Ole Gunnar Austvik;

Natural Gas; The Key Source of Energy for Northern Europe

Article in Structural Change in Europe - New Northern Knowledge
Hagbarth Publications, Germany.
May 2002.

As the EU Single market is expanded and deepened, substantial economic growth is expected to take place in a number of countries. Without substantial technological breakthroughs in the use of energy, this growth must be followed by demand for more energy.

Few alternatives are commercial available. If renewable energy sources are not developed in a much larger scale than before, non-renewable fossil fuels (oil, gas and coal) must cover most of the growth. In Europe, natural gas is “the winner”. According to forecasts, European gas demand shall increase some 75 per cent over the next two decades.

The sources for supply that shall meet this demand are limited to a few large production areas and fields, many of them at locations far from the market. Russia is and will remain the key supplier, but Norway will also be important. These two countries will dominate gas exports to Northern Europe. From the south, Algeria and Libya are expected to increase their exports. In the longer run, new gas may come from Central Asia and the Persian Gulf. Sources. The costs of developing most of these fields, and the new and expanded transportation capacity needed, are rather high, and need long term investment decisions to be realized.

At the same time, the European gas market is being liberalized. More unstable and lower producer prices may be the short and medium term consequences. The use of energy in general, and gas, in particular, may be taxed higher, as well. An important challenge for the EU is to organize and influence gas markets in a way that not only improves efficiency and enhances competition by market terms, but also gives sufficient growth in gas supplies and an acceptable supply security. It is not sure that all these goals are simultaneous compatible.
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Towards a more liberal European gas market

Until now, European gas has been sold and resold many times on its way from the field of production to the final user. Generally, exporters like Russia and Norway have sold gas to transmission companies (pipelines) in purchasing countries, who act both as transporters and merchants in the market. The gas the pipeline buy at its entry, it resells at its exit at the city-gate to their customers; local distribution companies (LDCs), power plants and large industrial users. In general, exporters and pipelines write long term contracts (up to 20 years), while pipelines write medium term contracts with its customers (1-5 years). Consumer prices have generally been set in relation to the prices of the alternatives to gas. Producer prices vary with consumer prices, while gross margins to LDCs and pipelines do not.

As the European gas market is liberalized, gas need not be sold and resold quite so many times as under today's system. Producers and exporting firms should make direct contracts with LDCs, power plants and the industry, and buy transmission services from the pipelines (as for a toll road). The fee for this transportation should cover pipelines' normal profit, but should not give any economic profit to them. Pipelines' roles as both transporters and merchants should be unbundled, and they should act only as transporters. Intermediates, such as brokers and marketers, is allowed to become new actors to clear (parts of) the market.

Until now, there has been little interference into the trade of gas between producers and pipelines from European policy makers. This is partly due to the fact that European gas trade is international and must be dealt with on a bilateral basis. Sometimes, and especially between former Soviet Union and the Eastern European countries and Finland, gas trade was part of larger barter deals. There were also examples on governmental interference in preventing contracts from, or promoting contracts to, being signed or fulfilled. Among such examples are the U.S. embargo of equipment to the Soviet pipeline, the French subsidization of Algerian gas import and the British rejection of the Norwegian Sleipner contract, all in the 1980s.

Now, the integration of EU economies and the need for even competition rules, as well as a desire for more efficient markets and more gas, cause public interference. The EU “Gas Directive” is one such step, aiming at opening up the pipelines for Third Party Access (TPA). The removal of barriers to the free movement of gas should improve market efficiency and increase the number of producer-consumer relations, and hence competition. This is a major consuming country view in favor of liberalization.

To some extent, producing countries appreciate downstream market liberalization. Easier access to customers and lower transportation costs would be beneficial for them, as well. But they are also skeptical: One aspect is that the loss of long term contracts with the pipelines will distort long term investments. Even though more gas may come to the market in the short and medium term in a more liberal market, less gas may come in the longer term. Security of supply will deteriorate.

Norway, as a member of the EU Single market through the European Economic Area (EEA), is, in addition, directly affected by the EU regulations in the way she runs her petroleum activities. Until now, The Gas Negotiation Committee (Gassforhandlingsutvalget, GFU) has sold all Norwegian produced gas on behalf of the companies. The Gas supply committee (Forsyningsutvalget, FU) has managed the coordination of depletion between gas field. EU requirements led to the abolishment of both during 2001. The idea is to increase competition on the Norwegian shelf in the sales of natural gas to Europe. If successful, Norwegian investment decisions will be “privatized” and become more short term. The gas resources will be developed faster than under the old regime.

Furthermore, the EC issued its "Statement of objections" relating to proceedings under article 81 of the EC Treaty and article 53 of the EEA agreement, both relating to competition law.  It was first related only to Statoil and Norsk Hydro (as members of the GFU), and has been expanded to cover all gas producing companies on the Norwegian shelf.  This case is yet to be resolved.

The companies having ownership rights to gas on the Norwegian continental shelf are now setting up systems for individual company sales of natural gas. However, the need to exploit economies of scale and scope in production and transmission on the Norwegian shelf, as well as general resource management needs, make it impossible to establish any perfect competitive structure on the supply side.

Of course, there is an element of interest conflict between seller and buyer, as well. Natural gas is a non-renewable resource. With a limited supply, and prices (over time) to a large extent fixed by prices of alternative energies, there is an economic rent to be earned in the market, even after it is liberalized. The existence of, and fight over this rent among commercial and political actors, contributes to politicizing the European gas market more than most other markets.

This brings us to the problems of partial market liberalization. From a consuming country point of view, if the oligopolistic supply side (only four exporters today) should be maintained, it may give sellers a disproportionate market power and potentially enforce an anti-competitive situation. From a producing country point of view, if downstream market liberalization is not fully implemented and competition should be implemented between producers, producers continue to face a monopsonistic demand side while the supply side is weakened. Obviously, there is a desire, from EU point of view, to weaken or dissolve gas-exporting countries’ sales monopolies, as they now pressure Norway towards (all exporting countries have organized their gas sales through single bodies).

At the same time: Marginal fields have no rent. If all producers get the same price for gas sold, marginal fields will be squeezed (not developed) when prices are lowered and less gas will be supplied than otherwise would be the case. Thus, the “fight over the rent” must be balanced with speed and magnitude of the desired growth in production capacity.

With these controversies and weighing of short and long term interests, liberalization of the European gas market should be viewed as a time-consuming process, as it also has been in the U.S.. Liberalization experiments will be in transition for a long time, rather than as a move from one static equilibrium to another.

Price volatility and higher energy taxes

In general, liberalization of the European gas market will increase the number of actors operating and transactions made in the market, as well as the speed of reactions in one segment to changes in another. For example, when producers and customers make direct contracts and pipelines are not acting as balancing intermediators anymore, market conditions may affect producers' prices more quickly. The number of actors increases and the volumes of each contract (at least for producers) decrease.

Prices (for exporters) become more volatile as they react to market changes not only in the long term, but through gas-to-gas competition also in the short and medium term (up to as much as 5-10 years). In a surplus situation, a "gas bubble" would lower prices in short-term contracts. A tight gas market will produce more long-term, and a weak market more short-term contracts (including possible spot sales). With a higher number of actors and increased volatility, "long-term" in a new market structure will be shorter than in the existing system. More short-term transactions indicate greater variations in short- and medium-term prices depending on market tightness. The increased number of short-term contracts will partly replace existing long-term contracts, but partly also satisfy customers not able to buy gas under today's system (with greater rigidity). Thus, demand may grow under liberalization.

Security of supply is also affected under liberalization. One aspect is that security of supply is improved, as access to pipelines is improved, new pipelines are built and storage facilities expanded. On the other hand, more volatile, uncertain and lower producer prices could lead to a drop in large investment projects and weaken supply security in the long run. This is an experience already made in the American gas market. After the deregulation in the 1980s, prices dropped (the “gas bubble”). While demand for gas increased, as prices were low capacity was not much expanded. The unused capacity has gradually been absorbed, prices have been rising, and eventually reached a level higher than in the European market. Thus, liberalization may lead to stop-and-go reactions in investments decisions and increase price volatility, over time.

The effects also depend on how policies and strategies develop. Seen from Norway as an exporting country, she may lose or gain from the European liberalizatio>

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esses proceed in various countries and market segments, and how companies and countries perform, alone and together. If oversupply of gas is avoided, and exporters succeed in an optimal downstream integration, she may not be worse off than in the present market structure. With no tax changes, a TPA regime in the transmission segment on the continent, as suggested, could benefit exporters as well as the customers, at the cost of the transmission segment.

On the other hand, an increase in gas excise taxes may become particularly attractive for consuming countries' governments when rent is made available in the gas chain. This is what happened in the oil market over the past 15 years. When crude oil prices dropped in 1986 and 1991, consumers could have derived the benefit from the loss of rent among producers. However, in Europe and to some extent in the U.S., consuming countries raised oil product taxation, which stabilized end-user prices and to some extent suppressed demand and (delayed?) a potential later price rise on crude oil. As downward trends in crude oil prices and cost-savings in oil exploration and production can be used to increase oil product taxation, an upward trend in oil prices can be used to increase natural gas taxes, as was seen in Italy some 10 years ago. Thus, potential lower margins in the transmission segment may also be taken by governments, rather than by producers or customers.

Because countries with open trade needs rules of minimum levels for taxation and cost-driving regulations, to avoid a “race-to-the-bottom” development; the EU set minimum rules for energy taxation, as well as in a number of other fields. This is an important reason for the pressure towards harmonization of energy taxation. Thus, national European gas taxes may, deliberately or not, serve a similar function as a customs tariff. For a large importing country, or a group of countries, such taxes may pressure exporting countries’ prices down. In fact, taxes may be orchestrated across borders in a way that maximizes purchasing countries social surplus, in same way an optimal tariff can do for large importing countries, as we know from international trade theory. Because such processes may lead to a pressure on exporting countries’ prices and the distribution of rent among countries, gas taxation may become a major political issue for oil and gas producers in their relations to importing countries in the years ahead.

Norway, Russia and the EU

Obviously, the EU processes are influencing the competitive situation for Norway and Russia. Norway must adhere to EU competition laws and regulations. This influences her ability to decide how she wants to organize her gas production, transportation and sales.  Russia has, on her side, organized gas production and transmission under one body (Gazprom). There are plans to unbundle and liberalize some Gazprom activities, but not to let Russian companies compete in export markets. Because Russia can maintain such a concentrated structure, and Norway not, Russia will be in a stronger position than Norway in the future in terms of market power. With a faster depletion of Norwegian resources, European dependency on Russian gas will increase.

On the other hand, even though Russia is not affected directly by EU gas regulations in the way that she organizes her industry, she will meet the same uncertainty in terms of increased volatility in prices. There will be more short-term contracts and she will run the political risk that gas taxes may suppress EU import prices (Norway’s and Russia’s export prices) as Norway does. This could hamper investments in the large new production fields and transportation infrastructure in Russia, as well.

Because Russia is so important to EU energy supplies, it is possible that the two finds ways to solve this problem. One possibility is that the EU will subsidize some of the investments to compensate for the potentially lower Russian export prices. From a social EU point of view, this will be cheaper than to pay high prices for gas.

An option for Russia is to turn her eyes to the growing Chinese market. If Russia starts to export gas to Asia, we will get a Eurasian gas market, linked through Siberian pipelines. This would change the dominant position of the EU as the most important buyer of Russian gas, and put Russia in an even stronger position as a world energy exporter.

Thus, for economic growth to continue as anticipated, Europe and the world are not only dependent on the continuous flow of oil from the Persian Gulf. Russian gas may become as important for both Europe and Asia. Because energy markets are interlinked, a tight market situation in natural gas will increasingly have the potential of spillover effects into the oil market, and not only the other way around. As gas consumption rises rapidly in Europe and in the rest of the world, a Siberian crises may in 20 years time have corresponding fundamental effects on world economy as an oil crises in the Persian Gulf.

Norway’s joint interest with the Russians to maintain prices at a certain level is a new element in her relation to her big nabour in the east, as well as to the EU. In a liberalized market, prices will vary more according to actual supply and demand for gas, and Norway and Russia share the interest in avoiding an oversupply in the market that could make prices fall. This parallel the interests between OPEC countries in the international oil market to maintain prices at a stable, but reasonable high, level The prices of gas in European markets is a common good for Norway and Russia.

In this situation, producers can play an important role in achieving the joint interest in remaining stable and foreseeable suppliers to the European gas market. In order to do this, producers need stable and foreseeable prices as well as the instruments and ability to optimize gas extraction over time. For producers, it is a genuine risk connected to the increased uncertainty and price volatility a more liberal market creates, in general, and of the possibility of increased gas taxation, in particular. It is difficult to see that the EU simultaneously can achieve lower gas prices, high tax revenues from gas usage, and a growth in both demand and supplies as expected.

One of the biggest problems for producers is that purchasing countries through energy taxes have a political tool that, ex post, can derive (much of) their expected rent. Worst case scenario for exporters occur when fields and pipelines are "fully" developed. At this stage, most producers' costs are sunk, and producers have no alternative but to continue supplying gas through existing facilities and grids even though prices are well below what was expected. In the very extreme, if no new capacity can be developed, taxes could be raised to the point where producers' prices just cover a little more than variable costs. With all cost sunken, producers would benefit from continuing producing even if prices do not even cover fixed costs.

If the long term stability and growth of the European gas market is to be secured, energy taxes should to a larger extent than today be set to reflect each carrier’s environmental benefits and costs. Taxes on gas should be lower than on other fossil fuels and liberalization should take a form that increases gas consumption. Among fossil fuels, natural gas is the environment's best friend. Low gas taxes would benefit producers through more stable and foreseeable prices, consuming countries through stable and continued increases in supplies as well as it would give us all a better environment. At the same time, market reform and liberalization should also be developed in a way that prices are stabilized over time, to give supply a better chance to grow in line with demand. In this way security of supply is improved, and the chance of a new major energy crisis is less obvious.