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European Supply Security in Natural Gas (CESSA Policy Brief)

August 17th, 2008 by Christian von Hirschhausen, Dresden University

In the discussion on European gas supply security, short-term aspects such as the physical availability of energy resources, technical disruptions, etc., should be distinguished from the long-term aspects.

Short-term emergency measures require a certain interventionist approach to restore supplies or to engage in cross-border support. However, market-based instruments should be utilized as extensively as possible, e.g. creating liquid, wholesale markets. Storage can assume a more important role for supply security than it did in the traditional world of vertically integrated companies.

Long-term supply security can be enhanced by diversifying supply regions and transport routes. Diversification is foremost the responsibility of industry, and in principle, governments should not interfere. Market interconnections and the development of infrastructure (pipelines, LNG terminals, and storage) favor supply diversification. Both theoretical arguments and empirical experience suggest that open, competitive markets enhance long-term supply security. This “low-cost” strategy contrasts with a “high-cost” strategy where vertically integrated monopolistic companies supply security. There is still a need for research concerning the relationship among the strategies pursued, the implied costs of capital for investment, and the investment strategy ultimately selected by a company.

Two examples of how competitive markets can provide supply security are the US and the UK. Competitive wholesale markets provide liquidity of trading hubs and incentives to expand capacities. Transparent information about supply, demand, prices, etc., allows for long-term planning and hedging opportunities. In both countries, the separation between transmission pipelines and trading activities was a condition for the emergence of liquid markets. These examples of two gas producers also indicate that if the regulatory framework is appropriate, infrastructure investment is forthcoming.

Asia is distinguished by two very different strategies. The “mature” natural gas countries, mainly Japan and South Korea, have traditionally pursed a policy of high supply security paid for by high prices. This strategy is now being challenged by large consumers that favor competition and lower prices. The emerging natural gas countries of China and India still must define their approaches to supply security and, subsequently, their gas sector restructuring policies. Both countries face uncertainty on the supply side and the demand side.

In Continental Europe, supply security was traditionally assured by monopoly suppliers, often vertically integrated, and in many cases state-owned. EU Acceleration Directive 2003/55/EC introduced a formal separation between gas transmission and trading, but the full effects of this unbundling have yet to materialize. While natural gas demand is increasing in many European countries, domestic production is at its plateau in several producing regions, leading to an increasing supply-demand gap and therefore more import dependency. Although Russia enjoys an important share of the European natural gas imports, its strategic role as supplier to Europe is often exaggerated: model simulations show that the its share of European natural gas imports, currently at 35%, will likely not increase. Even though Russia has refused to ratify the Energy Charter Treaty, efforts should be intensified in the Russian-European energy dialogue to guarantee long-lasting relations.

Most of the Continental European countries must take the EU reform agenda more seriously if they wish to reap the benefits of the internal market. Regulatory reforms should continue to pursue a fully integrated, single market for natural gas that will be favorable to supply security. Ownership unbundling should be introduced. The efficient use and expansion of storage should be promoted through regulation. Long-term contracts with foreign suppliers are an important component of risk management strategy, but they should not lead to a partitioning and foreclosure of the continent’s natural gas markets. To promote these goals, the European internal natural gas market should have a European regulator responsible at a minimum for cross-border operations.

In the long-term beyond 2020, contrary to earlier projections, natural gas demand is now anticipated to decrease (Jonathan Stern, OIES, coined it a “sunset industry” at the Cambridge CESSA conference) following the development and deployment of clean-coal technologies , especially Carbon Capture and Storage. Its deployment of CCS is anticipated by the industry of coal-fired electricity generation with the installation of “capture-ready” power plants. However, more research and research incentives are necessary before carbon capture and carbon storage technologies will be operational. The international coal market is expected to be amply able to supply the European energy needs, in addition to the growing Chinese and Indian import demand. Large amounts of coal reserves are located in politically stable countries and there is now an integrated global coal market. Competition control must ensure that the coal supply remains competitive despite the concentration efforts of the coal producing and trading companies.

Christian van Hirschhausen and Franziska Holz, Dresden University

P.S. This Policy brief is informed by the work of the CESSA program, especially by the CESSA Conferences held at Berlin in June 2007 and in Florence in June 2008.

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One Response to “European Supply Security in Natural Gas (CESSA Policy Brief)”

  1. Peter Says:

    Thank you for this post. I wonder if there is any relevant analysis you can recommend which looks at the end user prices of natural gas after ownership unbundling in the UK.
    The price increase is one of the main arguments against the ownership unbundling in Continental Europe, but there are good examples as UK or Netherlands.
    From my point of view we have to distinguish between the Western European and Central European member countries, as the the situation is completely different. In Central Europe the pipelines were constructed for transport purposes mainly. This leads to the high concentration of vertically organised companies. Another point is that these countries are solely dependent on only one gas supplier. Based on this do you think that the ownership unbundling is suitable for Central Europe as well?
    Thank you.

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