conditions for truly competitive gas

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DEPARTMENT OF TRADE AND INDUSTRY

Conditions for Truly Competitive GasMarkets in the EU

Report Prepared By:

ENERGY MARKETS LIMITED

UNITED KINGDOM

Volume 1

Final Report

November 2005

Energy Markets LimitedHalf Acre Mews37 Half AcreBrentford MiddlesexTW8 8BH UKTel: +44(0) 208 232 1570www.energymarkets.eu.com


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Conditions for Truly Competitive Gas Markets in the EU Final Report - November 2005

www.energymarkets.eu.com2

The views and judgements contained in this report are those of Energy Markets anddo not necessarily reflect the views of the Department of Trade and Industry, who donot necessarily endorse the conclusions.


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TABLE OF CONTENTS

EXECUTIVE SUMMARY .........................................................................................11

International Experience ..........................................................................................11

Current Conditions in the Key Markets ...................................................................12

Barriers to Competition and Changes Required ......................................................15

Transition to Competitive Markets ..........................................................................18

Actions for Consideration by the UK Government .................................................21

1. INTRODUCTION ...................................................................................................25

1.1. Background.......................................................................................................251.2. Report Structure................................................................................................25

2. DEFINING A COMPETITIVE MARKET FOR GAS ...........................................27

2.1. Economic Definition.........................................................................................27

2.2. Characteristics of Truly Competitive Markets..................................................34

2.3. Markets and Geographies .................................................................................40

2.4. Conclusions.......................................................................................................44

3. INTERNATIONAL EXPERIENCE........................................................................47

3.1. US Experience ..................................................................................................47

3.2. UK Experience..................................................................................................51

3.3. Australian Experience .......................................................................................54

3.4. Common Themes and Lessons for the EU .......................................................57

4. CURRENT CONDITIONS IN THE KEY MARKETS..........................................61

4.1. Production Market in the EU ............................................................................61

4.2. Wholesale Market in the EU.............................................................................68

4.3. Retail Market in the EU....................................................................................96


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4.4. Pipeline Supply Area ......................................................................................102

4.5. LNG Supply Area ...........................................................................................131

5. BARRIERS TO COMPETITION AND CHANGES REQUIRED.......................139

5.1. Barriers to Competition...................................................................................139

5.2. Changes Required in Key Markets .................................................................147

6. TIMING OF THE TRANSITION.........................................................................163

6.1. Overview of Scenarios ....................................................................................163

6.2. Market Characteristics by Scenario ................................................................175

7. IMPLICATIONS OF A COMPETITIVE GAS MARKET...................................183

7.1. Gas Price Implications ....................................................................................183

7.2. European Gas Supplies ...................................................................................190

7.3. UK Supplies....................................................................................................196

7.4. Price Signals....................................................................................................198

7.5. Summary.........................................................................................................201

8. ACTIONS FOR CONSIDERATION BY THE UK GOVERNMENT.................203

8.1. Options and Recommendations ......................................................................203

8.2. UK Government Strategy ...............................................................................2139. CONCLUSIONS....................................................................................................217


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INDEX OF TABLES

Table 1 EU Wholesale: Changes Required..................................................................15

Table 2 EU Retail: Changes Required.........................................................................16

Table 3 Pipeline Supply Production: Changes Required.............................................17

Table 4 Pipeline Supply Wholesale: Changes Required..............................................17

Table 5 Summary of UK Spot Prices 2015/16.............................................................19

Table 6 Gas Prices by Scenario ...................................................................................20

Table 7 Ranking of Changes Required........................................................................23

Table 8 Characteristics of Truly Competitive Gas Markets ........................................39

Table 9 Definition of Market / Geographical Sectors..................................................42Table 10 Importance of Competition by Sector and Geographical Area.....................43

Table 11 EU Gas Reserves ..........................................................................................62

Table 12 Current Status of the Production Market in EU............................................67

Table 13 Examples of Cross Border Flow Flows and Capacity ..................................83

Table 14 Comparison of Transportation Tariffs ($/mcm/100 km) ..............................85

Table 15 Current Status of the Wholesale Gas Market in EU.....................................95

Table 16 Throughput of Snam Rete Gas System.........................................................99

Table 17 Current Status of the Retail Gas Market in EU ..........................................101

Table 18 European Gas Imports by Country 2003 ....................................................102

Table 19 European Gas Imports by Company 2003..................................................103

Table 20 Russian Gas Contracts with Europe............................................................106

Table 21 Algerian Gas Contracts...............................................................................117

Table 22 Libyan Gas Contracts..................................................................................118

Table 23 Norwegian Gas Contracts ...........................................................................123

Table 24 Norwegian Export Pipelines.......................................................................125


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Table 25 Investment Interests in Langeled................................................................126

Table 26 Caspian Area Gas Contracts .......................................................................127

Table 27 Current Status of Production and Wholesale Markets in the Pipeline SupplyArea....................................................................................................................130

Table 28 LNG Imports to Europe by Origin..............................................................131

Table 29 LNG Supplies to Europe – Market Shares..................................................132

Table 30 LNG Gas Contracts to Europe ....................................................................135

Table 31 Cost Reductions in the LNG Chain ............................................................136

Table 32 Current Status of Production Market in the LNG Supply Area..................137

Table 33 Barriers to Competition ..............................................................................146

Table 34 EU Wholesale: Changes Required..............................................................148Table 35 EU Retail: Changes Required .....................................................................154

Table 36 Pipeline Supply Production: Changes Required.........................................157

Table 37 Pipeline Supply Wholesale: Changes Required..........................................158

Table 38 Gas Demand in Europe by Scenario (Net of Producers’ Own Use)...........165

Table 39 Pipeline Infrastructure Assumptions by Scenario.......................................167

Table 40 LNG Liquefaction Plant Assumptions By Scenario...................................168

Table 41 LNG Regasification Plant Assumptions by Scenario.................................169

Table 42 Key Outcome of DOE Reference Case.......................................................171

Table 43 Key Outcome of DOE Restricted Supply Case ..........................................172

Table 44 High Level Overview..................................................................................174

Table 45 Market Characteristics by Scenario - EU Production.................................175

Table 46 Market Characteristics by Scenario - EU Wholesale (Part 1) ....................176

Table 47 Market Characteristics by Scenario - EU Wholesale (Part2) .....................177

Table 48 Market Characteristics by Scenario - EU Retail.........................................178

Table 49 Market Characteristics by Scenario – Pipeline Area Production................179


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Table 50 Market Characteristics by Scenario – Pipeline Area Wholesale ................180

Table 51 Market Characteristics by Scenario – LNG Area Production.....................181

Table 52 Market Characteristics by Scenario – LNG Area Wholesale .....................181

Table 53 Gas Prices by Scenario ...............................................................................184

Table 54 Constrained Case Sensitivities to US Wellhead Price................................185

Table 55 Sensitivity to Oil Prices (Real 2004 Prices)................................................186

Table 56 Most Competitive: Transport Tariffs From Russia to Germany.................188

Table 57 Most Competitive: UK and German Spot prices ........................................189

Table 58 Fully Competitive: Gas Transportation Costs to Germany ........................189

Table 59 Fully Competitive: UK and German Spot Prices........................................190

Table 60 European Gas Supply by Scenario..............................................................190

Table 61 Russia/Gazprom Market Share of European Imports by Scenario.............195

Table 62 Algerian/Sonatrach Market Share by Scenario...........................................195

Table 63 Norwegian Market share.............................................................................196

Table 64 UK Supplies by Scenario ............................................................................197

Table 65 UK Supply Shares by Scenario...................................................................197

Table 66 Summary of UK Spot Prices 2015/16.........................................................201Table 67 Actions to Remove Barriers: EU Wholesale ..............................................210

Table 68 Actions to Remove Barriers: EU Retail......................................................211

Table 69 Actions to Remove Barriers: Pipeline Supply ............................................212

Table 70 Barriers and Achievability Matrix..............................................................213

Table 71 Ranking of Changes Required....................................................................214

Table 72 Barriers to Competition ..............................................................................221

Table 73 Summary of UK Spot Prices 2015/16.........................................................222

Table 74 Ranking of Changes Required....................................................................224


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EXECUTIVE SUMMARY

The UK is now a net importer of gas, with prices and access to supply increasinglydepending, therefore, on markets elsewhere. In this context, it is critical to understandwhat might stand in the way of effective and efficient competition in European as wellas global gas markets in the next 5-10 years. As a consequence the Department ofTrade and Industry (DTI) decided to commission a report to consider the “Conditionsfor Truly Competitive Gas Markets in the EU (and Globally)”.The objective of the report was to identify the potential barriers to the development oftruly competitive natural gas markets on the Continent (and globally) and, whereappropriate, identify ways in which the UK Government could influence the political,regulatory and market outcomes in order to maximise the benefits of competitive gasmarkets to UK consumers.The report firstly considers international experience of how competitive marketsdevelop, current conditions in the key gas markets, the barriers to competition andchanges required to remove the barriers, the transition to competitive markets and theimplications for prices in particular and actions for consideration by the UKGovernment.

For the purposes of analysis the overall gas market was divided into three distinctmarkets – the producer market, the wholesale market and the retail market – and threedistinct geographies – the EU25, plus accession and candidate countries, the PipelineSupply Area and the LNG Supply Area – creating a total of 9 sub-markets. Theimportance of each of the 9 sub-markets differs, however, in the context ofcompetition in the EU market. Four key markets were identified as being the mostimportant in respect of competition in the EU market – the EU Wholesale market, theEU Retail market, the Pipeline Supply Production market and the Pipeline SupplyWholesale market. The focus of the report, therefore, is largely on these 4 key sub-markets.

International Experience

The study considered, in terms of international experience, the gas markets in the US,UK and Victoria in Australia which are very different, ranging in size, diversity andcomplexity. Each market, however, has successfully introduced competitive gasmarkets particularly at the wholesale level. The common themes arising from theexperience of these differing markets are as follows:

• Effective Gas Release - If the existing market structure is one of a monopolysupplier of gas to end users or Local Distribution Companies (LDCs) then newentrants will require access to gas supplies to compete. In all 3 markets the releaseof gas happened relatively quickly, not only on the gas purchase side but also onthe gas sales side with incumbents rapidly losing market share.

• Access to and Availability of Capacity - Fundamental changes in moving towardscompetitive markets are often focused on the market for transportation capacity,especially at the transmission level. In the US there was a very effective large


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release of capacity on the interstate pipelines as their merchant sales businessdisappeared and they were forced by FERC to open up their pipelines toregulated third party access. In the UK and Victoria, in contrast, the process of opening upthe pipeline systems to third party access was much more of a planned transition,aided by the US experience, with a key difference being the adoption of commonor market carriage as opposed to contract carriage in the US.

• Unbundling - The unbundling of the pipeline services into transportation, supplyand storage in Order 636 in the US was seen as the culmination of the marketliberalisation process and the final confirmation that a fully competitive gasmarket, at least at the wholesale level, had arrived. Again in the UK and Victoria, building on the US experience, unbundling was seen as an essential prerequisiteright at the beginning of the liberalisation process.

Other factors which were seen as important in the introduction of competitionincluded the size and diversity of the market in the US, and to a lesser extent in theUK, government and regulatory commitment to liberalising the markets, thedevelopment of trading hubs as a consequence of access to capacity and gas and the

harmonisation and standardisation of rules, procedures and the transfer anddissemination of information.

Current Conditions in the Key Markets

Four key markets were identified for more detailed analysis. The current conditions,or status, in each of these key markets is considered below. For purposes of analysingthe current conditions the Pipeline Supply Production and Wholesale markets areconsidered together:

Wholesale Market in the EU

• Market dominance continues to be a major issue. Many national markets continueto be dominated by the incumbent gas company. We are also seeing the advent of powerful pan-European gas and power companies with high profile strategies based on acquisition and investment programmes aimed at controlling largesections of the physical infrastructure and access to end users via ownership ofdistribution companies. The implementation of the 2nd Gas Directive may go someway towards limiting any market dominance but on its own we do not believe it isenough. Major producers are also trying to establish market positions but they arelagging somewhat behind the gas and power companies in terms of sales. Whilstthere are some banks trading, notably absent from the market are the independentwholesalers such as Enron, Dynegy and other US companies who were trying toenter the market a few years ago.

• Legal unbundling of transportation, storage and supply has largely beenimplemented but how effective this has been in creating a level playing field fornew entrants is uncertain. Gas release schemes have also been introduced, whichconceptually is good progress, but their real effectiveness is uncertain. Better progress is being made in respect of gas contracts with more flexibility being


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introduced, the removal of destination clauses and the German cartel officedeclaring 75% of the 750 contracts between the transmission system operators(TSOs) and the LDCs as anti-competitive.

• The main issues regarding third party access relate to allocation of capacity. ManyTSOs operate a first come first served system which effectively denies access to

capacity to new entrants. Transit is generally treated separately from domestictransportation. Capacity in transit lines is frequently booked up under long termcontracts and there are cross-subsidies between transit and domestic charges.Analysis suggests that cross-border capacity is generally under utilised, exceptmaybe into Italy, and that there are also large discrepancies between transmissiontariffs within EU countries for transporation of similar loads and distances. It iscertainly noticable that tariffs are lower where regulators have taken an active rolein forcing out inefficiency and economic rent than in countries where independentregulators have been less forceful in regulating tariffs.

• Balancing regimes also differ between countries, with a mixture of hourly anddaily balancing, and evidence of overly penal charges. There is, therefore,

considerable scope for network operators to adopt a regime that implicitly favourstheir associated supply business. Progress is being made on the publishing ofconditions for access to both LNG terminals and storage facilities with a mixtureof regulated and negotiated TPA.

• At the institutional level the regulatory authorities in some countries would appearto be more proactive than in others, particularly where state ownership is stillimportant. Germany has only just established a regulator but the cartel office has been active.

Retail Market in the EU

• The process of introducing competition to the retail sector is in its infancy inEurope. Experience so far shows that just changing the law to allow consumers tochange supplier does not necessarily lead to effective competition. Manycompanies are finding it difficult to enter certain markets and there has been a lowrate of customer switching overall. However, in Spain there has been somesignificant switching of industrial and commercial customers amid a situation ofover-supply and a price war. In Italy the Letta decree is forcing down the marketshare of Eni wth Edison proving to be the main competitor.

• Apart from access to infrastructure and gas supplies, adequate systems are alsorequired at the LDC level to ensure a smooth switching process and to ensure thatinformation flows are maintained to support proper customer billing. In addition itshould be noted that a large proportion of customers’ bills are for componentswhich are beyond the control of the gas supplier (gas and transportation costs andtaxes). This makes it difficult for new entrants to undercut the prices offered bythe incumbent company and makes the financial advantage of switchingquestionable in relation to the potential problems and worries that switching can bring.


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• Analysis by Energy Markets (EML) indicates prima facie evidence that there is asignificant amount of inefficiency and/or economic rent in the distribution andsupply sector in particular, making the cross subsidisation of the supply side bythe incumbents pipes business much easier to achieve. This would indicate thatdistribution is yet to come under effective regulatory control and supply to smallusers (households and small industrials) has not been subjected to competitive

pressure. Pipeline Supply Area

• Europe (EU25 plus Romania, Bulgaria and Turkey) imported just over half its gassupplies in 2003. Russia accounted for half of the imports, Norway 25% andAlgeria 20%. Russia and Algeria will increase their exports to Europe in the next10 years, but new pipeline supplies are expected from Libya, Iran and the FormerSoviet Union countries in the Caspian Sea area (Turkmenistan, Azerbaijan,Kazakhstan and Uzbekistan). Europe will remain highly dependent on gas flowingfrom Russia through the Ukraine to Slovakia. However, alternative routes throughBelarus and Poland (Yamal) and direct to Turkey under the Black Sea(Bluestream), are now flowing gas with volumes expected to increase over thenext few years. A third route to Germany under the Baltic Sea (North EuropeanGas Pipeline) is also planned although the timing of this project remains subject touncertainty.

• Gazprom dominates Russian production at the moment but a decline in volumesfrom existing fields is forecast and Gazprom will need to develop other depositsmainly in Western Siberia. Independent production has doubled between 1994 and2004 to just under 100 bcm per year. Gazprom has been trying to buy up some ofthe independent producers and exercises effective control over all exports of gas.Most of the exported gas is routed through Ukraine but Yamal has diversifiedsome of the gas and Blue Stream into Turkey some more. The proposed Baltic pipeline will result in more diversification away from Ukraine. Gazprom iseffectively blocking any reforms of the gas sector in Russia.

• Algerian exports to Europe were 55 bcm in 2003 – 30 bcm by pipeline and 25 bcm by LNG. Pipeline routes are to Italy and Spain (via Morocco) but the Medgaz pipeline, which is under construction, will deliver gas directly to Almeria.Sonatrach dominates the gas industry and although foreign companies areaallowed to participate they may do so only in partnertship with Sonatrach.However, Sonatrach’s share is planned to fall as part of the reform to encouragemore foreign investment.

• Norway is the second largest importer into the EU market and recent reforms haveled to the break up of the GFU and producers selling their gas directly. Theoffshore transportation regime has also been reformed by the creation Gassco(operator) and Gassled (owner) with open access and an entry exit methodology.


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Barriers to Competition and Changes Required

Some 20 barriers to competition were identified in the 4 key sub-markets. The tables below describe the main barriers to competition which need to be addressed in each ofthe 4 key sub-markets – EU Wholesale and Retail and Pipeline Supply Production andWholesale – and the changes required to remove the barriers.

Table 1 EU Wholesale: Changes Required

Barriers to Competition Changes Required Main Drivers/Factors

Perceived lack of transmissioncapacity and problems withcapacity booking

Introduce market carriage TPAmodel to provide more flexibility incapacity booking including UIOLI,and allow “rolled in” treatment,where appropriate, for capacityexpansions

Some resistance from incumbentson freeing up capacity and will needincentives from regulatoryauthorities to make unused capacityavailable and encourage investment

Diverse tariff and TPA structuresmake transmission of gas, particularly transit, over long

distance difficult

Harmonisation of TPA structuresacross the EU but need to avoid the“pancaking” of charges

The widespread adoption of entry –exit is a move towardsharmonisation of regimes but needs

to be “modified” to incorporatetransit

Separate transit regimes Transit to be incorporated into maindomestic transmission systems.Increase importance of UK as atransit country.

Many transit contracts will be longterm “legacy” contracts with verydifferent terms and conditions. Will be difficult to incorporate

Lack of regulated TPA in storageand inappropriate balancingregimes

Presumption that all storage should be regulated TPA, unless it can beshown there is true competition.Simplified, non-punitive, balancingregimes, with daily being theminimum balancing period

There has already been resistancefrom incumbents and somegovernments. Strong pressure fromEuropean Commission needed

High import dependency anddominance of single importcompany in many countries orinsignificant competition betweenmultiple suppliers. Creates localmonopolies

Introduction of effective gas release programmes

Release at the gas purchase endneeds to be accompanied by releaseat the sales end as well. Currentschemes not ambitious enough.

Lack of liquid and transparent spotmarkets and hubs

Spot markets and hubs will developonce the conditions for effectivecompetition are in place

Will follow other changes

Oil price escalation and anticompetitive clauses in gas purchasecontracts

Removal of anti-competitiveclauses from contracts andencouragement of shorter termcontracts

European Commission makinggood progress on anti competitiveclauses

Introducing full competition into the EU Wholesale market is seen as a key priorityand an area where there are significant barriers to entry. This is particularly the case inrespect of access to, and availability of, pipeline capacity at reasonable tariff levels.


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Gas storage is also another key area and the Second Gas Directive and the Guidelinesfor Good Practice have failed to provide real access to storage at a reasonable price.For gas release programmes to be effective it will be important to release gas not onlyfrom purchase contracts but also at the sales end as well.

Table 2 EU Retail: Changes Required


Lack of TPA access to Distributionsystems

Introduction of consistent andcoherent Network Codes,specifically for distribution ifseparate from transmission

Overcoming resistance fromincumbents and concern about the possible high cost of introducingretail competition

Dominance of pipeline companiesin relation to sales to LDCs

Removal of exclusivearrangements, shorten duration ofcontracts and institute gas salesrelease programmes.

Strong incumbent resistance falling back on the security of supplyargument. Strong regulatory andcompetition authorities actionrequired

Minimal supplier switching as aresult of customer inertia andinadequate administrative structuresto enable customers to changesuppliers

Increase customer awareness of the benefits of switching. Introducecost effective and efficient supply point administration

Fear of the high cost of introducingnecessary systems but there arelower cost alternatives which can beutilised

Lack of unbundling. Incumbentscan “subsidise” the supply business

Proper legal unbundling oftransportation, supply and storage.Privatisation of state owned businesses. Cost reflectivedistribution charges to eliminateexcess profits and inefficiencies

Incumbent and possible governmentresistance. Strong action requiredfrom regulatory authorities, backed by governments.

A large proportion of the retail gas bill is outside the suppliers’ control,

including gas cost, transport feesand taxes, making it difficult toundercut the incumbents’ prices.

Introduction of full competition inthe EU Wholesale market and the

Pipeline Supply Production andWholesale markets and firmregulatory oversight ontransportation tariffs

Refer to sections on EU Wholesale,Pipeline Supply Production and

Wholesale

Introducing full retail competition is seen as a Medium to High priority. It is notconsidered essential for competition to develop at the retail level in order for the benefits of competition at the wholesale level to filter down to retail customers, as has been shown in the US and the UK. However, it is possible that the extension ofcompetition to the retail sector may assist the introduction of competition at thewholesale level. It would reduce the ability of the incumbent gas supplier to cross-subsidise between its competitive and monopoly customers and also overcomes the problem of defining where the boundary between the competitive and monopolymarkets should lie. In addition, if accompanied by effective unbundling oftransportation and supply, the regulatory authorities can ensure that the distributionnetwork charges are set at an efficient level.


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Table 3 Pipeline Supply Production: Changes Required


Dominant national producers,largely state owned

Encourage privatisation of national producers

Expect some resistance fromgovernments but generally thesecountries are in need of foreigninvestment

Restrictions on exports byindependent producers

Allow independent producers to selltheir own gas directly

Introduction of foreign investmentcombined with opening thewholesale market through regulatedTPA should help independent producers to sell their gas directly

Few foreign investors Put in place legal and tax structureto encourage foreign investment

Many countries do not have welldeveloped legal and tax structureswhich respect property rights

Because of the dominance of supplies to the EU by a few countries and largely stateowned companies introducing more competition in this area is seen as a High Priority.

Table 4 Pipeline Supply Wholesale: Changes Required


Lack of TPA to infrastructure in producer and transit countries

Introduce regulated TPA regimesconsistent with EU

Some countries are still resistant tothe introduction of regulated TPA

Lack of spare capacity in export pipelines

Promote privatisation of pipelinesystems and introduction of foreigninvestment

Infrastructure is generally in poorcondition and there is still resistanceto privatisation and foreigninvestment in key infrastructure

No transmission connectionsdirectly with specific (FSU in particular) countries with abundantgas reserves. Inhibits diversificationof EU supplies

Promote the construction of new pipeline links and try to reduce theinfluence of the incumbent producers

The incumbents will try and keepcontrol of any new pipeline links ortry and prevent them. Investmentfunds could also be an issue in somecountries

Gazprom in particular can exploitits exclusive access to informationin order to control the entirewholesale market.

Unbundling of Gazprom, separatingtransportation and supply, orenforcement of regulated TPAregime

Could encounter powerfulresistance from Gazprom andRussian Government

The wholesale markets in the Pipeline Supply area are also seen as a High Priority forcompetition because of the importance of diversifying supplies to the EU. Thediversification of supplies will require the construction of new pipeline links, particularly those adding to Russian and Gazprom’s routes.


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Transition to Competitive Markets

In order to consider the timing, and implications, of the transition to competitivemarkets, three distinct scenarios were identified and these were then tested usingEnergy Markets’ unique European Gas Model (EGM) for a spot gas supply year2015/16 (i.e. 10 years ahead). The three scenarios were:

• The Fully Competitive Case - The Fully Competitive Case represents the best possible world from the point of view of competition in the gas market. It depictsa fully competitive gas market in EU and globally by 2015/16. Within the EU theliberalisation process has been completed and there has been substantial reform inthe gas market in Russia and other gas producing countries. The LNG market becomes fully commoditised with extensive spot trade.The Fully Competitivecase is included as a benchmark against which to measure the other scenariosand is not necessarily considered to be a realistic picture of the market in2015/16 .

• The Most Competitive Case - This case represents the most positive outcome

from the point of view competition in the gas market thatcan reasonably expectedto be achieved over the next ten years. Long term contracts continue to play animportant part in the market but pricing terms move away from oil priceindexation to market-related pricing. Liberalisation within the EU itself issubstantially completed but there remain problems beyond the EU borders. Whilstsome reform has been attempted in Russia, and Russia has signed the EnergyCharter Treaty, Gazprom remains dominant over Russian production and stilleffectively manages to exclude gas from the Caspian area from direct access to theEuropean market.

• The Constrained Case - This case represents a fairly pessimistic view ofcompetition in the gas market by 2015/16. Whilst the second gas Directive has been transposed into national law by all member states there has been little realenthusiasm for competition and the European gas market continues to becharacterised as a series of national markets. Trade continues to be dominated bylong term contacts with price escalation clauses linked to oil prices. Gas prices,therefore remain sensitive to oil price outcomes.

In respect of key data inputs to the EGM, the assumptions were as follows:

• Demand - We have used a conventional view of gas demand in Europe which is broadly consistent with forecasts by IEA. In 2002 demand was just under 500 bcm. This is expected to rise to 715 bcm by 2015/16. In the UK demand wouldrise from 93 to 103 bcm. For the Most Competitive scenario, we have added asensitivity case with slightly higher demand assuming greater use of gas in the power sector in Germany, Italy and other countries. Total European demand in2015/16 would be 747 bcm and in the UK some 118 bcm.


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a result of capacity constraints preventing these countries accessing cheaper Russiangas. This would signal the need to build more capacity and over time these largedifferentials could be expected to be reduced.

In the Constrained case the spot price is higher than WACOG – that is marginal costsare higher than the long term gas contract price based on a $30/bbl oil price. The UKspot price is around 31.5 p/therm set by arbitrage with USA in the LNG market. On arange of reasonable assumptions for US prices, the UK spot price could fall within arange of 27.0 to 36.4 p/therm. Under this scenario many of the European countries’ prices are closely linked with US prices, since US prices are the main driver of LNGspot prices, which in turn are the “marginal” supplier to much of Europe. Long rungas supply contracts linked to oil in this scenario determine some European prices.However, this gas is limited in supply and is assumed to be unable to “arbitrage” intothe UK market.

Table 6 Gas Prices by Scenario

P/therm Real 2004 Prices Constrained Case MostCompetitive

MCSensitivity

FullyCompetitive

WACOG Spot Price

Austria 21.3 18.9 21.1 21.1 14.6Belgium 27.1 31.0 19.5 20.8 15.3France 31.7 37.4 20.6 21.7 16.1Germany 23.0 22.8 14.6 15.5 14.2Greece 20.1 18.6 11.9 11.9 12.9Ireland 36.6 36.6 24.6 26.1 18.2Italy 22.4 19.7 10.0 11.8 14.1Netherlands 23.7 26.1 16.1 16.5 12.7

Poland 19.0 11.5 9.8 10.7 9.2Portugal 21.7 12.7 20.5 21.5 17.6Spain 18.3 30.6 13.6 16.0 15.0Switzerland 28.0 32.8 20.5 21.1 15.2Turkey 23.5 34.9 14.1 14.1 11.2UK 31.4 31.5 20.4 22.0 16.6

It is important for Europe to secure adequate low cost supplies from Russia, FSU andother sources. The alternative is that potentially higher prices result from the EUcompeting with the US for LNG supplies. The Most Competitive case would bring insufficient supplies to Europe to lower prices in general. For the UK the gas pricewould be around 20.4 p/therm, or 11.1 p/therm less than in Constrained case. Supplies

from Russia are now the key in setting spot prices, with LNG supplies becoming a price taker, as opposed to the price setter as in the Constrained case.

The Fully Competitive Case would not only help contain gas prices, through greater pipeline capacities and increased liberalisation and competition, but also improvesecurity of supply to Europe because there is a much more diversified range of supplycountries contributing to supply. Russia will contribute a significant proportion of


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European gas requirements under any scenario because of its reserve position.However, in the Fully Competitive Case, the Russian share is limited to less than 35%and more importantly the gas is produced by a wider range of producers, because ofthe assumed break up of Gazprom, and independent gas producers can market theirgas directly to Europe.

European imports are currently dominated by three producers – Gazprom, Sonatrachand Statoil who control 84% of imports. The combined market share of these three producers declines to 69% in the Constrained Case, 59% in Most Competive and 51%in Fully Competitive.

Actions for Consideration by the UK Government

The possible options and recommendations are linked directly to the barriers tocompetition and the changes required in key markets as described above. The changesrequired in the key markets can be divided into the EU area and the Pipeline SupplyArea, since the actions that the UK Government can undertake will differ between thetwo areas. Direct action that the UK Government can take is relatively limited since

almost all the changes required are outside the UK. Much of the actions, therefore,will be limited to influence and persuasion, although under certain circumstances itmay be possible in the future for direct legal action to be taken under EU CompetitionLaw.

The changes are ranked in terms of their relative priority and possible achievabilityand linked with potential actions by the UK Government. The ranking of the changesis shown in Table 7 below.

Out of the top 10 changes required, 6 relate to the EU Wholesale market, focussing particularly on access and availability of transmission capacity and the flexibility ongas supplies both in terms of volumes and contractual terms. Changes in the EU Retail

market are of less importance, apart from the requirement to unbundle transportationand supply and reforming the gas sales contracts to LDCs. In the Pipeline Supply areathe focus is very much on expanding pipeline capacity both in terms of diversificationthrough new connections and privatisation of existing pipelines.

It is perhaps not too surprising that 3 of the top 5 ranked changes relate to acesss toand availability of capacity, effective gas release and unbundling, all of which wereseen as integral in the introduction of competition in the US, UK and Victoria inAustralia. In addition, the other 2 in the top 5 – new pipeline connections and moretransit through the UK - are designed to increase the EU’s diversity of supplies, also akey factor in the US and the UK.

A number of the recommended changes required, especially at the EU Wholesalemarket level, go well beyond the Second Gas Directive and further than has beensuggested at the Madrid Forum. If these changes are to be implemented, therefore,most, if not all, of the other countries in the EU and the European Commission willhave to be persuaded of the merits of the changes.


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In trying to achieve these changes in the EU, a programme of influence and persuasion of the reforms required can be undertaken at EU and national governmentlevel. A further factor could be redressing the informational advantage, for exampleconcerning capacity availability, that the incumbents have over their customers andregulatory and governmental authorities. This can be done through a detailed andthorough benchmarking study together with the aggressive use of EU competition

law.In the Pipeline Supply area, apart from encouraging UK company involvement ininfrastrucuture developments, the strategy would be more concerned with negotiatingfor reform within the producer and transit countries and implementation of the EnergyCharter Treaty.


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Table 7 Ranking of Changes Required

Rank Code Title Change Required

1 EUW1 Market Carriage TPA andCapacity Availability

Introduce market carriage TPA model to provide more flexibility in capacity booking including UIOLI and allow “rolled in” treatment, where appropriate,for capacity expansions

2 EUW5 Effective Gas Release Introduction of effective gas release programmes

3 PSW3 New Pipeline Connections Promote the construction of new pipeline links and try to reduce the influenceof the incumbent producers

4 EUR4 Unbundling of Transportation andSupply

Proper legal unbundling of transportation, supply and storage. Privatisation ofstate owned businesses. Cost reflective distribution charges to eliminate excessrofits and inefficiencies

5 EUW3 Transit Re imes Increase im ortance of UK as a transit countr .

6 EUR2 Gas Sales to LDCs Removal of exclusive arrangements, shorten duration of contracts and institutegas sales release programmes.

7 EUW4 Storage and Balancing Presumption that all storage should be regulated TPA, unless it can be shownthat there is true competition. Simplified balancing regimes, with daily beingthe minimum balancing period

8 EUW2 Harmonisation of TPA in the EU Harmonisation of TPA structures across the EU but need to avoid the“pancaking” of charges

9 PSW2 Export Pipeline Capacity Promote privatisation of pipeline systems and introduction of foreigninvestment

10 EUW7 Gas Purchase Contracts Removal of anti-competitive clauses from contracts and encouragement ofshorter term contracts

11 PSP3 Foreign Investment Put in place legal and tax structure to encourage foreign investment

12 PSW1 Regulated TPA Introduce regulated TPA regimes consistent with EU

13 PSW4 Gazprom Market Control Unbundling of Gazprom, separating transportation and supply, or enforcementof regulated TPA regime

14 EUW3(EU)

Transit Regimes Transit to be incorporated into main domestic transmission systems.

15 PSP2 Restrictions on IndependentProducers

Allow independent producers to sell their own gas directly

16 EUR1 Distribution TPA Introduction of consistent and coherent Network Codes, specifically fordistribution if separate from transmission

17 PSP1 Dominant National Producers Encourage privatisation of national producers

18 EUR3 Supplier Switching Increase customer awareness of the benefits of switching. Introduce costeffective and efficient supply point administration

19 EUR5 Upstream Costs Introduction of full competition in the EU Wholesale market and the PipelineSupply Production and Wholesale market and firm regulatory oversight ontrans ortation tariffs

20 EUW6 Spot Markets and Hubs Spot markets and hubs will develop once the conditions for effectivecompetition are in place


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1. INTRODUCTION

1.1. Background

The UK is now a net importer of gas, with prices and access to supply increasinglydepending, therefore, on markets elsewhere. In this context, the Department of Tradeand Industry (DTI) believe it is critical to understand what might stand in the way ofeffective and efficient competition in European, as well as global gas markets, in thenext 5-10 years. While the Government is already very active in influencing EUliberalisation, there are likely to be political, regulatory, technical and market factorsthat can either slow down or limit the extent of true competition on the Continent.Identifying these ahead of time will be key. As a consequence the DTI decided tocommission a report to consider the “Conditions for Truly Competitive Gas Marketsin the EU (and Globally)”. In the context of the DTI’s remit, the objective of the report would be to identify the potential barriers to the development of truly competitive natural gas markets on theContinent (and globally) and, where appropriate, identify ways in which the UK

Government could influence the political, regulatory and market outcomes in order tomaximise the benefits of competitive gas markets to UK consumers.

The full terms of reference are reproduced in Appendix 1. However they included thefollowing sets of key questions that would need to be answered:

1. What conditions (regulation, structure, conduct) would be required for the EU(and global/LNG) gas markets to be truly competitive around 2010-15?

2. What will be the most important drivers/factors, between now and 2010-15, whichwill determine whether these conditions will be met?

3. What are the likely outcomes on these key factors, and, on balance, howcompetitive is the European/global gas market likely to be around 2010-15?

4. What are the implications of this level of competitiveness for UK’s energymarkets, especially the prices and security of supply issues we might face?

5. Based on the above, what, if any, action (including influencing strategies) shouldthe UK Government consider in order to facilitate the development of competitivegas markets?

1.2. Report Structure

In considering the requirements in the terms of reference, Energy Markets added afurther 3 questions to the 5 that the DTI had posed:

1. Are there any truly competitive gas market in the world and what lessons can belearned from them?

2. What actions are needed by the EU and Regulatory Authorities in Member States?

3. What are the implications of a competitive gas market for responses to pricesignals both in the short term and the medium term?


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In respect of answering these and the DTI’s questions and in the context of achievingthe objectives outlined in the terms of reference, this report is structured as follows:

Section 2 defines what we mean by a competitive market for gas, expanding on thedefinition in the terms of reference, describes the conditions required in a competitivegas market. It also considers different markets within the gas chain and differentgeographies, including those outside the EU.

Section 3 outlines the international experience with reference to the USA, UK andAustralia, describing how the competitive markets developed and considering possible lessons for the EU.

Section 4 considers the current conditions in each of the key markets and geographies.

Section 5 considers the barriers to the development of competition and the changesrequired.

Section 6 considers the timing of the transition in the context of the 2010 to 2015timeframe using different possible scenarios and discussing the likely outcome.

Section 7 looks at the implications of a competitive gas market, describing the gas price differentials between scenarios, differences in gas flows and transportationcapacities, assesses the implications for security of supply to the UK and Europe as awhole and how the market may respond to the price signals and differences.

Section 8 looks at actions for consideration by the UK Government outlining a seriesof options, both for the UK Government and the EU and Member States RegulatoryAuthorities, and describes a strategy for the UK Government for the implementationof the report’s recommendations.


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2. DEFINING A COMPETITIVE MARKET FOR GAS

As was outlined in section 1, the objective of this study is two fold:1. To identify the potential barriers to the development of a truly competitive natural

gas market on the Continent (and globally); and,

2. Where appropriate, identify ways in which the UK Government could influencethe political, regulatory and marketing outcomes in order to maximise the benefitsof a competitive gas market to UK consumers.

As a starting point it is essential to develop a clear understanding of the meaning of‘truly competitive natural gas markets’, particularly as it relates to conditions wemight find in the European gas market.

In this section of the report we develop our understanding of this concept. Weexplore, conceptually, the issues involved and also the outcomes that one mightexpect to occur in a truly competitive gas market. The characteristics of a competitivegas market are also discussed. In later sections of the report, we then apply theseconcepts to the market structures we observe in Europe and the gas producing areasthat supply gas to Europe, so that we can understand the barriers that may exist toinhibit the development of truly competitive gas markets. Some barriers may be dueto the behaviour of individual players in the gas market, while other barriers may bestructural.

2.1. Economic Definition

In the Terms of Reference for this study a definition of ‘truly competitive natural gasmarkets’ was included as follows:

‘we would consider a ‘competitive’ market to be one where no company holds and/orexercises significant market power, where prices reflect the costs of marginal supply(and not, for example, contract prices conventionally linked to oil prices) and where

gas is available to anyone anywhere willing to pay the competitive market price.

The nub of this definition is recognition of the need to be able to identify how, whereand when players in the natural gas market could exercise market power. The naturalgas industry in Europe has been historically organised as either statutory or naturalmonopolies, which have enjoyed local market power. The political and regulatorychallenge of market liberalisation is to remove that market power, without eitherexpropriating the legitimate property rights of the existing players, or causing themarket or existing players to fail during transition.

The definition also uses the phrase“where prices reflect the costs of marginal supply” . Pricing at marginal cost underpins the economists’ concept of a competitivemarket. However, it is not always a straightforward concept in the gas industry. For agas producer, selling gas at its marginal cost is not the same as simply looking at thevariable costs of production, since the choice is between selling the molecule of gasnow or selling it at the end of the gas field’s life, which could be in 20 or 30 yearstime. This lost opportunity cost could outweigh the variable costs, making the


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effective marginal costnegative 1. At the infrastructure level there is a high level offixed costs and the short run marginal cost is very low. The gas supplier, on the otherhand, faced with possibly buying at the spot price is looking at a marginal cost muchcloser to the economists’ concept. Depending on the point of view of the buyer orseller of gas and also whether or not there is an excess supply of gas and/or capacity,the marginal cost of gas can vary enormously. Appendix 2 reviews the concept in

more detail.For the purposes of this report, however, it is helpful to add more detail to thedefinition. A useful expansion of the definition of a truly competitive gas market wasrecently published by the New Zealand Ministry of Economic Development2, who areresponsible for policy relating to competition and regulation of gas markets, in thecontext of the establishment of competition in their market. The key definitional points were as follows:1. A market where there is full competition in production, wholesaling and retailing

natural gas, and where gas can be freely traded between producers, wholesalers,retailers and consumers.

2. An interconnected transmission and distribution system with clear rules for accessby all prospective participants. Where pipeline capacity is in competition,capacity is tradable and transmission prices are set by reference to the market.Where natural monopoly exists, clear rules for reference pricing are availableand disclosure arrangements and legal remedies are available at an economicand timely manner to redress concerns.

3. Arrangements in the transmission, distribution and retail sectors that provideconfidence in the market that cross-subsidising is not occurring in verticallyintegrated organisations.

4. A market where clear market signals encourage the efficient allocation ofresources along the gas supply chain by providing information to market

participants through flexible pricing arrangement, contracts of variable length,efficient gas trading mechanisms, and the scope for commercially negotiated

settlements.5. A market where pricing is established according to a consumer’s willingness to

pay and market power does not interfere with the ability of consumers to exercisethis preference. This means that product differentiation does not occur betweenconsumer groups exhibiting similar willingness to pay.

6. Contestability in the market with the aim of achieving freedom of choice by allconsumers to access gas on the most attractive conditions in terms of price,quality and reliability of service from retailers, wholesalers and producers.

Industrial consumers able to negotiate supply and pricing terms that arecompatible with their business needs.

1 However, exploration and production (E&P) company management do not always take rationaleconomic decisions. Their bonuses will often be based on the accounting profit of the business, whichhas, as a “cost”, depreciation on a unit of production basis. This makes the accounting “marginal cost”much higher.2 This definition was not selected because what might, or might not, be happening in New Zealand is atall relevant for the EU market, now or in 10 years time, but simply that this definition provided a goodand succinct summary of what any competitive market for gas might look like anywhere in the world.


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The first point highlights the importance of competition in all steps of the gas chain asan introductory statement. The second point deals with the rules of access to theessential facilities of the natural gas networks. The remaining four points, however,address in different ways the issue of market power and possible abuse of market power:

•

Point three highlights the need to avoid cross-subsidies in vertically integratedcompanies, which could inhibit competition. This could be usefully extended toinclude the elimination of cross-subsidies in horizontally integrated companies.For example a company which enjoys a monopoly in its home market may be ableto cross-subsidise its entry into a neighbouring market. Cross subsidisation wouldnormally only be achievable if there were significant economic rents available in parts of the gas chain.

• Point four focuses on the need for transparency of information through flexibilityin prices and contract terms and conditions. It also implicitly confirms theimportance of transparent price signals to the market.

•

Point five emphasises that prices should not be distorted by market power norshould there be any form of price discrimination.

• Point six highlights that the terms of supply and service offered should be set bycustomers’ requirements and not by what a supplier dictates as being appropriate.

There is one further issue that is alluded to in this definition, but which would benefitfrom further clarification. This issue is the importance of market information beingfreely available to all. In a perfect market information must be available to both buyers and sellers about market prices, product quality and conditions of sale. A particular risk arises where an advantage could arise from a player’s interestselsewhere in the supply chain. For example, if a supply affiliate of a gas transportation

company has better knowledge of the system capacity and gas flows, from itsownership of the transportation business, than its competitors.

In the above definition, two clear issues are identified – market power and access toessential facilities. These are considered in more detail in the following sections.

2.1.1. Market Power

In considering the issues of market power, two aspects need to be considered. Firstlyit is essential to define the market in which market power might exist, and secondlyassessing the extent of market power.

The OFT recently published guidelines on the application of competition law to theUK energy sector 3. This guideline provides insights into the problems of defining amarket in the gas sector for the purposes of assessing whether market power exists. Afuller discussion of the OFT guidelines is contained in Appendix 3.

3 OFT. Application in Energy Sector. Understanding Competition Law. January 2005


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Market Definition

In these guidelines it is noted that a market definition usually contains a product, ageographical area and a temporal dimension. The guidelines are also applicable to theEuropean gas market because it is based on interpreting Articles 81 and 82 of the ECTreaty.

In product terms, superficially, natural gas might be regarded as a homogenouscommodity4. However, gas consumers do not receive the same molecules that theirshipper delivered at the entry point and natural gas has different values at differenttimes and in different locations. In a gas market, the product has to be defined both interms of the commodity (which is homogenous) and also when it is delivered. Ofgem points out, in its response to consultation on this issue5, in gas markets there is alimited ability to substitute transactions in one time period with another. There islimited capacity available to put gas in and out of storage from a day-to-day.

The temporal dimension conventionally used in market definition is one year.Transient distortions to prices are usually ignored. However, in the OFT’s guidelinesit is noted that the gas system in the UK is balanced daily. Due to the inelasticity ofdemand, high price spikes can occur for short durations resulting from severe weatheror supply outages. The OFT notes that large price increases for a short period of timecan be as damaging to the market and to competition as small increases that endureover a longer period.

The OFT paper also addresses the issue of geography. Again, the OFT notes that asituation, at one particular point on the network, may have a surprisinglydisproportionate effect on the market. They note, for example, that a market mightreasonably be defined as a particular entry point into the system, because there might be limited scope for substitution at that point.

This analysis serves to show that gas markets need to be defined carefully to assesswhether there is market power and also helps to explain why companies may claimthat their market is open to competition, while retaining sufficient control at key points to restrict competition. It also helps to explain why the liberalisation processtakes time, as regulators progressively expose and remove problems which emerge atthese key points. During this process the incumbent has a considerable informationaladvantage over the regulator, as the company will have a much better understandingof where key points exist and how to retain effective control of them.

4 It is not within the remit of this study to discuss, in detail, issues surrounding gas quality, whether it be the “low-cal” and “high-cal” systems in some EU countries e.g. the Netherlands, or the issuessurrounding UK gas quality relative to the rest of the EU. DTI have been leading an exercise on gasquality in the UK for the last 2 years and Marcogas and EASEE-Gas have been doing work on the EUaspect. Gas quality issues can be resolved, but at a cost which will need to be factored into the overallcost of gas supply, whether the market is fully competitive or not.5 OFT and Ofgem. Responses to the Energy Sector Consultation. January 2005


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Assessing Market Power

The starting point for assessing market power is market share, but it is no more than astarting point. There are no established market share thresholds for definingdominance. For example a company could have a very high market share, but in acontestable market (see below) where the barriers to entry and exit are low, it will not be able to exercise market power because raising prices would simply draw in newentrants which could leave the market in response to any subsequent price reductions by the incumbent without incurring undue losses. Thus market share is only a starting point in this assessment.

As market share, per se, cannot be regarded as sufficient evidence of market power,the OFT considerers a number of other factors:• Customers’ behaviour and options ( for example awareness of competition, the

extent to which alternative providers are chosen, the extent to which substitutesare available)

• Competitors’ behaviour and capacities ( for example their range of offers, theirability to increase output within the relevant time period)

• Market Operations (for example the extent of barriers to entry and exit) • An undertaking’s conduct in the market with regard to price setting as well as

financial performance (such as consistently earning a rate of return of profit significantly above competitors levels)

These are considered in more detail in Appendix 3.

Contestable Markets

While market power is an important measure in terms of considering thecompetitiveness of a market, it is also important to consider the issue of contestability.The term ‘contestable markets’ has been used by Baumol, Panzer and Willig6.

A contestable market requires barriers to entry to be low and perfectly contestablemarkets require a total absence of barriers to entry. If the barriers to entry are low thenincumbent companies have to consider the threat of potential as well as actualcompetition making it difficult to abuse a dominant position. If incumbent companiesare making super-normal profits and there are no, or low, barriers to entry then it isargued that new firms may enter the market quickly and existing firms will have anincentive to keep prices at a level where only normal profits are made.

It is also necessary that barriers to exit should be low otherwise there will be a threatthat incumbents can use predatory pricing to force new entrants out of the market withassociated losses. For barriers to exit to be low would require that sunk costs are verylow since they cannot be recovered if the company leaves the market.

6 Baumol W J, Panzer J and Willig R.D. (1986) Contestable Markets and the Theory of IndustrialStructure, Harcourt Brace and Jovanovitch.


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In practice few markets are perfectly contestable but scale is important. For examplethe gas supply market will be closer to being contestable if new entrants can enter themarket without investing in infrastructure which would involve significant level ofsunk costs or entering into long term contracts for gas which could involve seriousloss in the event of exiting the market.

Summary

This analysis indicates that the potential for companies to distort the market is notnecessarily predicated on dominance of the entire market at all times. In some cases itis sufficient to exercise control at key points in the network such as cross border entry points. Even then, this control may only need to be exercised for a short period suchas the peak demand period.

Prima facie evidence of market power can be found from excess profits and also theexistence of economic rent, which could still exist even if excess profits did not.Conversely, evidence for predatory pricing behaviour can be found from prices whichset temporarily below variable costs with a view to driving out competitors from themarket and returning to high prices in the longer term. In addition there is otherevidence that can be considered including the presence of real competitors in themarket; barriers to entry and exit; and the choices and options available to customers.

2.1.2. Access to Essential Facilities

The concept of essential facilities is key to understanding the economics of operatinga competitive gas market. In a gas network essential facilities may include pipelines,compressors, gas storage, gas treatment and LNG terminals. The concept of ThirdParty Access (TPA) to gas systems is based upon the idea that these are ‘essentialfacilities’ and competition will only occur if competitors are allowed access to themon the same terms as the incumbents – the “level playing field”.

The World Trade Organisation defines an Essential Facility as a facility that is• Exclusively or predominantly provided by a single or limited number of

suppliers• Cannot feasibly be economically or technically substituted to provide a

service.With a few exceptions gas infrastructure meets this definition. Whilst there are someexamples of pipe to pipe competition in gas infrastructure, these are rare. Even inthese cases the number of operators is limited. Thus the rationale for TPA is thatcompeting gas suppliers need to be allowed fair access to these facilities to enablethem to compete, because it is not feasible to duplicate them.

Long Life Irrevocable Investments

The key issue in respect of essential facilities is that natural gas infrastructure islargely a long life investment. Natural gas pipelines are conventionally givenaccounting lives of 40 years or more and so are most gas storage installations,although technically they can last much longer if well maintained. The long life, and


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the high initial cost of gas infrastructure, means that the costs have to be recoveredover a long period of time.

In addition to being long life, natural gas infrastructure is, for the main, an irrevocableinvestment. Once the investment has been made it is dedicated to the purpose forwhich it was built and cannot be used for other purposes. Construction and planninglead times are also a factor. Major gas infrastructure projects have a lead time of atleast 2 years and often more. The planning lead times are even longer and it can be adecade or more between the time a project is first proposed and the date whenconstruction actually begins.

Impact of TPA on Network Development

The introduction of TPA introduces a new dimension into the decision making process on investments. Where a gas utility is operating as a conventional verticallyintegrated business, the investment risk in long life assets can be managed in thefollowing ways:• The utility understands the expected future pattern of gas flows and can, to some

extent, exercise control over them;• The cost of any mistakes can be smeared across all of its monopoly customers:

and,• It is not exposed to competition, even at the margin (for example, competitively

supplied gas storage can act as a substitute for pipeline capacity).With the introduction of TPA, exposure to risk and the management of these riskschange. An operator of a TPA gas network has less information about the pattern offuture supply and demand on which to base investment decisions. While the networkoperator will have good information about future gas demand supplied from thenetwork, there is some degradation on the information that they have because they nolonger control the selling price of the product and do not have direct contact with new

and future customers to assess market trends.On the supply side the degradation of planning information is more marked. A privatesector monopoly minimises its costs by exactly matching gas supply to demand andonly providing the minimum capacity to meet that requirement plus an operatingmargin to allow for flexibility to respond to unforeseen circumstances such asequipment failure on or upstream of the operators system. Barring contingencies foroperational problems, a monopoly will only plan for one pattern of supply to meet its peak demand. With the introduction of competition, sources of supply become amatter for the gas producers and market wholesalers and not for the transportcompany. A competitive market will want more capacity than a monopoly market asvarious suppliers compete for the same customers. The problem that has to be solved

under TPA is to devise a method that gives the operator an incentive to invest in newcapacity by managing its risks.

There are a number of methods that have emerged in various jurisdictions:• Rolled in Rates (any new investment is added to the transporters asset base and

reflected in its charges – this method essentially maintains the risk at the same


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level as a vertically integrated monopoly). In some cases different rates of returnare used for existing assets and new investments.

• Joint venture projects to build interconnectors with participation limited to partiesinvolved in associated gas deals and/or the operator in the transit countriesinvolved

• Open Season (the pipeline is charged for on an incremental basis and gas shippers

are invited to bid for capacity under long term contracts – the capacity can then be traded in a secondary market).• Exemption from TPA requirements for major new projectsThe development of TPA is discussed later in the report and these methods will beaddressed in more detail then. However, what will become clear is that effectivearrangements are needed to ensure that there is an incentive for network operators toinvest in new capacity. Moreover the arrangements have to be compatible with thedevelopment of the market. A shortage of capacity can severely constrain theintroduction of competition.

Summary

Investments in gas infrastructure are long life with significant lead times forconstruction. Traditional vertically integrated monopolies have in-built structures formanaging the risks with these long life investments. The introduction of TPA altersthe risks from these investments and introduces complexity.

The network operators have less information about the patterns of supply and demand.Price signals from the market are of little value beyond indicating that there is a need. New arrangements need to be put in place when TPA is introduced to ensure thatthere is an incentive to invest in new infrastructure.

2.2. Characteristics of Truly Competitive Markets

In this section we address one of the questions posed in the terms of reference• What conditions (regulation, structure, conduct) would be required for the EU

(and global/LNG) gas markets to be truly competitive around 2010-15? The characteristics specific to the Production, Wholesale and Retail markets arediscussed below. Many of the characteristics apply equally to the three geographicalareas (EU, Pipeline Supply and LNG Supply) so we do not present these separately inthe text as that approach would become repetitive. Following on from the discussionabove the conditions, or characteristics, for competitive markets are considered in thecontext of the key identified areas of Market Power and Access to Essential Facilities.In addition a third category is added entitled Institutional, which is not a directcharacteristic of a competitive market, but includes those institutional, legal andregulatory factors which are seen as important. Table 1 summarises the characteristicswhich are described in more detail below by market.


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2.2.1. Production Market

An important prerequisite for a competitive market in the production sector is to havea multitude of producers involved in exploration, development, production and sale ofthe gas reserves. This clearly requires open and non-discriminatory licensing regimesand a tax regime which encourages investment.

The requirement for multiple producers is certainly met in the USA with 6,800 Oiland gas companies and to a lesser extent in the UK. One problem in the UK, which isalso typical in other countries as we shall see below, was that all gas produced wassold to British Gas. That problem was addressed first through a requirement for producers to sell 10 per cent of the output of new fields to buyers other than BritishGas and secondly through the gas release scheme described in section 3.2.3.

Even where a large number of producers are active there may be concentration ofsellers’ power through the operation of a cartel such as the GFU in Norway (nowdisbanded) or by joint venture partners in specific field developments selling gas jointly under identical terms with the revenue split between the partners. A

characteristic of competitive producer markets is that producers move away from the joint market approach and start to sell their equity shares in field productionseparately to separate buyers. For example in the UK equity partners now have theoption to sell their shares on long term contracts to a third party such as a powergenerator or another gas supply company or else sell the gas to their own down streammarketing affiliates for direct sale to retail customers.

It is often said that producers would never develop gas fields without the comfort of along term sales contract for all (or a high proportion) of the output of the field.However this need not necessarily be the case as evidenced by the UK market whereeven some large offshore fields, such as Britannia, have been developed for sale intothe spot market. This development clearly requires the spot market to develop

sufficient liquidity and transparency to be able to absorb the producers’ quantitieswithout a material impact on the price.

In respect of long term contracts, a competitive market should not include anti-competitive contracts between producers and buyers which could involve exclusivityarrangements or destination clauses. Nor should there be any special purchasearrangements for incumbent utlities.

On institutional side there should be open and non-discriminatory licensing procedures, tax regimes which encourages investment including in declining production areas and the active encouragement of foreign investment. Licensing procedures should also ensure that large companies cannot just buy up licences and

then delaying field development.2.2.2. Wholesale Market

The wholesale markets in the EU and Pipeline Supply area are regarded as high priorities for this study. On the institutional side the development of competitionwill be greatly assisted by proactive regulatory and competition authorities.


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As gas markets move from monopolistic structures to truly competitive markets it isnecessary to tackle the issue of market power and dominance by one, or a smallnumber of companies. This will require:

• Multitude of wholesalers and suppliers: multitude of alternative producers/importers willing and able to sell gas on the wholesale market,

competing with each other through gas-to-gas competition• Diversity of supply: low reliance on a dominant source of supply aided by

effective gas release schemes

• Flexibility of supply; medium term responsiveness of supply to pricemovements

• Customer pressure; pressure from customers for lower prices and/orimproved or innovative services.

• Multitude of customers: many alternative buyers of gas.

• Effective unbundling: clear financial and physical separation (establishing“Chinese Walls” and the supply function probably housed in separate buildings) of the transportation and supply functions within the network provider such that the supply function is treated like any other shipper.Information provided to Transmission System Operators (TSOs) andDistribution System Operators (DSOs) by shippers needs to be protectedfrom ‘leaking’ out to the supply function.

• Entry of new players: entry of new, strongly capitalised and committed players into the market.

•

Short term price elasticity of demand: degree of fuel switching andcommercial interruptibility in contracts.

• Shorter term and smaller contracts: a trend towards one day to one yearcontracts, away from the more traditional longer term contracts.

• Decline in take-or-pay commitments: removal of take-or-pay clauses oncontracts.

• Removal of ‘destination clauses’: removal of anti-competitive clauses inlong term contracts which restrict the resale of gas or the sale outside thespecified territory.

• Spot and future price indexation: use of price indices from futures marketsand/or price reporting services as escalators in longer term contracts, therebyincreasing their importance above physical share of the total market.

In respect of access to essential facilities the following will be importantcharacteristics:


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• Regulated access7 to networks, LNG terminals and storage facilities:mandatory third party access on a non-discriminatory basis with clear andtransparent access rules.

• Regulation of network charges: regulated control of tariffs and prices fortransportation, storage and LNG facilities, in the absence of true

competition.• Effective capacity allocation process; allocation procedures and booking

arrangements which allow new entrants to obtain capacity on an equal basisto the incumbent gas supplier. Measures such as use it or lose it (UIOLI)enable capacity to be transferred from incumbents to new entrants as thelatter build up market share.

• Maturity of networks: mature industries with heavily depreciated networkssuch that risks have been significantly reduced.

• Removal of transmission constraints and the absence of capacity

bottlenecks, by ensuring that the proper incentives are in place to invest andmake capacity available.

2.2.3. Retail Market

International experience suggests (see section 3), that it is not essential forcompetition to develop at the retail level in order for the benefits of competition at thewholesale level to filter down to retail customers8. On the other hand a trulycompetitive wholesale market is a pre-condition for successfully establishing acompetitive retail market as suppliers need to be able to obtain the gas andtransmission capacity they need at market prices to supply their customers.

All of the characteristics discussed above for truly competitive markets at thewholesale level generally apply equally to the retail markets. Consequently they arenot repeated here in the interest of brevity.

However, the retail market presents additional challenges particularly in relation tothe need to supply large numbers of customers consuming small amounts of gasannually. Customers in the wholesale market are LDCs and large end-users such asindustrial companies and power generation companies. For these customers, energycosts represent a significant proportion of total costs and most employ professional buyers. By contrast the retail market consists of smaller industrial and commercial,and household customers, where energy costs may not be significant

conditions for truly competitive gas

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