It's finally coming: the great European gas market transformation

April 5, 2012 | 00:00

It's finally coming: the great European gas market transformation

The European gas market is awaiting radical changes in the years ahead. The old market structure, based on bilateral long-term contracts between a limited number of big suppliers and buyers, will be replaced by (presumably) thriving wholesale markets where sellers and buyers meet on trading hubs to make short-term deals. Some analysts are sceptical. 'Europe is taking a big risk if it relies on this single model', says Dick de Jong of the Clingendael International Energy Programme (CIEP) in the Netherlands. 'We are too much focused on the internal market instead of on the external market on which we increasingly depend.' But Jean-Michel Glachant of the Florence School of Regulation is positive. 'The global gas market is changing fast. Europe has to adapt to the new realities. Otherwise there will be a bloodbath.'

The European gas market is about to undergo a radical restructuring (photo: European Dialogue)

News flash! Brussels, 23 March 2012. The European Gas Regulatory Forum (also known as the ‘Madrid Forum’) has endorsed the ‘Gas Target Model’ of the Council of European Energy Regulators (CEER). OK, so that didn’t make it to the front page of your newspaper. Yet, there is an important news story behind this abstruse message. One with major implications for the European economy and Europe's security of energy supply.

In a nutshell the story is that the EU and its member states are about to transform the European gas market: to integrate the various national markets into a single liberalised market. It’s a project that the EU has worked on for some 15 years and that is now quickly becoming a reality.

Three years ago, in 2009, Brussels finally put in place the definitive legislation (called ‘the Third Package’) to make this great transformation possible. The independent national energy regulators were given the task to supply the nuts and bolts of the new market structure. They went to work on technical measures, such as harmonised ‘network codes’, to implement the Third Package.

However, the regulators – which cooperate unofficially in the Council of European Energy Regulators (CEER) and officially in the Agency for the Cooperation of Energy Regulators (ACER) – did not want to confine themselves to nuts and bolts. They also felt a need to translate the legislative language of the Third Package into an overarching ‘vision’ of the future market structure. This vision came to be known as the ‘Gas Target Model’.

After a year of consultations with stakeholders, CEER in December of last year presented a final version of this ‘Vision for a European Gas Target Model’. On 23 March, as reported in our news flash, CEER’s‘vision’was endorsed by ‘the Madrid Forum’. This is a semi-official body, set up by the European Commission, whose participants include essentially everybody active in the gas market: regulators, transmission system operators (TSO’s), suppliers, consumers, traders, exchanges, member state governments and the Commission itself.

Huge change

So what does this‘vision’of the future EU gas market, which has been embraced by all stakeholders, look like? It basically says that wholesale markets should be created across the EU, each of which is large enough to allow for competitive spot gas trading. These markets are organised in the form of ‘entry-exit zones’, in which shippers only have to pay for entering the zone and delivering the gas at its final destination or at an exit point, but not for the distance the gas travels. This stimulates trading within the zone, which takes place at an exchange called a‘virtual gas hub’. In addition, the zones will be connected to each other in a way that stimulates competitive cross-bording trading. Thus the various market zones will be more or less integrated into a single market.

All this may not sound very spectacular, but it implies a huge change compared to the existing situation. For the last 40 to 50 years, the European gas market functioned very differently. Major suppliers, like Gazprom, Statoil, Shell and ExxonMobil, delivered gas on the basis of long-term contracts, with prices based on the oil price, through pipelines that they and their customers owned and controlled from start to finish. These contracts even came with ‘destination clauses’, meaning that the buyer had no right to resell the gas.

To be sure, over the last few years this traditional, tightly controlled structure has already started to crumble as a result of the EU drive for liberalisation. To begin with, the ownership of the high-pressure gas pipelines has been ‘unbundled’. That is to say, the pipelines may not be owned anymore by the

"Alexander Medvedev has threatened he will look at the spot prices every morning and then decide if he will send gas to Europe that day"

suppliers (unless they get a special exemption from the European Commission). Under the rules of the Third Package suppliers are still allowed to set up an independent company (called an ITO or independent transmission operator) that can own a pipeline, but this ITO will have to allow all players equal access to its pipeline. As a result, companies like Shell and ExxonMobil sold their gas pipelines in Europe some years ago and it is expected that other players will follow their example in the years ahead. Thus, the whole ‘infrastructure’underlying the market is quickly becoming separated from the supply and trading activities.

In addition, the gas trading platforms that were set up in various parts of Europe have already been seeing a great increase in wholesale spot trading in recent years. Great Britain’s National Balacing Point (NBP) has traditionally been the most liquid gas hub, but it is quickly being followed by hubs on the Continent, such as the Netherlands’ Title Transfer Facility (TTF) and NetConnect Germany. Prices on the various hubs are also rapidly converging, at least in North West Europe, showing that the markets are becoming more and more integrated. It may be added that in recent years the prices on the hubs have also been considerably lower than those being paid under the oil-indexed long-term contracts.

Mandatory release programmes

Indeed, some experts have argued that since the ‘initial kickoff’ for market reform was given by the policymakers, competition and market integration have acquired their own momentum, driven by market players pursuing arbitrage opportunities. According to these observers, not much additional ‘external impetus’ is needed to further develop the market. It will happen more or less automatically.

Nevertheless, additional external impetus is certainly what the regulators intend to provide. Thus, for example, regulators will take measures to open up pipelines to new entrants and to ‘auction’ cross-border network capacity on the trading hubs (meaning that this capacity cannot be monopolised anymore by certain players under long-term contracts).

But the Gas Target Model goes even further. It notes that even if wholesale zones have been put in place and the new market rules have been implemented, liquidity may still be insufficient and the market may still not be functioning well. In that case, regulators will have to take extra measures. These could include ‘mandatory release programmes’ whereby ‘those with significant market power are obliged to sell their gas on wholesale markets’. Alternatively, regulators should consider merging ‘their’national market zones with those of their neighbouring countries to make them big enough to have a competitive wholesale market.

Biggest opponent

Before discussing the pros and cons of the new setup, perhaps we should ask first of all: does it matter how the gas market is organised? The answer is: yes, it matters a great deal. At this moment, the EU

"You cannot leave the market to be developed by the market players"
already imports two-thirds of the gas it uses, and this could rise to 90% in the future. At the same time gas is likely to become increasingly important in Europe’s energy mix at the expense of coal and nuclear power. Thus it is vital that the EU has a market structure that will ensure a sufficient supply of gas at reasonable (cost-effective) prices. In addition, as CEER notes, there will be an increased demand for ‘downstream flexibility’ of gas supply, as the introduction of renewable energies will lead to much greater short-term fluctuations in gas demand.

So, in this context, is it really a good idea to change the existing structure? Opponents of the plans like to point out that, although the market may not have been ‘free’by EU standards, it has always delivered the goods. Gazprom, arguably the biggest opponent of the EU’s reform effort, prides itself on always having been a reliable supplier (unless they were obstructed by unreliable intermediaries such as Ukraine).

Gazprom and others also argue that the current structure did not come about by chance. Those long-term, oil-indexed contracts were necessary, they say, because of the long-term horizon of the investments. Gas production and pipeline projects require huge investments – the long-term contracts make these investments possible by giving ‘security of supply’ to the buyers and ‘security of demand’ to the sellers. Oil-indexation is necessary, they say, because there is no global gas market and hence no reliable independent benchmark for gas prices.

The critics admit that the US market and to some extent the UK market are different, based as they are on spot trading and independent benchmark prices set at the Henry Hub in the US and the NBP in the UK. But, they say, the US in particular cannot be compared to Europe, since there are many different suppliers and buyers active in that market, and the US is not dependent on imports from outside sources, like Europe.

Little islands

This last point is also made by Dick de Jong of the Clingendael International Energy Programme (CIEP) in the Netherlands. CIEP presented their own, alternative version of a Gas Target Model in a report that came out last year. In fact, initially CIEP was involved in the preparation process for CEER’s Gas Target Model, but the think tank dropped out of it because it did not agree on where the model was leading.

“CEER's model is too much focused on achieving one particular internal market structure”, says De Jong. “We believe that Europe should concentrate on attracting imports at competitive prices and facilitating investments in new infrastructure. It cannot afford the luxury of experimenting with a new gas market design.”

De Jong says he is afraid that by following a single prescriptive model, Europe is “digging a hole for itself. We have created a lot of little islands – the entry-exit zones. Within those islands you can buy and sell gas fairly easily. But to get from one island to the other is very difficult. As we pointed out in our report, in this way you shift risks and costs from short-term traders to other market participants, both consumers and producers. For instance, if a supplier like Gazprom wants to deliver gas to country X through country Y, they have a problem arranging timely investments in cross-border infrastructure. The short-term nature of the proposed model makes such investments more complicated.”

CEER’s Gas Target Model, say the CIEP researchers, is “a way of stimulating short-term spot trading at the expense of long-term relationships. You create competition within a hub, forcing the suppliers to play along. But what if they have different ideas or requirements? We are taking a big risk.”

De Jong questions whether the new market structure will lead to lower prices in the long term. “Alexander Medvedev (the head of Gazprom Export, editor) has threatened he will look at the spot prices every morning and then decide if he will send gas to Europe that day! If the Russians have an interest in driving up the spot prices, they may be in a position to do so.”

The CIEP researchers concede that right now there are different gas prices in different markets, e.g. gas in Italy or Bulgaria is more expensive than in the Netherlands or the UK. But they describe “the objective of price alignment”as “the quest for the Holy Grail”. It should be accepted, they say, that gas prives will vary regionally and over time, according to market circumstances. “Market players will see these price differences as signals to act upon and pursue arbitrage opportunities.”

And De Jong sees another big problem: will there be sufficient investment in gas production and infrastructure projects, like pipelines and LNG terminals, if investors do not have long-term supply and capacity contracts to rely on? “The Russians and Qatari’s probably need financial security to make investments in upstream projects. And investments in cross-border pipelines will also become problematic without long-term capacity contracts. The market parties are not likely to build those anymore in the new context. This means the regulators will have to to do it, and the taxpayers will have to pay.”

According to the CIEP report, the international gas market is continually re-inventing itself. How it will develop is uncertain. In such an environment, Europe should concentrate on remaining an attractive market. What De Jong pleads for is “instead of interfering in the market, to let the market sort things out. Let a thousand flowers bloom. No new market design is needed.”The European market, he adds, “should not be shoe-horned into the theoretical model of the neoclassical market”.


But other experts have a different view of things. Jean-Michel Glachant, Director of the Florence School of Regulation, on whose work CEER’s Gas Target Model was partly built, rejects the criticisms of the CIEP report.

“You cannot leave the market to be developed by the market players”, he says. “The incumbents don’t want to change the structure. They don’t want to open the door to new players.”

Glachant points out that Russia and Algeria largely control gas prices now, together with some of their partners in the EU. “They are keeping European markets fragmented.” As an example he mentions the relatively high prices on the Italian market, where gas is much more expensive than in North West Europe. “Do the market players respond to this? No, not much. They have no incentive to do so.”

Glachant accepts that there will be some limited price differences across Europe, but they should not be as large as they are now. “Prices should be reasonably aligned” he says, “within Europe but also internationally, e.g. with US prices, which are much lower than European prices.”

Glachant also rejects the idea that investments in upstream projects and pipelines will not be made when they cannot be based on long-term oil-indexed contracts. “The global gas market is changing

"I think the European energy industry has come to realise that those long-term, 20 or 30 year contracts are a guarantee for incurring big losses."
rapidly”, he says. “Gas is becoming a global commodity like oil, as your own writer Alex Forbes has pointed out in European Energy Review. This is because the international oil companies are making huge investments in LNG and unconventional gas production. We are on the verge of a worldwide transformation of the gas market. In Europe we have to be ready for this development. We have ten years or so in which to adapt our market structure. Let’s do it. Otherwise there will be a bloodbath.”

Common vision

Glachant’s views are echoed by Walter Boltz, Head of the Austrian Energy Regulatory Authority (E-Control), Vice-President of CEER, Vice-Chair of the Board of Regulators of ACER, and generally recognized as one of the founding fathers of CEER’s Gas Target Model. He explains that the Gas Target Model was initiated by the energy regulators because “we wanted to have a common view on the future of the gas market. We followed the example of the electricity target model. We felt we had to have something similar.”

Boltz explains that the process was started one-and-a-half years ago. “The Florence School of Regulation designed the concept. We combined this with input from other consultants. We held five workshops with all stakeholders. Now it’s a common vision.” The Gas Target Model was necessary, says Boltz, because the Third Package essentially focuses on the national level. “You can have implementation of the Third Package and still have 27 distinctly separate markets. What we want to have is an integrated market.”

The Gas Target Model is not legally binding, but it gives guidance to national regulators. “For large markets the Third Package may be sufficient. But some markets are too small on their own to become competitive. The model provides criteria for this. If a market is smaller than 20 billion cubic metres and has fewer than 3 suppliers, it should be merged with another market. This can be all the way down to distribution level or at the wholesale level only.”

Thus, the Gas Target Model foresees that the EU will be divided into a limited number of ‘regional’ markets. Will this turn the EU market into Europe into ‘a lot of little islands’, as critics claim? No, says Boltz. “Right now Europe is a lot of little islands. That’s exactly the problem. For example, Russian gas is more expensive in Bulgaria or Romania than in the UK! Right now you have gas being sold under long-term contracts with contractual paths and destination clauses that cannot be traded in the markets through which it passes. So from the point of view of e.g. Gazprom the new structure will break up the flow, yes, but from the point of view of e.g. Eastern European countries they will cease being islands and become part of a larger market.”

Boltz argues that long-term contracts with destination clauses “go against the idea of a common market. This is what the new structure will put an end to. It will integrate the market”, he says. “In the

"It is possible that in future all infrastructure investment may be directed from above. Investing in pipelines will no longer be a purely commercial decision."
past you had a limited number of sellers negotiating directly with individual buyers and trying to get as high a price as they could. That worked as long as consumers had no other choice. But now they will get more choice. Many countries only have a single supplier. If we integrate those markets, we will make competition possible. For example, if Austria and Italy are integrated, LNG supplies can go to Austria.” He adds that “I think the European energy industry has come to realise that those long-term, 20 or 30 year contracts are a guarantee for incurring big losses.”

Boltz is also convinced that the new European market will become more rather than less attractive for outside suppliers who are faced with the choice of making large investments. “In the past, the market was limited. If you built an LNG-terminal in northern France, for example, you could only supply to the French market. In future, you can sell in the whole European market. So suppliers will have a much larger market, which is connected and transparent, and which everyone can access on an equal basis. That will make the market much more attractive than it is now.”


What about incentives for investments in pipelines? For example, do the unbundled, independent transmission system operators (TSO’s) have sufficient incentives to invest in cross-border connections in the future?

At this moment investment decisions by TSO’s are based on long-term requirements from shippers. The TSO normally holds a so-called Open Season procedure and if it gets enough long-term commitments from shippers, it will build the pipeline. In future, the market will be much more short-term oriented. Capacity will therefore be used on a short-term basis. “This means that you can’t expect shippers to commit themselves to long-term investments in cross-border pipelines”, Boltz concedes. So how do you make sure sufficient capacity will get built? “It’s a question we have now started to discuss. We are looking at different investment incentives. I think the outcome will be that regulators will increasingly decide on the capacity that needs to be built. This means that a larger share of the costs will be socialised.”

He notes that it is already the case that the Ten Year Network Development Plan drawn up by ENTSO-G, the organisation of the European transmission system operators, may stipulate certain investments that national TSO’s are compelled to make. So, he says, “it is possible that in future all infrastructure investment may be directed from above. We have had this system in Austria for years and it works very well. Investing in pipelines will no longer be a purely commercial decision.”

Boltz also thinks that in future it will be more difficult for suppliers to get exemptions to build dedicated pipelines or LNG terminals for ‘their own use’. “The logic for granting exemptions will go away. This was based on the idea that some region would not get a pipeline if no exemption was made. But what we are aiming for is to have a system that everybody can use. Compare it to road transport. We want to have a common highway that everybody can use. If we have that there is no need for anyone to build their own roads.”


"It makes sense for TSO's to merge"

The new gas market structure that the EU is developing will have major implications for the new unbundled gas infrastructure companies, like Gasunie, Fluxys and National Grid, according to Walter Boltz, Vice-President of the Council of European Energy Regulators (CEER) and one of the foremost gas market experts in Europe. As a result of the unbundling, liberalisation and integration process, the infrastructure companies will become independent market players in their own right, if they aren’t already, says Boltz. “They may have less to say about which pipelines should be built in future, as these decisions will increasingly be made by the regulators. But as infrastructure activities are becoming separated from supply and trading, the infrastructure companies can focus on their own core activities: building pipelines, selling pipeline and storage capacity, coordinating gas flows and stimulating competition and trade.”

Boltz notes that, for example, Italian energy company ENI, when it was still vertically integrated, had to be forced by the European Commission to expand pipeline capacity from Austria to Italy. “They did not want more competition. But in future TSO’s (transmission system operators) will get worried if prices in their system are too high. They will run the risk of ending up with stranded assets. We are already seeing that TSO’s are more and more focused on their core activities – attracting gas flows and facilitating rather than hindering competition.”

In this context, Boltz says that “it makes sense for TSO’s to seek international cooperation”, e.g. in the form of mergers or takeovers. Dutch Gasunie is the only TSO that has so far expanded abroad by acquiring pipelines in Germany. Boltz thinks this example is sure to be followed by others. “In the past, the pipeline division of Eon couldn’t merge or cooperate with that of RWE because their companies were competitors. But now they can follow their own strategy. As national markets are merging, it makes perfect sense for TSO’s to merge across borders. We don’t need 38 TSO’s – five to seven in Europe would probably be enough.”


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