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Using EU gas supply diversification to reinforce Member States’ buyer power

June 9th, 2010 by Gijsbert Zwart, Tilburg University

A recurrent theme in the EU security of supply debate is the need to diversify natural gas imports, and to reduce the EU’s dependence on a few large suppliers.

In 2008, the EU’s gas imports comprised some 65% of its total consumption, with over 80% of those imports originating from only three large sellers: around 40% from Russia, 28% from Norway, and about 17% from Algeria. The EU Commission, in its Second Strategic Energy Review, stresses the need for diversification and promises support for investment in infrastructure required to connect to new source countries.

Of course, high import shares in themselves do not necessarily warrant the conclusion that this dependence is excessive and detrimental, or that EU intervention is called for. One should motivate why individual Member States underprovide supply diversification – and why EU coordination would improve on this situation.

The Commission’s current public consultation, “Towards a new Energy Strategy for Europe 2011-2020”, suggests one such motivation. In this document, one of the issues is how the EU can use a coordinated external energy policy to ensure improved security of supply for its Member States. Such a policy could help to “leverage the EU’s buying power”. Indeed, Russia, Algeria or Norway undoubtedly enjoy market power, but the large EU buyers are not mere price takers, they possess countervailing buyer power of their own.

In a recent paper, we analyse how a joint European policy towards diversification can contribute to strengthening the individual Member States’ bargaining positions in their negotiations with external gas sellers – beyond what these Member States could achieve in the absence of coordination.

It is intuitive that diversification of suppliers will help individual buyers in improving their own bargaining positions. When a buyer has more potential suppliers to turn to, his negotiating position is evidently stronger. Yet, this individual benefit from supply diversification alone does not provide a justification for coordination among Member States.

To see why individual Member States may underprovide supply diversification from the joint EU point of view, we identify spill-over effects from the gas purchasing decisions of the Member States. We show that these spill-over effects may call for coordination to
i) reduce import dependence on specific suppliers, and
ii) increase dependence on others,
as compared to the level of dependency that importing countries would have without such coordination.

To illustrate the idea, consider a policy in which the EU would impose restrictions on Member States’ gas purchases from certain external suppliers. A limit on, for example, Germany’s imports from Russia will not be profitable for Germany (but rather weaken its bargaining strength in its relations with other suppliers, such as Norway). But such a policy will also weaken Russia’s bargaining position. As a result, the other Member States may benefit from such a measure. Thus, Italy, in its negotiations with Russia, will face a negotiator who knows that its outside option – selling gas to Germany – is not that valuable due to the cap on its exports. This positive spill-over effect on other Member States may in fact outweigh the negative effect on Germany.

Of course, in this particular example, Germany would lose from the policy measure, and such a policy would not be easily accepted without any form of compensation. However, we show that one can often find combinations of caps (e.g., simultaneous import restrictions for Germany, Italy, and France) that make every individual buyer better off.

Hence, this spill-over argument provides a justification for coordination towards restricting imports for individual importers. Indeed, such a policy of capping imports from particular suppliers is not unprecedented. Spain’s Hydrocarbons Sector Law, introduced in 1998, obliges gas marketers to limit their imports from any single country to 60% of their total portfolio. This has had the effect of limiting Spain’s reliance on Algerian gas imports. Our analysis gives support for a similar measure on the EU level.

Crucially, import restrictions should be defined at the individual Member State level, and not at the aggregate EU level – at least if the aim is to increase the countervailing power. We show that an aggregate import cap never improves EU buyer power. The limitations imposed on one producer will make the other sellers stronger, redistributing power among sellers rather than benefiting buyers. In contrast, restrictions on bilateral trade of individual member states with individual producers can have a positive effect both on the individual buyers’ bargaining power and on the buyers’ trade surpluses. On a practical level, such a measure might be applied in terms of limits on pipeline capacity between producing regions and the different buyers.

The second policy to encourage supply diversification focuses on increasing imports from new suppliers. Here the EU has been particularly active – witness the recent 200 million Euro support of the Nabucco pipeline project, under the Economic Recovery Package. Clearly, the importers who contract with new exporters benefit from the expansion of opportunities to purchase gas. However, those buyers who are not engaged with the new suppliers will also benefit. They will find themselves in a better bargaining position vis-à-vis the “old” suppliers. To see this, consider the example of Italy investing in a pipeline to buy gas from a new supplier. Russia’s potential gains from trading with Italy will decrease if Italy can buy gas from elsewhere. As a consequence, other buyers (such as Germany) also enjoy increased bargaining power when negotiating with Russia: the latter’s outside option of selling gas to Italy has become less valuable. This bargaining-power effect warrants buyers’ cooperation in increasing import capacities beyond the individually preferred level.

To conclude, considerations of buyer power can provide a rationale for EU policies aiming at increased supply diversification. It is useful to analyse the precise mechanisms through which diversification reinforces buyer power. Such an analysis provides guidance in devising effective diversification policies. For example, broad-brushed restrictions on aggregate imports from Russia are ineffective as a tool to increase buyer power; restrictions on imports by specific buyers can do a better job.

Svetlana Ikonnikova, University of Texas at Austin, and Gijsbert Zwart, TILEC, Tilburg University and CPB, Netherlands Bureau for Economic Policy Analysis

P.S. For a more comprehensive analysis of the gas bargaining game, see our working paper.

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2 Responses to “Using EU gas supply diversification to reinforce Member States’ buyer power”

  1. Paul Hunt Says:

    Many thanks for highlighting this excellent paper. Its focus on key features of how things are – rather than how we might like them to be – is very welcome. Unfortunately, it raises more questions than answers. Perhaps this is to be expected in a paper that focuses on two possible policy instruments.

    The authors acknowledge the requirement to assess the impact of downstream competition on their conclusions, but there are other factors that may also need to be considered. Chief among these is the strategic context. Though perhaps without full-blooded Member State commitment – or without great effectiveness – the EU, strategically, has sought to engage key external suppliers such as Russia and Algeria (and other neighbouring suppliers) in the process of gas market liberalisation which it has being pursuing for almost 20 years. For obvious reasons – chief among them the ability to capture significant rent from the high willingness-to-pay levels of EU consumers – these external suppliers see little incentive to depart from their dual-pricing policies. The current apparent global “gas glut” – arising from a recession-induced reduction in OECD demand, a large increase in unconventional gas supplies in the US and huge sunk costs in LNG production and export capability – is compelling some flexibility in pricing and supply terms, but it may be viewed as a temporary tactical response until the current supply overhang is worked out of the system.

    Faced with this obduracy it makes sense for the EU to develop its policies and this paper endorses one instrument – supporting investment in access to additional supplies – and advances another – internal regional quotas on imports. However, deploying these instruments is a tactical, rather than a strategic, response and there is no guarantee that their deployment would be in the best interests of the Union or of its citizens.

    The traditional, long-term, oil price-linked supply contracts broadly imposed volume risk on buyers enjoying exclusive rights to supply and price risk on sellers. Final prices were set close to consumers’ willingness to pay levels and the expected rents were shared between the buyers and sellers. This process secured the required investment in long-lived, specific assets, but it was based on maximising the capture of consumer surplus. The primary initial motivation for EU electricity and gas market liberalisation was to increase consumer surplus – initially in the industrial sector, but, ultimately, for all consumers.

    Unfortunately, the current approach to EU market liberalisation is fragmenting EU buyers countervailing market power viz-a-viz external suppliers and is destroying the ability and willingness of internal EU suppliers to commit to reserve (and pay for) production and transmission capacity on a long-term basis. (This applies equally to gas and electricity. And the reluctance of some dominant, incumbent EU players to compete in some national markets – cited by the authors, while acquiring businesses in other national markets and seeking to invest upstream in external supply countries, is a perfectly rational corporate response to this fragmenting pressure.)

    In the absence of long-term tradable contracts for production and transmission capacity, full retail competition and short term wholesale markets are incapable of securing the required investment in long-lived, specific assets. Even if the investment were forthcoming, the perceived risk would be high and the cost of capital commensurately high. And, even if they were to benefit from lower prices in the short-term from gas-to-gas competition, consumers would be almost certain to experience higher costs in the medium to long-term either via higher prices or insufficient supplies.

    The two fundamental flaws of the EU’s gas (and electricity) market liberalisation process stand revealed. The first is a failure to recognise that the capture of rent (either by external suppliers or internal supply and service providers) is a matter for policy and regulation prior to the introduction of competition. Introducing competition, while this remains unresolved, makes matters worse, not better. The second is a failure to recognise the fundamental requirement for long-term, tradable contracts in production and transmission capacity.

    As a result, the policy instruments advanced in this paper – internal regional market quotas to reduce rent capture by external suppliers and public subsidy of investment in access to additional gas supplies, while well-intentioned, address the symptoms and not the cause of the problem.

    In the interests of the EU’s economy and of its citizens it would make far better sense to enforce policy and regulation that provide the basis for long-term, tradable contracts in production and transmission capacity. The dual-pricing policies of key external suppliers (which comprises a combination of universal and specific subsidies) will, in due course, fail. A vibrant and competitive EU market will help to accelerate this process and point the way forward.

  2. Geoff Cunningham Says:

    WARSAW, Poland, Sept. 1 (UPI) — Germany and Poland have faced off over a Polish liquefied natural gas terminal to be built on the Baltic Sea coast.

    Poland in July signed a deal with a consortium led by Italy’s Saipem to build an LNG terminal at the port of Swinoujscie, next to the border with Germany. Construction was to start this month but Germany has called for a re-evaluation of the permits.

    Berlin asked Poland to carry out an environmental assessment study under the Espoo agreement, a U.N. treaty that handles cross-border environmental concerns, Polish daily Dziennik Gazeta Prawna reports.

    Polish Deputy Finance Minister Mikolaj Budzanowski said the demand could delay finalization of the terminal, envisioned for 2014, by two to three years.

    “It would also invalidate the construction permit and the environmental decisions,” he told Dziennik Gazeta Prawna.

    Budzanowski added that Germany is opposed to EU financing of the terminal.

    Poland is eager to finalize the terminal to become less dependent on Russian natural gas imports. Polish observers have speculated that Germany aims to delay the LNG terminal because it would compete with the Nord Stream pipeline under the Baltic Sea, designed to move Russian gas unilaterally to Germany.

    The first of Nord Stream’s twin pipelines is scheduled to start operating in 2011. Officials say Nord Stream will eventually deliver up to 55 billion cubic meters of gas per year to Europe — enough for around 25 million households.

    Russian President Dmitry Medvedev in April called the $10 billion project a “contribution to Europe’s energy security.” Poland was one of Nord Stream’s harshest critics and is still opposed to the pipeline. Its construction was delayed by a lengthy and difficult permitting process that involved major environmental impact assessment studies.

    The companies involved in Nord Stream — Russia’s Gazprom, Eon Ruhrgas and BASF/Wintershall from Germany, Gasunie from the Netherlands and GDF Suez from France — aim to sell Russian gas to Poland, Dziennik Gazeta Prawna writes, adding that the LNG terminal could satisfy at least 30 percent of Poland’s gas needs and make the Nord Stream gas less attractive.

    The daily reports that the German government wasn’t satisfied with the environmental impact analysis conducted by Gaz-System, Poland’s state-owned gas grid operator, which green-lighted the terminal saying it doesn’t have a cross-border impact.

    The terminal would have a capacity of 5 billion cubic meters of gas per year, with shipments coming in from all over the world, including LNG giant Qatar.

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