direct supply to the highest value use and if the high price is due to a scarcity rent beyond production and marketing costs, it will attract more entrants to the market on the supply side reducing the scarcity rent.
Security of supply is an issue for basic goods which are necessary for maintaining a reasonable standard of living and which cannot be easily substituted.
Another issue is reliability of supply, i.e., that supply which has been committed will in fact be delivered. This is an issue for the type of goods and services which cannot be easily stored or substituted to bridge a failure in delivery, and where a default in delivery has serious consequences for the customer. A striking example is certainly failure of power supply, but also gas for household customers.
Why gas is special
There are several features which distinguish gas from other commodities:
Natural properties of gas
Gas needs large-scale investment into a fixed infrastructure which cannot be used for other purposes. Gas is a natural finite resource, which is found in deposits varying from small fields of several million cm to a few billion cm, like in North America, to fields of 1,000 bcm and more, like Groningen in the Netherlands, Troll in Norway and a limited number of other identified super giant fields, all of which are outside IEA countries.
Gas may come in association with oil or condensates and its components vary from field to field. Contrary to solid minerals or coal, single gas deposits need a uniform management under a single operator due to their uniform pressure regime. Depending on geology, production of gas may have an atomistic structure, such as in the US with more than 9,000 producers, or may have an oligopolistic structure, where (potential) production from one large field could cover a large share of market supply (Groningen in the Netherlands).
Governance elements linked to gas
Laying pipelines requires using public or private ground along a defined route. Endorsement by public authorities is required, either as owners of the ground, as in the case of municipalities, or to enforce – if
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necessary – ceding of ground rights all along the route of a pipeline.
The rights to gas as a finite resource are – except for the US – vested in the state. Exploration and production are subject to sovereign decisions by governments, defining the development and eventually the depletion rates of large reservoirs as well as the rent taking regime for gas. For gas exports, in particular, sovereign decisions of the government of the resource-owning state will matter.
Special economic features of gas
Gas pipelines have strict capacity limits defined by pipeline diameter and the pressure at the inlet and outlet points. Any capacity change requires additional, substantial investment like looping the pipeline (laying a parallel pipeline for part of the distance) or adding extra compression. The transportation capacity of pipelines has substantial economies of scale.
Gas distribution will always be a natural monopoly which can only be contested for very special customers. Gas transportation may or may not be a natural monopoly: pipeline-to-pipeline competition exists, e.g., in North America and in Germany.
Gas by pipeline is delivered through a long fixed chain of capacity- bound investment, where any part of the chain may prove to be a weak link for the rest of the chain. LNG supplies, because of lower economies of scale and because of easy re-routing of tankers offer more flexibility.
Short-term and long-term reliability of gas supply
Reliability of gas supply depends on providing sufficient capacity and adequate gas volumes to supply gas to the final customer. Both are defined by past investment decisions. For reliability of supply, not only do possible supply disruptions have to be bridged, but varying demand also has to be met. Demand may vary as a function of external parameters, like temperature, which are beyond the control of customers. A failure to deliver gas on a cold winter day would have serious consequences for most households which mainly use gas for heating and may have only very limited alternatives. While household customers expect gas to be as reliable as the main alternative – oil, reliability of gas supply to households
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has a “public good” character, as it is delivered via a distribution grid, and there is no possibility of discrimination between customers. A failure in gas supply may also have serious consequences for industrial purposes, when gas is used as process gas, e.g., for the production of sheet glass. In the given example, gas is perfect for providing the constant and uniform heat required, but any interruption may destroy not only the glass output but may damage the whole plant.
Governments may have to define objectives, and eventually even standards, for reliability of supply. These are usually defined in terms of extreme weather conditions, supply disruptions and facility failures to be covered.
Some customers may be in a position to accept interruptible gas supply or may even make their off-take dependent on price. For them the level of reliability is a question of price linked to the alternatives available; their gas demand is price elastic. They implicitly or explicitly value reliability of supply. However, for other important segments of the gas market, reliability of supply is vital because their gas demand is price inelastic. To ensure a high level of reliability to these customers, the gas supplier has to invest in insurance instruments, like storage or extra supply capacity to cope with low-probability events (i.e., extreme weather conditions or supply disruptions). Gas companies have developed a specific mix of tools and mechanisms, often in cooperation with national governments, to ensure reliable and secure gas supply. Traditional instruments include:
diversification of supply sources and routes, interconnection of national grids, long-term contracts, storage facilities, flexibility instruments (supply flexibility; interruptible contracts, etc.) and back-up and cooperation agreements. Relying on curtailment of supplies to interruptible customers or buying extra gas at the price requested by the market, can be used as an instrument in deep and liquid open gas markets to avoid investment into extra capacity which may never be used.
At the wholesale level, the inelastic demand for reliable gas (aggregated by distribution companies or retailers) meets the more price elastic demand by industrial users and power generators. The wholesale level in open markets offers the possibility to provide extra supplies by buying gas in spot markets or redirecting supply away from interruptible customers to
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meet the inelastic demand. Trade can be organised on a shorter-term basis, i.e., relying on finding a seller or buyer when needed, as compared to agreeing deliveries under longer-term contracts. This way decisions can be fine-tuned close to the time when the gas is needed. However, companies responsible for reliable supplies are limited by the depth and liquidity of the marketplace. Otherwise they will have to rely on more long-term contractual arrangements or other instruments.
At the retail level, gas distribution will usually be a regulated monopoly and include supervision of the adequacy of the grid, in particular for defined extreme weather conditions. Ensuring sufficient supply under these defined conditions will be left to the gas retailer. However, distribution companies may have to act as suppliers of last resort.
For long-term reliability of supply, as supply and demand develop additional investment into increased capacity and supply will be needed as well as investments into additional insurance assets. While market prices for gas and transport capacity give location and time signals of scarcity, investment in insurance assets against low-probability/high-impact events may not be valued by the market. In such cases, as well as when investment into infrastructure is made by a regulated monopoly, it is up to the government/regulator to allow for a rate of return which is competitive with other alternatives. Part of government actions is to reduce (perceived) regulatory and other policy uncertainties.
Another issue is that projects for the expansion of gas production and supply have to compete for financing, decided by the rate of return on investment.
Competition for financing would normally result in the best allocation of capital, i.e., investing in an enlargement of parts of the gas chain where it is most needed vs. investment into other parts of the economy. However, political and regulatory risks – even if only perceived by the investors – may hamper new investment. These risks can include risks stemming from acts of either governments or monopolies of non-OECD countries.
A major issue is how signs of capacity constraints will be translated into timely investment to remove those constraints and what signals will be needed for an expansion of infrastructure and supply. From the moment new capacity comes on-stream the scarcity might disappear, and with it
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the scarcity price, so that the investment may be obsolete the moment the capacity is put into operation. Investors may prefer to rely on fundamentals, like a robust increase in demand for the time horizon of the commitment of the new investment.
The internal and external dimensions of security of gas supply So far, security of gas supply was mainly viewed as an insurance against interruption of external supplies. While this definition is still valid, the concept of security of gas supply needs to be revisited in view of the changes taking place in global and IEA gas markets. The new concept involves recognition that security of supply no longer stops at the border but extends to the final customer. Security of supply has also two equally important constituent parts: physical availability and price.
Security of supply is best seen in terms of risk management, i.e., reducing to an acceptable level the risks and consequences of disruptions. Five main categories of risks can be distinguished:
■ Technical risks, i.e., system failure due to weather, etc;
■ Political risks, i.e., interruption of external supplies;
■ Regulatory risks, i.e., failure of deliveries due to flawed regulation;
■ Economic risks, i.e., when gas producing countries are not willing to develop reserves for export at prevailing prices and conditions; lack of investment; and
■ Environmental risks, i.e., unacceptable level of greenhouse gas emissions.
The time horizon of the different risks differs considerably. Short-term risks refer to supply interruptions due to technical failures, accidents, political intervention, or extreme weather conditions. Long-term risks generally cover economic and political risks. They refer to the lack of investment – or insufficient investment in the development of production and transportation facilities for new supplies – or to politically driven interruption of supplies.
As gas is network energy and as gas projects have a long lead-time, risk relates not only to the commodity or sources of supply (which are abundant, although access may be an issue) but also to the adequacy of the
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linking infrastructure and the timing of investment. With market reforms and unbundling of the transportation and supply functions, the link between investment decisions on infrastructure and the development of new resources may weaken.
In open markets, unbundling raises new challenges for reliability and security of supply. In the past, in most countries, governments delegated responsibility for reliability of supply to one single actor, either a de facto monopoly state-owned gas company, or a private company with exclusive concession rights. This entity was responsible for reliability of gas supply across the whole gas market. In open gas markets, a single national company can no longer be assigned the responsibility for security of supply of the whole gas market. It will have to be a shared responsibility to ensure that within the gas chain all issues have been assigned and responsibilities are performed.
The unbundling of gas companies implies unbundling the responsibility for reliability along the gas chain, which raises the issue of how to ensure consistency of compliance with reliability standards by all players from the production site to the burner tip. Instead of handling reliability within an integrated company, reliability now has to be passed on from one company to the next along the gas chain under contractual arrangements.
The internal challenge, as described above, is to ensure reliable gas supply long enough into the future, by mobilising investment for the development of the gas infrastructure and production capacity in time to ensure future reliable supplies. Gas as a natural resource is under the sovereignty of governments, and its supply may not only be subject to resource rent optimisation but also to non-economic political influence.
When it comes to the resources of their own country, governments often have a clear policy on depletion and rent-taking, while investment and depletion decisions are left to commercial operators. For very large fields, like Groningen and Troll, governments tend to maintain a strong influence on the management of the field, e.g., by state participation.
As OECD countries become more import dependent, gas supply becomes subject to decisions made by non-OECD countries. To ensure short-term reliability, defined threats of external disruptions of gas supplies (for
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whatever reason) should be manageable by the domestic gas system:
through market reaction and instruments developed to cope with disruptions. But governments must be increasingly alert to collective vulnerabilities inherent in an internationally integrating market.
So far exporting countries have demonstrated their interest and capacity to bridge any shortfall in deliveries by their own means, like Indonesia providing additional LNG from its second LNG plant during the shut- down of Arun, or Algeria boosting deliveries from Arzew and from the Maghreb and Transmed pipelines after the Skikda accident. Beyond their interest in the continued cash flow, they are anxious to maintain their standing as reliable suppliers, fulfilling their contracts. However, security of supply risks for gas from non-OECD countries remain beyond the risks which are accepted as normal business standards in OECD countries.
These risks especially include political interference into commercial transactions, impacts of political instability and a lack of enforceability of contractual and other legal provision.
Definition of security of gas supply
Security of gas supply is the capability to manage, for a given time, external market influences which cannot be balanced by the market itself.
In open markets, supply and demand can be balanced by the market according to the preferences of market participants. Open markets ensure that gas goes to its highest value use. They provide a variety of instruments to mitigate external market influences in line with the preferences of market participants.
Security of supply has always been a question of how to handle external supply disruptions. In open markets, ensuring reliable gas supply all the way to final customers according to their preferences raises other issues.
For most small customers, individual demand reaction is limited and, for household customers in particular, demand itself varies strongly depending on the temperature. Customers linked to a distribution grid with a ‘public good’ character cannot individually value reliability of supply.
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In the short term, security of supply covers the adequacy of supply and capacity to avoid unforeseen interruptions of customers. In the long term, it includes the capacity to mobilise investment to develop supply and infrastructure as well as the insurance assets to ensure reliable supply.
Security of supply is best seen in terms of risk management, i.e., reducing to an acceptable level the risks and consequences of disruptions.
Management of risk is a central activity for the gas industry and its customers. Where possible, market mechanisms should be the basis of security decisions. Nevertheless, governments do have a role to play:
■ In providing a market framework and its implementation that ensure gas markets can work properly;
■ In setting a framework in which risks can be managed and costs reduced, in particular through securing an international framework for investment and trade, and facilitating interconnection and exchanges among neighbouring countries;
■ In determining acceptable reliability levels, especially where small customers and safety are concerned;
■ In providing a clear policy for dealing with emergency situations.
Role of open markets for reliability and security of supply
Open gas markets are powerful “tools” for providing efficiency and ensuring that gas goes to its highest value. In the short term, they allow supply and demand to be balanced by the price mechanism. In deep and liquid markets, like the US and UK, suppliers/consumers will always be able to sell/buy gas on the spot market, providing they accept the market price. As there are a larger number of players, responsibility for reliability of supply can be more effectively arranged in open markets.
With the opening of gas markets, the role of the customer has changed.
Eligible consumers, like power generators, industrial users and, in some markets, residential and commercial users have the possibility to choose their supplier and to buy (eventually regulated) transportation services and (negotiated or regulated) storage services. This choice extends to the
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level of security of supply the consumer desires/requires. Eligible customers have to assume responsibility for reliability of supply themselves by having back-up solutions to deal with interruptions or to contract for a certain level of security of supply from their supplier and pay for it accordingly.
The opening of the gas and electricity sectors to competition raises the questions of whether the market itself will value security of gas supply and deliver timely signals for investment to guarantee secure supplies. Since companies are only responsible to their shareholders and customers, they will not provide extra investment for reliability of supply if they are not ensured a competitive payback on this investment. And the government will be held responsible for security of supply by voters/small customers even if it is the companies that have the contractual obligation to deliver gas. Hence the importance of making sure the market works and making it clear what markets can or cannot deliver.
Reliability of supply, where it goes beyond what can be delivered by mar- kets, has two main aspects:
■ Short-term, i.e., continuity and reliability of gas supply, under rare and extreme conditions;
■ Long-term, i.e., concerns about timely investment into supply and infrastructure capacity to ensure reliability in the future. In addition there are the internal and external dimensions of security of supply.
Both short-term and long-term gas supply aspects require attention to:
■ The availability of gas volumes to meet firm demands;
■ The availability of transportation and distribution capacity to move these volumes of gas to the end consumer;
■ Insurance assets in case of low-probability/high-impact events.
Availability of gas
In the short term, markets will play a key role for better allocation of supply/demand. Short-term deep and liquid markets will contribute to security of supply by matching supply and demand. The development of
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