Energy and Climate Change CommitteeWritten evidence submitted by Policy Exchange (ISG 11)

Introduction

1. Policy Exchange is one of the UK’s leading think tanks. We are an educational charity whose mission is to develop and promote new policy ideas that will deliver better public services, a stronger society and a more dynamic economy.

2. Earlier this year we published a research paper on what the development of shale gas might mean for the UK’s energy and carbon policy, Gas Works? Shale Gas and its policy implications.1

3. That report concluded that shale gas, and gas more generally, has the potential to serve as a transitional fuel while remaining consistent with required emissions reductions. However, commentators who argue with great certainty that shale gas is the answer to future energy needs fail to recognise uncertainty about the future and neglect the importance of developing zero carbon technologies to meet long term emissions reduction goals. But gas sector developments do present the prospect of gas becoming a cheaper than previously expected transition fuel to a low carbon future.

Specific Questions

What are the estimates for the amount of shale gas in place in the UK, Europe, and the rest of the world, and what proportion is recoverable?

4. Other organisations are better placed to answer this, although it is probably worth noting that, given the pace with which new information is uncovered, any estimate submitted to this review is liable to be out of date by the time it is published.

Why are the estimates for shale gas so changeable?

5. Estimates for shale gas resources and reserves are so changeable because the business is still at a very early stage. Comprehensive assessments of gas in place have been conducted in very few fields outside the United States. Shale businesses outside the US are predominantly focused on exploration, rather than production. The costs of production that factor in to producible reserve estimates are also evolving as technology improves. This changeability is unlikely to subside in the near term, as exploration and innovation processes continue.

What are the prospects for offshore shale gas in the UK Continental Shelf?

6. Offshore shale gas production remains a tougher technical and economic prospect than onshore shale production. At a time when we have yet to see any onshore production occur in the UK, or offshore production occur anywhere in the world, it seems premature to be speculating about this option. Government should prioritise making the necessary regulatory decisions around onshore shale gas production, and about the wider role of gas in the UK energy sector.

Should the UK consider setting up a wealth fund with the tax revenue from shale gas?

7. Policy Exchange has no view on this.

What have been the effects of shale gas on the LNG industry?

8. The major initial impact of shale gas on the LNG industry has been the effective cessation of LNG imports into the United States. This has freed LNG cargoes to go elsewhere in the world. However, this is at a very early stage in shale gas development, when the United States remains the only significant producer of gas from shale.

9. If other countries also develop shale gas production industries, the effects on LNG demand (and, potentially, supply) may become much more complex and far-reaching. US firms are developing plans for LNG export facilities (mostly oriented towards Asia from the Pacific coast). New exporters could emerge. Countries which are presently major importers (most notably, China) could see their reliance on LNG reduced by the development of large-scale domestic shale gas production.

10. At this stage of development, most predictions about the impact of shale on LNG markets are speculative and inherently uncertain. The scale of potential for production outside the US is poorly understood. From a UK policy perspective, it is worth being prepared for and adaptable to a range of possibilities, as competing trends in gas supply and demand around the world interact, leaving the price that UK firms will need to pay to secure LNG cargoes unpredictable. Cheaper LNG is a possibility we should be in position to take advantage of should it materialise, but is not a certainty to rely on.

Could shale gas lead to the emergence of a single, global gas market?

11. Alongside other developments in the gas business, shale gas could contribute to deeper integration of gas markets by increasing the volume of gas able to be produced, and the number of potential producers.

12. Historically, long-term gas contract prices have been indexed to spot oil prices, both in Europe and North America. This pattern reflected a number of characteristics of the gas business—markets were illiberal and frequently monopolised, transport connections were (and still mostly are) fixed long-distance pipelines, and sources of supply could not be easily switched. Overlapping uses meant that oil and gas were often substitutes. However, developments in more recent years have loosened the oil and gas price link, particularly in the US. Evidence suggests that a similar shift may be starting to take hold in Europe.2

13. A number of factors have contributed to the growing divergence between oil and gas prices in the US. Large quantities of unconventional gas reaching the American market have eased supply concerns. Weak economic growth, and high gas volumes in storage kept prices down. The North American gas market is also more insulated from global trends than the oil market—higher (LNG) gas transport costs relative to oil shipping have prevented surging East Asian demand from pulling gas prices up in the way that has occurred with oil prices. Since December 2008, US gas prices dropped by 25% while oil prices, which have spent almost all that time above $75/barrel, had risen by up to 175% at their peak. The uses for oil and gas have also shifted, with oil seldom used for power generation, and of decreasing appeal in industrial applications due to its cost. Whereas oil has become predominantly a transport fuel, gas increasingly occupies a role in electricity generation, alongside heating and industrial applications.

14. Europe differs from the US in important ways. It is not self-sufficient in gas in the way the US is, and so the high costs of LNG transport remain a factor. However access to LNG is reducing market power, in particular that of Gazprom, meaning that competitive pressure exists on the supply side. Long-term contracts with pipeline and LNG suppliers are still predominantly oil linked. Spot pricing of gas in European countries remains a small part of the total market—in 2008 10% of OECD Europe’s gas was spot traded—but is steadily increasing, with the UK’s spot market being Europe’s largest and most liquid. A recent IMF Working Paper hypothesised that “the decoupling of gas prices from oil prices witnessed in the US could take place in Europe as a changing buyer base puts pressure on suppliers to sell at prices reflecting total gas supply, new gas deregulation laws, environmental concerns, and cost of other energy sources rather than the evolution of spot oil.”

15. In the UK, the gap between oil and gas prices is widening. The rate of any continued move away from oil-linked pricing of gas is a key source of uncertainty about the future gas market. Changing patterns of import dependency are relevant to this, as production from old fields declines and ends, while new sources become available elsewhere. For the UK, this has involved reduced reliance on North Sea production, and an increasing proportion of gas being imported, with new pipelines from Norway and the Netherlands and, increasingly, LNG terminals making up the difference. What proportion of those future import prices will be subject to oil-linked pricing and what proportion will be more market-driven is impossible to predict.

16. It would be going too far to state with certainty that these trends will inevitably lead to lower gas prices. But it can no longer be taken for granted that gas and oil prices will remain entwined.

What are the effects on investment in lower-carbon energy technologies?

17. Successful development of shale gas at a large scale will inevitably have consequences for other energy technologies. The objective of UK and EU policy should be ensuring that any utilisation of shale gas occurs within the constraints of carbon reduction targets. Properly done, this will ensure that shale gas drives out coal and less cost-effective methods of decarbonisation. The main mechanism for accomplishing this is the EU Emissions Trading Scheme (ETS). By capping Europe-wide greenhouse gas emissions, it effectively also caps the extent that gas (including shale gas) can be burned in Europe. It also provides a mechanism to ensure that gas is a transition fuel, giving the incentive for its removal from the energy system in later years as the cap tightens.

18. Cheaper-than-expected gas would enable lower-cost short term emissions reductions. The relative savings in energy costs from utilising gas generation—consistent with meeting a long-term EU carbon cap—could effectively provide a large pot of resources which society could then choose how to deploy. It could be invested in effective low carbon innovation support—research, development and demonstration, and early stage deployment of a range of low carbon technologies with global potential. The global climate impact of such an approach could be far greater than focusing our resources disproportionately on domestically deploying expensive offshore wind (which is just one technology which might, but probably will not, become a major global contributor to carbon reduction). Europe-wide, carbon emissions from electricity, capped under the EU ETS, would be the same under either approach.

19. Implied in that would be some scaling back of immediate deployment ambitions for other low-carbon technologies (most likely offshore wind, as the most costly technology planned for large-scale deployment).3

20. More important than the outcome in terms of which technologies account for which proportion of the UK energy system, is the process by which that outcome is reached. The possibility of large shale gas resources adds weight to questions about the UK’s approach to energy policy—particularly its proposed Electricity Market Reform. This is not because shale gas will certainly be a game-changer, but because it could be.

21. The Government’s proposal for Electricity Market Reform (EMR), based on signing long-term fixed price contracts (Contracts for Difference) with its preferred mix of generators, is unsuited to a world of uncertainty. It is predicated on an assumption of relatively high future gas prices. It risks imposing large expense on UK energy bill-payers if that assumption proves wrong.

22. Electricity Market Reform (EMR) should be recast in a way that enables the market to deliver electricity market decarbonisation (under the EU ETS cap) in the most cost-effective ways, including through using gas as a greater or lesser transition fuel, depending on whether future gas prices follow a higher or lower cost-path than EMR assumes.

23. Energy policy needs to reflect uncertainty about the future. The long-term centrally planned approach of the Government’s proposed EMR is much less able to handle uncertainty than market-based approaches.

What is the potential impact on climate change objectives of greater use of shale gas?

24. There has been debate in the scientific community about the climate change impact that harnessing unconventional gas resources will have. There are two parts to this debate. The first is whether the process of extraction of unconventional gas results in more greenhouse gases (GHGs) being emitted in comparison to conventional gas, with leakage of methane (ie “fugitive emissions”) being a prominent concern. The second is the impact a move to a more gas-oriented energy system, enabled by a boom in shale gas production, would have on carbon emissions as the gas is consumed.

25. At the combustion stage, there is no difference between the greenhouse gas emissions of conventional and unconventional gas. So far, the best information suggests the additional greenhouse gas impact from shale gas compared with conventional gas is modest, less than 3% higher where gas is flared during well completion, up to 13% higher when that gas is vented. Shale gas therefore results in much lower emissions than coal. Industry and regulators should take steps to improve the quality of information on fugitive emissions from drilling sites to help ensure methane losses are minimised. Relevant UK agencies should collect data on emissions at production sites, either directly or by establishing a requirement on producers to do so. Best practice from around the world should be shared. Companies must also be forthcoming with relevant data. This process should be undertaken in coordination with similar efforts occurring overseas (especially in the US). However, the role of fugitive emissions is relatively minor in the context of the overall climate burden of gas use.4

26. Is it possible to make use of shale gas while still pursuing a decarbonising pathway? To the extent that gas displaces coal in the global energy mix, it could constrain greenhouse gas emissions. For example, switching China’s use of coal to gas would on its own reduce emissions by more than five times the UK’s entire emissions. However, gas could also displace deployment of zero carbon technologies. Gas as a transition fuel is only useful if it means that the coal is never burned, rather than just burned later.

27. To take full advantage of the potential benefits from any low gas price future, and to ensure that the development of gas is consistent with carbon emissions reduction targets, it is even more important that long-term climate policy is enhanced.

28. In the European context, the EU Emissions Trading Scheme (ETS) is supposed to provide the main building block of abatement policy. (Although on top of this have been layered a large number of other policies, including technology specific scale-deployment policies, which are less cost-effective and severely limit the ETS pricing signal.) The immediate focus for the UK and other member states should be on creating a more long term, more certain carbon cap, under the Emissions Trading Scheme. Providing a credible carbon cap is in place far enough ahead, gas generation will be able to play whatever role turns out to be consistent both with its future costs and with required long-term emissions reductions. Investors would be able to take a commercial view about whether to invest in gas generation, with the prospect that the plant could in due course need to fit Carbon Capture and Storage, run as back-up or retire early.

29. The Emissions Trading Scheme already provides the legal mechanisms to enforce its carbon cap, but to date caps have been set over relatively short timescales, inconsistent with long investment horizons. The current cap runs out in 2020. There should always be complete clarity on the ETS carbon cap at least 15-years in advance to reflect investment payback periods.

30. Given that the EU continues to back the ETS, the EU should begin work immediately on establishing the Phase IV cap, with the intent to establish a certain cap through to at least 2035, at a level in accordance with scientific understanding about required emissions reductions. (Renewable subsidies guaranteed over 20 or 25 year periods are common around Europe, so governments are evidently comfortable at least with the principle of that length of commitment.) Committing to a longer term Emissions Trading System is a far stronger commitment to reduce emissions than simply setting a carbon target.

31. Recent discussions of the ETS have focused heavily on reducing the number of permits in the near term, with the possible objective of aiming to cut emissions by 30% by 2020 compared with 1990 (rather than the 20% implied by the current trajectory). Increasing the durability of the ETS, however, is at least as important as the shorter-term cap. Establishing a longer term, more certain cap, as well as effective banking and borrowing mechanisms, should also have the effect of bringing permit prices up today—one of the objectives of those arguing for a tighter 2020 cap.

32. If after Phase IV negotiations, it becomes clear that the political or market design challenges to the ETS have not been overcome, and if the ETS, in the wider policy context, remains inadequate to the task of providing a long-term, credible carbon pricing framework, then the arguments for shifting to a carbon tax are likely to become stronger. Either way, the key is to have a credible long term pricing framework.5

September 2012