial conditions test resilience of households, firms, governments and property markets
Financial markets are vulnerable to disorderly adjustments, given investment fund vulnerabilities, stretched valuations, high volatility and low liquidity
Euro area banks robust to recent stress outside the euro area, but higher funding costs and lower asset quality may weigh on profitability

According to the May 2023 Financial Stability Review published today by the European Central Bank (ECB), the outlook for euro area financial stability remains fragile, in the context of recent banking stress outside the currency union.
While economic conditions have improved slightly, uncertain growth prospects paired with persistent inflation and tightening financing conditions continue to weigh on the balance sheets of firms, households and governments. Furthermore, an unexpected deterioration in economic conditions or financial tightening could lead to disorderly price adjustments in either or both financial and real estate markets.
“Price stability is crucial for durable financial stability,” said ECB Vice-President Luis de Guindos. “But as we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system. It is critical that we monitor such vulnerabilities and fully implement the banking union to keep them in check.”
Looking more closely at vulnerabilities, euro area firms face tighter financing conditions and uncertain business prospects. This could be particularly challenging for those firms that came out of the pandemic with greater debt and weaker earnings. At the same time, high inflation is hitting households – particularly those on lower incomes – by reducing their purchasing power and compromising their ability to repay loans. Demand for new loans, especially mortgages, declined sharply in the first quarter of 2023 in response to rising interest rates. While falling energy prices in recent months have reduced pressures on governments to fund additional fiscal support, public authorities nevertheless face rising funding costs.
Euro area real estate markets are undergoing a correction. In residential markets, house price increases have cooled considerably over the last few months, reducing overvaluation in the sector. While price adjustments have been orderly so far, they could turn disorderly if higher mortgage rates increasingly reduced demand. Commercial real estate markets remain in a downturn, facing tighter financing conditions and an uncertain economic outlook, as well as weaker demand following the pandemic. The ongoing correction could test the resilience of investment funds with interests in the commercial real estate sector.
Financial markets and investment funds remain vulnerable to asset price adjustments. Stretched valuations, tighter financing conditions and lower market liquidity might increase the risk of any adjustment becoming disorderly, particularly in the event of renewed recession fears. So far, investment funds have been largely unaffected by recent tensions in the US and Swiss banking sectors. This could change, however, if funds suddenly required liquidity, forcing them to sell assets quickly.
Euro area banks have also proved resilient to stresses in US and Swiss banks on account of their limited exposures. This resilience was supported by strong capital and liquidity positions resulting from regulators’ and supervisors’ efforts over recent years. It will be essential to preserve this resilience amid some concerns about banks’ ability to build up capital. For example, higher interest rates reduce lending volumes and increase banks’ funding costs, which may impair their profitability. Furthermore, there are already signs of deteriorating asset quality in loan portfolios exposed to commercial real estate, smaller firms and consumer loans. Banks may therefore need to set aside more funds to cover losses and manage their credit risks.
In this context, it is essential to complete the banking union and, in particular, to establish a common European deposit insurance scheme. Additionally, vulnerabilities in the non-bank financial sector require a comprehensive and decisive policy response in order to further increase trust in the financial system and its ability to withstand risks.
Contact:

Daniel Weber | Daniel.Weber1@ecb.europa.eu

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Interview with Fabio Panetta, Member of the Executive Board of the ECB, conducted by Karl de Meyer| 24 May 2023 |

To safeguard financial stability, we need to keep central bank money at the heart of the financial system, Executive Board member Fabio Panetta tells Les Échos as the ECB turns 25. And a digital euro would be a risk-free means of payment that Europeans can use anywhere in the euro area.

As the ECB celebrates its 25th anniversary today, where do things stand with the digital euro project that you are responsible for?
We are studying the design of the digital euro, its distribution and its impact on the financial sector. There are around 50 people in the team working on this project. We are in regular contact with the European Commission which is due to present a legislative proposal in June. This will provide the regulatory framework for the digital euro. Then in October the Governing Council will decide whether to launch a preparation phase to develop and test the digital euro. This phase could last two or three years. If the Governing Council and the European legislators – Member States and Members of the European Parliament – agree, we could launch the digital euro in three or four years.
Why does the euro area need a central bank digital currency?
To safeguard financial stability, we need to keep central bank money at the heart of the financial system. And we want to offer citizens a risk-free European digital means of payment that they can use free of charge anywhere in the euro area, in shops, online or for payments between individuals. Such a solution doesn’t exist at the moment. The digital euro will also provide a platform for European financial intermediaries to offer innovative payment services across the entire euro area. At present, services developed in one European country are often not available in others. And the European card payments market is dominated by two non-European companies whose cards are not accepted everywhere. Can you imagine a similar situation in the United States? And this situation would be exacerbated by the growth of big techs, which don’t hesitate to use their customers’ personal data to make money.
Some in the political world or from consumer associations are also worried about how the ECB could use the data collected via the digital euro.
The European Central Bank will not have access to personal data.
As for the financial intermediaries that will distribute the digital euro, a balance will need to be found between ensuring data confidentiality and combating money laundering and terrorist financing.
This balance will be determined by the legislator. In current discussions, some want to prioritise confidentiality, while others want to prioritise the fight against illegal activities.
What can we expect from the digital euro?
The simplicity of a payment instrument that is easy to use, available across the entire euro area and which will strengthen the use of our currency. Increased competition in the payments market and innovation based on this financial “raw material” that we will make available to European financial intermediaries. And greater monetary sovereignty.
In concrete terms, what will people be able to do with their digital euro account?
The ECB will ensure that all users benefit from a basic service that enables payments between individuals, retailers and public authorities. Europeans will, for example, be able to use it to pay online or in shops, to send money to their loved ones or to pay their taxes. And banks will be able to offer additional features such as recurring payments, payments based on usage or access to other financial services.
Some commercial banks are clearly concerned that the ECB might take some of their business.
We have been very clear: the ECB would issue the digital euro but would not distribute it. Citizens will not have an account at the ECB or at the national central banks. We do not have any expertise in dealing with customers, and it would not make sense for us to enter into this business. And we are not looking to gain a large market share. We want to build a presence everywhere, but be dominant nowhere. Europeans will know that they always have the option to use the digital euro, but they will only use it for a fraction of their payments. We are not seeking to expand the role of public money, but rather to preserve it, as in its current form – cash – its use is declining. Making the digital euro available as a complement to cash is a natural development in an increasingly digital economy.
Why will digital euro accounts be capped?
Because we don’t want to create tensions for financial intermediaries that could negatively affect the financing of the economy and the transmission of monetary policy. The digital euro would be a means of payment, not a form of investment or savings. We have at times mentioned a ceiling of €3,000. This amount is close to the average gross salary in the euro area and would not cause problems for financial stability. Larger payments will be possible thanks to a link between digital euro accounts and traditional bank accounts.
Just to make it clear: the idea is not for the digital euro to replace cash is it?
Absolutely not. We are working on issuing a new series of high-tech banknotes with a view to preventing counterfeiting and reducing the environmental impact. We will make banknotes available to citizens for as long as there is demand for them. But it’s possible to imagine that one day the digitalisation of the economy could lead to cash becoming marginalised. We cannot run the risk that central bank money is no longer used. That’s why we need a digital euro.
Will these new banknotes that you just mentioned feature well-known European figures?
We want people to relate to the new series of banknotes we are working on. We are considering a number of themes, including European culture, and we will soon consult the wider public. Personally, I would like to see famous Europeans represented on our future banknotes.
The interoperability of the digital euro with other central bank digital currencies is another important topic…
We are already working closely with the central banks of the United States, the United Kingdom, Switzerland, Canada, Japan and Sweden. We are in a preliminary stage where we compare notes on our progress. But interoperability will require more work. For example, while interoperability is desirable, different national rules on confidentiality would make it more challenging.
The ECB is currently celebrating its 25th anniversary. What progress do you think Europe will make in the next 25 years?
If we, as Europeans, want to continue to play a role on the world stage, we need to act together. We need to make further progress towards closer integration, introduce more efficient decision-making processes, and develop a permanent fiscal capacity at the European level. We need to be able to provide a common response to crises, as we did during the pandemic. A European fiscal policy that complements monetary policy would enable us to avoid many tensions and imbalances.
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The euro is more than a currency, says President Christine Lagarde. It is the strongest form of European integration and stands for a united Europe that works together, protecting and benefiting all its citizens. The ECB, with its commitment to price stability, will always be a cornerstone of that effort.

On 1 June 1998, the European Central Bank was established to prepare for the launch of the euro – the world’s largest ever currency changeover. As a lawyer at the time, I remember how frantically we were revising contracts based on foreign exchange rates that would soon disappear. Could the common currency really work? Today, as we celebrate the 25th anniversary of this institution, we know that it works and that the euro has brought Europe closer together.
Entrusted by European Union governments to safeguard the euro, our staff in Frankfurt, together with colleagues in the 20 national central banks of the currency union, work tirelessly to achieve our mandate of maintaining price stability. That work is critical for the prosperity of European citizens.
Over the past 25 years, we have welcomed nine new countries to the euro area, bringing us from 11 to 20. And we have taken on new roles, including the supervision of European banks. Today the euro is the second most important currency in the international monetary system, after the US dollar.
There have been some tough times along the way. But through the economic highs and lows steered by my predecessors Wim Duisenberg, Jean-Claude Trichet and Mario Draghi, the ECB has always focused on building a stronger foundation for Europe’s future through delivering on our mandate.
The pandemic and Russia’s unjustified war against Ukraine have shown that stability cannot be taken for granted. And growing geopolitical rivalries may mean that the global economy becomes increasingly volatile in future. In a world of uncertainty, the ECB has been, and will continue to be, a reliable anchor of stability.
We have shown that we can act and adapt quickly in the face of even the most serious challenges. Only a few months after I became President of the ECB, we responded swiftly to the pandemic with an array of measures to support the euro area economy through its most acute phase, avoiding deflationary risks.
Today, we are acting with the same determination to bring inflation down. After years of being too low, inflation is now too high and is set to remain so for too long. That erodes the value of money, reducing purchasing power and hurting people and businesses across the euro area – especially the most vulnerable members of our society.
But we will bring inflation back to our target of 2% over the medium term. That is why we have raised interest rates at a record pace, and why we will bring them to sufficiently restrictive levels – and keep them at those levels for as long as necessary – to return inflation to our target in a timely manner.
As recent events in the banking sector remind us, the task of monetary policy is aided by a robust banking system. Financial stability is a precondition for price stability, and vice versa. Since 2014, when we took over banking supervision, we have worked to keep banks in the euro area sound. And banking supervisors chaired by Andrea Enria will continue our efforts to make sure that banks are well-capitalised and resilient to changing conditions, so that they can keep lending to businesses and households.
Our monetary union has been tested many times in the past quarter century. We have been confronted with crises that could have torn us apart – not least the great financial crisis, the sovereign debt crisis, the pandemic. But on each occasion, we have emerged stronger. We now need to build on that inner strength.
As the world becomes more unpredictable, Europe can foster resilience on two fronts. By integrating its capital markets, Europe can better facilitate investment in the green and digital sectors that are so crucial to powering its future growth. And by completing the banking union, we can ensure that the banking sector helps to dampen risks during future crises rather than amplifying them.
The former President of the European Parliament Simone Veil once said that “we need a Europe capable of solidarity, of independence and of cooperation”.  This captures well what the euro represents. Ultimately, the euro is more than a currency. It is the strongest form of European integration and stands for a united Europe that works together, protecting and benefiting all its citizens.
And the ECB will always be a cornerstone of that effort.
Author:

Christine Lagarde, President of the ECB

This blog was published as an opinion piece in newspapers of all 20 euro area countries
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Closer ties allowed Europe to find new natural gas sources after Russia’s supply cutoff, and growing global export capacity can reduce market fragmentation.

Natural gas might be the same commodity everywhere in the world, but prices can vary dramatically because of the complex network of infrastructure needed to transport it.
The result is a partially fragmented global market, mainly because most natural gas moves by pipeline—unlike the market for crude oil, which is more integrated and tends to trade at a single price in most places. Such fragmentation in the natural gas market means not only that prices differ across regions, but also that high prices in one part of the world don’t necessarily transmit to buyers in other places.
Russia’s invasion of Ukraine provided a stark illustration of the effects of segmentation. Pipeline flows to Europe from Russia dropped by 80 percent since mid-2021, sending the continent’s gas prices up 14-fold to a record level in August 2022.  Prices for globally traded liquefied natural gas saw a similar jump. But LNG prices in the United States merely tripled, remaining several times below Europe and Asia.

The disparity in prices, and the US insulation against global gas-market shocks, stems from the idiosyncrasies of gas extraction and transportation. Historically, the US market was linked to crude oil prices because gas was mostly a byproduct of oil drilling, but this relationship, sometimes called artificial integration, has been unwinding over the past decade, mainly because of rising shale gas production. And as gas production surged in the US, which surpassed Russia in 2012 as the world’s largest producer, and export terminals were built, it became easier to sell into markets beyond North America.
Another important factor for gas prices is the technology needed to liquefy and ship the fuel, which must be converted into a compact form—about 600 times smaller by volume than in its gas form—called liquefied natural gas before it can be loaded onto specially designed carriers for transport by sea or road.
LNG export capacity is fixed in the short-term. Facilities for the liquefaction, exporting, importing, and regasification require major investment, so a regional shock, such as Russia’s invasion of Ukraine, can send regional prices moving in different directions.
After the invasion last year, Europe turned to LNG to replace pipeline imports of Russian gas, and US shipments emerged as a key substitute. Why was that possible when US LNG export capacity is fixed? With gas in Europe commanding a temporary price premium during the spring and summer of 2022, Asian customers of US LNG decided to reroute their cargoes to sell in Europe.

There is another important quirk of the natural gas market at play. Pricing formulas for long-term delivery contracts with US companies usually use US prices. That meant Asian customers with long-term deals could buy more cheaply from the US, then reroute tanker ships at sea to sell cargo at the much higher European spot market price.
Despite an increasing reliance on LNG as a substitute for Russian pipeline gas, European LNG import capacity turned out not to be a binding constraint on market integration. European import terminals had plenty of spare capacity before Russia’s invasion of Ukraine, and with the addition of mobile floating storage regasification units, Europe has the necessary infrastructure to accommodate higher volumes of LNG imports.
On the other hand, the United States and other gas producers are exporting at the limits of their capacities, and expansions to global LNG export capacity are needed to bring European and Asian prices back to historically normal levels over the longer term. In the United States, these capacities are poised to keep growing, even after already rapid gains. The first LNG export terminal in the country opened in 2016, followed by many more.

Sizable expansion projects already under construction in the United States, Africa, the Middle East, and elsewhere are likely to increase global LNG export capacity by 14 percent by 2025. Other planned projects could bring export capacity to around 1 trillion cubic meters, roughly a quarter of last year’s global gas consumption.
Securing financing to build new terminals, however, can face major hurdles. Companies need 15- to 20-year contracts to obtain bank financing for construction. Terminals usually cost $10 billion to $15 billion and take two to four years to complete. Timelines are less certain for projects without long-term sales contracts, and some may never be built.
Ultimately, expanded LNG export capacity for the United States and other producers may prove crucial to creating truly global gas markets that are balanced across regions. As advanced economies increase reliance on weather-dependent renewable energy from wind and solar, they will likely see critical periods of increased demand for supplemental natural gas to meet power generation needs. Integrating global gas markets and building needed infrastructure allows prices to stimulate demand and supply reactions in larger, more integrated markets. This helps to buffer global energy markets against supply shocks.
Authors:

Rachel Brasier, Research Officer in the Commodities Unit in the Research Department of the International Monetary Fund

Andrea Pescatori, Chief of the Commodities Unit in the IMF Research Department and associate editor of the Journal of Money, Credit and Banking

Martin Stuermer, Economist at the Commodities Unit of the IMF’s Research Department

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