The European Gas Target Model: how it could be improved

September 3, 2012 | 00:00

The European Gas Target Model: how it could be improved

European regulators have adopted a "Gas Target Model" on the basis of which they will determine whether gas markets in Europe are functioning properly. However, although this model is useful as a starting point, it has a number of shortcomings which urgently need to be addressed. The model is based on a set of indicators which are in some ways unclear and not integrated into a coherent methodology. In addition, its vision of what constitutes the size of the relevant market is too limited and the model ignores the important function of long-term contracts.

Gas supply in Europe (c) European Business Review

The meeting of the European Gas Regulatory Forum (Madrid Forum) in September 2010 set the stage for the first official discussions about a European Gas Target Model. The Madrid Forum is a high-level discussion platform, which meets once or twice a year, and brings together all the stakeholders in the gas sector: national regulatory authorities, Member State governments, the European Commission (EC), transmission system operators, gas suppliers and traders, consumers, network users, and gas exchanges. The idea behind the Gas Target Model (GTM) is to provide regulators and policy-makers with a broad and non-binding framework which they can use to evaluate whether their gas markets are functioning properly.

The decision made in September 2010 to develop such a model led to a series of public workshops during which a number of GTMs were presented and discussed. The principal models discussed were those presented by the Robert Schuman Centre for Advanced Studies (both the EURAM or European-American Model and the MECO-S model from the Florence School of Regulation), the Clingendael International Energy Programme (the ASCOS model), the Office of Gas and Electricity Markets of the United Kingdom (prepared by consultancy LECG) and GDF Suez (prepared, in part, by Frontier Economics).

These five models take distinctive and, at times, quite diverging approaches to wholesale market design. For example, whereas the MECO-S model stresses downstream, retailer-level competition, the ASCOS model (ASCOS stands for Ample, Secure and Competitive Supply) from the Clingendael International Energy Programme (CIEP) focuses on the overall value chain as well as the growing needs for imports. As another example, the EURAM model promotes private intervention into the market for capacity while the MECO-S model envisions a more regulated approach to investments in infrastructure. The results, as can be expected, are widely differing target models based on unique assumptions about what constitutes a functioning wholesale market, and what are the aims of a single European gas market.

Based on these inputs, the Council of European Energy Regulators (CEER), the Brussels-based body in which national energy regulators cooperate, presented stakeholders with a Gas Target Model that was eventually endorsed by all stakeholders at the 21st Madrid Forum held in March 2012. The CEER GTM follows largely from the MECO-S model, in that it seeks to enable the creation of a number of “functioning wholesale markets” organized largely around national boundaries and then merge them into single-price cross-border entry-exit zones with unified balancing regimes.

The CEER GTM also closely follows the MECO-S model in that it defines ‘functioning’ on the basis of five benchmarked economic indicators: the Herfindahl-Hirschman Index (HHI), a Residual Supply Index (RSI), the churn rate, size of aggregate market demand and the number of sources of gas servicing that market. (We will return to these indicators shortly.)

General approach

By selecting a discrete number of indicators, and providing performance benchmarks, the CEER set its GTM apart from other gas target models in a very profound way. Both the CIEP and Frontier models, for example, provide more qualitative definitions of market functioning, based on the general ability of

The CEER approach seems to envision a European wholesale market where all trading is, ultimately, essentially spot in nature
varying sources of gas to compete, and on the ability of market participants to satisfy their short- and long-term gas and risk-management needs. Thus, the CIEP model defines a well-functioning market as having, first and foremost, ample, secure and competitive supply of gas, abundant infrastructure (from market-led investments), and a multitude of varying commodity transactions agreed by market participants. The Frontier model offers a very general approach, whereby effective functioning is achieved when different sources of gas can compete with one another.

In addition, the CEER approach seems to envision a European wholesale market where all trading is, ultimately, essentially spot in nature (even if gas is supplied on the basis of long-term contracts). In this vision, long-term contracts (LTCs) no longer ship gas to internal delivery points, rather delivery is pushed to EU border points from which the gas is then injected into a “virtual point,” namely the hub of a national, regional or multi-regional spot-market. The long-term contracted gas is then traded from hub-to-hub until it is delivered to the appropriate retailer or consumer.

By contrast, the CIEP, Frontier Economics and LECG models all fundamentally accept that long-term contracts, which currently supply 55% of Europe’s natural gas demand, will continue to provide gas to customers in much the same way as they do now. For CIEP and Frontier, the wholesale market consists of both long-term contracts as well as sales on the spot markets. Taken together, they constitute the entirety of the wholesale of gas in Europe. This is very much a reflection of the current market structure.

Note that Gazprom has also responded critically to the CEER model. Gazprom has proposed a hybrid approach in which liquid hub development continues more or less along the CEER lines, while LTCs continue to supply customers at agreed-upon internal (to the EU) delivery points. The nuance behind the hybrid approach is that long-term contracted gas will supply base-load demand, while the internal spot market will be responsible for providing peak-load gas.

In any case, what is clear is that the CEER indicators essentially measure the functioning of a spot market, and not of a wholesale gas market as it is currently understood and as it currently exists. Unlike the CEER model, the CIEP and Frontier definitions for wholesale markets do not make use of economic indicators because such indicators simply do not apply to the contractual element of gas sales in Europe, which are, by nature, confidential. Additionally, some concepts, such as the churn factor, are meaningless when applied to LTCs.

We will not pursue this discussion here but will confine our discussion to the CEER model as it is. In our view, the CEER GTM has certain shortcomings even on its own terms, apart from its failure to include LTCs in its approach. We want to suggest some ways in which we believe the model can be improved.

Discrete parameters

The CEER GTM offers a discrete and limited set of parameters that are supposed to help regulators determine whether or not individual gas markets are functioning. These parameters, which build upon structural conditions set out in the Florence School’s MECO-S model, are:

  • the Herfindahl-Hirschman Index (HHI), which measures the level of competition in a given industry or sector by looking at the market shares of the 40 largest suppliers 
  • a Residual Supply Index (RSI), which measures the capacity of non-dominant suppliers to the market, and their ability to sustain supplies 
  • the number of sources of gas servicing that market 
  • the size of aggregate market demand 
  • the churn rate (the volume of trades compared to the physical volume)

It is on the basis of these indicators that national regulatory authorities (NRAs) have been asked by CEER to publish reviews of the functioning of their markets by the end of 2012.

There are, however, several problems with this approach, as some NRAs have already discovered. Broadly speaking we can identify three issues that are problematic. Firstly, the CEER’s market indicators are not integrated into a methodology. Secondly, the indicators themselves are in some cases based on undefined or problematic market concepts. Thirdly, the concept of a functioning market is not explicitly defined.

The CEER GTM implicitly defines a functioning market in terms of liquidity. In other words, the five

Only one of the five indicators - the churn rate - actually measures liquidity, the other four do not
indicators are supposed to say something about a given market’s liquidity. A liquid market is apparently assumed to be a well-functioning market. In fact, however, only one of the five indicators – the churn rate – actually measures liquidity, the other four do not.

Let’s look at the various indicators in somewhat more detail.

HHI and RSI

Both the Hirschman-Herfindahl Index (HHI) and the Residual Supply Index (RSI) are common measures of market power. HHI is, by definition, a measure of market concentration and therefore relates primarily to the degree of competition in a market. The RSI also communicates similar, if more nuanced, information about the state of competition. Unlike HHI, which measures market shares, RSI measures the degree to which a given firm’s capacity to supply is pivotal to satisfying market demand.

In other words, HHI and RSI essentially relate to the degree of competition in a market. Markets, however, can be liquid or illiquid irrespective of the level of competition in the market. Also, the effects of release programs on wholesale market development seem to indicate little correlation between supplier-level competition and active trading on the spot markets. That is why the two parameters above are rarely, if ever, taken as an indication of liquidity.

It should also be noted that in current economic and legal literature, it is widely accepted that competitive markets can be characterized by an HHI of between 0 and 1000. The CEER GTM, however, takes a markedly higher HHI ceiling of 2000 as indicative of acceptably competitive wholesale gas markets. The underlying assumption seems to be that an HHI of 2000 is acceptable provided that the other four benchmarks (RSI, churn factor, sources of gas and market size) are being met. It appears that the CEER GTM, then, implicitly accepts a trade-off between market characteristics.

Sources of Supply

The CEER GTM requires a minimum of three different sources of gas servicing a market. With this parameter, the model is effectively seeking to impose a security of supply constraint on the definition of a functioning market. This, again, is a different dimension than liquidity. While a wholesale market can technically be liquid even if serviced by only one source of gas, greater sources of gas add to overall security. If and to what extent they also improve the quality of competition and, ultimately, liquidity is uncertain and involves only indirect effects.

In addition, this indicator is not very well defined in the model. It offers NRAs no guidelines as to which

Stakeholders are often confused as to what exactly constitutes a source of gas, and how these sources of gas can be counted
sources of gas are relevant and significant enough to constitute some kind of guarantee of security of supply. As public consultation has shown, stakeholders are often confused as to what exactly constitutes a source of gas, and how these sources of gas can be counted. For example, an LNG terminal may or may not count as more than a single source given the possibility of receiving shipments from multiple producers.

For this reason, it may be helpful to use a proxy for measuring security of supply that is both clearly quantifiable and that communicates a clearer perspective of both source-related supply side risks as well as infrastructure-related risks. As a possible proxy, the N-1 principle effectively measures the ability of a market to respond to the failure of the single largest gas infrastructure, and is considered by the European Commission as “a valid starting point for an analysis of the security of gas supply of each Member State.”

As defined in the Regulation (EU) No 994/2010 of the European Parliament and of the Council of 20 October 2010, the N-1 formula “describes the ability of the technical capacity of the gas infrastructure to satisfy total gas demand in the calculated area in the event of disruption of the single largest gas infrastructure during a day of exceptionally high gas demand occurring with a statistical probability of once in 20 years.”

For countries with little or no indigenous production, the failure of the single largest gas infrastructure servicing their markets is essentially equivalent to the failure of the single largest foreign supplier of gas to deliver. As a proxy, a member state’s N-1 score communicates both infrastructural as well as supply-side risks in a coherent, easily quantifiable manner.

The N-1 principle is certainly not beyond criticism, since as an underlying assumption it expects a given country to, in extremis, allocate any or all transit gas to its domestic market, thereby cutting off its neighbor(s) regardless of geopolitical costs. Though this undercuts solidarity as well as some of the other norms that motivate the creation of a single European market, as a concept there is some realism behind the N-1 calculation.

Market Demand

As to size of aggregate market demand, the CEER GTM requires a minimum of 20 bcm (billion cubic metres) per year. This guarantees, albeit tangentially, a certain degree of security of supply (and perhaps even liquidity), but the choice of a discrete number of billion cubic meters is ultimately an arbitrary one. It should first of all be preceded by determining what constitutes the relevant market size. Moreover, it is rather the combination of size, sources and interconnections together that guarantees that a market both has access to different suppliers, and is large enough to attract them in the case that one or more suppliers can no longer deliver to that market.

One could also argue that, in addition to local demand, transit flows at virtual hubs should be included in determining market size. This would also be consistent with the logic behind the use of N-1 as a proxy for gas sources, and provide a more authentic picture of the gas volumes that a given market is able to attract, either by means of actual gas demand or its attractiveness to traders.

Churn Factor

The churn ratio offers NRAs the most straightforward means of measuring the liquidity of their markets. The churn ratio measures traded volumes to delivered volumes, and communicates the immediacy with which trading can be carried out (i.e. liquidity).

However, if the churn ratio is to offer the unique perspective on liquidity for the GTM, then it must be made as instructive as possible. This can be achieved by standardizing the definition of the churn factor, and by bringing into force clearer reporting requirements, both by the Regulation on Market Integrity and Transparency (REMIT) and the European Market Infrastructure Regulation (EMIR) process. At the moment, churn ratios remain inconsistently calculated due to technicalities surrounding the availability and estimation of over-the-counter (OTC) trading data. With greater transparency and more complete data on over-the-counter (OTC) sales, churn ratios would provide a greater amount of information on liquidity. Data collection on the part of the NRA’s and the Agency for the Cooperation of Energy Regulators (ACER) should technically be possible already by 2013, allowing regulators and market players to make the most of a more complete picture of gas market performance.

In addition, it should be noted that while the churn ratio is an effective and simple tool, it only communicates one part of the complex notion that is liquidity. Measuring the trade-to-delivery volume effectively captures the speed or ease of trading, namely the immediacy of the market’s liquidity. However, there are other, equally important, characteristics of a liquid market. These include market depth, market tightness and market resilience, among others. Several stakeholders have suggested the bid-offer spread to the list of CEER parameters. The bid-offer spread is a measure of market tightness and communicates both the differences in expectation (or valuation) by buyers and sellers as well as a sense of the scale of the transaction costs impeding trading. Such a spread indication provides an instructive additional measurement of the quality of a market’s liquidity. As a benchmark, regulators could track hub spreads to the global minimum spread of all hubs over the period measured.

Scorecard

It is clear, then, that liquidity is not the unique characteristic of a functioning market as defined by the CEER’s GTM. It is, rather, one of three primary elements characterizing the functioning market, the other two being competitiveness and security of supply.

Given the three market characteristics described by the CEER’s indicators, it would be natural to introduce three separate scores, one each for a given market’s level of: competition, security of supply, and liquidity. This would enable a somewhat more explicit and precise discussion about market performance, and provide a much easier way of comparing Europe’s individual spot markets and, ultimately, of ranking them. Moreover, if considered useful for reasons of assessment or comparison, a weighted aggregation of these three scores could be taken that will allow for directly quantifying overall spot market functioning performance. A simple, yet effective scoring system would ensure greater clarity about what market characteristics are being discussed, and would enable regulators to better monitor hub formation and appreciate varying degrees of market functioning.

In a follow-up article for EER we will propose such a scorecard and will evaluate a number of regional gas markets in Europe on the basis of it.

By extending the CEER benchmarks into an effective methodology, regulators would be able to assess the degree to which their respective wholesale markets are functioning. As noted above, given the current state of Europe’s wholesale natural gas markets, this methodology can be applied to less than half of gas sales on the continent, namely the spot sales.
As a final note, an important element that needs to be addressed, which is not included in the CEER’s GTM, concerns the size and scope of the market, i.e. the delineation of the boundaries of the geographically relevant market. As Harmsen and Jepma have noted before in European Energy Review, in particular the North West European gas market is highly integrated already. By restricting the CEER methodology to national (spot) markets, performance scores may appear artificially lower than they would, were the relevant market expanded to a more modern and meaningful regional scope.

 

Santiago Katz is energy analyst at the Energy Delta Institute in Groningen, The Netherlands. Professor dr. Catrinus Jepma is professor of energy and sustainability at the University of Groningen and Scientific director of the EDIaal programme at the Energy Delta Institute.

This article will shortly be followed up with a second one in which the authors will further develop and apply their method to assess the functioning of gas markets.

See also their earlier article on European Energy Review: "Regulatory lag threatens to slow down the stormy growth of the European gas market", (1 February 2012) and the article by Rudolph Harmsen and Catrinus Jepma: "North West European gas market: integrated already" (27 January 2011).

And see Karel Beckman’s overview story: "It's finally coming: the great European gas market transformation" (5 April 2012) and Kirsten Westphal, "The four great challenges for the European gas market" ( 2 July 2012).

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