Regulatory lag threatens to slow down the stormy growth of the European gas market

March 1, 2012 | 00:00

Regulatory lag threatens to slow down the stormy growth of the European gas market

Gas trading markets on the European continent have developed surprisingly fast in recent years. Europe, or at least North Western Europe, is closer to a single gas market than many might realize. There is just one snag: policymakers have yet to catch up with this reality which they themselves have helped to create. Regulations are lagging behind. As a result, pipelines remain utilized suboptimally, and investment in cross-border infrastructure is hampered. According to Santiago Katz and Catrinus Jepma of the Energy Delta Institute, regulation will have to catch up with the markets if the EU is to become a fully-functioning single market.

Two-speed development leads to inefficiency and may prove unsustainable in the long term (photo:

Continental Europe's natural gas markets have experienced an impressive, and at times, greater than anticipated, level of development in recent years. In the past year alone, the Netherlands' Title Transfer Facility (TTF), for instance, has arguably surpassed Great Britain's National Balancing Point (NBP) as the most liquid natural gas hub outside the United States, according to the ICIS Heren Tradability Index (2011). Other hubs, such as NetConnect Germany (NCG) and the French Point d'Echange de Gas (PEG) have seen traded volumes increase while bid/offer spreads have, on the whole, decreased (meaning that sales and purchases could be made more quickly than in the past).

This development, which is taking place predominantly in North-Western Europe, has involved a rapid increase in both nominated and traded volumes across hubs, ever greater numbers of market participants and an expanding range of tailored short- and long-term products offered. Concurrently, prices are continuing to converge across the various hubs. These trends indicate that when it comes to gas Europe is closer to fulfilling the Third Package's single market ambitions than many might realize.

However, the regulatory backdrop to this progress reveals a much more static reality. Despite strong normative direction from Brussels, natural gas market regulation is still very much national and focused on home markets. The directives and regulations that have been adopted to empower the European Agency for the Cooperation of Energy Regulators (ACER) will take time to be incorporated into national legislation, and ACER itself is still not fully developed. The result is that gas markets are hampered by regulatory lag and fragmentation. Confronted with this situation, market players and Transmission System Operators (TSOs) in North Western Europe are taking their own steps to integrate their markets and ensure sufficient liquidity. However, this two-speed development leads to inefficiency and may prove unsustainable in the long term.

Real progress

This regulatory lag is, in itself, not surprising, given the scope of the market reforms undertaken since the First Energy Package led to Directive 98/30/EC in the late 1990s. Market liberalization and the subsequent creation of an internal energy market (IEM) have required years of dialogue, research, comitology and implementation. This has inevitably been a complex and tedious process.

In addition, policymakers may not even have anticipated the rapid progress that has been made in trading. After all, historically Europe has largely relied on oil-indexed long-term contracts with Russia, Norway and the Netherlands. In the un-liberalized markets of Europe, these contracts proved reliable and convenient, as they efficiently distributed the price and volume risks to sellers and buyers, and assured producers that exploited resources would have dedicated markets. At that time national regulators did very little to stimulate wholesale markets, with the exception of the UK, where the privatized incumbent British Gas was forced to release volumes to independent suppliers. The result was that the Continent's hubs developed at a slower pace than in the UK. The lack of progress on the Continental hubs was exacerbated by the unequal regional development of infrastructure and markets throughout the continent, as well as the existence of a wide variety of national regulatory norms and balancing rules.

However, despite these challenges, gas trading hubs on the Continent have developed and matured surprisingly fast in recent years. For example, the Title Transfer Facility, nearly doubled traded volumes in 2011 to become the Continent’s leading virtual hub in terms of volume, churn ratio (the volume of

Despite strong normative direction from Brussels, natural gas market regulation is still very much national and focused on home markets
trades compared to the physical volume of gas available), and general measures of overall liquidity, such as the ICIS Heren Tradability Index. This index, which aims to measure liquidity by quantifying the magnitude of bid-offer spreads over the course of day for a basket of products, now ranks the TTF above NBP, implying that the Dutch hub has achieved greater liquidity than its British counterpart. Additionally, data that includes over-the-counter products shows that the TTF had a higher churn ratio than the NBP for nearly half of 2011.

Nor is the TTF the only Continental gas hub to show strong growth. The ICIS Heren index also gives positive trends in liquidity for several other continental hubs, including the NCG in Germany, PEG Nord in France and the Continental European Gas Hub (CEGH) in Austria. PEG Nord, in particular, more than doubled its liquidity from 2010 to 2011.

Real progress can also be seen in the expansion of products and services on offer. Market participants are offering ever more complex short- and long-term products, including continuous intra-day products, cross-border bundled capacity offerings, temperature-related profiled products, balancing and hourly products as well as virtual flexibility products. The scope of these new products, particularly intra-day ones, means that the market for flexibility is radically changing. Shippers are now able to satisfy very short-term demand to such a degree that TSOs increasingly need to maintain less control of last-recourse flexible gas for peak-shaving (i.e. to meet emergency needs).

In addition to these developments on the individual hubs, there has been surprising progress made towards a single gas market. Recent cointegration analysis, for instance, shows significant price convergence across the major North-Western European gas hubs. The fact that individual hub price-series follow similar patterns (stochastic drift) implies that the Law of One Price (meaning that identical goods sell for the same price in separate markets) holds for most of the gas traded on the TTF, NCG, PEG, Zeebrugge, Gaspool and NBP.

Contractual congestion

This impressive market development stands in stark contrast with some of the transport-related physical realities that continue to hamper trade and deliveries of natural gas. Capacity markets continue to pose difficulties for Europe’s regulators, with the issue of contractual congestion remaining particularly problematic.

Contractual congestion occurs when the demand for capacity exceeds the technical availability, while there is no real physical shortage of capacity. In other words capacity is underutilized: shippers who are

This impressive market development stands in stark contrast with some of the transport-related physical realities that continue to hamper trade and deliveries of natural gas
willing to pay for capacity are unable to do so. The reason that this happens is that parties which have booked capacity in advance (e.g. for long-term contracts) neither use it for themselves nor are willing to release it to the market, because they benefit from limited supply (which leads to higher prices). Although it is difficult to obtain concrete data on contractual congestion, there can be no doubt that it is a persistent and growing problem.

Attempts at regulatory solutions, such as Use-it or Lose-it (UIOLI) schemes (under which the party that has booked capacity must use it or lose it to a third party), first proposed in the early 2000s, are difficult to implement from a legal perspective, as they appear to challenge traditional contract norms. Incentivizing market participants with alternatives such as Use-it or Sell-it (UIOSI) and secondary market creation (which means that they can sell their unused capacity on a secondary market) run into difficulties because they often fail to address the underlying motivations for capacity hoarding. While progress is being made within the framework of discussions on Capacity Allocation Management (CAM) and Capacity Management Procedures (CMP), a practical and applicable solution has yet to be agreed upon.

One possible response to persistent contractual congestion is additional investment in infrastructure. But this is a solution which faces its own difficulties. Money, to begin with. As the European Commission has noted in its Infrastructure Package (October 2011), it is particularly difficult to find funds for cross-border infrastructure projects. Neighbouring countries often have differing or even contradictory regulatory regimes, meaning that projects cannot expect consistent approaches to risk and incentivization. In addition, individual projects, especially those aimed at improving security of supply, often present neighbouring countries with greatly imbalanced costs and benefits, e.g. in the case of investing in compressors to ensure flow reversal capability.

The European Commission's response has been to come up with the notion of "Projects of Common Interest" that will be able to benefit from European funding and specially designed fast-track permitting procedures. But this policy will become effective only in 2014 and then has to prove itself in practice.

Uneven ground

Another regulatory problem that is hampering market development is the fact that from a legislative perspective, Europe is still on uneven ground, as some states are still struggling to implement the First and Second Energy Packages, while others have already implemented the Third Package. Given that Europe is only two years away from its single market target year, 2014, a process that was begun nearly 14 years ago, one would expect by now a fully functioning European regulator, or at the very least a series of regional regulators, However, there is no European regulator. Instead, Europe has a platform for regulatory cooperation, ACER, which is, however, not even functioning at full capacity yet.

ACER will reach its projected size of 40 employees only in 2013, by the time the portfolio of regulations and directives that empower it will finally be implemented on the various national levels. Given the size

The prospect of a single internal market looks increasingly attainable
of the challenge laid out by the Third Package and by new regulations such as those on Energy Market Integrity and Transparency (REMIT), ACER will likely have to grow even further to carry out its tasks adequately. Though ACER does seem focused on the right issues, it remains to be seen whether it will be able to effectively deal with the regulatory and infrastructural challenges facing it.

One negative consequence of this still nationally dominated regulation is that national regulators sometimes act in ways that are self-serving on a national level and go against the idea behind the Third Package.As an example, we can take the Norddeutsche Erdgasleitung (NEL Pipeline) project which seeks to link Nord Stream gas with the North German market, Denmark, Sweden and the Netherlands. The project was denied exemption from third party access by the Bundesnetzagentur (BNetzA), the German regulator, partly on the basis that the pipeline was not cross-border, and therefore not eligible for exemption. In fact, though, the Danish-German border faces an inherent deficiency of capacity, and linking these markets to Russian imports is a critical step in ensuring regional and European security of supply. But that is a European-wide perspective of course, which the BNetzA understandably does not take.

Nevertheless, it is interesting to note that even in the absence of effective European-level regulatory cooperation, the facts show that it is still possible to make meaningful progress in competition and integration of markets. Not only are trading hubs growing and prices converging in North Western Europe, we also see TSO's undertaking cross-border operations, as in the case of Dutch TSO Gasunie expanding into the neighbouring German market. Thus, the prospect of a single internal market looks increasingly attainable. But for the foreseeable future, the major stumbling block to full market integration will certainly be regulatory fragmentation along national lines. To sum up, the European continent will have to wait for regulation to catch up with markets before it can finally establish a fully-functioning single gas market.


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