A proposed target model for the European natural gas market

June 29, 2011 | 00:00

A proposed target model for the European natural gas market

A report prepared for GDF Suez by Frontier Economics as contribution to the debate on a European target model for the natural gas market.

Executive Summary

One of the main aims of the 3rd Energy Package is to complete the European internal market in natural gas. Key to achieving this is ensuring that there is an effectively functioning wholesale gas market in Europe, where different sources of gas can compete. To this end, the 3rd Energy Package creates the concept of European Network Codes, which would apply throughout Europe and describe (among other things) key aspects of the framework for the wholesale gas market. This would include the way in which those with gas will get it to customers, the way in which trading will work, and the extent and nature of competition.

The European regulators, at the request of the European Commission, have launched a consultation process to define a “target model” for the gas market. This market model would set the framework for the development of the Network Codes. This report considers the objectives of a target model and provides a possible vision for the model, and this summary sets out some of the key characteristics of this model, and some of the key debates in its design.

The overall objective of completing an efficient internal market for gas is clearly in customers’ interests. However, we demonstrate that the devil is in the detail. Depending on the approach taken, we believe European customers could end up beneficiaries of greater competition for the supply of gas and more efficient use of gas infrastructure, or paying billions of Euros for infrastructure which is not necessary, and paying a premium to attract investors to the gas sector.

We argue that Regulators and the Commission must be clear that customers’ interests are at the heart of the design of any target model. In particular, in defining the target model, it may be important to notice that (a) competition is a means to further customers; interest, not an end in itself, (b) there can be conflicting objectives in defining the way in which producers can get their gas to market, (c) there is a risk in simply adopting approaches used in the electricity markets, and (d) the timing of implementation and future evolution of the market must be taken into account.

Competition as a means, not an end

Almost the starting point for the target model is the division of European into geographic regions within which different sources of gas (e.g. Norwegian, Russian) can compete freely. We consider the approach to defining such regions, and conclude that ensuring that all sources of gas can compete freely with each other should not be a goal in itself. It is unrealistic to assume that all gas sources will be able to compete to serve all customers in Europe, as this would require a gas transport network with huge capacity. For example, while gas supplies to GB might be able to compete with gas supplies to Ireland, it would cost much more to ensure that supplies from North Africa could compete throughout the continent with supplies from Norway.

Some contributions to the debate on the gas target model have taken the starting point that bigger regions are necessarily a good thing because they provide for more competition. We demonstrate that this is not necessarily in customers’ interests, showing that there is a trade-off to be considered between the cost of infrastructure on one hand and the customer benefits of access to a variety of sources of gas on the other.

There are significant benefits from competition which can come from the creation of regions where all gas sources can compete freely (true “entry-exit” regions). This is preferable to designing larger regions but restricting the extent of competition within them. However, to ensure customers get the maximum overall benefit, we suggest that a case-by-case approach is needed to the definition of regions, based on robust cost-benefit analysis.

Moving gas from producer to consumer: conflicting objectives

Access to the gas network to allow producers to get their gas to customers is clearly of critical importance. Gas networks are typically regulated natural monopolies, so regulation must ensure that they make capacity available in a way which is:
„Í attractive to producers, in order that Europe can secure its gas;
„Í attractive for investors in the network, to ensure that required network developments can be financed;
„Í supportive of competition, so that customers receive the best price possible for their gas supplies; and
„Í fair for customers, so that customers do not end up paying for network investments which benefit other people.

We demonstrate that it is not necessarily possible to fulfil all of these objectives at once, and that a balanced view must be taken across them. Europe competes with other markets to secure its gas. European operators and regulators have much less influence over the nature of this competition than is the case within Europe. We note that while long term contracts are often considered as being bad for competition, if this is the basis on which producers outside Europe sell gas, it may be important for European networks to sell transport services on the same basis.

If they do not, producers may perceive a risk of being left with gas which they cannot transport (and hence sell to European customers). If, as a result, producers take the view that Europe is becoming less attractive as a market, customers will end up facing the risk of higher prices, and needing to pay a premium to secure supplies. Such a price risk could be significant, because the costs of the gas commodity itself make up a large proportion of the costs paid by final customers for gas supply.

We make clear that well-intentioned rules aimed at promoting competition can lead to higher costs for customers overall. For example, in some countries, companies who have rights to use the network are required to give up these rights if they do not use them sufficiently. This can lead companies to use the network inefficiently (meaning customers may not be offered the lowest cost sources of gas) just so that they maintain their rights. We highlight alternate arrangements which may secure the same outcome without such problems, and which could therefore form a preferable starting point.

We also note that regulatory decisions which may seem to be in customers’ interests in the short term can have damaging impacts in the longer term. For example, from a customer-value perspective it may seem perfectly reasonable to reduce the regulated revenue of infrastructure investments which are not fully utilised. And if investors put up their money knowing that this would be a risk, there may be no problem. However, if investors believed they would earn a regulated return irrespective of the degree of use over the lifetime of the asset, then such regulatory behaviour will undermine confidence in the regulator. Future investors will then demand a risk premium associated with their investments, and this premium will be picked up by customers in their gas bills.

For cross border flows of gas, we make clear that there will inevitably be some tension between encouraging competition between sources of gas in different countries while making sure that those who use the pipeline network to cross countries pay for it and do not leave national customers to pick up the bill. We indicate that a pragmatic solution will be required to balance these objectives.

Don’t just say “they do it in electricity”

The market arrangements in electricity are often perceived as being “more advanced” than those in the gas market. However, we argue that there is a danger in importing arrangements which have been implemented in the electricity sector without considering the differences between the sectors.
For example, in electricity there is a well-established process of holding auctions for the sale of power a day ahead of the time of delivery. There is now a trend to using such auction processes across countries to facilitate cross-border trade.

However, the costs of electricity generation are relatively easy to predict at the day ahead stage, as a function of fuel prices at that time and power station efficiency. Equally, because electricity network operators must balance electricity production and consumption every second (i.e. balancing must be “instantaneous”), they need to understand the plans of producers and consumers well ahead of the actual time of delivery and plan for a wide range of eventualities (e.g. forecast errors, plant failures etc.)
Neither is the case in the gas network:

„Í  determining the value of gas is more complicated. The value of gas in storage or in a production field today is a function of the expected value of gas in the future (“opportunity cost”). Historically gas markets have been based on continuous trading which allows traders to adjust their positions in the light of evolving current and future pricing information; and
„Í gas production and consumption needs only to be in balance over periods of hours or even days (as a result of the ability to store gas in the gas pipelines) rather than second by second. There is therefore no need for production and consumption plans to be determined a long time in advance. Indeed in some markets they can change without major consequence right up to the point of delivery.

We note that it is not therefore clear that simply implementing the auction process used in the electricity market would be the approach which is in the best interests of customers overall. This may be particularly relevant when there are continuous trading processes also used by the electricity market which could effectively facilitate cross border trade.

Timing and evolution

Finally, we make clear that to be of value in terms of ensuring competition and investment in the gas market, any target model must be designed with the potential future evolutions of the gas market in mind. And there are many such potential evolutions, from the future of indigenous production and shale gas through to the demand for gas in a decarbonised society.

Faced with such uncertainty, it is important that market forces are relied upon where possible, as experience indicates that they are more likely to adapt to future developments than administrative arrangements put in place by regulators. So whether it is avoiding unnecessary regulation of assets which can compete effectively in the wholesale market (such as storage or LNG terminals) or allowing the market to determine the details of traded markets (such as the development of arrangements for trading at hubs or on exchanges), avoiding the risk of unintended consequences of regulation should be at the forefront of the minds of policymakers and regulators.

Where regulation cannot be avoided, we note that implementation timescales must be realistic and futureproofing must be considered. The future nature of gas demand, and increasing demand volatility (as gas generation provides a back up to intermittent renewables) must be taken into account. And defining evolutionary arrangements which build on existing practice may carry less complexity and risk, and so result in a greater likelihood of earlier developments in the interests of customers than attempts at more revolutionary

For the full report, click here.


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