FRAMEWORK DESIGN FOR SPOT GAS TRADING IN IBERIAN MARKET

Transcription

1 UNIVERSIDAD PONTIFICIA COMILLAS FACULTY OF ENGINEERING (ICAI) OFFICIAL MASTER IN ELECTRICTY SECTOR MASTER THESIS FRAMEWORK DESIGN FOR SPOT GAS TRADING IN IBERIAN MARKET RAVI PRATAP SINGH MADRID 23 October 20,

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3 Frame work design for spot gas trading in Iberian Market by Ravi Pratap Singh A thesis submitted to OMEL as a partial fulfillment for the degree requirement of MASTER OF SCINECE Thesis Supervisors; Tutor- Director - Juan Bogas Julián Barquin Comillas Pontifical University Madrid, Spain

4 Table of Content Chapter 1- Introduction ) Liberalization of Natural Gas market ) Liberalization process of gas sector initiated by European Union ) Increase in demand for natural gas ) Import dependency of Natural gas supplied from outside the European Union...10 Chapter 2 -Past to present methodology for gas trading ) Old Model for gas trading ) Transition towards new model ) New model of Gas Trading- National balancing points or Hubs...14 Balancing ) Modes of Gas Trading at Hubs or National balancing point ) Advantages of promoting Hubs development ) Examples of new model in liberalization process...19 Chapter 3 Overview of existing competitive gas market ) Netherlands ) Market Restructuring ) Market Functioning ) Present and future status of Trading at TTF ) Status of TTF in terms of Liquidity, Market Power, Transparency ) Measures to increase liquidity at TTF ) United Kingdom ) Market Restructuring ) Market Functioning ) Present and Future Status of Trading at NBP Present status ) United States of America ) Market Structuring ) Market Functioning ) Gas Trading in United States...39 Chapter 4- Spanish Gas Market ) Overview of the Spanish gas market ) Market Structure ) Recommendation ) Market Functioning ) Recommendation ) Present Status of gas trading ) Shortcoming of Spanish gas market...46 Chapter 5- Conclusion...48 Appendix...50 Bibliography

5 List of Abbreviations CCGT Combined cycle gas turbine TPA OTC CNE LNG OMEL GDP ENAGAS EU bcm UK TSO TTF NBP GTS APX BGC BG SAP SMP OCM LDC NYMEX NGX NG Third Party Access Over the Counter National Energy Commission, Spain Liquefied Natural Gas Electricity Market Operator, Spain Gross Domestic Product Gas Transporter, Spain European Union British cubic meter United Kingdom Transmission System operator Virtual balancing point, Netherlands National Balancing Point, UK Gasunie Transmission system operator, Netherlands Amsterdam Power Exchange British Gas Corporation British Gas System Average Price System Marginal Price On the day Commodity Market Local Distribution Company Spot market at Henry Hub Spot market at NIT HUB Natural Gas 5

6 Acknowledgements Erasmus Munds Master course has been a continuous learning experience throughout. I would like to extend my thanks to all those, who had been a part of my journey through out this master course and have supported extensively during ups and down. I would specially like to thank from bottom of my heart to Juan Bogas, Director OMEL for providing me an opportunity to do my thesis in OMEL and would always remember and cherish the love and affection which I got from him and his colleagues at OMEL. I would also like to thank Julian Barquin, Professor Universidad Pontifical Comillas for guiding me at what ever moment, I need his guidance. Without his supervision, it would have never been possible to finish the work. I would also like to thank Prof. Tomas Gomez, for providing me flexibility, motivation and extensive support to come out of the unexpected situation that I faced during my thesis. This work would have been never possible to do, without the support of Prof. Javier Garcia Gonzalez, who not only helped me to come out of the unexpected situation that I faced but also facilitated all possible help to finish my work. I would also like convey my love and affection to all my colloquies (especially Hirshikesh, Rahul, Ritesh) and my family without whom this life would not have been as wonderful as it is today. 6

7 Abstract In Europe gas demand is increasing due to increase use of gas; for power production by combined cycle gas turbine (CCGT) and to comply with Kyoto protocol in terms of CO 2 emission. At same time there is decrease in the indigenous gas production in most of the European countries forcing them to mostly rely on import. In today s scenario Europe has import capacity 50% more than its yearly consumption which facilitates to have security of supply and respond to any variation in gas demand. This security of supply and flexibility to respond is based on gas import, therefore there is a need of a robust market mechanism which can bring transparency, efficiency and increase liquidity in the gas market. Various instruments like storage, balancing, flexibility which are essential for efficient gas market should be monetized to give incentive to the players providing it, by bringing it to a market center or Hubs, where users and suppliers can bid for it. Initially most countries in Europe were based on long term contract for gas trading with some short of flexibility in it like take or pay. It helped to attract investment in infrastructure (pipeline network) by providing minimum risk to the investors. Most of these businesses were developed as monopoly, diminishing the benefit that should be passed to end users. In mid 1990 the process of liberalization started in gas sector to bring competition. Several regulatory changes like third party access (TPA) to network were allowed,which helped in reducing monopoly in the market by allowing large consumers (qualified consumers) to buy gas directly from producers, limiting the possibility of overcharging. To further extend competition several countries did a major restructuring; separating network activity as a regulated service and bringing commercial activity (trading of gas) through competition. Countries like, United States of America, United Kingdom has fully competitive market for gas trading today. Netherlands and Belgium are also in the league of becoming fully competitive market. In these markets gas trading is done at Hubs, which are considered as one shop for all products. Trading is mostly done through OTC market, bilateral market or through exchange (spot or future). OTC market and bilateral market are very confidential way of gas trading as they don t reveal the market price and volume of gas traded. It is believed that, if there is transparency in the market, it will increase trading of gas by bringing liquidity and providing ease for shippers (market players) to balance their portfolio and avoid penalties they face due to imbalance caused in the system. In developed market like United Kingdom and United States of America major part of trading is done on spot market which has short duration and standardized product. This facilitates shippers to be balanced and avoid high imbalance penalties. Beyond gas trading, Spot markets also allow trading of storage capacity, pipeline capacity in order to reduce contractual congestion. In some market future trading is also done, were payment is made on the day of gas transaction and volume of gas delivered later. Price of these future markets is used for indexing gas contract in some markets. Spanish gas market was completely liberalized in 2003 but still it is divided into regulated and non regulated markets. To facilitate whole sale gas trading several restructuring was done by regulatory commission (CNE) and OTC trading is facilitated by Enagas (system Operator and Transporter). Spanish market which completely rely on import; 68% by LNG and rest by pipeline need a better market mechanism for gas trading to bring transparency. LNG shippers which sell gas in Spanish market run through credit risk and there is lack of market signals for investment. The trading through exchange spot market can bring transparency and increase liquidity in the market. I have tried to analyze the restructuring and market functioning in developed market and comparing it with Spanish current state of market. Based on this analysis I have drawn conclusion for efficient gas trading in Spanish market. In my introductory chapter, I have talked about the challenges ahead in the process of liberalization in gas sector. In second chapter; past to present 7

8 methodology of gas trading, I have talked about the different model that evolved for gas trading till now and have described in brief several factors like balancing, storage, Hub and their advantages. In third chapter; Competitive model for gas trading, I have analyzed the evolution and present status of market in Netherlands, United Kingdom and United States of America. In fourth chapter, I have studies about the Spanish market then I have drawn conclusion based on this study in fifth chapter. 8

9 Chapter 1- Introduction Liberalization of European Energy sector started date back to early 1990, and till now it draws attention, perhaps even more than before. The reason behind this; the products they provide are essential for the efficient functioning of entire society and therefore the economic and social impact of serving disruption is great, although energy industries account for only small part of our Gross Domestic Product (GDP). Secondly the energy markets are based on physical energy infrastructure, which has peculiar characteristics making it different from other market. 1.1) Liberalization of Natural Gas market Natural Gas which is an integral part of the energy sector is under going a transition phase, in continuation with liberalization process. It has three main challenges ahead for the next decade to be resolved, which are identified as follow; 1) Liberalization process of gas sector initiated by European Union. 2) Increase in demand for natural gas 3) Import dependency of Natural gas supplied from outside the European Union ) Liberalization process of gas sector initiated by European Union European Union has pushed progressive liberalization of natural gas sector, to increase competition for welfare of end users and prevent misuse of market power. Some measures which has been initiated and implemented are: Ownership unbundling, Third party access to gas transport, end of the destination clauses, bring price transparency, promote spot trading for short term balancing etc. However, the liberalization process has progressed very slowly in natural gas sector. Most of the European countries is still characterized by national monopolies of wholesale trading like Gaz de France in France, ENI in Italy, ENAGAS in Spain or by very limited number of active companies like EON, Ruhr gas, RWE, winter-shall, BEB in Germany,which leaves considerable space for strategic behavior of these companies ) Increase in demand for natural gas European demand of natural gas is steadily increasing. Natural gas share in total primary energy demand in EU-25, is expected to increase from 23% at presents to a projected 32% in 2020, which goes along with an increase of the absolute level of gas consumption from approximately 430 billion cubic meters (bcm) per year today to a projected 790 bcm/year in The reasons behind this increase are; 1) Increase in power consumption due to economic growth and residential utilization. 2) Increase use of natural gas as for power generation ap1. It is expected that natural gas Share in power generation will rise from 15% in 2002 to over 35% in ) Natural gas is less CO 2 emission intensive than coal or oil ap2. 4) Natural gas is cost competitive with respect to renewable energy ap4. 5) Decline of natural gas resource in Europe With increase gas demand and decrease in gas production for EU, there has been demand supply constraint and more import dependency to meet EU gas need. This has lead to increase in gas price over the last few years. This price of gas is correlated with the price of electricity because gas is major fuel for power production through CCGT. In countries like Netherlands, U.K, where CCGT 9

10 are marginal units for power production, price of electricity is high in comparison to other countries which rely on other sources of power production like hydro. These countries therefore demand a robust and efficient market mechanism for gas trading so that overcharging is not possible by market player and gas can be available at lowest possible cost. Figure 1.1, Electricity Price on rise all over Europe Source: Sector Inquiry (EU, 2006), based upon data from Argus Media, Platt s and NordPool 1.1.3) Import dependency of Natural gas supplied from outside the European Union Europe can partly satisfy its gas demand with indigenous production. Indigenous production in the European Union is traditionally concentrated in the United Kingdom and Netherlands that accounts for three quarters of the European production. However production in these countries is decreasing because gas fields in the North Sea are running out of gas ap3. With the decline of European gas production, it is facing the following challenges; 1) Procurements of natural gas from region outside Europe 2) Security of natural gas supply ) Procurements of Natural Gas from region outside Europe To procure gas from several countries like Netherlands, Russia, Norway and United Kingdom, network of high pressure pipeline was laid. Pipeline business was funded via the netback principle (price of gas in the destination country remained linked to competing fuel and gas producer receive revenues from gas sales minus transportation cost). But to diversify the supply portfolio as a part of the diversification efforts of many European countries (to have gas from many countries not only from Russia) newly emerging LNG exporters gained the market share of gas import. In different scenarios, the gas import dependency of the EU-25 is estimated to increase from the current 49 % of supplies (233bcm in 2002) to over 80% (639 bcm in 2020) 1. 10

11 Figure 1.2, Gas Demand and Imports Dependency Projection Gas Demand and Imports Dependency Projection 1000 Billion cubic meters Imports Demand Imports( alternative) Demand( alternative) Source; World Energy outlook 2007 LNG imports are mostly priced on a global market basis influenced by; North America (Henry Hub), Asian import price and hence circumstances in those markets. Gas importers face price and volume risk in most of the European LNG market, due to lack of market transparency. Even though their has been more growth in LNG infrastructure in comparison to pipeline network in Europe, in last few years because of; 1) Relatively low barrier for entry in gas sector: New pipeline constructions were mostly Confined to historical TSOs. New entries was possible by buying out the historical player, including its transport facilities which creates high barrier of entry and difficult to get regulatory approval. But in case of LNG terminals it s easy to get regulatory approval i.e. low barrier for entry in the market. 2) Higher flexibility of LNG deliveries in comparison to pipeline supplies as pipeline Deliveries are more bounded by asset-specific infrastructure availability: Since LNG ships can be brought and stored but pipeline gas can only be transported if there is availability of pipeline capacity. Their should be a better market mechanism to increase gas import because it is only the instruments available in Europe, to overcome the treat which is arising such as; growing vulnerability coming from increased use of gas to electricity without sufficient coverage in terms of flexibility, threat of external disruption (like natural disaster, financial market tension, oil based pricing) ) Security of Natural Gas Supply Due to demand- Supply constraint and increase dependency on import from outside EU, has increased the use of LNG, which is mostly priced on a global market basis. Even the large scale import pipeline needed to meet gas demand, crosses multiple national frontiers within and outside Europe. This all together raises concern to enhance security of gas supply to overcome political and economical strategy of gas producing countries and avoid penalties imposed by government for serving social disruption. There are many possible instruments suggested to enhance security of gas supply. These instruments are selected for market on the basis of several factors like geographical location, gas resources, market concentration, few of them are as follow; 1) Domestic production of gas: to reduce the external dependency and increase security of gas supply. 2) Long term import contracts: to increase reliability of supply 11

12 3) Investments in infrastructure for gas import via regasification terminals and Pipelines: to overcome physical constraint, reduce probability of gas disruption. 4) Geographical diversification of source of gas supply: reduce the monopoly of gas Suppliers, avoid charging high gas price and weaken there economical and social strategy against gas consuming countries. 5) Liquid tradable gas markets: to increase number of market players and transparency. This provides the possibility of arbitrage in the market bringing lowest possible cost for the end users. 6) Developments of interruptible demand: to prevent the system failure and avoid high penalties cost for disruption. 7) Use of alternative back-up fuels in industrial and power generation plants: reduce the probability of interruption during scarcity of main fuel source. 12

13 Chapter 2 -Past to present methodology for gas trading During the 1960 and 1970 the demand for natural gas in most of European countries started to outpace indigenous production and imports were needed. United Kingdom and Netherlands which had enough production started importing gas to other European countries by investing in transportation network to trade gas. Till now several models have evolved for trading gas, which is discussed in the following chapter. 2.1) Old Model for gas trading High oil and gas price in the world market and perception of scarcity for natural gas resources, attracted attention of market players all over Europe to increase gas production by exploration and to increase investment in transport facilities to trade gas among them. To give incentive to investors and to minimize the risk of their investments, gas sales were based on long term contracts having following characteristics; 1) Long term; 20 to 30 years contracts, matching the duration of investment. 2) Take or Pay; buyers has to pay for certain amount of gas regardless of whether he uses it or not. 3) Market Value Principle: Price of gas, linked to the price of the alternative fuel in the market for producers to maximize their revenues. 4) Netback Price: Transportation costs, subtracted from the price that producers received. 5) Price Review clause (typically 3 year review): To ensure that the contract price always represent the market value. Most of the Gas businesses (infrastructure) were developed as a monopoly with a geographic area under this long term contracts. These geographic locations provide security of customer base for long term investments in infrastructure for that location at low risk, knowing that they can get back their money over a period of the import contract. But the model that evolved with this strategy has several flaws like; 1) Lack of potential contestability in a given market area, as it was supplied by limited number of production sites through a limited number of transport infrastructure. 2) Reluctance of mid-streamers to invest in new pipelines and storage capacity, without having long term guarantee, given the threat to their future market size. 2.2) Transition towards new model To reduce monopoly and address the above flaws in gas sector, process of liberalization was initiated, to bring adequate and efficient investment in infrastructure (pipeline, storage). Several regulatory changes and market restructuring was also initiated to increase security of supply, to bring transparency and generate market signal to attract investments and to increase liquidity. Some measure steps taken in this regard were as follow; 1) Unbundling of sales and infrastructure; Infrastructure (pipeline) to be considered as natural monopoly and service (gas sales) subject to competition. 2) Third party access to pipeline; provide access to the infrastructure, on an objective and transparent basis. 13

14 3) Entry- Exit pricing system; to have efficient allocation of transmission capacity to reduce contractual or physical congestion in pipeline network. Entry- exit pricing system provided the ease to comply with third party access rule. It also helped to recover annual costs of providing transmission capacity in a non-discriminatory, transparent and objective manner. In entry- exit pricing, price difference between two connected markets is limited to cost of transportation between them except during congestion when price is higher reflecting the need of investment in infrastructure or secondary capacity trading of contractual capacity. It also provided flexibility for shippers and new entrants to book capacity without specifying before hand where this gas has to go. Entry- exit pricing system also helped in development of notional balancing point in the system, from where gas can be traded for any entry and exit point and it served as a balancing point for network user s to balance their portfolios. For trading on this national balancing point or Hubs, there should be liquidity in the market. Liquidity means; 1) Market should be deep, in which large volume can be bought or sold without moving price excessively. 2) Market should be wide, in which large number of different bids and offers are present in the market. 3) Market should have ability to trade large volume of gas in a short period of time. 4) Market should have resilience i.e. has ability to recover towards its natural Supply/demand equilibrium after having been exposed to shock. 5) There should be fairness and transparency in the market. Unbundling of sales and infrastructure has also increased competition in the market, reducing monopoly of Incumbents. Even the third party access to infrastructure has increased the number of market participant and liquidity in the market. It has brought transparency in the market, providing ease of arbitraging by marketers and brining lowest possible cost gas for end users. 2.3) New model of Gas Trading- National balancing points or Hubs This national balancing point or trading Hubs are defined as a specific point (nexus of two pipeline) or as a virtual point. If it is defined as specific point, then it implies the necessity of having many such points within a given network. If gas trading is conducted at many different geographical location in the transportation network, market is considered to be more subdivided meaning that liquidity is dilute in that market zone. This market zone becomes more susceptible to manipulation by key players at those points. So the market should be design in such a way that there is balance between liquidity and locational information. If it is defined as Virtual Point, i.e. non physical point, through which all delivery take place in particular transmission network. The advantage of such a system is that gas becomes a completely standardized commodity having a uniform price no matter where it is delivered within the domestic transmission system. The problem of this design is that if bottleneck emerges within the transmission system, this could have potential to force the TSO to reduce capacity in the entire system, instead of only in a specific part of pipelines. To overcome this many Hub operator uses tactics like its own action to buys capacity, to scale up and down available capacity into the system from different points receiving domestic production or 14

15 imports, closely monitor the degree of congestion, optimize system operation, smarter investments and overcome the weakness of the postage stamp transport pricing system. This implies that virtual hubs are better positioned to be a truly liquid than physical hubs (specific point), since all gas on a system regardless of its physical location inside the system can be traded. A truly liquid hub therefore takes away the need for liquid markets on exit, if buyers and sellers can find each other easily on a hub. In this case exit point will be simply a delivery points, rather than potential trading points and Hubs would then be both a delivery and trading point of short-term and long-term products. Beyond gas trading Hubs also offers other service like; Balancing, Flexibility service and pipeline capacity allocation. Balancing Rapid demand variation, a pipeline disruption, an upstream problem or a downstream interruption all this leads to a imbalance, which is normal feature of gas market. It is necessary for network operators to have some flexibility to ensure that the pressure of the system they manage is kept within its physical constraints. Balancing action by TSO incur cost to the system, therefore it is better for the TSO, to incentivize this balancing portfolios in market design. There are two different time frames or balancing periods that exists, for dividing balancing responsibility between TSO and other actors in the market. TSOs require daily balancing meaning that the shippers flow into and out of the system must be balanced by end of gas day. Within each day, it is the responsibility of the TSO to balance the system. Due to dynamics nature of gas industry, TSO allow shippers to be out of balance within some technical tolerance limit, which is charged for the hours, day or month depending upon balancing frame used. Some TSOs also offer to sell additional tolerance service to shippers and for additional service; demand can be met by purchasing unused tolerance service from other shippers. Flexibility service; The most hub offer degree of flexibility service in form of gas storage to overcome high variability in daily and seasonal demand for gas compared to usually limited flexibility in gas production. This high price flexibility is always an incentive for companies to balance their portfolio either by investing in storage facilities or trade from near by storage (e.g. Dutch TTF and German BEB). But problem with this type of exchange is that the price are mostly based on the traded market is interconnected with an area mainly priced on long term oil contracts. 2.4) Modes of Gas Trading at Hubs or National balancing point Trading on this hubs takes places through bilateral, OTC and exchange (spot and future) market. Trading bilaterally and through OTC is always confidential, lowering the transparency in the market. In OTC (over the counter) trading, two companies enter into contracts on basis of bilaterally negotiated framework, if trading agreement exits with counterparty. Forwards (settled after delivery) and Swaps are prime example of OTC contracts. Whereas trading through exchange requires that all member sign up to a uniform contract drawn up specifically for that exchange. Advantage of trading through exchange is that it require minimum of contract negotiation and with a single counterparty i.e. exchange. Most of the exchange facilitates both Spot and future trading. In Spot trading at exchange, commodity are standard and traded in day-ahead, within day and forward market. These spot products are highly valuable, to producers and consumers who wish to change their production or consumption in short term by providing them an ease of balancing their portfolio and increasing liquidity in the market. If these spot prices are mature 15

16 i.e. representing true value of gas they can be also used for development of derivatives, which are short of financial products. Advantage of having future products at exchange is, they are financially settled daily, as opposed to forward contracts where payments are conducted after delivery, therefore day to day change in credit exposure is limited. Price of this future market can also be used for indexing gas contracts which are mostly index to oil price and help in mitigating the credit risk that exits, enhancing the trust of market players. Exchanges also publishes settlement price for all tradable contracts, increasing price transparency in the market. This price transparency can give insight to market players to balance their portfolio, invest in storage facilities and get rid of incumbent suppliers to balance the market at high cost. Figure 2.1 Comparison of trading platform (Highlight represents the best mode of trading) OTC Exchange Bilateral Without Broker Contracts Agreement between the companies needed Agreements with exchange Agreement between the companies needed. Trading Method Through Broker-either Electronic platform Personal Contact Electronic platform or voice brokering Counterparty Other Company Exchange Other Company Transaction Cost Medium High Low Transparency Good, Different publication on end of day prices High, Information given by exchange None Anonymity Company has to reveal itself to other company after deal Anonymous Before deal companies already know others identity Main Usage All products Most liquid product Liquid product and large volume Types of Agreement Source: IEA Framework contract One agreement with exchange Bilateral Contract To have contracts with exchange is easy because only one agreement is needed for all trading. Whereas in OTC and bilateral without broker require contract with many actors making process more complex. Trading through exchange is done by electronic platform, which is more preferable as it bring transparency in the market than other modes of trading. Exchange trading is more anonymous since buyers and sellers don t know each other identity reducing the possibility of fixing or manipulating the gas price. Trading through OTC market facilitates all products trading but with exchange only most liquid product can be traded. In bilateral trading transaction cost for trading is too low in comparison to other mode of trading but there is no transparency so higher chance of manipulation in gas price is possible. It is perception that hub price exhibit greater volatility in comparison to oil index contract. It may be conceived by ordinary customer, an impression of increase uncertainty in his gas bill. The following graph shows that, the standard oil index price changes four times a year where hub based price changes daily. 16

17 Figure 2.2; Oil index price vs. Hub price (NBP day ahead) Source: Heren, Industry source Above graph, gives impression that gas contract linked to daily spot price would be facing greater uncertainty, but it s not the case because the price that customer face with hub contract is average of the spot price over the entire period of his contract. Looking on historical data of one year contract, indexed to the NBP day ahead, compared to traditional oil indexed contract gives impression that types of contracts does not differ substantially except in case there is a physical shortage of gas which has negative consequence for the consumer in form of high price. Figure 2.3; Oil indexed vs. yearly averaged Hub (NBP day ahead) Source Heren, industry source 2.5) Advantages of promoting Hubs development 1) Liquid hubs promote downstream competition; New entrants on the wholesale gas market generally don t have access to substantial upstream source of gas, or to enormous supply of import capacity. Availability of gas at wholesale level enables wholesales players to supply gas downstream and provide choice to buyers (distribution companies, large consumers) and ultimately to households. The availability of gas at wholesale level also allows wholesale players and retail suppliers to optimize their portfolios. For e.g., a distribution company will be able to buy flexibility from wholesale player with a gas storage facility, base load commodity in a bilateral import contract, hedge its price risk by contracting with a financial service company, and use the hub to provide for seasonal swing and sell any excess commodity. The portfolio benefit gained at wholesale level can be passed on to end customers, providing competitive offers downstream. 17

18 2) Liquid Hubs concentrate liquidity Liquid hubs centralize supply and demand in one market place through exchanges and brokers. Buyers can not only buy commodity but also financial services, balancing service, access to storage and so forth. 3) Liquid Hubs strengthen security of Supply; Liquid Hubs attracts upstream companies to bring gas to the hub knowing that their gas will find buyer, without the need to identify or contract with buying party. Hubs also attract buyers, as long as price is right. Secondly liquid hubs provide an efficient price signal that in turn leads to investment in infrastructure (LNG, storage, pipelines). This new infrastructure will ensure that gas will reach the hub. 4) Liquid Hub will increase flexibility; When gas is delivered at a hub, it is not yet clear where the gas will flow. Flow pattern could change; if it is cheaper to buy gas on a hub in country A than bilaterally from country B, the flow will tend to come from A rather than B. With increase in Hub liquidity, flow patter will probably change more often than they do today and this will also decrease dependence on long term contracts. Hubs can provide base for swap and help them to changes ownership on the hub. 5) Reduce Market abuse; Suppliers on hub need to offer price at which they would sell and at which they would buy gas. If they set price too high it will cause these suppliers having to buy gas and setting price too low will cause them to sell their gas for less than they would like to sell it and would increase demand. This prevents companies in question from asking too high price for their gas and bidding too low for other party s gas. Therefore the price at which they trade will be market based and by this measure suppliers will absorb the price risk of being a market maker. The following graph shows the liquidity of some of the central European Hubs. Zeebrugge (Belgium) is most liquid hub as it has maximum physical volume delivered and maximum volume traded. TTF (Netherlands) is second to Zeebrugge, other hubs are still immature. Figure 2.4; Gas traded at European Hub Source: Based on TSOs published data. The physical volume is the amount of gas delivered through the hub at the end, while traded volume is the amount of gas that has been traded. Because gas can be traded more often before finally delivered, the traded volume is higher than the physical volume. 18

19 2.6) Examples of new model in liberalization process 1) Market mechanism to bring Price Transparency in the market 29 ; The majority of gas in Russia is brought form Gazprom at regulated tariff which is different in terms of price for residential users and non residential users. Customer can buy certain volume of gas at a price which is unsustainably low in open market. If customers need more gas, traditionally he has two options, either to ask Gazprom to raise his quota or if pipeline capacity is available purchase the gas from some independent producer at non-regulated price. Generally regulated price is the lower one and act as a floor to non-regulated price. In November 2006, Gazprom through its 100% subsidiary Mezhregiongaz (MRG) introduced an additional way for industry to purchase excess gas: via auction. Initially monthly auctions were held for front month deliveries, but later the schedule was expanded so now auction are held every 10 days. Initially 10 bcm was planned to be auction off, with 5 bcm supplied by Gazprom and 5 bcm by independent producer. Customer can bid on gas delivered at three different compression stations in western Siberia namely Nadyum, Yuzhno Balyksy and Vyngapurovskoye, through the Electronic Trading Exchange. About one day before each auction MRG publishes how much spare capacity Gazprom has in its pipeline running from the three delivery points to the exit zones in which customer are located. Since the inception price at the exchange have been around 120%- 140% of the regulated price, making the state of under price clear. Figure 2.5; Evolution between TTF (Dutch) and ETP (Russia) month-ahead prices Source: based on Heren and Industry Sources Advantage of launching the ETP is that current situation where gas is priced below the market is addressed. It will also help to support Russian system which is trying to remove price regulation and bringing price up, on a net back basis, to level charged for export to rest of Europe. This net back price is exclusive both of transport out of Russia, and crucially export duties (which are currently 30 % of export revenue) so even after fully liberalized, Russian gas will be still cheaper domestically compared to delivered export price. It also goes well that traded hub based market will provide price signals as to where and when production and infrastructure investment are most needed. 2) Market mechanism to bring Investment in the market 29 ; Rocky Mountains have enough gas production than its consumption, so remaining gas is exported to other states. In recent year, the inter-state pipelines exporting natural gas were already running close to maximum capacity, resulting in low and volatile price in Rocky Mountain area. In order to export the anticipated new production, extra infrastructure was needed. Price signal which is differential between the value of gas at one point and another was so high that it attracted investment in Rocky pipeline. 19

20 Chapter 3 Overview of existing competitive gas market There should be a market mechanism, which can generate market signals for efficient investment, to provide much needed infrastructure in pipeline capacity, storage capacity, LNG terminals etc. This service can be priced and included in market design or internalized in the regulatory framework, so that there is financial incentive to deliver objectives such as greater diversity, storage or even supply security at least costs. This would help to guard against unwanted situation and provide physical insurance for the gas market. Most of the European countries are developing spot market at hubs or National Balancing point as a one shop for all products. Several Hubs are providing these services through different market mechanism. In following chapter I have talked about the market restructuring, market functioning to provide service of flexibility, trading, storage and balancing in developed market like Netherlands, United Kingdom and United States of America. 3.1) Netherlands Existence of gas market in Netherlands, way back to 1959 when a huge gas filed in northern Netherlands, in the province of Groningen was discovered. This gas is considered as low calorific value gas which is mostly used for domestic purpose in Netherlands and Belgium. Most of gas need is satisfied by Groningen production and importing gas from British market and for that market has evolved drastically in coming years which have been discussed as follow ) Market Restructuring Before the liberalization of gas sector, Netherlands had a linear structure i.e. Producers were selling all gas to Pipeline Company (Gasunie) which owns the high pressure transmission network. They further used to sell this to distribution company and then to end users. Gas value chain was highly concentrated and there was complete monopoly. Figure 3.1.1; Traditional Structure of gas market in Netherlands With the ongoing process of liberalization, several restructuring was done to bring competition in the gas value chain. TPA (Third party access) which was one of the major steps in restructuring the gas sector, brought little competition with buying and selling of gas in wholesale market by importers and other fields( Frig, Norway). Pipeline Company (Gasunie) was responsible for the following tasks; 1) Transport activity: Performing monopolistic activity, in which Gasunie was managing national transport network, import and export interconnection. 20

21 2) Commercial activity: Selling and buying of gas. Due to third party access (TPA) to pipeline- Distribution Company, retailers and large consumer (electrical utilities), started purchasing gas directly from wholesale market reducing the monopoly of Gasunie to some extent. Distribution Company purchase gas at regulated price from Gasunie pipeline, can supply gas to all end users, but large consumers like Industrial and electrical utilities also have opportunity to purchase gas from retailers. Figure 3.1.2; Open Access to pipeline transportation in Netherlands To increase more competition in the Gas sector, it was decided to separate monopolistic and commercial activity of Gasunie i.e. 1)Monopolistic activity will look for transport network, future network and act as system manager. GTS, fully state owned Company was responsible for all monopolistic activity. 2) Commercial activity such as trade and delivery of gas will be under company named Gasunie T&S. It was also made compulsory for Gasunie T&S (Gasunie Trade & Supply) to receive gas from small field producers, giving them first priority. This was done to reduce the risk of balancing portfolio for small producer, which they face due to their small production capacity in comparison to Gasunie T&S. Separation of monopolistic, commercial activity together with TPA facilitated spot trading on the Dutch network. 21

22 Figure 3.1.3; Unbundling of gas sales from pipeline transportation in Netherlands Gasunie pipeline was responsible for providing pipeline capacity to distribution company and large consumers (Industrial & electric utilities) at regulated rate. Distribution Company further provides pipeline capacity to end users at regulated rate. Qualified consumers ( Industrial & electrical utilities) can buy gas directly from Gasunie T&S in the spot market reducing the probability of overcharging gas price by retailers or they can buy gas from retailers. Distribution Company can also buy gas from Gasunie T& S to supply to its end users ) Market Functioning Spot gas trading in Netherlands was confined at entry and exit points of the GTS gas transmission network. Because of large number of such points in the gas transmission network, liquidity in the market was dilute, discouraging the development of mature market. In 2003 virtual marketplace Title Transfer Facility was created, to facilitate gas trade regardless of their entry or exit point. TTF helped in the development of the Dutch wholesale gas market and it evolved as complex system which is shown as follow. 22

23 Figure 3.1.4; Market functioning at TTF In the above diagram double pointed arrows indicate which actor s controls which part of the system. The arrows with single points indicate the direction of trade in gas. GTS which is transporter in Dutch system has to perform two tasks. 1) System Operator 2) Network Manager As a network manager, GTS takes care of the independent management and development of Dutch high pressure gas network and provision of transport services on basis of regulated tariff. But the import pipeline which is booked till 2013 can be traded among shippers on secondary market to solve contractual congestion problem. Imbalance on gas network may occur due to change in demand and supply, GTS as a system operator tries to maintain physical balance between supply and demand preventing the network from large service interruption. Balancing Dutch system uses hybrid balancing i.e. hourly and daily balancing for the network. The advantage of hourly balancing is that it makes those customers who have intraday variability in their demand pay for it instead of spreading the cost across the whole market, but it has certain disadvantage too. 23

24 1) It subdivides liquidity on the markets by splitting the commodity in time rather than in geography. 2) It requires actors on the market to hold a substantial portfolio of hourly flexibility. This is a significant barrier to entry of new entrants without substantial supply Portfolio, as they have to purchase high deliverability storage in market. On Dutch network among shippers and GTS, GTS has been made responsible for balancing the system, because if both are made responsible imbalance will be meshed in the virtual world and actual physical imbalance to be managed by GTS may decrease. Beyond this there are other advantages too in balancing the system by GTS. 1) GTS balancing at TTF will boost the liquidity of short term product as GTS will trade hourly, enhancing gas trade at exchange and bringing transparency to the market. 2) Imbalance penalties in the grid will be based on the prices GTS has to pay in order to restore the system balance, taking away the price risk faced by GTS and even serve as an investment signal for short-term gas storage. Due to lack of steering information, market participants are not sufficiently able to organize their imbalance themselves so they rely to large extent on different flexibility tools like 1) Buy third party balancing i.e. another shipper balance for them. 2) Use different tools offered by GTS like combiflex, extended tolerance etc. 3) Use gas storage to match supply and demand. 4) Stand by gas contract with Gasunie T&S. Even after using flexibility, if shippers are not balanced in hourly and daily time frame and are out of certain tolerance level. They are charged fine, based on extent of imbalance and day-ahead price prevailing in the market at that time as follow; 1) If market participants have withdrawn too much gas from the grid, they are charged highest of the prevailing day-ahead price at TTF. 2) If parties have fed too much gas into the grid, they will receive the lowest of the prevailing day-ahead prices at TTF. Trading of gas for balancing is done by GTS on OTC market bilaterally. Exchange (APX) is used for very small portion of balancing at present moment because the products available on exchange are mostly standard product, with low liquidity and no steering information available to get clear insight of balancing market. Pipeline Capacity A contract need to be signed for reserving entry and exit capacity on Dutch pipeline network on regulated tariff basis with GTS (national TSO). These contracts are entered for specific entry and apply to a specific capacity (MW). Reservations are accepted for capacity on a first come, first served basis. As long as the required capacity is certain not exceeding the available capacity, a firm reservation is made. However, in practice shippers frequently consume less than they have reserved, as they contract for peak requirement, GTS continues to take reservation. Reservation above total available capacity is then made on an interruptible basis. Interruptible capacity is cheaper than firm capacity, but there is a chance that the capacity will not be available. But capacity holder can trade unused capacity among them in secondary market. In Netherlands secondary capacity is traded on APX to avoid contractual congestion. Secondary capacity trade on APX started in 2006 and helps to generate transparent price signal for owner of surplus capacity to sell unused capacity. 24

25 Shippers who have reserved capacity must nominate with GTS, one gas day previously the amount they are actually going to use. They can change these values (re-nominate) up to two hours beforehand. In principle, a shipper will lose any capacity which has been contracted but not nominated two hours beforehand. Flexibility Service The flexibility requirement is mainly the result of two factors 1) Consumption by household is highly temperature-dependent and gas demand fluctuates with the temperature. 2) Households consumption often follows a specific pattern, with peaks in demand during the morning ( getting up peak ) and during the evening ( homecoming peak ), giving rise to an hourly flexibility requirement. Shippers use various flexibility instruments based on regulated tariff. This instruments are based on type of flexibility requirement (hourly flexibility to seasonal flexibility) and differ among them on basis of speed at which it can be utilized, period for which it can be used and source of flexibility which it use. Figure 3.1.5; Types of flexibility service in Netherlands Type Flexibility requirement Tolerance (service) Combiflex Flexible Production contracts Interruptible Contracts with customer Virtual storage Physical storage Flexible contracts Structuring via TTF Within day Within week month Within year Several Most Important Important Least Important Tolerance and combiflex offered by GTS is mostly used to match hourly gas flow. However, flexible production contracts, use of virtual gas storage and trading at TTF are used for meeting flexibility requirement in short term. For long term flexible contracts, physical storage and TTF are used. Most of the demand for flexibility is covered by the flexible production capacity in the Groningen fields. The physical supply from this flexible source is offered to shippers in the form of commercial products. But with decline of production capacity of Groningen field, the importance of storage is increasing. But only 4 % of the storage capacity in Netherlands is available to third parties as storage facilities are actually considered to be additional production capacity for the Groningen. Due to this there is low utilization of storage facilities in Netherlands. But there is a considerable amount of storage capacity near the border in Germany, from which gas storage can be supplied to Dutch wholesale market. A number of market participants are offering virtual storage service combining it with transport to Netherlands. Most of the storage trading is done bilaterally and that lacks transparency in the market. Even the estimation made for flexibility is based on the largest difference in consumption and contracts is based on average of minimum and maximum consumption to bridge the difference with flexibility. But this assumption is overestimation of flexibility requirement. 25

26 3.1.3) Present and future status of Trading at TTF Present Status TTF, virtual trading point for natural gas has developed as a spot market. Status of traded volume, delivered volume and number of transaction has been shown in the following graph which shows gradual increase in liquidity on Hub. Figure 3.1.6; Status of volume delivered and traded at TTF Source: GTS All modes of trading is used on TTF i.e. through exchange (APX, Endex), OTC and bilateral, but OTC (over the counter) market through brokers or directly between market participants on bilateral basis accounts for maximum trading at TTF. Trading through OTC (over the counter) market is most preferable on TTF as it offer parties greater scope to purchase products which match their requirements than trading on the exchange (APX) which offer standard products for short term. Short term product at exchange account for a smaller proportion of total trading volume and reason for this is as follow 1) Due to lack of timely and accurate data, most of shippers do not know their actual balance position, therefore lack to buy and sell actual volume of gas at appropriate time. 2) For within-day market it is difficult to increase liquidity, since it has many different products: each hour in each day constitutes one product. Market makers are needed for such market but today due to less number of suppliers on TTF, it is not possible. Lack of information on TTF is due to existence of maximum number of bilateral & OTC contracts which are confidential, as a result of which there are no good data available regarding their price and duration, preventing the development of short term product and spot trading at exchange. On TTF the product traded are commodity (gas) and pipeline capacity (secondary capacity) which are categorized into three category curve, prompt and within day product. 91% of total trading volume relates to curve product, while within-day products account for 0.1%. The reason behind this; curve products are mainly used to meet part of base load demand, whereas within day products are used to meet short-term fluctuations in demand and secondly due to lack of information, market participants are less prepared to use within day products for balancing purposes. 26

27 Figure 3.1.7; Breakdown of TTF trading by marketplaces and product Source: GTS Future Status Types of consumer and its pattern are very important to decide the type of market mechanism being used for gas trading. At present three categories of gas consumer are distinguished based on their type of consumption. 1) Large consumer with a consumption that exceed ten million cubic meters per year. They account for 45 % of gas used in Netherlands. These are large companies like heavy industry and electricity producers. Daily and seasonal consumption patterns vary by consumer, but they have relatively flat load profile 2) Intermediate consumer with annual consumption between 0.17 and 10 million cubic meters. Consumption patterns typically are somewhat variable throughout the year. They include small and medium sized business. 3) Small consumer-households etc with an annual consumption of less than cubic meters per year are highly temperature and time sensitivity. They constitute about 20% of total consumption. Major portion of gas used is for curve product, having relatively flat load profile. Trading for curve product will continue mostly through OTC, Bilateral and Endex rather than APX (physical short term market) which has very volatile price. Trend of trading on bilateral market (21.3%) and OTC market (78.3%) will shift toward future market which only account for 0.3% (Endex) if liquidity and maturity has to be increased on Hub. Trading at Endex will bring transparency, reducing the risk of shipper and will attract investment helping TTF to be developed as major trading hub and increasing liquidity on it. Increase liquidity and transparency will also boast up the trading volume of short term product on APX, giving incentive to shippers to be more balanced and avoid penalties of unbalance faced by GTS. 27

28 3.1.4) Status of TTF in terms of Liquidity, Market Power, Transparency TTF has low liquidity in comparison to other hubs and customers cannot use it as sourcing instruments for any sizeable part of their portfolio. The reason behind this is as follow. 1) Overall volumes offered at hub are too low, as all gas not passes through Hub. 2) Too many standard products are insufficiently liquid. Suppliers need to build a profile matching end customer demand over time, and therefore need many different building blocks e.g. Standard products with different duration. 3) Not enough gas from international source reaches TTF, since import capacity is finite and fully booked long-term (beyond 2013). This affect volume offered at TTF, but also limits the probability to diversify the supply. 4) Quality conversion, with which high calorific gas can be converted to low calorific gas, is a finite resource and has to be booked in advance. This means that a supplier to household cannot simply buy high calorific gas on TTF without ensuring about quality conversion. 5) In Netherlands almost all components of gas value chain, is highly concentrated (measured in HHI index), with HHI index above threshold value of Trading in high calorific gas at TTF is moderately concentrated, which indicates a reasonably operating market but trading in low calorific gas at TTF is highly concentrated so hardly any low calorific gas is traded at TTF. Connectivity of TTF, with other neighboring Hubs like Zeebrugge and National Balancing point is significant, which can be analyzed from the following graph, which show similar price trend in day-ahead natural gas price. But price sensitivity in Dutch market is low due to less gas to gas competition and strong dependent on oil price. This is the reason why Dutch market is insulated from major price shocks in U.K market. Price shock in U.K led to similar price level in Zeebrugge due to Interconnector between Zeebrugge (Belgium) and Bacton (U.K). Figure 3.1.8; Trends in day-ahead and year-ahead prices at hub Source; Platts 28

29 3.1.5) Measures to increase liquidity at TTF For mature Hub; liquidity, transparency and gas to gas competition has to be increased, either using physical measures like infrastructure improvement or virtual measures like improving the rules of play. Some of the measures are as follow; 1) Increase TTF trading volume and the number of trading parties 2) Making TTF better accessible either by investing in transports capacity and harmonizing transport procedure which cost time and money to manage. This will increase accessibility of Hub from abroad improving liquidity, increasing volume offered and diversification of supply to Hub 3) Gas quality conversion should be made part of system service in grid code, this will help to eradicate market of different gas quality and ease trading of all gas quality on Hub. 4) All suppliers should be obliged to deliver their gas at Hub instead of delivering it behind exits. This will enable to pass more gas through Hub and that gas delivered at Hub would still be tradable. This will give opportunity to buyers either to buy, trade or resell their gas, thereby enhancing liquidity. It also means that suppliers with a significant portfolio can optimize their position, for instance by using a storage facility to absorb gas already bought that turns out to be unused. 5) Grant buyers of the gas the right to re-enter the national grid after their gas has been delivered at a national exit point. In such a condition buyers will have the possibility to re-enter, when they have an excess of gas and sell this excess gas at Hub. This will increase volume traded and the number of counter parties at Hub. 6) Possibility of Gas swaps between hubs means without physical transport capacity, a shippers can have gas in certain geographic area. 7) Accurate price signal on within day market, historical price etc will reduce the risk of market uncertainty and will boost the trading of short term product. 8) New entrants and Industrial customers have large demand swings to meet and have fewer opportunities to hedge their imbalance risk as they don t have access to storage facility. TTF can provide opportunity by increasing the liquidity in short duration project (within-day products) 9) Due to delivery of gas to Gasunine T & S, limits the potential for upstream competition. If these small field producers are made active at Hub by providing some risk hedging, the volume of gas traded and number of active parties at TTF will increase. 3.2) United Kingdom The United Kingdom is one of the largest gas markets in Europe. Gas accounts for around 29% of total primary energy supply. Gas demand has increased largely due to commissioning of a number of gas fired combined-cycle gas-turbine (CCGT) power station. Gas is supplied mostly from U.K offshore fields in the North Seas. Small portion of U.K need is also provided by Norway from country s share of Frigg field. In last many years there have been several changes either regulatory or restructuring, which have helped the British market to become most liquid Hub in Europe today. 29

30 3.2.1) Market Restructuring Before the liberalization of gas sector, United Kingdom too had a linear structure. Producers were selling gas to BGC by long term contracts index to oil price, with provision of swing and take-or-pay( under which buyer is obliged to pay for minimum volume of gas). BGC further used to sell this gas to Distribution Company, which further sells to end users. Gas value chain was highly concentrated, with monopoly of BGC. Figure 3.2.1; Traditional structure of gas market in United Kingdom But with the ongoing process of liberalization, TPA (Third party access) was allowed to have access of BGC transmission network by market players. Oversupply of gas in the market and third party access, promoted wholesale market for trading were the price of gas was too low than the price of gas at which BGC was supplying to its customers. BG (British gas) was prevented from contracting more than 90% of the production of any new gas fields, which further boost up the wholesale gas trading by lowering market entry barriers for new suppliers. British gas was responsible for providing pipeline capacity to Distribution Company, large consumers on regulated tariff. Distribution Company which purchases gas from BG at regulated tariff provides gas to all end users. Qualified consumers (electrical Utilities and Industrial) also have possibility to purchase gas directly from producers in wholesale market or purchase from gas retailers. Figure 3.2.2; Open Access to pipeline transportation in United Kingdom 30

31 To further boost up the competition in the Gas sector, it was decided to separate monopolistic and commercial activity of BG. In 1995, BG after restructuring was replaced by a transport company (Transco later National Grid), an upstream company (BG International) and a downstream company (Centrica). Few years later, its transportation and storage service was also separated and residential market was opened to competition. The newly created companies have the following responsibility in the British market; 1) National Grid was responsible for all monopolistic activity like transport network, future network and act as a system manager i.e. held responsible for maintaining the security of network, balance supply and demand. 2) Commercial activity such as trade and delivery of gas will be under company named Centrica. 3) Storage service will be under BG Storage This restructuring facilitated spot trading, which are located at different nexus of gas pipeline network in British market. British market was relatively small to support functioning of five to six spot markets, attracted idea of central location of gas trading know as National Balancing Point (NBP), which is a virtual point. Figure 3.2.3; Unbundling of gas sales from pipeline transportation in United Kingdom Centrica Distribution Company National Grid Pipeline Company Commercial Residential Producer BG International BG Storage Industrial Spot Market NBP Electrical Utilities Gas Transportation Gas Sale Retailer In this newly market structure all end users, even residential (residential market is opened to competition) can buy gas from NBP increasing liquidity in the market. National grid as a transporter provides pipeline capacity to all end user on basis of regulated tariff. Small consumers can also buy gas from Centrica (one of the retailer) without going to the spot market at NBP. Large consumers (electrical 31

32 utilities and Industrial) which are not prone to take risk by buying gas at NBP can rely on retailers for buying gas. All end users can also access storage service at NBP on basis of TPA, to have flexibility in their portfolio ) Market Functioning In British market almost all the gas passes through virtual point NBP (National Balancing Point). This has increased the number of traders and market player in the market increasing liquidity. National Grid and BG storage further support this liquidity, by publishing the price of transportation and storage, reducing the risk of market players and bringing transparency in the market. Due to all this there is complex market in United Kingdom, which is analyzed as follow. Figure 3.2.4; British Market functioning In the above diagram double pointed arrows indicate which actor s controls which part of the system. The arrows with single points indicate the direction of trade in gas. Trading at National balancing point has been attractive to shippers because; 1) The gas traded at NBP can be directly registered with National Grid, involving this gas within the system and thereby counting towards the shipper s daily balance. 2) At NBP, uniform commodity charge is applied to all gas throughputs on NTS, giving no cost benefit to customer located near to entry points 32

33 National grid as a transporter and operator in the system has responsibility to balance the system network either by efficient allocation of pipeline capacity or by buying and selling the gas. Pipeline Capacity National grid offer primary capacity of pipeline by periodic auction for both short term and long term. The auctioning of pipeline capacity has following added benefit; 1) It allows equal access to the network. 2) It provide strong price signal for the investment. When there is capacity constraints in the pipeline either due to contractual or lack of physical capacity, auctioning price for pipeline capacity are too high. This gives incentive to trade unused capacity in the secondary market or do investment in pipeline infrastructure. For e.g. Following diagram shows development in price for entry capacity at the Easington terminal in United Kingdom. Steep price increase can be seen in some winter months, its signal that the network has not been upgraded to cope with all of the newly added Norwegian production. This price signal, if strong enough, will naturally give incentive to start construction or expansion of pipeline where necessary. Figure 3.2.5; Entry capacity price at Easington. Source: National Grid Unused primary capacity is traded among shippers bilaterally or on secondary market managed by National grid. But transfer of this capacity, is required to be registered with National Grid. The shippers who have initially booked capacity remain liable for payment of capacity charges to national grid. To increase transparency in pipeline capacity, national grid publishes capacity information such as technical capacity, utilization rates and annual average flow at all relevant points. It also publishes every 12 minutes the physical flow on Internet for all entry points on the NBP. Balancing Shippers are required to balance their deliveries and off takes on a daily basis around NBP and for this National grid post the pressure of the system throughout the day. Because of this daily balancing, there is more emphasis on day- ahead and within-day gas market, which encourage trading at Spot 33

34 market( APX). If there is still imbalance in the system, National grid is responsible for correcting that imbalance by buying and selling gas through auction. Auction promotes efficient pricing of natural gas trade under flexibility mechanism because if shippers want to ensure that BG accepts their bids, they will reveal their true willingness to buy or sell natural gas. National grid use flexibility mechanism to overcome the imbalance in the system. The market for balancing is organized by National Grid which helps in identifying actual marginal costs of balancing the system over any gas flow day, thereby providing correct price signal to shippers in balancing their portfolios. The actual marginal cost of balancing is identified as follow; 1) When system is balanced, the shippers who are out of balance have to pay or are compensated for there imbalance at system average price( SAP) i.e. average price paid or obtained by National Grid in balancing action over the gas flow day. 2) When system is out of balance, then shippers who are out of balance are obliged to pay or are compensated at system marginal price (SMP) i.e. the highest or lowest price paid by National Grid for gas on the gas flow day. In extreme condition, National Grid can call on bids from the Top-Up-Manager ap5, but price charged for this gas is extremely high. National Grid may also interrupt delivery to prepare itself for emergency, in this situation National Grid makes arrangement with shippers, under which some of their largest customer are declared interruptible. Storage Storage facility in United Kingdom is owned and operated by BG storage. Storage is a regulated business and primary storage capacity is made available to shippers through periodic auction. Depending on total amount of storage booked by shippers and expectation of Top-Up-Manager s need, the manager may auction off surplus capacity at regulated rates. Shippers may trade storage capacity, with or without gas in it at unregulated rates at any time in secondary market. Unregulated trading is done by APX in cooperation with Centrica storage, where secondary storage capacity and gas stored at Rough (U.K largest gas storage facility) is traded. Following storage products are made available at APX for trading Product Secondary firm injection rights Secondary firm withdrawal rights Secondary firm space Gas in storage Product Trades day ahead and within day day ahead and within day day ahead and within day Within day. The APX gas storage market is available to all members of the On-the-day Commodity market (OCM) provided that they are signatories of CSL s storage service contracts and associated credit agreement ) Present and Future Status of Trading at NBP Present status Trading at NBP is done through Exchanges, OTC and bilateral market. Due to presence of enough liquidity and transparency, different types of short duration and standardize products exists, which are traded in within day or day ahead spot market. Curve products account for base load, i.e. industrial or electrical utilities are traded through future market (Endex) or on OTC market. Spot trading helps in balancing the system whereas future trading products are used for hedging, speculation and in some case physical delivery too. Spot trading is done via OCM (On-the-day commodity market) and APX is market operator for spot trading at NBP. Products which are traded on OCM are Locational, Physical and Title. Out of this title is most traded product, whereas physical and locational products are traded to alleviate specific system issue on national transmission system. 34

35 These spot prices for different categories are published and these estimates in turn are used as basis for price indexing in some contracts and risk management instruments such as swap. Spot price is very volatile and very much integrated with the seasonality. Storage gas and physical prompt gas product are also traded on APX. Prompt products offered by APX contribute towards National Balancing point. Future market Type of consumers and their consumption patterns are important factors to decide the type of market mechanism being used for gas trading. In U.K, market can be categorized as follow; 1) Large consumer which account for 43.4 % of gas used in U.K. These are large companies like heavy industry and electricity producers. Their daily and seasonal consumption patterns vary by consumer, but they have relatively flat load profile. 2) Intermediate consumer which account for 13.9% of total gas consumption annually. Their Consumption patterns typically are somewhat variable throughout the year. This includes small and medium sized commercial activity. 3) Residential Consumer which alone account for 42.7% of total gas consumption yearly. They are highly temperature and time sensitivity. This may cause more imbalances in the system, so they demand for more short term product to be traded in the market. Therefore short term products are very important for British market, considering the percentage of gas used for residential consumer. This increase the need of trading gas on spot APX (physical short term market), which is possible in British market because of enough liquidity and transparency. United Kingdom is self sufficient to satisfy its gas demand so most of curve product trading can be through bilateral market and OTC. But increase trading of curve product on Endex (future market) will help shipper to hedge their risk and use this future price for indexing gas contract, which are mostly index to oil price. 3.3) United States of America The United States has the largest natural gas market in the world. Gas supplies account for 24.4% of total primary energy, in which almost half of total deliveries is for industrial sector. It is self sufficient market for gas as its indigenous production accounts for around 85% of total supply. It also has a vast network of high pressure interstate pipeline connecting large production area to major consumption area together with considerable storage capacity. It is today one of the most dynamic and liquid market which has evolved through liberalization process which started very early. In following discussion we have analyzed the evolution of gas market in United States over the years ) Market Structuring United States had a linear structure before the liberalization process started i.e. production companies produce gas and sold it to inter state pipeline companies, who in turn deliver it to city gate and sold it to LDC (Local Distribution Companies), who then sold it to end user. 35

36 Figure3.3.1; Traditional structure of Gas industry in U.S Later third party access was facilitated to reduce the monopoly of pipeline network. This created wholesale market where marketers, Distribution Company, and large consumer (electrical utilities and industrial company) can purchase gas directly from wholesale market at cost lower than pipeline company. Pipeline Company was responsible for both commercial and transportation of gas. Pipeline capacity was offered to all end users on basis of regulated tariff. Distribution companies were responsible to supply gas to small consumers. Figure 3.3.2; Open Access to pipeline transportation 36

37 To further reduce the monopoly of Pipeline Company, its role was changed to a single service i.e. gas transportation. Expertise in commercial activity of pipeline i.e. managing gas transaction and balancing the network was brought to market, to further increase competition. This lowered the risk of trading and attracted new market player by facilitating spot market trading. Figure 3.3.3; Unbundling of gas sales from pipeline transportation Residential sector in United States was partially opened to competition, so they can either buy gas from retailers, spot market or they rely on Distribution Company for supply. Distribution Company which is not prone to risk can also rely on retailers for buying gas. Pipeline Company was providing pipeline capacity to all end users on basis of regulated tariff. Since all the gas was traded through spot market, it increases the liquidity on the Spot market developing them as a Hub on interstate pipeline. These trading Hubs have been developed at junction of multiple pipeline interconnections and usually they have access to natural gas storage facilities, which facilitates the hub operator to offer balancing services, enhancing the trading option for buyers and sellers. Hub operators also help in arranging primary and secondary pipeline capacity for shippers to overcome the contractual congestion. It has been observed that if sufficient capacity is available to transport gas between hubs, price differential between these hubs will represent marginal transportation costs between different locations. If price differential is above the transportation costs it means there is 37

38 congestion in the network, which may be either due to contractual or physical capacity in the pipeline. Figure 3.3.4; U.S natural gas spot price at major trading Hubs, Source: FERC- State of the Market Report ) Market Functioning North American gas market which is almost self sufficient in gas has evolved as a highly competitive market along the whole gas value chain. It is now characterized by 38 different hubs mean it has specific point for gas trading throughout the network of United States not like virtual point in U.K and Netherlands. Spot market on this Hubs are characterized by numerous market participant and access to service such as balancing, storage, gas transportation, pipeline capacity and ownership transfer. Each Hub has different market operator, responsible for balancing pressure of the network, owing pipeline capacity etc. Figure 3.3.5; Trading at Hubs Retailer Producers Distribution Company Pipeline Company Spot Market Pipeline Company Large Consumer Storage Capacity 38

39 Pipeline capacity In United States primary pipeline capacity is reserved via long term contracts by paying regulated tariff. But to overcome contractual congestion, capacity can be traded on secondary market at Hubs. Storage Capacity Storage capacity for gas is vital for stability of volatile Hub price. Third party access is allowed for storage capacity, which facilities market player to keep there portfolio balanced. Storage service in United States is more developed as financial instruments. On NYMEX exchange, a liquid market exists for future and option natural gas storage. Across all the Hubs in United States, Henry Hub and NIT Hub are the most liquid one because they are connected to many large pipelines serving different market, largest grouping of LNG regasification terminals and high deliverability of storage facilities. Publication of spot prices by NYMEX at Henry hub and by NGX at NIT hub increases the liquidity and transparency of these Hubs. These Spot prices are used to determine the market price of natural gas and to evaluate contract portfolio, consumption and investment decision. Prices at other hubs are referred as differential between Henry Hub and NIT. Transparency in Spot price has also helped in reducing market power, bringing lowest possible cost gas for end user by changing the gas flow direction. For e.g. suppose that the price of natural gas in U.S Midwest rose relatively to California. In such a situation Canadian and U.S natural gas sellers would prefer to sell in the U.S Midwest because the returns would be higher. More supplies would be offered in the U.S Midwest and sellers would divert their volume from California. As more supplies were offered in the U.S Midwest, the price there would tend to fall on contrary price would rise in California because of less availability ) Gas Trading in United States Trading on these Hubs is mostly through OTC market, where trading of natural gas, pipeline capacity and storage service at all interconnected hubs and pipelines takes place. To hedge the price risk due to volatility of natural gas price at spot market on these Hubs, future market exists in parallel at NYMEX. 39

40 Chapter 4- Spanish Gas Market Spanish gas market has come to full liberalization in 2003 and is still divided into two segments of market that are regulated and non- regulated market. Due to the lack of any indigenous production of gas within Spain, it relies on other countries for its gas needs. It has limited pipeline connectivity with other European countries, but it ranks third all over the world for LNG consumption. Maximum percentage of gas is consumed by power production to comply with the Kyoto protocol, since there is not enough Hydro production, wind production and Nuclear power plant in the country to cover the electricity needs. In the following chapter we have studied Spanish gas market in terms of its present status; market structure, market functioning, gas demand and supply. 4.1) Overview of the Spanish gas market Gas consumption and forecast In Spain, gas was mostly used for industrial purposes and domestic consumption, but with the increased installation of CCGT power plants, which are marginal unit in Spain, gas consumption for power production has increased tremendously in previous years. Figure 4.1.1; Gas consumption by different sector Source: Spanish wholesale market, CNE Spain Gas consumption in Spain for 2007 was 408 TWh; 86% of this total gas consumption was used for power generation and industrial sector. Figure 4.1.2; Gas consumption in 2007 for different sector 2007 Gas consumption by different sector 51% 12% 35% 2% Power Generation Raw Material Residential Industrial Source; CNE Spain 40

41 It has been projected by ENAGAS (Spanish gas Operator and transporter) that gas consumption by different sector will grow with a CAGR 1* of 5 % till Figure 4.1.3; Natural gas demand and forecast till 2016 Source: ENAGAS Spain Gas Import Spain due to the lack of indigenous production of gas is completely dependent on imports. It is connected with a small capacity pipeline with France and has limited gas pipeline interconnections with other non-eu countries. Most of the gas demand needs is fulfilled by LNG supplies. LNG supplies account for 68.41% of total supplies and provide flexibility service for seasonal load demand, which was lacking earlier due to small percentage of underground storage (2 bcm) in Spain and increase security of supply. According to EU policy, to diversify supply sources to further increase security of supply, Spain imports gas from many countries either through pipelines or LNG cargo. Figure 4.1.4; Natural gas supply per country Natural Gas Supply per country 1.24% 0.26% 10.29% 34.40% 2.24% 6.53% 14.29% 24.31% 6.44% Source: Ministry of Economy, Spain Egypt Nigeria Trinidad & Tobago Gulf Countries Norway Libya Algeria National Other * Compound annual growth rate (CAGR) is a business or investment specific term for the geometric mean growth rate on an annualized basis. It describes the growth over a period of time for some elements of business. 41

42 Spain today has operational regasification capacity of 49.5 bcm, which is the highest in Europe ap6. Sufficient amount of entry and exit capacity ap7 of LNG terminals, allows the Spanish gas market to be accessible by international market player. The following table shows the different entry capacity of the Spanish gas network. Regasification Capacity( 6 LNG Terminals) Interconnection Algeria-Morocco-Spain-Portugal( El Magreb) Under construction Algeria-Spain( Medgaz) Interconnection France( only from France-Spain) Source :Enagas Entry Capacity of gas network 49 bcm 12 bcm 8bcm 2.5 bcm 4.2) Market Structure Traditional structure of Spanish gas system was linear but with the complete process of liberalization in 2003, third party access (TPA) was allowed to bring competition in the market. This allowed market players to access network of transmission, distribution, LNG and underground storage by paying regulated tariffs. This facilitated wholesale market whether qualified consumer (Industrial & Electrical Utilities) and retailers can purchase gas from producers and retailers directly and have access to storage facility and pipeline capacity by paying regulated tariffs. These regulated tariffs are fixed by government and is the same for the entire national territory depending upon volume, supply pressure and form of consumption. Transportation system which was earlier based on point to point system was changed to Entry-exit system, which facilitated creation of single virtual balancing point (CDG) for the Spanish gas transport system. It also helped new LNG players to easily get LNG entry capacity on the system without reveling before gas trading where the gas has to go. Figure 4.2.1; Open-access to pipeline transportation in Spain 42

43 Enagas is responsible for both commercial and monopoly activity in the Spanish gas system, buy NG and LNG gas from different countries. Distribution Company can buy gas and pipeline capacity from Enagas at regulated basis to supply gas to regulated consumers (either residential or large consumers). To increase competition in the market, Enagas also facilitates wholesale gas trading where qualified consumer and marketers can purchase gas on non regulated basis. Large consumers (Industrial and Electrical utilities) who are not prone to risk can purchase gas from retailers at non regulated basis too ) Recommendation 1) System operation is a monopoly activity that must be carryout by ENAGAS. But transmission capacity should not be based on regulated tariff but its primary capacity should be auctioned in the market like British market to bring transparency and generate market signal for investment. Secondary capacity of pipeline should be traded on the spot market like in the Netherlands where it is traded by APX. It will solve the problem of contractual congestion and will increase liquidity in the market. 2) Underground storage should not be available on basis of regulated tariff but it should be brought to spot market with TPA rule as in the British market. It will provide flexibility for small market players to balance their portfolio and avoid imbalance penalties. It will also facilitate trading of short duration product on Spot exchange at OMEL. 3) LNG capacity should also be auctioned like pipeline capacity and secondary capacity should be traded on the exchange. 4) Monopoly and commercial activity of Enagas should be divided into two separate branches of ENAGAS, like the Netherlands, the U.K and the United States did. It will bring more transparency to the gas market 5) Regulated tariff consumer should be removed from the market and residential sector should be completely opened to competition. It will increase the number of market players in the market and will increase trading of gas. 4.3) Market Functioning Even after the full liberalization of gas sector in 2003, Spanish gas market is divided into two segments; regulated market in which products like re-gasification plant, storage capacity, Pipeline capacity and balancing (tolerance limit) is available at regulated tariff and de-regulated market in which products like supply of gas to qualified consumers and secondary pipeline capacity is available at non regulated tariff. 43

44 Figure 4.3.1; Market Functioning in Spanish gas market Enagas which act as system operator and transmission network manager is responsible for managing and balancing transport network. Regasification plant, storage is also partially owned by Enagas, which is accessible to all qualified consumers on basis of regulated tariff. Enagas allot the capacity in these services for long term contract (approx 1 year) on first come first basis. Distribution business in Spain which supplies gas to regulated consumer on basis of regulated tariff is in the hands of private companies. In 2007, 88.45% of Natural Gas consumption was supplied through liberalized market and 11.55% through regulated market. Increased trading through liberalized market was due to increase use of gas in power production, which is considered as qualified customer. Gas coming to Spain through El Magreb pipeline from Algeria,75 % goes to Enagas for supplying gas to tariff consumer( mostly residential) and 25 % of gas goes to marketer to sell it to qualified customer. Spanish gas network has frame of daily balancing with certain tolerance limit for shippers. It helps shippers in neutralizing the penalties imposed by TSO. Access to storage facilities on basis of regulated tariff helps in facilitating different flexibility tools in the market. Types of Flexibility Requirement Within day Within week Within month Seasonal Source: CNE, Spain Underground storage Most Important LNG regasification Least Important LNG storage Pipeline 44

45 4.3.1) Recommendation 1) Spanish market should be integrated into one non-regulated market. 2) Pipeline network, re-gasification and liquefaction capacity could be divided into Separate company to bring more transparency as it is United States and UK. 3) Trading at OTC and bilateral market should be discouraged. For long term products Future financial market should be facilitated and short duration product should be traded on spot exchange. It will bring transparency in the market and reflect real price of gas in Spanish market and developing Spanish market as more liquid market. 4) Secondary- storage, pipeline capacity should be traded in daily balancing market at exchange to provide flexibility and increasing trading of gas in the Spanish market. 5) More flexibility product like combiflex, virtual storage and higher tolerance width should be facilitated in the Spanish market. It will ease shippers to be balanced most of the time. 6) Balancing frame should be daily like U.K. Advantage of it should be that those who create imbalance should pay for it. Secondly it will encourage investment in LNG storage facility as Underground storage capacity in Spain is limited to 2 bcm. 4.4) Present Status of gas trading In Spain different market players are active in the market providing different types of service. Following table summarize major market player active in the Spanish market. LNG operator Storage Operator Transmission System Operator Source: Enagas Main market players in Spanish gas system 3( Barcelona, Cartagena, Huelva) power owner Enagas 1(Bilbao) power owner BBG 1(Sagunto) power owner SAGGAS 1(Mugardos) power owner Reganosa 2 ( Underground Storage) power owner Enagas 89% power owner Enagas Most of the gas trading between this market players and consumers takes place through OTC market at LNG regasification plant and underground storage facilitates. Figure 4.4.1; Spanish OTC gas market Source: Enagas 45

46 Uncertainty in the gas market due to large consumption of gas by qualified consumers has increased the volume of gas traded in OTC market. Following graph shows gas consumption vs. trading in OTC market. Figure 4.4.2; Spanish OTC gas market vs. Consumption Source: Enagas It can be clearly depicted that due to high summer temperature in the month of May and June increases the uncertainty in gas market for power production to be used in air conditioning in Spain. This increases volume of gas trading for balancing the system which arises due to this seasonal variation. To concentrate liquidity and increase transparency in the market, virtual balancing point CDG has been created in Trading on this virtual balancing point takes place through OTC market know as MS-ATR managed by Enagas. Trading on OTC is done bilaterally on anonymous basis (without revealing the name of the users and party negotiating the gas price). In 2007 volume of gas traded on MS-ATR was 408 TWh which represents 109% of total gas consumption of Spain which is still far behind the volume of gas traded on NBP (United Kingdom). Country Gas Traded 2006( TWh) Trading as % of total demand U.K % Netherlands % Belgium % Spain % ( 408 TWh in 2007) 109% in ) Shortcoming of Spanish gas market 1) LNG import share a major percentage in supply matrix of Spain and price of this gas is strongly influenced by global LNG market i.e. Marginal price of gas in Spain is linked to the price that LNG cargo could obtain in other market such as Henry Hub, NBP or linked to Brent (oil price). But actual price of gas in Spain may or may not be equivalent to marginal price of gas fixed by LNG cargo, which increase the credit risk for the LNG shippers. Having a mature market by trading more gas through spot and future market will bring true price of gas in the market and help LNG cargo to hedge risk for scenario where price of gas is low in Spanish market 46

47 2) Due to lack of price and volume transparency in the Spanish gas market, shippers are not able to predict the future price of gas in the Spanish LNG market. This bar them to divert their LNG cargo to other importing countries and reduce their risk, which is a barrier for the development of Spanish gas market. 3) LNG shippers also have risk of storage penalties depending on the gas stock levels i.e. their is 5 days of LNG storage free of charge in daily regasification capacity booked but if monthly average LNG stock level is above 8 days of daily contracted capacity(adding stocks in all LNG plants) there is big penalty. Transparency in the market will help shippers to overcome through this problem and give insight to balance their portfolio to avoid risk of paying high storage cost. 4) There has been increased growth in LNG import but from 2006 onwards there has been stagnation in LNG import. If this trend continues there is increased concern over security of supply due to lack of LNG cargo coming to Spain. Increasing transparency in the market will reduce credit risk for LNG shippers and will bring confidence in the market. Figure 4.5.1; Trend in natural gas imports (in GWh) per supply type Source: Ministry of Economy, Spain 5) In Spain maximum gas exchange is through LNG terminals. Trading through these LNG terminals is not a regulated activity. Most of this gas is traded on OTC market bilaterally or through marketers and there is enough probability of arbitrage the gas price which is barrier to competition and bar the benefiting reaching to end users. Figure 4.5.2; Gas exchange per infrastructure Gas exchnage per Infrastructure 7% 2% LNG Terminals( GWh) 91% Transmission Network( GWh) Underground Storage (GWh) Source: National energy commission (CNE), Spain 47

48 Chapter 5- Conclusion 1) Like other existing competitive model, Enagas should also divide its commercial and monopoly activity. One branch of Enagas should only be responsible for monopoly activity i.e. pipeline network and its commercial activity i.e. gas trading should be brought to market. It would help in increasing liquidity on the spot market. 2) Spot trading at exchange (OMEL) should be created and facilitated, it will increase the number of short duration product in the market and will help the market player to balance their supply needs and avoid penalties caused due to imbalance. 3) OMEL should facilitate exchange trading of secondary pipeline capacity. Secondary pipeline capacity trading will solve the contractual congestion problem if any and if there is physical congestion, then trading price at OMEL can be short of a signal for investment in infrastructure. 4) OMEL should also facilitate exchange trading of storage capacity. It will attract small market player to be active on the market, without having sufficient portfolio of gas. Short duration trading of storage capacity can provide them opportunity to balance their portfolio. 5) Spot trading at exchange (OMEL) will increase liquidity in the market by increasing number of market players being active on the market and volume of gas traded. It will facilitate future trading of gas at OMEL. If there is enough maturity and liquidity in the Spanish market, price of gas at future market can be used to index LNG gas contract which is today index to Henry Hub or NBP. Future price in Spanish market will reflect the real price of gas in the Spanish market and will give insight to shippers to make decision whether to supply gas or not to Spanish market. 48

49 6) Price of Spot trading and future trading should be published to bring transparency in the market. 7) Spain is biggest LNG hub in Europe, if there is enough transparency and liquidity in the market by trading gas at spot and future market. It will increase the confidence of LNG suppliers in the Spanish market as it will reduce the credit risk for LNG supplier and would further help in the development of LNG Hub in Spain. It will be in accordance to EU policy of creating Pan European new Hubs providing opportunity of swap and arbitrage between different markets bringing competition. Figure 5.1; EU market as LNG and Pipe gas Hub 49

50 Appendix 1) Gas Consumption for Power Generation in EU Source: Enagas 2) CO 2 emission by type of Fuel CO2 emission by type of Fuel KgCO2/GJ Lignite Anthracite Fuel Oil Gas Oil Natural Gas Type of Fuel Source: IEA 3) Overview of Import Dependency in EU Source: IEA 50

51 4) Production Cost by type of technology Production cost by type of technology( 5,000 hours per annum, not subsidized) Euros/MWh Nuclear Fuel Oil Biomass Lignite CCGT Source: EC (real costs, year2000) 5) Top- Up- Manager Top-Up Manager is an organization within National Grid, responsible for ensuring that enough gas is injected into and held in storage during the summer to meet expected peak winter demand. Storage is booked by shippers, but their booking may be insufficient to meet peak demand needs. In that case Top-Up-Manager may buy gas and inject it into un-booked empty storage by estimating the amount of gas that is lacking to meet the seasonal demand. The gas injected by Top-Up-Manager, is available on peak day, either through the flexibility mechanism or by direct sale to shipper with booked storage space but insufficient gas at very high price 6) Regasification capacity 2007 in EU Source: IEA 51

52 7) LNG entry point on Spanish gas network Source: Gas Natural 8) Spanish and French market Integration to increase liquidity France and Spain are preparing to merge their gas markets. CRE, the French energy regulatory commission and Spain s National Energy Commission (CNE) recently endorsed the first coordination gas capacity allocation between two countries. With increase in Interconnection will create a step towards developing a regional gas system integrating French, Spanish and Portuguese market. Integrating the systems makes it possible to book exit capacity from one country in coordination with entry capacity on adjacent network in both directions improving market fluidity. Total Infrastructure Gas France (TIGF) and Enagas jointly carried out long and short term allocation. The long- term capacity and short term from France to Spain was fully subscribed, with demand largely exceeding offered capacity. At present through Larrau pipeline, it s possible to flow gas in southward direction between France and Spain but not possible to import gas from extensive network of LNG terminals (capacity 58% bcm/year) in Spain. If infrastructure is upgraded it will improve liquidity in Southern gas markets 52