|Ole Gunnar Austvik:
"EU gas market liberalization; Security of Supply, Russia and Norway"
Draft paper. Norwegian-American Seminar, Center for Transatlantic Relations, Foreign Policy Institute. Paul H. Nitze School of Advanced International Studies (SAIS), Johns Hopkins University, Washington DC. Monday November 5, 2001.
After the September 11 terrorist attacks, world economic growth has taken a turn to the worse. The hope and believe is, however, that the conflict will not develop in a way that leads to a recession. After a temporary setback, economic growth is expected to continue in an increasingly larger number of countries throughout the world. Without substantial technological breakthroughs in the use of energy, this economic growth will be followed by demand for more energy. In the short and medium term there is a more or less fixed relationship between economic growth and energy demand. Energy intensities remain high (albeit lower than in the seventies and the eighties), and energy efficiency has improved less after the oil price collapse in 1985/86.
On the supply side there is a concentration around a few energy types
and sources to meet this expected demand growth. 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 it. The consensus forecasts
by institutions like IEA and EIA are that demand for all fossil energies
will increase substantially towards 2020. Oil demand is expected to grow
some 50 per cent (!), and most of this oil must come from the Persian Gulf.
The “best-seller”, however, is natural gas. This is particularly the case
for Europe. According to the forecasts, European gas demand shall increase
some 75 per cent over the next two decades.
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The sources for supply that shall meet this European gas demand are limited to a few large production areas and fields, many of them at locations far from the market. Russia will remain the key supplier, but Norway will also be important. 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. The costs of developing most of the 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, with possible more unstable and lower producer prices in the short and medium term as a consequence. The use of energy in general, and gas, in particular, may be taxed higher in Europe, as well. This raises the focus for this paper: Are markets being organized in a way that not only improves efficiency and enhances competition by market terms, but also gives sufficient growth in gas supplies and a better supply security? The change in market structure will also be followed by a change in behavior among firms and countries involved in European gas trade. How will the competitive situation between gas selling Norway and Russia, and their relation to the EU, be influenced?
Towards a more liberal European gas market
Until now, in the highly concentrated structure of the European gas market, gas has been sold and resold many times on its way from the field of production to the final user, often between monopolies/oligopolies and monopsonies/oligopsonies. Generally, producers (exporters) sell gas to transmission companies (pipelines) who act both as transporters and merchants in the market. The gas the pipelines buy at its entry, they resell at its exit at the city-gate to their customers; local distribution companies (LDCs), power plants and large industrial users. The LDCs act as both transporters and merchants, as pipelines do, and resell the gas to final consumers (end-users) in private households and businesses. Power plants and large industries are end-users themselves, and use gas as input factor in production processes, such as for electricity, chemical products etc. In general, producers and pipelines write long term contracts (up to 20 years), while pipelines write medium term contracts with its customers (1-5 years).
Prices for consumers have generally been set in relation to the prices of the alternatives to gas for each consuming group. The highest gas prices can be found in households and businesses (the markets for the LDCs), the lowest for gas used in electricity production. Prices for producers are in contracts net-backed from consumer prices, with the withdrawal of margins to LDCs and pipelines, respectively. These margins are mostly based on capital costs and negotiation strength, and are independent on the market price of gas. Thus, producer prices vary with consumer prices, while gross margins to LDCs and pipelines do not. Furthermore, for gas to penetrate European energy markets, consumer prices in some contracts are set below the price of its alternatives.
As the European gas market becomes liberalized, gas need not be sold and resold quite so many times as under today's system. In a (theoretically) completely and perfectly liberalized market system, producers 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, may become new actors to clear (parts of) the market.
This model parallels the deregulation of the U.S. gas market in the 1980s. While pipelines are often natural monopolies (or at best natural oligopolies) a public authority should regulate their behavior and pricing practices, such as the Federal Energy Regulatory Authority (FERC) in the U.S. In Europe this should be done on national levels, and overlooked on a community level (EU 2001). Producers and customers, on the other hand, are not necessarily natural monopolies. In order to create competition in these segments, sales monopolies in exporting countries should be abolished, and customers should compete for gas (as they to some extent already do in today's market). Since LDCs are natural monopolies in the areas in which they operate (not their merchant function, though) it is necessary to regulate them as well. If the market (theoretically) is completely and perfectly liberalized, each firm in the gas chain either operates as a price taker, due to perfect competition, or is efficiently regulated by a public authority.
Even though there have been elements of public policies towards production rights, the building of pipelines and operation of LDCs in Europe there has, until now, been little interference into the trade of gas between producers and pipelines. 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 (Austvik 1991).
Now, the integration of EU economies and the need for even competition rules, as well as a desire of more efficient markets cause public interference. The political steps are met with both enthusiasm and skepticism. On the enthusiastic side, 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.
On the other hand, producing countries, such as Norway, claim that the need to exploit economies of scale and scope in production and transmission (within the exporting countries), as well as of general resource management needs, make it impossible to establish any perfect competitive structure on the supply side. Furthermore, the loss of long term contracts with the pipelines will distort long term investments.
Of course, there is an element of interest conflict between seller and buyer underlining an important difference between the European gas market and many other markets being liberalized; Natural gas is a non-renewable resource. Gas will not be found in countries that do not have the deposits, even if prices are high. 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 total rent is determined by the difference between market prices and the sum of cost of production, transportation, storage, distribution, gas use etc. How this rent is distributed throughout the gas chain depends mainly on cost structures in firms, degree of competition (market power) in market segments and taxation policies. Rent may be redistributed between producers, pipelines and customers, respectively, as a result from the liberalization processes. It may end up as governmental tax revenues and for shorter or longer periods as lower consumer prices, as well.
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 leads us to one argument against partial market liberalization; maintenance of an oligopolistic supply side (only four exporters today) while the market is liberalized downstream, may give sellers a disproportionate market power and potentially enforce an anti-competitive situation. Obviously, there is a desire, from EU point of view, to weaken or dissolve gas-exporting countries’ sales monopolies (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., as well. Liberalization experiments will be in transition for a long time, rather than be as a move from one static equilibrium to another. Thus, the EU “Gas directive” (EU 1998) is only a step on the way.
Higher energy taxes
The liberalization processes must be view in light with policy developments in other areas, as well. One such important aspect is taxation. For two decades, EU countries have been the forerunners in increasing energy taxes. Until now, this has first of all been a concern for oil products. EU countries have the highest petroleum product prices in the world. As percentage of end-user prices, the typical European tax is some 75-85 % on gasoline, 50-60 % on diesel and 30-70 % on light fuel oils (1999). Taxes on a barrel of Brent crude oil reached some 50 USD/bbl in the mid 1990s, while in the early 1980s they were in the range of 20-30 USD/bbl. The higher petroleum taxes implies that the price of a weighed barrel of oil to EU consumers decreased (only) from 95 to 70 USD/bbl in the period from 1981 to 1994 (Austvik, 1996). In the same period, the price to producers declined from some 70 to 15-20 USD/bbl.
Even though oil producers may have lost from the high oil product taxation, European gas producers have benefited. Generally, in today’s contracts, gas prices are linked to the price of its alternatives, mostly oil products, such as fuel oils. When fuel oil prices are increased, either it is due to higher crude oil prices or higher taxation, gas prices have followed. Therefore, exporters’ gas prices have been much more stable than crude oil prices over the past 15 years (Austvik 1997). This stability has contributed to securing the investments made in gas production and transportation infrastructure in exporting countries in the period.
However, taxes on the use of gas itself are on their way up. As share of end user prices to household consumers, gas taxes have typically increased from some 15 % in 1984, to slightly more than 20 % in 1994 and to 20-50 per cent in 1999 (including both excise taxes and VAT). The Netherlands, Italy, Finland, Denmark and Austria, have the highest taxes, so far. Taxation on gas to power plants and the industry is lower than taxes on gas to households, in many countries zero. Even though gas taxes are still low compared to taxes on oil products, taxes on polluting coal is even less. In fact coal is subsidized in many countries.
The proposal for a directive restructuring the community framework and the harmonization of taxation of energy products (EU, 1997) was presented approximately at the same time as the “Gas Directive” was approved. For natural gas, the minimum rate should be increased as much as 350 per cent, much higher than suggested for oil products, but at the same level as for coal. This tax-structure confirms the impression that energy taxation in consuming countries has primarily not been set with reference to the environment. Rather it is determined from fiscal needs and set higher the more inelastic demand and / or supply is (according to the so-called “inverse elasticity rule”, Ramsey 1927).
Effects of liberalization and taxation
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. When demand exceeds supply, spot and other short-term prices will be pushed up. When a short-term market for natural gas is developed, it may work as a barometer for the (underlying) trend in long-term prices. Depending on how the balance between supply and demand develops, prices may actually end up both below and above the prices within the existing system.
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. How strong and quick responses will be, depends, besides on market conditions, on degree and shape of liberalization and firms' remaining market power. 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.
However, the effects also depend on how policies and strategies develop. Seen from Norway as an exporting country, we may lose or gain from the European liberalization processes depending on how the processes 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, we may not be worse off than in the present market structure. With no tax changes, a TPA (Third Party Access) 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.
Within certain limitations (and temptations), gas taxes may be aimed at becoming revenue generators for consuming countries’ governments in the way oil product taxes already are. 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
The EU processes are influencing the competitive situation for Norway and Russia. Norway is a member of the EU single market as part of the EEA agreement, and 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. 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.
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 (Khristenko & Lamoureux, 2001). 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 a 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 a crises in the Persian Gulf.
Both the EU, Norway and Russia share the interest in maintenance of long term investments and market stability. In price terms, this means that no one should be interested in too high or too low prices on gas. However, given these constraints, exporting and importing countries may hold diverging views on how high prices should be. 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.
Less new gas to the market?
When market liberalization and/or increased taxation causes lower and less foreseeable gas prices, supply of gas may be affected. The level of and predictability of prices is especially important for the development of huge new and expensive projects. The cost of getting new gas to the market (long term marginal cost of gas production) is particularly high for new gas from Iran, Kazakhstan, mid and northern Norway, the Barents Sea and Siberia. Gas from many of these areas is needed in order to meet the expected demand growth. The higher the ambition of increased gas consumption, the higher and/or more foreseeable prices must be.
On the other hand, from a consuming country’s point of view, producer prices need not be higher than what is "necessary" to make producers invest in new capacity. The more cost effectively producers can operate, the lower prices can be. As long as some rent, with "reasonable certainty", is left to a producer making calculations for new field developments, he will invest if he consider himself as a price taker. The only fields making economic rent may then, eventually, be those of the lower cost than the marginal one, as in competitive markets. In this case, the owner of gas as an exhaustible resource will, over time, not necessarily earn resource rent, even if consumer prices are rising, contrary to what economic theory of exhaustible resources usually tells us.
However, the European gas market may never become “completely and perfectly” liberalized, only more exposed to competition and regulation than it has been. The degree and form of liberalization may differ between sectors and regions, and throughout the gas chain, also on the producers’ /exporters’ level. A (theoretically) completely liberalized market prerequisite competition between exporting firms, within and between countries. For producing countries, this may be the case only to a limited degree, caused by the characteristics of the European natural gas industry. Because we are facing a non-renewable resource, geographically located in large amounts in few areas remote to the market, there is a need for a certain level of long-term planning and coordination within each producing area. It is important for all parties that exporting countries exploits the economies of scale and scope in the expensive projects and perform an optimal resource extraction in a way that they are able to supply gas on a stable basis over time. Furthermore, the production profile of gas often depends on the speed of oil production from the same field, and vise versa. Hence, in all gas exporting countries, centralized bodies orchestrate resource extraction, transportation and sales to the market, until now.
A problem is, of course, that when benefits of scale and scope is exploited and coordination takes place, the firms remaining tend to become large and, thus, may gain some market power. This is a major EU concern. It is the interest of consumers that market inequities caused by extensive concentration in transmission and production are neutralized. From a consuming country’s point of view, there is a risk whether there in Europe are enough sellers to create a real market with competition or whether the exporting countries will be able to enforce an anti-competitive situation. Obviously, this concern must be weighed against the economic characteristics of European gas and it’s non-renewable and long-term nature. There are no easy once-and-for-all solutions when the European gas market shall be liberalized and/or taxed.
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.
Therefore, future contracts should include rules over how a tax burden shall be shared within the industry in order to reduce the political price risk producers otherwise face. It is, of course, difficult to limit future parliaments' ability to put new taxes on the use of gas. On the other hand, if gas taxes are further increased, across EU countries, producers are not anymore facing market prices only, nor in today’s or in a liberalized market. Prices will be heavily influenced by political decision making, as well. If this situation cannot be solved, producers may not be able to take the commercial and political price and tax risk involved, and, consequently, delays huge new investment projects. Lower prices in the short and medium term that is to the benefit of importing countries may then turn into higher prices in the long run due to lower long term investments in production.
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.
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