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Natural Gas Notebook - Industry Organization

At its inception, the vertically integrated company (VIC) was the prominent form of organizational structure in the natural gas industry. In this kind of organization, a single operator controls the entire utility value chain, from exploration and production to transmission and distribution to end-users. The main drive for the emergence of VIC’s must be sought in the low energy density (kWh/m3) of natural gas relative to liquid fuels. In fact the energy content of natural gas is almost 1000 times less than that of crudes.

The result is that the investment in gas transportation, being capital intensive, required both the reduction of business uncertainties at the interfaces along the supply chain and the cost reduction through economy of scale.

The large scale gives to transport and distribution systems the characteristic of natural monopoly since a single operator can supply energy at lower cost relative to the sum of costs borne by a number of small companies each one contributing only partially to the overall offer.

Owing the gas grid, the VIC’s were in the position to exclude competing suppliers from the use of the transmission infrastructure, and preventing any competition they could rely on the broad customer base needed to raise the certain cash flows required to remunerate the large invested capital and to cover the debt service.

Because of their natural monopoly character, the gas transmission and distribution system have been regulated either as public utility or as government monopoly. Political systems generally promoted the formation of large vertical integrated companies to pursuit the following public utility objectives:

i. Reasonable prices for energy

ii.   Consumers access to the utility also in less profitable areas (in exchange of incentives and subsidies)

iii.   Long term strategic investments in the public interest.

In the 70’s, the steep raise of energy prices, due to the oil crisis (triggered by the Yom Kippur War and Iranian Revolution) set in motion a significant demand of  natural gas. The gas prices control at wellhead set forth by regulatory authorities brought about supply shortages resulting in soaring utility bills. An increasing number of industrialized countries, most notably those owing abundant resources, launched liberalization policies to implement market mechanisms to promote competition, costs reduction and increasing efficiency. The liberalization process entailed the progressive dismantling of the vertically integrated companies.

Dislodging the wellhead price control was the very first phase of the liberalization process followed by the opening of markets to allow competing operators for the access (third party access, TPA) to gas transmission infrastructures so to spark the competition mechanism. The key element to achieve said objective is the so called unbundling that means separation of the transport infrastructures ownership from their operation.

By and large, the unbundling can be achieved according to three different separation models.

1.       Ownership unbundling.

The distribution systems are being sold to an independent operator upon which the seller have no stewardship control. The major drawback of this model is the weakening of domestic companies relative to large international supplier which are often state-owned, monopolistic companies. In these cases, the energy security of the importer countries becomes vulnerable. 

2 – Independent System Operator (ISO)

The infrastructure property remains in the hands of the former integrated companies, but its operation is entrusted to an independent legal entity subject to stick monitoring by a regulatory body. The lack of integration of regional networks is reportedly the result of infrastructure ownership retaining by the former monopolists. 

3 – Independent Transmission Operator (ITO).

In this unbundling model, the energy company owns both the infrastructure and the operating company. However, jurisdictions mandate that this latter be totally self-contained and subjected to stringent regulations to prevent any possible bias for the hand-off parent company.

The second stage of liberalization is about the establishment of an independent, impartial and transparent energy authority committed to regulatory function and supervision to ensure effective opening of markets and protection of consumers.

With the opening of markets, the former monopolists had no more interest in investing in new infrastructure. Thus, to spur investments in strategic infrastructures of public interest, regulations embed TPA temporary exemption provisions relieving the obligation of granting access to third parties. The exemption was also allowed for old projects until the transportation capacity is committed to long-term contracts signed in the past.

The implementation of a commodity-type market is conditional on abundant gas reserves endowment and on sufficient number of suppliers willing to compete in the gas market. This was the case of US, Canada and UK which have a high share of domestic supply made of small, medium gas fields and substantial absence of swing producers.

On the contrary, import-dependent countries are contract-markets as they have to secure their energy supply through international transmission pipelines or LNG. Investments in trunk lines or LNG are capital-intensive and have long lead times between project initiation and completion with significant front end loads.

Commonly, these investments are debt-financed, and the lenders call for long-term contracts fitted with risk sharing mechanism according to which the buyer typically takes the volumes (marketing) risk and the seller takes the price risk.

In these contracts the gas price is often pegged to liquid fuels (basket of crudes, distillates, and others) according to the replacement value principle. In Japan for example, natural gas replaces oils in the power generation sector, thus the price Japan pays for LNG is indexed to oil price.

Under these conditions, liberalization in some importer countries involves the unbundling of its onshore transportation system from gas marketing, establishing third-party access on both pipelines and LNG terminals, and permitting customers to choose their own suppliers. The resultant gas industry can be defined as “contract gas-to-gas competition market” instead of “commodity gas-to-gas competition”.

Energy rent is an important budget item for most of exporter countries. Their gas industries are generally committed to large state-monopoly companies toward which the independent (often small sized) operators of liberalized importer countries may have little bargaining power. It is thus disputable whether the market opening in net-importer countries is the best arrangement for the gas industry organization.

In conclusion, the gas industry structure differs by regions according to their resources endowment and their preferences of economic models (market mechanism versus natural monopoly). US, Canada and UK, being reliant on their own resources and having a relatively large number of competing players, opted for a commodity market organization. By contrast, Continental Europe, Japan and Korea, being reliant on importation, are basically “long-term contract industry”.N

Lorenzo Micucci's picture

Thank Lorenzo for the Post!

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Matt Chester's picture
Matt Chester on Aug 6, 2019 6:45 pm GMT

Very thorough and interesting, thanks Lorenzo.

the gas industry structure differs by regions according to their resources endowment and their preferences of economic models

How do you see this fact affecting things when a country goes from mainly importing to mainly exporting-- for example, has the shift in U.S. LNG markets to being a big export brough with it unique hurdles that are against the typical U.S. gas industry set up?

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