House of Commons - Trade and Industry

Select Committee on Trade and Industry Written Evidence

APPENDIX 52

Memorandum by Professor Jonathan Stern[131]

SECURITY OF SUPPLY CONSEQUENCES OF GROWING UK GAS IMPORT DEPENDENCE

INTRODUCTION

This short paper on the security of supply consequences of growing UK gas import dependence focuses, as requested, on the role of Russian gas and Gazprom. It also touches on other issues such as the development of a "gas-OPEC", and the development of liberalisation and competition in Continental European gas markets.

UK GAS DEPENDENCE, IMPORT DEPENDENCE AND SECURITY

Natural gas is the largest fuel component of the UK energy balance. In 2005, it contributed 43% of primary fuel input, a figure which rises to around 50% if the transportation sector is excluded. [132]In 2005, nearly 38% of electricity was generated by gas, which also provided 36% of industrial and 70% of residential energy demand. [133]Given this very large role of gas, the protection of consumers against security incidents which create substantial price volatility and, in the worst case, cause interruptions of supplies to end users, has become very important.

As UK Continental Shelf (UKCS) gas production declines, the country will become increasingly dependent on imported supplies. There is a consensus that by the early 2010s, the UK could be 50-60% dependent on imported gas supplies and by 2020, as much as 80% dependent. These import projections may be overstated, but even if they prove to be correct, they say little about the impact on future supply security—defined as the likelihood of supply interruptions to customers.

The principal reason why security has diminished in the 2000s, and may diminish further in the future, is not because a lower percentage of gas demand is coming from UKCS fields per se, it is because there is no longer surge capacity in those fields which can be called upon at times of high demand or supply failure. Surge capacity in both fields and transportation capacity was contractually required by the state-owned British Gas Corporation (partly) in order to avoid the need for significant storage capacity. Hence, the UK's gas storage was "offshore" in the fields, rather than (as in Continental European countries) in specially converted structures onshore. In the UK, the only major storage reservoir was created in the depleted offshore Rough field; plus a small amount of onshore salt cavity storage, and liquefied gas storage to meet daily demand peaks.

UK GAS IMPORTS AND SECURITY IN AN INTERNATIONAL CONTEXT

While the UK traditionally saw itself as a "gas island", it is increasingly clear that the country's gas market needs to be viewed in a European—and indeed even broader Atlantic Basin—context. Present knowledge of the European ie Norwegian, UK, Dutch, and other Continental European resource base suggests that total European gas production will not increase significantly after 2010 and is likely to fall; this decline is likely to accelerate by 2015. This will mean an acceleration of imports from non-European sources—pipeline and LNG which may have reached 80% of total European Union gas demand by 2030. [134]Thus over the next quarter century the UK will move from being one of the few gas exporting countries in Europe, to the position of the average EU member state in terms of gas import dependence.

Development of UK import infrastructure is already well advanced. Chart 1 shows the pipelines and LNG facilities which have either been completed or are firmly committed to be completed by 2010. By that date, the UK will have around 100 Bcm/year of import capacity—almost equivalent to annual demand—and additional LNG terminals are being planned which would further increase import capacity.

Chart 1

These projects will deliver gas from diverse sources via a number of different pipelines and LNG terminals. As such, they promise to add to UK security of supply by reducing dependence on a single source of supply or supply route. The majority of early imports will come by pipeline from Norway and continental European sources—including the Netherlands and Russia—and from diverse LNG sources (Egypt, Algeria, Qatar and others).

SECURITY AND IMPORT DEPENDENCE: SOME EMPIRICAL OBSERVATIONS

There is a natural inclination among politicians, citizens and the media, to regard energy supplies which are produced domestically as "secure", and supplies which are imported as "insecure". This dates (at least) as far back as the 1973 Arab oil embargo which was a formative experience for most current politicians and decision-makers in terms of energy security. A worldwide survey of gas security incidents since 1980 carried out by this author, divided incidents into three types: source, transit and facility. [135]During the period 1980-2001, there had been one or two source incidents and some transit incidents relating to Russian gas supplies through Ukraine, but no significant facility incidents. [136]However that situation has changed since 2001 with three serious facility incidents affecting European gas supplies: the liquids contamination of the Interconnector UK pipeline in 2002; the fire at the Algerian Skikda liquefaction plant in 2004; and the fire at the UK's Rough storage facility in 2006. The only other significant European incidents during this period have been the 24 hour interruption of Russian gas supplies to Belarus in February 2004, and the January/February 2006 Ukraine crisis and subsequent shortfalls due to cold weather (see below). As far as the UK is concerned, the risk of facility incidents has become increasingly worrying due to the tightness of the supply/demand balance and the lack of storage capacity. [137]

There is no evidence from Europe or anywhere else in the world that imported gas supplies have been—or are necessarily likely to be—less secure than supplies of domestically produced gas. Indeed history suggests that all serious security incidents—ie where customers have lost gas supplies for a considerable period of time—have stemmed from failure of indigenous supplies or facilities. No empirical experience would lead to the conclusion that a country with substantial dependence on imported gas supplies would be necessarily less secure—ie more vulnerable to supply interruptions—than one which was self-sufficient. Increased security—whether for domestically produced gas or imports—requires increased diversity of: sources, transportation and transit routes, and facilities. These facilities include: pipelines (onshore and offshore), beach terminals, LNG terminals, processing plants and storages. Clearly the higher the percentage of gas in a country's energy demand, the greater is the importance of source, route and facility diversity as protection against security incidents.

THE IMPORTANCE OF RUSSIA GAS AND GAZPROM

Much of the European debate on the supply of external gas has focused on the role of Russia and Gazprom, there has been a great deal of recent excitement in the UK about this subject. Despite the large numbers of commentators who only discovered the issue of Russian gas security on 1 January 2006, it is a subject which has been extensively discussed in Continental Europe over the past 30 years. What has changed in the 2000s, is both the increasingly pan-European scope and the increased volumes of Russian gas supplies. Historically this subject has been of less concern in the UK, partly because of lower levels of import dependence, and partly because imports have been from European sources. But starting in 2001, Gazprom Marketing and Trading began to sell small quantities of gas in the UK. In 2006, press reports about Gazprom's intentions to purchase Centrica—which appeared to have little basis in reality—placed a spotlight on the potential role of Russian gas in the UK.

In 2005, Russia exported more than 154 Bcm gas to 21 European countries. [138]All of this gas was exported by the dominant Russian gas company Gazprom, via its export subsidiary Gazexport. Russia is the largest single supplier of gas to Europe providing around 25% of European gas demand in 2004. However, the dependence on Russian gas is not uniform throughout Europe: many central and east European countries are totally dependent on Russian gas and there is heavy dependence in north west Europe. But the Iberian Peninsula imports no Russian gas; Belgium and the UK have so far imported minimal quantities. In 2005, sales of Russian gas in the UK amounted to around 4 Bcm or 4% of total demand. [139]

The crisis which occurred during 1-4 January 2006 when, following failure to agree a higher price, Gazprom cut gas supplies to Ukraine, with the consequence that Ukrainian consumers diverted substantial quantities of gas in transit through their country to Europe, produced a huge negative reaction from governments and commentators on both sides of the Atlantic. [140]Around the same time, an explosion on the main pipeline carrying Russian gas to Georgia deprived the country of gas for several days. Georgian president Saakashvili immediately interpreted this as a political act on the part of the Russian government attempting to exert pressure on a democratic government seeking greater political independence from Russia. No evidence to support this allegation was produced and a much more likely explanation was a terrorist act by a separatist group in the North Caucasus region.

The two months immediately following these events saw a period of exceptionally cold weather in both Russia and many parts of Europe, Moscow experienced temperatures well below minus 30 degrees Celsius during a 10 day period. [141]This raised gas demand in Russia and much of central/eastern Europe to extremely high levels, placing a huge strain on Russian gas and power networks. During January and February 2006, there were again diversions of Russian gas in transit to European countries through Ukraine. These diversions—mostly not disputed by the Ukrainian government—prevented Gazprom from being able to meet the delivery nominations requested by a number of its European customers. While Gazprom did not fail to deliver contracted volumes, it was unable to deliver as much as customers requested given their very high demand requirements during this period. Buyers in Poland, Hungary, Italy and Austria reported that deliveries were between 10-35% below requested volumes on a substantial number of days in January and February. [142]

The overwhelming conclusion of the public commentary throughout Europe on these episodes has been that, by this action, Russia was attempting to exert political pressure on the Ukrainian government and president in order to reassert its influence on a country attempting to make a decisive move away from Russian political influence towards the European Union and NATO. The lack of any official public European censure of Ukraine for taking gas supplies to which it was clearly not entitled, demonstrated where European politicians believed the blame lay.

Irrespective of the contractual situation (ie the technical issues of entitlements, prices and payments), the January/February 2006 episodes, and ongoing problems and uncertainties in the Russian-Ukrainian relationship, have raised serious doubts in the minds of European politicians as to whether Russian gas can be considered reliable. There have been suggestions that the Russian government was—by this action—"sending a signal" to Europe that it had the power to cut off gas supplies should it choose to do so and that, should European countries act in ways which it did not like, it might choose to do so. This is based on an increasingly popular view of Russian foreign policy which holds that the Putin Administration sees energy trade as an important means—and perhaps the principal means at Russia's disposal—of projecting its political power and influence. [143]In this view, the Ukrainian crisis is seen as a "trial run" for what Europe might suffer in the future, particularly if there should be a significant deterioration of European relations with Russia.

While it is impossible to say for certain that such a view is wrong, some balance is needed to these overwhelmingly negative views. For example, in 2005 more than half of Gazprom's revenues came from exports to Europe which probably accounted for 15-20% of total Russian foreign currency earnings. [144]It would be a major decision for both Gazprom and the Russian state to act in ways which would jeopardise the long term future of that revenue stream. However, European and US reaction to the following passages in Gazprom's press release of 18 April 2006 suggested that the company was contemplating such action. [145]

"...one cannot forget that we are actively developing new markets such as North America and China...

"It is necessary to note that attempts to limit Gazprom's activity in European market and politicize gas supply issues, which are in fact solely economic, will not lead to good results"

This produced a front page banner headline in the Financial Times[146]: "Gazprom in threat to supplies: EU told not to thwart international ambitions; Group says it may divert sales to other markets". This was despite the fact that Gazprom has no current capability to divert European supplies to North America or Asia and—in the most optimistic of all possible scenarios—will not have such capability for a decade. Moreover, this reaction to 18 April press release appeared to ignore other passages which read:

"Alexey Miller noted at the meeting that "Gazprom was and is the main supplier of natural gas to Europe. We understand our responsibility and henceforth will remain the guarantor of energy security for the European consumers. All the contracts signed to supply gas will be implemented. There are no any doubts at all.

"Gazprom is interested in developing mutually beneficial energy cooperation with partners in Europe. A good example is the North-European pipeline project. We sign new contracts to supply gas, for the first time, start working jointly with German companies along the entire chain from production, transmission and up to gas sales to the consumer. This enhances cooperation reliability for all project participants and even broader—for all consumers of the Russian gas in Europe."

The adverse reaction to 18 April press release was followed, in early May, by US Vice President Cheney's speech to a conference of east European leaders in Lithuania when he noted in relation to Russia: [147]

"No legitimate interest is served when oil and gas become tools of intimidation or blackmail, either by supply manipulation or attempts to monopolize transportation."

European and US comments on Russian energy security have been hailed in Moscow as hysterical and hypocritical: hysterical in the sense that Russian comments are being taken out of context and interpreted in a needlessly confrontational light. Hypocritical, in that—as seen from Moscow—Russia is held to standards of gas commerce—in relation to monopoly (specifically the creation of national champions) and liberalisation—which EU countries themselves have failed to meet. The Russia Energy Minister suggested that, 15 years after the end of the Soviet Union, it was time to phase out subsidised energy prices and this is the Russians explanation for the Ukraine crisis (and similar but less acute problems between Russia and other CIS countries). [148]Reduction of energy subsidies has been a consistent recommendation of international financial institutions over the past decade, and are part of the conditions for Russian entry to the World Trade Organisation.

These events are unlikely to prevent the North European Gas Pipeline (NEGP) from north west Russia through the Baltic Sea to northern Germany, from going ahead. The first string of this pipeline, in which the German companies E.ON and Wintershall have agreed to take 49% equity share, is due to be completed in 2010 with the second string to be built soon thereafter, adding a further 55 Bcm to Russian gas export capacity to Europe. This would increase theoretical Russian export capacity to Europe from around 230 Bcm in 2006 to 285 Bcm by the early 2010s. [149]

But there are doubts that that either Gazprom or the Russian government has ambitions to increase exports beyond 220 Bcm/year. The Russian energy strategy sees total exports—including those to CIS and Europe—rising from 194 Bcm in 2000 to 250-265 Bcm in 2010, and 273-281 Bcm in 2020, suggesting very moderate increases in the second decade of the century. [150]There are several reasons for limited Russian export aspirations:

— Limits to Gazprom's production after 2010 due to the need to invest in a new generation of fields on the Yamal Peninsula. Lead times for the development of these fields mean that they cannot now be producing significant volumes of gas prior to 2015.

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A somewhat surprising conclusion therefore is that any reticence from Europe to take substantially more Russian gas, may be matched by a similar Russian reluctance to export significant additional volumes to Europe.

What does this mean for the UK? Gazprom senior management have expressed aspirations to supply 10% of the UK gas market by 2010. To this end, Gazprom has reserved capacity in both the Interconnector (IUK) pipeline and (together with partners) the new BBL pipeline to the Netherlands. [153]Particularly for the UK, a distinction needs to be made between physical deliveries of Russian gas from Siberia, and gas sold by Gazprom Marketing and Trading. The latter could be selling gas from a range of sources in addition to Russian supplies, well illustrated by the delivery of a cargo of LNG to the Isle of Grain terminal in April which Gazprom had purchased from Gaz de France (and probably originated in Algeria). While it is possible that Gazprom Marketing and Trading could be selling more than 10 Bcm of gas in the UK (ie 10% of total market volumes) by 2010, it is unlikely that the majority of these volumes will physically originate in Russia. Should gas prices decline from current levels by 2010—as this author believes they will—Gazprom is likely to be selling smaller volumes because of the relatively high cost to the company of delivering gas to the UK.

The main reason to doubt Russian gas supply security—at least for this author—is the relationship between Russia and Ukraine—both in terms of natural gas and politics—where in May 2006, hopes of an immediate, significant and sustained improvement seemed slim. The March 2006 EU Green Paper on energy security was a great disappointment in relation to the potential contribution which Brussels might make in resolving this problem. Suggestions of a deepening of the existing energy partnership with Russia and arguments that the G8 should intensify efforts to secure Russian ratification of the Energy Charter Treaty and its Transit Protocol seemed unlikely to succeed. [154]Neither did they advance the existing EU-Russia Energy Dialogue in the wake of the failure of European Commission to play any significant role during or after the events of 1-4 January 2006, using the institutions of the EU-Russia Energy Dialogue and the EU-Ukraine Summits. [155]

AN OPEC FOR GAS?

The creation in 2001 of the Gas Exporting Countries Forum (GECF) can be seen either as an event of no importance, or as the start of an "OPEC for gas".[156] During the five years since its creation, the GECF has been a rather chaotic organisation with neither stable membership, well-defined membership rules, mission or objectives. The Venezuelan presidency of the Forum in 2006 is somewhat curious given that the country is not, and has no concrete timetable for becoming, a gas exporter; a fact which lends no credibility to the Forum. The Forum is notable for its relative lack of active pipeline gas exporters: Canada and Netherlands are completely absent and Norway is an observer. Russia has attended all of the meetings but (as far as can be ascertained) has taken very little active part; neither has an organisation of Eurasian (CIS) gas exporters—suggested by the Russian president and prime minister in 2002 to 2003—made any visible progress. Algeria and Libya—which are pipeline as well as LNG exporters—and Iran are among the most active members of the Forum which is therefore more heavily biased towards LNG exporters and, in terms of active members, more heavily biased towards Atlantic rather than Pacific Basin LNG trade.

At present, the most that can be said about the prospects for the GECF metamorphosing into anything akin to a "gas OPEC" is that they are not immediately foreseeable, and that the Forum would need to develop considerably greater institutional capacity and cohesion for this to become a reality. In a longer term (10-20 year) perspective, the possibility of some type of price setting organisation should not be ruled out. The most likely characteristics of such an organisation would be that:

initially at least, it is more likely to:

— be focused on exports of LNG rather than pipeline gas;

— develop with a regional—Europe or the Atlantic Basin—rather than a global focus;

— develop quickly in the context of a crisis for exporters eg prices sinking to very low levels which threaten revenues, rather than the price environment of the post-2004 period.

LIBERALISATION AND COMPETITION IN CONTINENTAL EUROPEAN GAS MARKETS?

The past 15 years have seen a succession of EU initiatives, backed by legislation, to create liberalised and competitive gas (and electricity) markets. These initiatives have, to a significant extent, attempted to replicate the much more rapid and far-reaching developments which have occurred in the UK. Since the start of the EU liberalisation era, the assumption of UK government, regulators and market participants has been that Continental European countries—both individually and as a group—would at some stage "catch up" with the UK in terms of ease of access to pipeline networks and reduction of influence of dominant players. In 2006 that assumption needs to be seriously questioned.

Despite the annual reports by DG TREN—and the DG COMP sector investigation report of 2006—which amply demonstrate the shortcomings of liberalisation and competition Continental European gas markets, it should not be assumed that major changes will take place in the direction of UK-style competition and liberalisation. [157]The reasons for this need to be explained on a country by country basis, but have two fundamental causes:

— many (if not most) Continental European governments have never accepted that creation of efficient markets should be the main policy priority for their utility industries; and

— most Continental European governments believe that "national champion" companies are essential to represent national interests on a European stage.

Despite the fact that DG COMP and DG TREN have criticised these policies, it is uncertain whether they will prevail against the governments of some of the largest states in Europe.

It is therefore important for the UK to consider its position in a future European gas (and electricity) market with limited liberalisation, dominated by national champion companies protected by their governments. In such a market, UK companies should not expect their Continental European counterparts to provide the degree of access or market opportunities which are available in the UK. The consequence for UK gas security are that—as demonstrated during winter 2005 to 2006—government, regulators and market players should not assume that short term price signals to bring forth gas in winter as and when the UK may need it. UK market players will need to sign longer term agreements for both gas and transportation (and possibly also storage) capacity to be sure of obtaining gas during winter periods.

CONCLUSIONS

The general consensus that growing UK dependence on gas imports will necessarily increase the risk of security of supply incidents is not supported by worldwide or European experience. Gas security emergencies are just as likely, and arguably more likely, to arise from domestic facility failure—such as in the UK when the Rough storage reservoir was closed by a fire in February 2006—which was far more serious than the January 2006 Russia-Ukraine crisis despite the fact that the latter attracted far more press attention.

There is no reason for any immediate panic about security implications of growing UK or European gas import dependence. Some of the European and US reaction to the 2006 Ukraine crisis in relation to the security of gas imports from Russia, and the potential role of Gazprom in European gas markets, has been out of all proportion to actual events and statements. During the next 20-30 years there may be a potential constraint on UK and European gas supplies arising from a combination of indigenous production decline, and the political conditions within key gas exporting countries—and between those countries and Europe—could prevent the latter from accessing gas reserves which are known to exist and could be profitably delivered to European countries including the UK. The combination of these factors may present a challenge which the European gas market has not previously faced.

There are two policy implications for the UK which flow from these conclusions: one international and one domestic. The international policy implication is that government should keep a careful watch on how gas demand trends, supply potential, liberalisation and competition, unfold over the next decade in and around Europe. There is much uncertainty on all sides of the European natural gas balance. Any suggestion that supplies are likely to remain tight for a considerable period after 2015 because of geopolitical uncertainties, would have important implications for availability of gas for Europe—and the UK within Europe.

The domestic policy implication is that: so important has gas become to the UK energy balance, and therefore to the UK economy, that the consequences of a major supply failure—domestic or international—could be dire. Because of this, and mindful of the narrow escape which the country has had during the winter of 2005-06 due to the closure of Rough storage: [158]

— significant additional commercial storage needs to be built in the UK, probably in excess of what market participants are currently planning. A likely surplus of supply over demand during the period 2007-12 will provide a breathing space, in relation to storage needs, to allow new facilities to be built. Any new gas fired power plants should be required to create stocks of distillate fuel on their sites and to switch from gas to distillate when requested.

— In addition to this commercial storage, strategic storage is needed in order to cater for catastrophic supply or infrastructure failures which may have a devastating effect on regions of the country or the nation as a whole.

In order to ensure that commercial and strategic storage are built in a timely fashion ie by the early 2010s, government will need to ensure that market and regulatory frameworks are adjusted appropriately, and that local planning objections are not allowed to delay the construction of storage facilities.

May 2006