GASTALE: An oligopolistic model of production and trade in the European gas market

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1 August 2003 ECN-R GASTALE: An olgopolstc model of producton and trade n the European gas market M.G. Boots, ECN F.A.M. Rjkers, ECN B.F. Hobbs, Johns Hopkns Unversty

2 Preface In ths report, the emprcal model GASTALE s descrbed and used to analyse the European natural gas market. The analyses focus prmarly on the role of the downstream trad companes and ther nteracton wth olgopolstc gas producers. A condensed verson of ths report was submtted to The Energy Journal (wthout know n ths stage f t wll fnally be accepted for publcaton). Ths report contans more detaled nformaton than the verson sent to The Energy Journal. The authors would lke to have ths study - nclud ts detals - publshed, n order to be able to refer to t n ther oo work. The research descrbed n ths report was conducted under ECN project number n Ths research was funded by the Mnstry of Economc Affars, Government of the Netherlands. In addton, partal support for B. Hobbs was provded by the US Natonal Scence Foundaton, grant ECS The authors would lke to thank B. Danëls for hs contrbuton n the modell process. Abstract In ths paper, the emprcal model GASTALE s descrbed and used to analyse the European natural gas market. These analyses focus prmarly on the role of the downstream trad companes and ther nteracton wth gas producers. By default, producers of natural gas are assumed to form an olgopoly n the paper. Meanwhle, downstream wthn-country traders of gas are represented n dfferent versons of the model as local olgopolsts or perfect compettors. The model therefore has a two-level structure, n whch producers eage n competton a la Cournot, and each producer s a Stackelberg leader wth respect to traders, who may be Cournot olgopolsts or perfect compettors. The case of Cournot traders results n a new form of energy model, that of successve olgopoly. The model s formulated as a complementarty problem, and s solved by nonlnear programm. Consder ths olgopolstc market structure, several tentatve conclusons emerge. Frst, our model results show that successve olgopoly (so-called double margnalsaton ) yelds sgnfcantly hgher prces and lower consumer welfare than f olgopoly exsts only on one level. Second, olgopoly n the trad market (because of the hgh concentraton of traders) results n more dstorton than olgopoly n producton. Thrd, the level of traders profts depends on the possbltes of dscrmnaton on the border prces. If prce dscrmnaton by producers s allowed, these producers collect a greater share of the margns on end-use prces. Fourth, when the number of traders ncreases and assum an olgopolstc downstream structure, end-use prces converge to prces correspond wth perfect competton. Thus, t s mportant to prevent (or abolsh) monopolstc structures n the downstream gas market. In the case where olgopolstc competton amo downstream gas companes cannot be prevented, vertcal ntegraton should be supported (or at least not be dscouraged), especally f t would result n a greater number of traders. 2 ECN-R

3 CONTENTS 1. INTRODUCTION 5 2. SUCCESSIVE UPSTREAM AND DOWNSTREAM BEHAVIOUR Downstream Upstream EMPIRICAL SPECIFICATIONS Demand Elastctes Upstream producton and costs Downstream trade and TPA tarffs Non-elgble and non-mature markets EQUILIBRIUM MODEL Basc Cournot producer model Addtonal constrants PERFECTLY COMPETITIVE VERSUS OLIGOPOLISTIC TRADERS Results VARYING THE NUMBER OF TRADING COMPANIES Results INCOMPLETE MARKET OPENING Results DISCUSSION AND CONCLUSIONS 29 REFERENTIES 31 APPENDIX A: SENSITIVITY ANALYSIS OF ELASTICITIES 33 APPENDIX B: COST OF TRANSPORT 36 ECN-R

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5 1. INTRODUCTION European natural gas markets are undergo dramatc chaes (Stern, 1998, Radetzk, 1999). In August 2000, most EU Member States mplemented the Gas Drectve concern the nternal European market for natural gas. The Drectve specfes common rules for the trade, dstrbuton, supply, and storage of natural gas. Lberalsaton of the European gas market s mposed at the demand sde, by gradually allow consumers to choose ther suppler. Member States have specfed elgble customers,.e., those customers that have the legal capacty to contract for natural gas. As a frst step, all gas-fred power generators, rrespectve of ther annual consumpton, are desgnated as elgble customers, as are fnal customers who consume more than 25 mllon cubc meters per year. Ths defnton of elgble customers ensures that at least 20 percent of the total annual consumpton of each natonal gas market s opened for competton. Further market open (at least 33 percent) and customer elgblty s gradually be ntroduced. For the organsaton of access to the network, Member States can choose between negotated and regulated access. Natural gas companes are requred to keep separate accounts for ther gas trade, dstrbuton, and storage actvtes (admnstratve unbundl). The EU Gas Drectve defnes the mnmum actons to be taken by the Member States. However, the ensu development of gas markets not only depends on ths nsttutonal framework, but also on the reacton of market players,.e., gas companes as well as ther customers, to these nsttutons (see also Ells, Bowtz and Roland, 2000). In ths paper, the nsttutonal framework presented n the EU Gas Drectve s taken as a start pont for an analyss of possble developments n the natural gas market. We then make a rae of assumptons regard the behavour of market players: upstream producers, downstream traders, and end users. The man purpose of ths paper s to analyse the role of downstream trade companes n the European gas market. Therefore, a quanttatve model of the market for natural gas n the European Unon has been developed. The model allows us to vary the behavour of the traders and producers and to analyse the effects of ths behavour on, e.g., end-use prces of natural gas. The model can also be used to analyse the general effects of gas market lberalsaton upon prces (see also European Commsson, 1999). Here, we focus on complete market open by lett all consumers free to choose ther suppler. Our model bulds on earler modell work n ths feld. In a thorough revew artcle, Smeers (1997) dscussed the potental of combn Industral Economcs and computaton of economc equlbra n order to analyse the restructur of European electrcty and gas markets. In the context of the European gas market, most recent models represent the market as be ether purely compettve (e.g., Capros et al, 2000) or, equvalently, based on cost-mnmsaton prncples (e.g., Parcebos and Valette, 1996). In realty, however, the gas market s hghly concentrated, and f unregulated, t s reasonable to expect that prces wll devate from the margnal cost deal. When mperfect competton has been smulated n the European gas market, Cournot paradgms have been appled. Mathesen et al (1987) concluded that the gas market s best descrbed by the Cournot game (.e., as a game n quanttes). Competton can be expected to take place through quanttes, snce lo-term take-or-pay contracts stll preval n the natural gas market. Some potental effects of lberalsaton were analysed by Golombek et al (1995, 1998). In ther 1995 artcle, they focused on the effects of prce dscrmnaton and arbtrage possbltes. They concluded that as gas traders wll explot arbtrage possbltes, the development of market power could be prevented. Us the same model, ther 1998 artcle studed the optmal organsatonal structure of gas producton. However, unlke the model n ths paper, thers dd not consder the effects of mperfect competton amo traders, or the results of olgopoly n ECN-R

6 both trad and producton. 1 Golombek et al allowed us to use ther model as a bass to develop GASTALE (Gas market System for Trade Analyss n a Lberals Europe). GASTALE was ntally developed to analyse the effects of gradual gas market lberalsaton on end-use prces and market shares of producers (Oostvoorn and Boots, 1999; European Commsson, 1999). In ths paper, GASTALE s elaborated n order to analyse the role of gas trad companes n the European gas market. GASTALE descrbes the European gas market n terms of two layers of companes on the supply sde alo wth consumers n three basc sectors on the demand sde of the market. The market structure s assumed to consst of an olgopoly of upstream gas producers and a layer of downstream gas traders, all of whom are proft maxmsers. However, the poston of traders s up to the modeler and can vary from a natonal monopoly to perfect competton between traders. The case of mperfectly compettve traders results n a model structure that s new n the energy modell lterature: that of successve olgopolsts. In equlbrum, total gas demand equals total supply n each market sector n each country. Ths equlbrum s drven by producton costs, thrd party transmsson tarffs, demand elastctes of the consumers, and the ntensty of competton amo producers and traders. Prevous theoretcal studes have addressed the propertes of successve olgopoly models, and a few applcatons have focussed on the effects of vertcal ntegraton wthn partcular markets. Greenhut and Ohta (1976) consder an abstract sle market n whch there s an upstream monopolst producer and ether a monopoly or duopoly downstream. Later, they generalse ther model to allow olgopolsts n both levels (Greenhut and Ohta, 1979). They derve optmal prc strateges for the upstream frms, who are Stackelberg leaders wth respect to the downstream frms. They found that successve olgopoly results n hgher consumer prces, lower output, and lower total profts than vertcal ntegraton, results that are largely confrmed here. Sheral and Lelano (1988) study the exstence and computaton of a more general case n whch vertcally ntegrated olgopolsts compete sde-by-sde wth unntegrated upstream and downstream frms. Our model can be vewed as an extenson and applcaton of the successve olgopolst model of Greenhut and Ohta (1979) to a stuaton n whch, frst, multple consumer markets are separated n space and, second, producers have nonlnear producton costs. A contrbuton of ths paper s the presentaton of a practcal computatonal approach for large successve olgopoly models based on nonlnear programm. In the next Chapter, an overvew of the theoretcal economc model descrb the behavour n the European gas market s gven. In Chapter 3, emprcal assumptons regard consumer demand, producton costs, and costs of nternatonal transport and thrd party access (TPA) to wthn-country transmsson systems are descrbed. Then, Chapter 4 presents two market equlbrum models, one allow border prce dscrmnaton amo consum sectors and the other assum no dscrmnaton. The models are formulated as complementarty problems, 1 There exst a number of other soluton concepts that can be used for energy market games, such as Bertrand (prce) competton, supply functon equlbra, and tact colluson (Trole, 1988; Day et al, 2002). Bertrand competton s sometmes used as a lower bound for mperfectly compettve prces. Bertrand competton under some assumptons yelds the pure competton soluton; however, under other assumptons, Bertrand games can gve prces above margnal cost, but well below Cournot levels. In our model, Bertrand competton amo two or more traders would result n the pure competton solutons presented n the tables, and can be vewed as a lower bound to prces under trader olgopoly. However, we beleve that ths optmstc outcome s relatvely unlkely when the trad sector s hghly concentrated n a country (e.g., monopoly or duopoly). Supply functon equlbra (Klemperer and Meyer, 1989) are most approprate when demand s hghly varable or uncertan, and there s lttle storage; thus t has found wde use n electrcty market models (especally n aucton-based markets), but not n the gas sector. Tact colluson models are theoretcally attractve n concentrated markets charactersed by frequent nteracton (e.g., as n daly power auctons). However, they have not been used n detaled energy sector models for several reasons, nclud the absence of models for nonsymmetrc frms and the lack of computatonal methods for markets wth complex cost and demand structures, as n the EU gas market. For these reasons, characterzaton of the gas market as a game n quanttes s a reasonable pont of departure for analys strategc nteractons amo producers and traders. 6 ECN-R

7 and are solved by nonlnear programm. Chapter 5 descrbes the cases regard downstream trade behavour and analyses the results. In Chapter 6 the number of traders s vared, whle Chapter 7 llustrates the modell of varous degrees of market open and ther effects. The paper ends wth a set of conclusons. Appendces summarse senstvty analyses wth regard to prce elastctes of demand, alo wth nternatonal transmsson tarff assumptons. ECN-R

8 2. SUCCESSIVE UPSTREAM AND DOWNSTREAM BEHAVIOUR The end-use markets are dstushed by country, denoted by n=1,..,n, and by market segments, denoted by g=1,..,g. End-user markets are suppled by trad companes r=1,..,r, where each trader r s lnked to one or more markets. That s, traders have a predetermned supply regon. The producers supply the traders wth gas. A dstncton s made between =1,..,I major producers and a group of reman regulated provders for whom we assume that producton and sales are exogenous (exogenous sales to market are denoted by the constant exog ). 2.1 Downstream Traders are assumed to be ether perfectly compettve or Cournot players n end-use markets. The maxmsaton problem for trader r s gven by: π r = max r n, g ( p bp dc ) y r (1) where p s the retal prce of natural gas n consumer market, whle y r s gas delvered to market by trader r. Retal prce s endogenous to the market, be a functon of total gas delvered by all traders, nclud r, but s exogenous to traders f they are compettve. The trader has to purchase gas from producers at the border prce bp and subsequently pays transmsson tarff dc for transport gas to consumers; we assume the tarff s the same for all r. 2 We also assume that traders are prce-takers wth respect to the border prce of gas; however, ths may not be strctly true for very large traders or consumers (such as power companes). Another assumpton s that all traders have dentcal costs of serv a partcular market segment, and that they are prce-takers wth respect to the border prce. The consumer prce s determned as a functon of consumed quanttes,.e., the nverse demand functon s p 1 = D ( x exog ), where x s the total amount consumed n market. Recall that exog s defned as the amount of exogenous (nonprce-responsve) gas suppled to market (for nstance, by publcly-owned utltes); as a result, x = yr + exog. (Note that we neglect gas losses due, for example, to leakage and fuel requred r to operate compressors.) If we assume Cournot competton amo traders and the above demand functon, downstream proft maxmsaton results n the follow frst-order (Karush-Kuhn-Tucker) condton: π y r π ( bp + dc ) + p y 0, y 0, y = 0 = p r r y r r (2) Ths equaton depcts the ndvdual trader s demand for gas y r gven the border prce bp. The expresson for the border prce can then be derved from (2) as: bp p dc + p y (3) r 2 In calculat ths tarff for each country, we assume no substantal chae n present taxes and cross-subsdes by country, whch can be very substantal. The tarff coeffcent s also assumed to nclude trad costs and a normal return to captal for the traders; we assume that these are relatvely small compared to wthn-country transmsson costs. 8 ECN-R

9 If y r > 0, then (3) holds as an equalty. If we nstead assume perfect competton amost traders, the term p yr n equaton (2), denot the effect of an extra unt of throughput on the proftablty of nframargnal sales, would be omtted. The border prce would then be no less than the dfference between end-user prce and transmsson costs: bp p dc (4) Agan, ths holds as an equalty f y r > 0. Follow Golombek et al (1995), we assume a lnear (affne) consumers demand curve for natural gas. The emprcal specfcaton of the lnear nverse demand functon s: p = D 1 ( x exog ) α + β ( x exog ) (5) where α > 0 and β < 0 are the parameters to be calbrated at assumed prces, consumpton and elastctes for the base year (1995). Ths procedure ensures that all demand functons go through the actual market outcomes n that base year (Mathesen et al, 1987). Moreover, we wll assume that each consumers quantty demanded s postve,.e., that retal prce s less than the prce ntercept of the demand functon: p < α (6) Where traders are compettve, Equaton (6) s equvalent to the condton that the border prce bp < α - dc. In the case of Cournot traders, t can be shown that the upper bound s tghter: bp < α - dc + β y r for any r, where β y r < 0. (These results can be obtaned by recognz that p < 0 n (3), and (3) and (4) hold as an equalty f y r > 0; then (3) or (4) s substtuted nto (6).) An mplcaton of the forego assumptons, alo wth the assumpton that the cost of serv a partcular market segment s dentcal for all traders, s that all throughput quanttes y r > 0, and (3) and (4) hold as equaltes. Snce symmetry of traders mples that there s no prce dscrmnaton amo traders, there s no need to dvde the sales varable for producer nto sales to ndvdual traders. Therefore, q can denote the total gas delvered to all traders n market by producer. We assume that total sales to by producers q equal total sales to that segment by traders y r. Therefore, f traders are perfectly compettve, and (6) holds, then the effectve demand r curve that faces producers for market segment s: bp = α + = + β ( x exog ) dc α β q (7) where α α dc and β β. Equaton (7) shows that n the compettve trader case, the demand fac producers s the consumer demand that traders see, but shfted downward by amount dc. On the other hand, f traders are Cournot players, the expresson for the R + 1 slope of the curve chaes to β β, where R s the number of traders serv R market segment. (The ntercept α s the same as n the compettve trader case.) Thus, wthn-country transmsson costs shft the orgnal demand curve downwards, snce α < α, whle market power amo traders makes the demand curve steeper, as β > β. Wth zero transmsson costs and a large number of traders, the effectve demand curve converges to the consumers demand curve. Ths result s derved from the Cournot equlbrum amo dentcal ECN-R

10 traders, gven that the traders are prce-takers wth respect to the border prce of gas. Some further relatonshps can also be defned. In each market, equatons (5) and (7) mply that when traders are compettve, the border prce s related to the retal prce as follows: bp = p - dc. But n the Cournot stuaton, we have nstead bp = p - dc + β q /R. Because β < 0, ths shows that for a gven border prce bp, Cournot traders ncrease the retal prce (and thus ncrease ther margn) by amount β q /R. Fnally, n ether the compettve or Cournot trader case, each trader r n market sells the same amount y r = (x - exog )/R, under our assumpton that traders and producers ncluded n the model do not supply the exogenous porton of consumer demand. 2.2 Upstream Assume that the producton sde of the gas market forms an olgopoly. Assume also that producers choose ther producton and sales quanttes smultaneously (one-stage game). Each producer maxmses ts proft gven the quanttes chosen by the other frms. The result equlbrum, f t exsts, s therefore a Nash-Cournot equlbrum. As s well known, a Cournot equlbrum wth a large number of frms s approxmately compettve,.e., the market prce converges to margnal cost (Trole, 1988). The objectve functon of a proft-maxms gas producer s gven by: π = max q n, g ( bp t n ) q c ( n, g q ) (8) As explaned below, the border prce bp s an endogenous functon of the quantty varables n the producer s model (8), unlke the trader s model (1). Thus, the producers antcpate the reacton of traders;.e., producers are Stackelberg leaders wth respect to traders who are followers. Costs of produc quantty q are denoted by c ( ). It s assumed that the cost functon s n, g ncreas and convex n producton, that s, c > 0 and c 0. The cost of lo-dstance transport from producer to country n s denoted by t n per unt of gas delvered q. Agan, we neglect losses of gas dur transmsson; we also do not explctly consder ppelne capacty lmtatons, but assume that they, alo wth losses, are reflected n t n. In order to lnk the upstream and downstream proft maxmsaton problems, the expresson for the border prce n (7) s substtuted for bp, mak prce endogenous: π = max ( α + β q j tn ) q q n, g j c ( n, g q ) (9) The frst-order condton for maxms producer s profts s then: π qr π = α ( ) ( + + β q j + β q t n c ) 0; q 0; q = 0 j qr (10) If q > 0, the frst-order condton for q yelds: q = [ bp ( t + c )]/ β (11) n 10 ECN-R

11 In general, a Cournot equlbrum amo producers mples that margnal delvered costs of producers are not equalsed, as would be the case n a perfectly compettve market. Too lttle s produced and the ndustry s cost of producton s not mnmsed. Snce t s assumed here that the trade companes also compete on quanttes, ther throughput quanttes are also too lttle gven bp and, n general, transmsson costs are not mnmsed (although n the symmetrc cost case consdered here, transmsson does occur at mnmum cost). As our results below show, market dstortons decrease when trade companes are perfectly compettve,.e., when the border prce n equaton (7) s defned us β =β. In contrast, n the Cournot trader case, β > β, and the q found n equaton (11) wll be smaller than f traders are perfectly compettve. ECN-R

12 3. EMPIRICAL SPECIFICATIONS 3.1 Demand Consumpton of natural gas n the European Unon (EU-15) totalled 346 bcm n 1995 (IEA, 1997). However, the majorty (97%) of total EU consumpton occurs n just eght countres. In ths study we focus on those countres that can be classfed as mature gas markets. Thus, n={austra, Belgum, France, Germany, Italy, Netherlands, Span, UK}. Wthn a country, natural gas s consumed n three man sectors: g={households, ndustry, power generaton}. The share of each sector n domestc consumpton dffers substantally amo countres. For example, due to the domnance of nuclear power n France, gas s hardly used to fuel power plants. Based on the eght countres and three market segments, 24 separate gas markets wthn the EU-15,.e., 24 gas prces, are dstushed n ths study. 3.2 Elastctes The prce elastcty of demand for the case of lnear demand s defned as: ε. e., β ( x = = exog p ε ( x p ) ( x exog p exog = β ) and α = ) 1 p ( x 1 ( 1 ) ε p exog, ) (12) We specfy the prce elastcty of the demand curve for each country and sector at the 1995 prce/quantty pars (Table 3.1). Elastctes are taken from Pndyck (1979). However, he dd not dstush power generators as a separate sector, therefore, n the base case we take the elastctes for ndustry as a proxy. (Senstvty analyses n Appendx A consder other elastctes for the power sector.) Moreover, Austra and Span were not dstushed as consum countres by Pndyck. In ths study, elastctes n Austra and Span are set equal to those of Germany and France respectvely. These elastctes are admttedly dated, but the Pndyck study provdes the most complete and consstent set of elastctes for our purpose (for several households and ndustry n several countres). The gas markets n the dfferent European countres have developed consderably snce the end of the seventes, and consequently ther demand elastctes may also have chaed. Another dffculty s the dfference n the level of gas market maturty between the countres. In a mature gas market, where the nfrastructure for substtutes of natural gas has deterorated (e.g., fuel ol delvery for household heat), we mght expect lower prce elastctes. Fnally, a revew of gas elastcty estmates obtaned by a varety of methods n other jursdctons shows wldly dvergent results, wth lo run values n the rae of 0 to n the resdental sector and 0 to for the commercal sector (Dahl, 1993, summarsed n Wade, 1999), wth most of the elastctes be n the rae of -0.2 to -2. Therefore, for want of a more recent complete set of elastctes, we use the Pndyck values as a start pont, and conduct senstvty analyses to assess the robustness of our conclusons wth respect to those values (see Appendx A). 12 ECN-R

13 Table 3.1 Assumed elastctes and 1995 market prces and consumpton Country Market Segment Prce a [US$/1000 m 3 ] Consumpton b [bcm] Elastcty c Austra households ndustry generaton Belgum households ndustry generaton France households ndustry generaton Germany households ndustry generaton Italy households ndustry generaton Netherlands households ndustry generaton Span households ndustry generaton UK households ndustry generaton Total a Source: IEA (1998a), p (1000 m 3 =1.19x10 7 kcal on a gross calorfc bass). Gas prces for power generators n Austra and France were unavalable. Therefore, they are assumed to equal prces for ndustry n the respectve countres. b Source: IEA (1997) (1 Mtoe=1.322 bcm). Consumpton by power generaton n Span was bcm; however, we used a hgher amount n order to get reasonable parameters for the demand functon. c Source: Pndyck (1979), table 4.7 and 5.2. Elastctes n Austra are assumed equal to Germany. Elastcty for ndustry n Belgum s assumed equal to ndustry n Germany. Elastctes n Span are assumed equal to France. Elastctes for power generaton are assumed equal to ndustry. 3.3 Upstream producton and costs The ownershp structure on the supply sde of the European gas market s a complex olgopoly. The most mportant upstream gas companes supply the EU - n terms of producton volumes - have been selected as the Cournot producers n our model (see Table 3.2: = {Gazprom,..,Lasmo}). Producton of subsdary companes (e.g., BEB n Germany, owned 50:50 by Shell and Exxon) are allotted to the companes own the subsdary. For smplcty, producton and sales of natural gas by Gazprom, Sonatrach and GFU (the Norwegan Gas Negotat Commttee) are assumed equvalent to the producton and sales by the Former Sovet Unon, Algera and Norway, respectvely. Exogenous producton s defned as total consumpton n each country mnus total producton from Cournot producers. Note that total producton per Cournot producer only conssts of the producton that s destned for the eght consum countres consdered here. Other producton quanttes of the companes, such as producton of Gazprom for ther domestc market or for Poland, are not taken nto account. We assume that upstream gas s smultaneously extracted from several felds that may have dfferent unt costs. The yearly capacty of the felds that are exploted by producer s gven by Q. ECN-R

14 A proft-maxms producer who extracts from two or more felds extracts gas from a partcular feld untl ts margnal cost equals the margnal cost of the other felds (net of transmsson costs). Thus, the margnal cost of producer equals the hghest margnal cost amo actve felds. The margnal cost functons have to satsfy our assumptons of be ncreas and convex n producton. Assume the follow form for the margnal cost functon (see Golombek et al, 1995): c ( q ) = γ + δ q + κ ln(1 q / Q ) γ, δ > 0, κ < 0, 0 < q < Q (13) The assocated prmary cost functon s: 2 1 c ( q ) = γ q + δ q κ ( Q q ) ln(1 q / Q ) κ q (14) In the equatons above, q = 2 q n, g. The parameters of the margnal cost functon, γ, δ and κ, are selected consstent wth avalable nformaton (manly from Golombek et al, 1995). The ntercept, γ, s nterpreted as the margnal cost of the frst unt of producton. Table 3.2 shows the assumed parameters for the margnal cost functon of each Cournot producer. Table 3.2 Producton, market share, capacty and cost parameters, 1995 data Producer Producton Market share Capacty γ δ κ [bcm] [%] [bcm] Gazprom Sonatrach GFU Shell ExxonMobl EBN a Agp/ENI BG BP Amoco TotalFnaElf Amerada Hess Wntershall Lasmo Exogenous Total a Energe Beheer Nederland, the Dutch state enterprse that partcpates n the Gronen gas feld. In addton to the producton cost, delver one unt of gas to market nvolves the expense of transport, dstrbuton, load balanc and storage. There are costs nvolved n the transport of gas over lo dstances from the wellhead to the border of the consum country (t n ). These costs depend on dstance, and offshore transportaton s usually more expensve than onshore transportaton, f avalable. We assume that these costs are borne by the upstream producer. There s a dffculty n defn the nternatonal transport cost from each producer to each country, snce a partcular producton company usually explots several gas felds that are located n dfferent regons. We assume that gas s sold from the nearest or man producton feld of the producer. Table B.1 n Appendx B documents the lo dstance transport costs we assume. 14 ECN-R

15 3.4 Downstream trade and TPA tarffs Downstream European trade of gas tradtonally had a monopolstc structure. Roughly speak, each country used to have a major (state-owned) company responsble for the mport, export, transt, and wthn-country transmsson of gas and for operat the hgh-pressure ppelne network. Germany s the excepton, where the share of the largest trad company, Ruhrgas, s lmted to about 70% of the market. Therefore, the ntal group of trad companes n our model contans two companes n Germany and one company n each of the other countres, r={omv, Dstrgas, GdF, Ruhrgas, Was, Snam, Gasune, Gas Natural, Centrca}. However, n subsequent runs of the model, the number of traders are vared and a trader may be allowed to operate n dfferent countres. Note, however, that the number of traders n a country s specfed exogenously n every run; we do not model endogenous entry. In our model, the trad companes are pure traders; they purchase gas from the producers and supply t to the consumers. Ths actvty requres the use of the wthn-country ppelne system for transport of gas. We assume that the trad companes face gven TPA tarffs for the use of these ppelnes. These tarffs are country specfc and we assume that they cannot be nfluenced by the trad company. We have based our calculaton of the TPA tarffs on a study of PHB Hagler Bally (1999). The TPA tarff dstushes a more-or-less natonal or HTL tarff, and a regonal or RTL tarff. 3 The wthn-country transmsson costs stroly depend on dstance (dstrtl ) and load factor (loadrtl ). Equaton (15) descrbes the fnal format of the wthncountry transmsson costs n our model for larger (ndustral and power) customers. dc = 2 HTLtarff n + RTLtarff n (8000 / loadrtl ) ( dstrtl /100) (15) The dstance and load for HTL are assumed to be 200 km and 8000 hours respectvely n all countres and market segments. 4 For RTL, the dstance and load dffer between countres and market segments. However, RTL tarffs n Span and the UK are nether dstance-related nor load-related,.e., the last two terms n equaton (15) are assumed to equal one. The Dutch RTL tarffs are not dstance-related (last term s one) and Italy s tarffs not load-related (next to last term s one). For ndustry and power generators we assume a RTL dstance of 30 and 5 klometres, respectvely. As a load factor, we assume 5000 hours for ndustry and power generators. Correspond transmsson costs per country are gven n Table 3.3. The cost of gas transportaton, dstrbuton, and account servce for resdental customers s much larger than for ndustral and power customers. Indeed, these costs can exceed the commodty cost of gas (IEA, 1998b). In the absence of country-specfc cost data, we assume that the dfference between 1995 ndustral and resdental rates prmarly reflects dfferences n transport, dstrbuton, and account costs. As a frst approxmaton, dc for each naton s resdental customer class s set equal to the assumed value for ndustral customers plus the 1995 dfference n prces between the two classes (Table 3.3). Better estmates would be based on actual costs of servce n each country, how those costs are splt between fxed and commodty charges, and exstence of cross-subsdes, nclud taxes. 3 HTL = Hgh-pressure Trunk Lnes, RTL = Regonal Trunk Lnes. 4 Ths results n the factor 2 = (8000/8000) (200/100) for the HTL tarff n the equaton. ECN-R

16 Table 3.3. HTL and RTL tarffs [1998 US$/1000 m 3 /8000 hours/100 km] and transmsson and dstrbuton costs [US$/1000 m 3 ] Tarffs Ppelne transmsson and dstrbuton cost Country HTL RTL Industry Power Households generaton Austra Belgum France Germany Italy Netherlands Span UK Source: PHB Hagler Bally (1999). 3.5 Non-elgble and non-mature markets In two sub markets, there s lttle reason to expect that the way n whch prces on the natural gas market are formed wll chae, namely emerg (mmature) markets and non-elgble (captve) customers. Immature gas countres are omtted from the analyss. For captve customers, developments are the result of autonomous factors (such as expanson of gas dstrbuton networks) and not of market open. Demand of the captve customers n the model s exogenous; that s, x = const_x (see also Chapter 7). 5 The projected demand determnes retal gas prces n the non-elgble markets, based on the assumed demand functons and prce elastctes (see Table 3.1). Non-elgble markets are assumed to be served by a monopoly trader whose sales are fxed at the assumed level. The amount that each producer sells to a non-elgble market s defned as q = const _ q = s const _ qn, where s s the share of segment g n country n, and const_q n the gven producton of producer for country n. As an approxmaton, border prces n non-elgble markets are determned us ether the compettve or olgopolstc relatonshps of equatons (3) or (4), respectvely. 5 We use 1995 demand data (IEA, 1997). 16 ECN-R

17 4. EQUILIBRIUM MODEL The combned frst-order condtons (10) for producers n Chapter 2 (whch account for equlbrum reactons of downstream traders), together wth the emprcal assumptons presented n Chapter 3, defne a set of condtons that can be solved for an equlbrum. Ths equlbrum represents a Cournot equlbrum amo producers, each of whch s also a Stackelberg leader wth respect to ether monopolstc, Cournot, or purely compettve traders. By vary the (number of) elements of several sets and actvat addtonal constrants, dfferent cases are smulated wth ths system. Before we dscuss some of these cases n the next Chapter, we wll descrbe the overall equlbrum model and the addtonal constrants. 4.1 Basc Cournot producer model Based on the development above, the market equlbrum when producers are Cournot players s a soluton to the follow mxed nonlnear complementarty problem. 6 Fnd {q, y r, x, bp, p } such that: π = + ( ) + q α β q j β q r q q j q 0; ( t π qr q n + c ) 0 = 0, E (16a) = const _, NE (16b) c = γ + δ q + κ ln(1 q / Q ) (17) x r = exog n, g + q n, g (18) y = ( x exog ) / R r, (19) bp = α + β q (20) p = α + β ( x exog ) (21) The set E s defned as the set of elgble markets, whle NE s the set of non-elgble markets. Condton (16) defnes the equlbrum producer sales; (16a) s the frst-order proft maxmz condton for each producer n each elgble market (equaton (10), Chapter 2), whle (16b) sets q to a prespecfed producton allocaton n non-elgble markets, as prevously explaned. Note that α and β need to be defned accord to whether traders are assumed to be Cournot or perfectly compettve, as dscussed n Chapter 2. The margnal cost term n (16a) s defned by (13) (Chapter 3). Equatons (18) and (19) defne consumer demand and trader quanttes suppled, respectvely, for both elgble and non-elgble markets; the quanttes are 6 In general, a pure complementarty problem s to fnd vector x such that x>0; f(x) < 0; and x T f(x) = 0. The dmenson of the two vectors x and f(x) must be the same. A mxed complementarty problem augments the problem to nclude an addtonal vector of varables y and a set of equalty condtons wth the same dmenson as y: x>0; f(x,y) < 0; x T f(x,y) = 0; and g(x,y) = 0. The complementarty problems are lnear f f(x,y) and g(x,y) are affne; otherwse the problems are nonlnear (Cottle et al, 1992). Energy sector models are often phrased as complementarty problems and solved us wdely avalable complementarty solvers (e.g., Labys and Ya, 1992; Capros et al, 2000; Hobbs, 2001). ECN-R

18 free varables for elgble markets and are exogenously specfed n non-elgble markets. Fnally, equatons (20) and (21) defne the border and retal prces, respectvely. The equlbrum soluton can be obtaned by frst solv the nonlnear complementarty problem (16)-(17) for producer sales q. Then we can use q to solve (18) for consumpton x, and fnally nsert q and x n (19)-(21) to obtan trader sales y r and the border and retal prces. As n any mxed complementarty problem, the problem (16)-(21) must be square, wth the number of condtons (16)-(21) equall the number of varables {q, y r, x, bp, p }. Ths s the case here. Nonlnear mxed complementarty problems can be solved by complementarty solvers such as PATH and MILES, whch are avalable n standard optmzaton packages (e.g., GAMS and AIMMS). Cottle et al (1992) descrbe necessary and suffcent condtons for assur that a soluton exsts for a lnear mxed complementarty problem. Because the above nonlnear complementarty problem can be converted nto a lnear one by approprate pecewse lnearsaton of the ncreas margnal cost functon (13), these results can be appled here. An alternatve soluton approach s to nstead defne a nonlnear programm problem whose frst-order (Karush-Kuhn-Tucker) condtons are (16)-(21). If such a NLP exsts, and s convex (.e., any local optmum s also a global optmum), then any soluton to t s also an equlbrum. Any convex NLP problem has an equvalent mxed complementarty problem, but the reverse s not true (Cottle et al, 1992); therefore, t mght not be possble to defne such a NLP. However, Hashmoto (1985) defnes an equvalent NLP for a spatal Cournot equlbrum wth affne demand that s applcable to our problem. Consder the follow NLP: max q 0 s. t. 2 β β α q + q + E 2 E 2 tnq + c q n, g n, g q = const _ q, NE q 2 (22) The frst square bracketed term n the objectve s the ntegral of the effectve demand curves fac producers, and the last square bracketed term represents costs to producers. Thus, wth β the crucal excepton of the mddle term q 2, the objectve of ths NLP s dentcal E 2 to the standard socal welfare (producer + consumer surplus) maxms NLP wdely used to calculate perfectly compettve equlbra n commodty markets (Takayama and Judge, 1971; Labys and Ya, 1991). The mddle term, whch s Hashmoto s (1985) contrbuton, converts the standard perfect competton condton P=MC to MR=MC, where MR s the margnal revenue for the Cournot producer. After some algebrac smplfcaton, t can be shown that the Karush-Kuhn-Tucker condtons for ths NLP are equvalent to the orgnal equlbrum condtons (16)-(17) for producers. After solv the optmsaton problem for the q, equatons (18)- (21) can then be used to nfer the values of the other quanttes and prces, as before. As the objectve functon of (22) s to be maxmzed and s strctly concave, whle the feasble regon of (22) s a convex set, there s a unque optmum set of q that s also a unque soluton to (16)- (17). As a result, any soluton to (22) s therefore also an equlbrum amo Cournot producers. 18 ECN-R

19 4.2 Addtonal constrants Two modfcatons can made to the model the results of arbtrage and legal restrctons on market share. The frst modfcaton arses from the possblty of wthn-country arbtrage. Up untl now we used a general defnton for the border prce,.e., specfc border prces for each combnaton of. However, n the presence of arbtrage wthn a country, t s unlkely that a gven trad company r operat n country n wll face dfferent border prces for dfferent market segments. Therefore, a reasonable alternatve assumpton s that there s no border prce dscrmnaton amo g,.e., bp = bp n for all g. There are at least two ways ths can be modelled. One s to ntroduce costless arbtrage varables between market segments n a country wthn the NLP. Another s to sum the three demand functons (one per segment) for each country nto one aggregate demand curve. Ths results n a pecewse lnear convex demand curve. However, f we assume that the border prce s below the prce ntercept for each and every market segment, then we can derve the follow expresson from (7) to represent the porton of the total natonal demand curve n whch all segments of the market have postve quanttes demanded: bp n = α n + β n g q (23) where β = n 1/ (1/ β ), and α = n β n ( α / β ). 7 When there are three segments (as g g n our applcaton) and one of the segments (say, Segment 1) s non-elgble, then the expressons for the coeffcents are nstead β = 1/ (1/ ) and n β g= 2,3 ) ( / )] 1 1 n exog n + α β g = 2,3 α = β [ ( const _ x. n n Aggregaton of a naton s demand curves n ths manner allows us to smplfy the NLP (22) for calculat equlbrum producer outputs n the follow manner: 2 n n β β 2 max n qn qn qn tnqn c q q n α n n n n 2 2 s. t. q const _ q, NE n n (24) where q n = q, the total sales by producer to naton n. The constrant n (24) s a modfed verson of the one n (22) so that producer s sales to naton n are at least equal to ts as- g sumed sales to the non-elgble market. (The specfc formulaton of the constrant n (24) assumes that there s no more than one non-elgble market segment g per naton n.) The follow smplfed verson of (18)-(21) can then be used to calculate the prces and other quanttes of nterest: 7 Consder the possblty that prce mght be above the choke prce for some market segments would requre that a convex pecewse lnear functon be defned, wth as many peces as there are demand segments. In general, consderaton of such functons poses sgnfcant analytcal problems, as each producer s optmzaton problem can no loer be guaranteed to be convex. In fact, the problem becomes a so-called MPEC (mathematcal program wth equlbrum constrants) (Luo et al, 1996), n whch each producer optmzes ts proft subject to a demand curve descrbed by a set of equlbrum condtons (Karush-Kuhn-Tucker condtons) that make the constrant set nonconvex. There exst algorthms to solve such problems, but MPECs can possess multple local optma, mply the possblty of multple and qute dstnct market equlbra. Future research should address the calculaton and nterpretaton of equlbra n that case. ECN-R

20 x x = exog x r bpn α + β E = const _ NE (25a) (25b) y = ( x exog ) / R r, (26) bp p n = α n + β n q = α + β n ( x exog ) n (27) (28) The second modfcaton we consder follows from derogaton possbltes n the Gas Drectve. Member States hav only one man external suppler (a suppler hav a market share of more than 75%) may derogate from the Drectve. Producers market share per country s therefore not allowed to exceed 75% n the model. That s, the follow constrant s added to the NLP (22), n the case of prce dscrmnaton amo sectors: q 0.75 ( q j + g g, j g exog ) (29) In the absence of prce dscrmnaton, (29) smplfes to: q n 0.75 ( q jn + exog j g ) (30) The follow Chapters show results of the model under several alternatve assumptons and condtons. 20 ECN-R

21 5. PERFECTLY COMPETITIVE VERSUS OLIGOPOLISTIC TRADERS In order to examne the effects of strategc behavour of downstream trad companes, four alternatve model runs are analysed. Frst, we ether assume perfectly compettve behavour or olgopolstc behavour for the traders. Secondly, the border prces are ether constraned to be equal across market segments and traders wthn a country or they are not constraned. The latter stuaton represents the possblty of prce dscrmnaton by the producers. If prce dscrmnaton on the border prces s allowed n the model, t means that producers can ncrease prces for less elastc consumers (generally households) whle compet more ntensely for more elastc market segments (ndustry and power generators). Moreover, f producers apply prce dscrmnaton, the margn that can be set by traders for nelastc consumers wll be reduced. The four alternatves are denoted as case PC-ND, PC-D, O-ND and O-D, see below, where PC-ND represents the most compettve downstream case and O-D the least compettve. Table 5.1 Modelled cases No prce dscrmnaton Prce dscrmnaton Perfectly compettve traders PC-ND PC-D Olgopolstc traders O-ND O-D All other assumptons are held equal across these four cases. Upstream producers are assumed to behave olgopolstcally. The group of downstream traders s fxed by set r defned n Chapter 3. We assume that all consumers,.e., gas-fred power generators, ndustral gas consumers, and households, are free to contract for ther gas supply. Thus, all consumer markets are assumed elgble (complete market open). The four cases are compared wth the 1995 data n Table 3.1 and wth a benchmark case, represent perfectly compettve market structures (both upstream and downstream) and no prce dscrmnaton. Effects are descrbed n terms of result end-use prces, border prces, producton, profts, consumer surplus, and socal welfare (total proft plus consumer surplus). 5.1 Results Compar end-use prces under market open (Table 5.2) wth the 1995 data (Table 3.1) reveals some strk results. Compettve benchmark prces n the UK are smlar to 1995 prces (see Fgure 5.1), ndcat the UK s a frontrunner n effectve gas market lberalsaton. UK gas prces already were unregulated and reasonably compettve n 1995 (see e.g., IEA, 1998c). German 1995 prces are smlar to, and for ndustry and power generaton even hgher than, smulated olgopolstc prces (see Fgure 5.2), suggest that gas producers and traders had qute some market power n Germany. Indeed the German market was charactersed by a complex structure n whch cross-ownershp and vertcal ntegraton were wdespread. Exclusve demarcaton and concesson agreements lmted competton n Germany (EJC Energy, 1997). In general, for most countres, actual 1995 prces are closest to smulated prces under olgopolstc producers and compettve traders. ECN-R

22 1995 US$/1000 m data Compettve benchmark Compettve traders, no prce dscrmnaton Compettve traders, prce dscrmnaton Olgopolstc traders, no prce dscrmnaton Olgopolstc traders, prce dscrmnaton Households Industry Power generaton Segment Fgure 5.1 End-use prces n Brtsh markets 1995 US$/1000 m data Compettve benchmark Compettve traders, no prce dscrmnaton Compettve traders, prce dscrmnaton Olgopolstc traders, no prce dscrmnaton Olgopolstc traders, prce dscrmnaton Households Industry Power generaton Segment Fgure 5.2 End-use prces n German markets Gven olgopolstc producton, results n Table 5.2 show that assumptons regard the behavour of traders have a large effect on prces. If the downstream structure s also olgopolstc 22 ECN-R

23 (successve olgopoly), the result s substantally hgher end-use prces, lower throughput, and lower border prces than when traders are perfectly compettve. Wth olgopolstc traders, enduse prces are 7 to 89% hgher than the benchmark, whle wth compettve traders they are only 3 to 36% hgher. Traders make no economc proft when they are compettve; all profts accrue to the upstream producers. Consequently, total producers profts are hgher when traders behave compettvely. In that case, the dvson n market shares between two (or more) traders n the same country (n ths case Ruhrgas and Was n Germany) s rrelevant as they make no proft (and no losses). In an olgopolstc downstream trad structure, however, trader market share s relevant regard the optmal soluton. Gven the symmetrc and lnear transmsson costs we assume, total throughput s equally dvded amo the traders. As expected, prce dscrmnaton wdens the gap between prces for small consumers (households) and large consumers (ndustry and power generaton), because the latter have more elastc demand. Thus, large gas users gan at the expense of households. Compar profts n cases O-ND and O-D reveals that when prce dscrmnaton occurs at the country border, upstream producers gan at the expense of traders; trader profts fall because the margn they can charge on the end-use prces s reduced (Table 5.2). Indeed, trader profts fall so much that total producer and trader proft s less under prce dscrmnaton. Fgure 5.3 hghlghts the chaes and redstrbuton of socal welfare between the cases consdered n Table Total surplus falls as the market moves from the compettve benchmark to olgopolstc producers/compettve traders and then to olgopolstc producers and traders. Ths decrease n surplus occurs even as producer and trader profts rse, because consumer surplus falls even more. The fgure also shows that f border prce dscrmnaton occurs, then producer proft ncreases at the expense of both trader profts and consumer surplus. However, ths effect s not large; t would be greater f the producer market was more concentrated, or f elastctes are more dvergent than assumed n Table 3.1 (as consdered n Appendx A) No border prce dscrmnaton Border prce dscrmnaton by producers Surplus Consumer surplus Trader proft Producer proft Compettve Benchmark Olgopolstc Producers, Compettve Traders Olgopolstc Producers & Traders Fgure 5.3 Total socal welfare and ts allocaton amo consumers, traders, and producers 8 Note that the ndcated surplus for producers excludes fxed costs, and so should be nterpreted as represent just the producers operat margn. Producer profts are postve even under the compettve benchmark; ths occurs not only because fxed costs are not netted out, but also because margnal producton costs are strctly ncreas. ECN-R

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