EU Gas Import Infrastructure – why more is good for both suppliers and consumers.

In my previous article (EU Gas Import Infrastructure – why more is good and why looking at annual utilisation figures alone is wrong) I explained why looking at annual utilisation figures was misleading when looking at usage of import infrastructure, and whether Europe needs more gas import infrastructure. In this article, I will explain why the argument that Europe already has enough import infrastructure is wrong from a market economics standpoint. 

A brief recap first. A number of commentators have argued that Europe does not need another import pipeline from Russia as there is already sufficient overall import capacity to meet Europe’s needs. It is true that Europe has import capacity which exceeds its annual demand for imports. However, this aggregate analysis fails to understand the welfare benefit that such “surplus” import capacity has for European consumers. To put it simply, European consumers benefit from competition between external suppliers of gas to the EU. To understand why there is this competition between external suppliers, and why this results in “surplus” import capacity, one needs to understand how such suppliers view the EU gas market.  

The external supplier perspective first. Gas reserves are no good unless you can monetise them. To do that you need to get your gas to market. This requires transport infrastructure from your reserves to the market, whether it be pipelines or LNG plants, ships and receiving terminals. 

A prospective gas supplier will also look at the potential of the market he wishes to supply in terms of both size and ease of access. Gas production and transportation is an economies of scale business, so the larger the demand potential of a prospective market, the more attractive it will be. It is also worth noting that developing a gas market can be a time consuming and costly business. Not only do you have to persuade energy consumers to use gas instead of other fuels, you have to build the infrastructure to transport the gas to the power stations, factories, shops and households that will use it. The EU single gas market already ticks both these boxes as it is both big (491 bcm in 2017)[1] and well connected. It also has liquid traded markets which enable prospective suppliers to manage their price risk easily, and rules which ensure that anyone can use the EU pipeline network to reach customers easily. Last but not least, Europe will need more imports (about 120 bcm/y by 2035 compared to 2015)[2] because its own production is declining and overall demand is expected to remain the same (based on the EU’s own 2016 Reference Scenario).[3] EU own production is expected to halve by 2035, a reduction of around 70 bcm, along with declines in other current sources of supply such as Norway and North Africa.

This means that the EU is an attractive market for those wishing to monetise their gas reserves. But gas reserves are in different countries which means that there needs to be infrastructure connecting those countries to the EU. As different suppliers are competing to sell gas into the EU this makes it likely that there will be more import infrastructure than aggregate EU demand for imports. This is because suppliers without import infrastructure have no chance of selling their gas to Europe, no matter how big or low cost their reserves. A supplier will therefore build sufficient capacity to match what he thinks he can sell to the market. However, the EU is a competitive market, which means suppliers cannot be sure that customers will buy all their gas if competitors offer a better price. If suppliers sell less gas than they expect then they will have spare export capacity to the EU. Unfortunately, this spare capacity cannot be used by other exporters to the EU as it is in the wrong place. Spare Norwegian pipeline capacity cannot be used by Algerian or Azeri gas and vice versa. Hence, the EU ends up with “excess” import capacity, thanks to competition between different suppliers from different countries. This also is one of the reasons why it would make no sense to extend the Gas Directive to import pipelines, as proposed by the EU Commission.

It is also important to note that this “excess” import capacity can have value for suppliers. For example the quantity of LNG regasification (i.e. import) capacity in the world is 850 million tonnes per annum (mtpa) (approx. 1080 bcm/y) compared to current total liquefaction capacity of 365 mtpa (approx. 464 bcm/y).[4] Hence the average utilisation figure for an LNG regas terminal worldwide is 43%. In Europe utilisation is about 25%. On the surface, this looks like a waste of money. However, such “excess” LNG import capacity gives LNG suppliers the ability to choose the most attractive markets for their LNG. As demand for LNG (and gas) in many markets is driven not just by competition between different gas suppliers but also by competition with other fuels in local markets (e.g. coal or renewables in power generation) this optionality can have considerable value. Because of its size, liquidity and ease of access, the EU now represents a valuable “back stop” market for LNG suppliers who know they can always sell cargoes here if the price is right. 

When looking at economics from a supplier perspective, one must also take into account the other parts of the gas value chain. Exploration and production of gas (or oil) is a capital-intensive business with relatively low variable costs. Hence, once investment has been made in production facilities, so long as any sale of gas is covering the variable cost of production and contributing to the fixed costs, it makes sense to do it. According to industry estimates, Gazprom has spare production capacity of around 100 bcm on top of existing production. Therefore, so long as Gazprom is covering its variable cost of production and the cost of transportation to market, it makes sense for it to increase transportation capacity to markets. As the EU is Gazprom’s most valuable market, more pipeline capacity to Europe makes economic sense.

The same logic applies to LNG suppliers. Here the fixed costs in the chain are even greater than for pipeline suppliers because as well as the costs of production, there are also the costs of liquefaction, and LNG ships necessary to get the gas to market. However again the economic imperative of selling gas if it covers the variable costs, including the cost of regasification, means that LNG suppliers will sell gas to the EU so long as the market price is higher than these variable costs. This helps explain why some cargoes have come to the EU even though the EU market price does not cover the full (fixed and variable) cost of LNG. 

All of the above also puts European consumers in a very good position to get the best deal. Put simply they can play off different suppliers against one another. This would not be possible if import capacity matched import demand. In such a case, suppliers would know that customers would not be able to source the gas they needed from alternative suppliers because there would be insufficient import capacity. The situation would create the perfect conditions for an oligopoly situation whereby suppliers did not compete with each other and therefore the gas price in Europe would be higher than it should be. To understand how, imagine a situation whereby all suppliers to a market have import capacity that exactly matches their market share. If one of those suppliers puts up his prices he can do this safely in the knowledge that the other suppliers cannot increase their supply to the market and therefore cannot take away his customers without sacrificing their existing customers. If his customers cannot switch to an alternative fuel, they have no choice but to accept the price increase.

Moreover, the “excess” import capacity, particularly of LNG terminals, has created the right conditions to ensure that, even if an individual supplier to the EU is able to gain a large market share, this will not necessarily translate into market power and the ability to raise prices. This is relevant to the EU as some commentators have worried that Gazprom will be able to do this if the EU imports more Russian gas. However the theory of contestable markets holds that if there is a real threat of “hit and run” competition, then incumbent firms will be prevented from putting up prices as to do so would mean they would lose business. Even the threat of such “hit and run” competition should be enough to constrain incumbents. LNG suppliers can provide hit and run competition because there are a growing number of them, and they have the ability easily to switch their ships from one destination market to another, thanks to the plentiful LNG import capacity described above.

A key characteristic of contestable markets is that there should be no entry or exit barriers as these discourage competitors from entering the market. To enter the EU market LNG suppliers need to book regas capacity at an LNG terminal, and then pipeline capacity from the LNG terminal into the EU. For regulated LNG terminals and pipelines the capacity booking rules are the same for incumbents and new entrants, everyone participates on a level playing field. “Use it or Lose it rules” ensure that even if capacity is booked by competitors, those competitors cannot hoard that capacity. If the original booker is not using his capacity, it is made available to the market. The original booker therefore has an incentive to use it himself or to do a deal with a competing LNG supplier who wants to use it. LNG terminals which have received exemptions from full regulation, such as the ones in the UK or the Netherlands, may not have to sell their capacity in the same way as regulated terminals but they still tend to have Use it or Lose it rules.[5] The combination of plentiful regas and pipeline capacity, combined with the Use it or Lose it rules, means that LNG suppliers do not need to book regas and pipeline capacity on a long term basis. 

The combination of plenty of LNG import capacity and the Use it or Lose it Rules thereby ensure that there are low barriers to entry for “hit and run” LNG suppliers. An LNG supplier with a spare cargo can easily supply the EU market when prices are attractive, and withdraw and supply other markets when this is no longer the case. This seems to be borne out by actual market experience with the number of LNG cargoes coming to Europe varying according to prices in Europe compared to elsewhere. 

The EU rules on capacity also help enable one of the other conditions of contestable markets, namely the absence of sunk costs. This is because sunk costs increase barriers to exit and hence make a market unattractive to a hit and run competitor because it risks losing the sunk costs if it has to leave the market. Booking regas capacity and pipeline capacity can be considered a sunk cost, and indeed some market participants have booked long-term capacity so that they have the optionality to supply the EU. However, as noted above, plentiful availability of both regas and pipeline capacity, coupled with Use it or lose it rules, means that LNG suppliers to the EU do not have to make long term bookings and  incur large sunk costs. 

Finally, it is worth noting that what may appear as excess import capacity to European eyes may appear less excessive when looked at in a global context. LNG chains and pipelines are simply means to an end, namely the delivery of gas to a market. They supply a homogenous product. The only difference is that LNG ships can go to different markets whereas pipelines are tied to one geographical market. But they both have an impact on the global supply/demand balance, and hence the price of LNG. If pipeline capacity from Russia, or any other producer, to the EU were restricted, this would mean that, ceteris paribus, the EU would have to buy more LNG to meet its import needs. This would tighten the global supply demand balance of LNG, and again, ceteris paribus, lead to price increases for LNG for all buyers not just European ones. This also demonstrates why “excess” EU import capacity is not only good for Europeans but for all gas consumers in terms of prices.

In conclusion, we can see that competition between gas suppliers from different countries means that EU import capacity in excess of actual EU import demand is not only likely but also inevitable if supplying countries wish to access the attractive EU market to monetise their gas. The high fixed costs of production and liquefaction and shipping mean that there are strong economic incentives for suppliers to transport gas to the EU so long as the market price at least covers their variable costs. The existence of plentiful import capacity enables European buyers to play one supplier off against the other, and it also creates the conditions to prevent a supplier with a large market share from exercising pricing power. Lastly, without such “excess” import capacity, prices paid by European and other LNG buyers would be higher as a result of the EU being forced to buy more LNG instead of pipeline gas. So from an economic view point one can see that why more import capacity is good for both suppliers and consumers.

 [1] European Commission “Quarterly Report on European Gas Markets. Volume 10 Issue 4. Fourth Quarter of 2017.” March 2018 https://ec.europa.eu/energy/sites/ener/files/documents/quarterly_report_on_european_gas_markets_q4_2017_final_20180323.pdf

[2] In this context, Europe includes EU 28 plus Switzerland and Ukraine. Ukraine has been importing all its gas needs from the EU since 2015. See Prognos “Current Status and Perspectives of the European Gas Balance” January 2017. https://www.prognos.com/en/publications/publications/690/show/6cc1f00f48b3cbfb40b3e384c9166b42/

[3] https://ec.europa.eu/energy/sites/ener/files/documents/ref2016_report_final-web.pdf

[4] International Group of LNG Importers (GIIGNL) Annual Report 2018 https://giignl.org/

[5] Where granted, exemptions are tailored to the individual terminals. In order to receive an exemption from full regulation terminals need to show not only that an “exemption must not be detrimental to competition” but also that the project must “enhance competition in gas supply and enhance security of supply.” (Third Gas Directive 2009/73/EC Article 36). Regulators have included Use it or Lose it rules as a means of ensuring this.

(Publication from Alex Barnes Linkedin profile.)