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The internationalization of gas markets

2013-10-07

Economists have to revisit their theory to explain recent changes in gas markets

Aad Correljé (Photo: EDGaR/Paul Zijlstra) Aad Correljé (Photo: EDGaR/Paul Zijlstra)

Patterns of gas supply and demand are internationalizing, according to some economists. The European Union (EU) has become dependent on foreign sources of supply by the deployment of the gas infrastructure. New cross-country pipelines, such as the North Stream and South Stream, have entered into operation, adding to the existing pipelines from Russia, Norway and Algeria. Sea going vessels arrives to European terminals with liquefied natural gas (LNG) from Qatar, Algeria and Nigeria. No economic theory provides a satisfactory explanation of these international activities, according to Aad Correljé, an associate professor of economics at Delft University of Technology.

Mr Correljé and his team of the research project “Upstream – downstream: securing gas supply and demand and the governance of the gas value chain” are developing a novel analytical framework. It encompasses gas-related activities from upstream to downstream. That is, the set of activities that connect exploration, extraction and transport of gas on one side with the processing, distribution and use of gas on the other side. More precisely, the project stresses the notions of geopolitical threats and the security of gas supply and demand. “These notions are among the main kind of changes that have been taken place in the gas sector starting mid-2000s,” Mr Correljé said in an interview.

Upstream and downstream disconnected

The internationalization of gas markets has contributed to disconnecting upstream and downstream gas. On the upstream side, Mr Correljé said, “Hydrocarbon producing and transit countries are prone to resource curse, the obsolescing bargain and other strategic behaviors. At the same time, they look for security of demand. What approaches secure gas supply and the use of the infrastructure?” The problem looks different from the downstream side. “The European Union becomes increasingly dependent on external sources of gas supply. What are the modes of governance and regulations that can secure gas supply, investments and the use of the infrastructure?” asked Mr Correljé.

The problem of having disjointed upstream and downstream gas regimes hinders the efforts of the European Union to introduce competition on the internal market. The Conference of European Energy Regulators has come up in 2011 with a Gas Target Model for a competitive, internal market to ensure the lowest cost of gas to consumers. It assumes that gas enters the Union through entry-exit points located across the borders. European energy companies compete with each other, with regional zones of higher concentration of wholesale activities.

This model is far from working. “A new system of market coordination between consumers and suppliers through the infrastructure has not yet crystallized,” explained Mr Correljé. “Inside of the European Union, principles of coordination are generally set by national laws of the member states or European directives,” continued Mr Correljé. “Yet, when companies transmit gas across jurisdictions of Russia, Turkey, Norway and some other more, Europe loses its jurisdiction where these countries establish their rules.” In other words, what falls off the borders also falls out of state power and poses security risks.

Part of Correljé’s problem consist of finding arrangements that can coordinate the gas supply chain, from upstream to downstream, by taking into account gas technology, markets and institutions. On the technical side, this pertains to activities such as capacity of transmission via pipelines and shipping, access to entry points, interconnections with pipelines networks and the positioning of reservoirs for storage. On the market and institutional sides, that concerns the pricing of gas, investments in infrastructures and the overall functioning of international markets.

Institutional economic theory

How to interpret the impact of technological and institutional arrangements on the economic outcomes of the gas market? Several economic theories are competing for a solution to this problem. “One of the main issues with classic economic models is that they are able to look forward. However, most of them are based on the continuation of past trends. They assume a stable institutional framework, a stable functioning of the gas market and, to some extent, stable technologies,” explained Mr Correljé. “Yet, everything is on the move these days.”

Other economists analyses energy markets with the structure-conduct-performance theory. It assumes that several suppliers compete to deserve several consumers. “This competition is supposed to bring down the prices of the most expensive suppliers on the market. That will provide society with the most efficient supply of natural gas. Therefore, the policy focus is about bringing competition on the gas market, which, in turn, will bring more performance.”

“This theory has its merits if you assume that the supply side can easily adjust to its demand patterns,” continued Mr Correljé. “The problem with the gas industry is that it requires massive investments over the long term and that investors need a high degree of certainty on their investments over that period. This certainty can be provided through long-term contracts and by vertical integrations of the companies and other means of coordination.”

For Mr Correljé, the school of transaction costs economics offers a better starting point for the analysis. Economists such as Roland Coase and Oliver Williamson have demonstrated that there is a broad spectrum of institutional arrangements that govern economic activities, from firm integration, to regulation via contracting. This theory assumes that the government is there to set the formal institutional framework, by enforcing property rights, for example, in which the economic game takes place.

Following Pablo Spiller’s work, Mr Correljé thinks that a significant theoretical contribution can be made by seeing the state beyond this traditional role of national rule setter. “Governments are able to change the rules, the laws, and that makes them different trading partners than private firms on international gas markets,” said Mr Correljé. “Obviously, this is the case with upstream as well as downstream governments.”

By Jean-François Auger