Privatesector P U B L I C P O L I C Y F O R T H E Note No. 137 March 1998 Competition in the Natural Gas Industry The emergence of spot, financial, and pipeline capacity markets Andrej Juris Countries in Asia, Europe, and North and South America are introducing reforms to boost efficiency and attract new private investment in their natural gas industries. The trend has been to unbundle along vertical and horizontal lines and to open wholesale gas markets to new entrants. These new entrants stimulate competition and the development of new markets—in gas supply, in financial gas contracts, and in pipeline capacity. Such has been the success of these new markets—especially in the United States and the United Kingdom—that it has prompted a search for other potential markets in the industry. This Note, part of the broad effort to aid reformers by disseminating knowledge from early reforms, describes the underlying structural and trading arrangements in the gas and pipeline markets. Two companion Notes examine these markets in the United Kingdom and the United States. The emergence of gas and pipeline participants trade natural gas as a commodity markets and minimize price and supply risks, and the transportation market, where participants trade Government’s traditional control of gas com- transportation services for shipping gas through panies and intervention in their operations and the pipeline system (figures 2 and 3). investment decisions often led to distorted prices, inefficient operation, and deteriorating The increasing complexity of transactions in infrastructure. Thus reforms have aimed at lim- both markets calls for the use of intermediar- iting government’s role in the industry’s day- ies and for spot markets that promote efficient to-day operations and establishing an effective pricing and minimize transaction costs. Well- regulatory framework under which market functioning spot markets concentrate trading forces would balance demand and supply in in a central location where gas supplies and segments of the industry where competition is pipeline capacity are easily accessible. Spot feasible, and only those segments where com- market trading typically arises first in natural petition is not feasible would remain subject gas because of the viability of competition in to economic regulation. the gas market. As deregulation of the gas in- dustry continues, however, markets may also A traditional, vertically integrated gas industry emerge in other segments, such as natural gas typically has only one market, where natural storage, metering and meter installation, pipe- gas and transportation services are sold as a line construction, and system balancing. “bundle” to final consumers (figure 1). Intro- ducing open access to pipeline transportation But markets cannot be created in all segments or unbundling supply from transportation cre- of the gas industry, so reformers must consider ates two distinct markets: the gas market, where the viability of competition and markets in each The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 Competition in the Natural Gas Industry segment separately. The market for natural gas Gas reform in the United Kingdom did involve has great potential for competitive supply and both structural and regulatory changes, but in demand because economies of scale are rela- an inappropriate sequence. Gas supply to large tively unimportant in natural gas production consumers was liberalized and opened to com- and trading. Multiple firms can operate in the petition in 1986, but the government failed to market unless it is extremely small, and prices vertically unbundle British Gas, the former mo- of natural gas can be freely determined by nopolistic gas company. Independent supply market forces. By contrast, the natural mo- companies could not compete effectively with nopoly characteristics of pipeline transporta- British Gas, which controlled access to trans- tion prevent efficient operation of multiple portation and thus gas supply. Only after re- pipeline firms in the same market unless it is peated regulatory interventions in the gas market in the early 1990s and an intricate separation of British Gas into two companies in 1996 could The increasing complexity of transactions competition flourish in the wholesale gas mar- ket. Correcting the initial failure to decentralize in both markets calls for the use of the industry structure took ten years. But the new industry structure offers better conditions intermediaries and for spot markets that for liberalizing the retail gas market. promote efficient pricing and minimize Argentina and several other countries in Latin America adopted a more radical approach to transaction costs. Well-functioning spot reform, vertically unbundling the industry and markets concentrate trading in a central deregulating the wholesale gas market in one quick stroke. In these countries gas reform was location where gas supplies and pipeline part of a larger economic reform package to enhance efficiency and investment in all major capacity are easily accessible. infrastructure sectors. The natural gas market extremely large. As a result, tariffs for pipeline transportation must be subject to economic In the natural gas market, where natural gas is regulation to prevent an incumbent pipeline traded as a commodity separate from transpor- company from exercising its market power. tation services, participants typically trade natu- ral gas under contracts. These contracts are of Both structural and regulatory changes have two main types, physical and financial, traded generally played an important part in reforms in different markets. The main participants in of the natural gas industry. In the United States, both the physical and the financial gas markets however, reform has focused on gradual regu- may include producers, traders, suppliers, pipe- latory changes, since the industry was already line companies, and distribution utilities, de- vertically unbundled. The government created pending on the industry’s degree of vertical and a competitive wholesale gas market by dereg- horizontal unbundling. ulating wholesale gas prices and unbundling the supply of natural gas from transportation The physical gas market on interstate pipelines. And it promoted flex- ibility in pipeline transportation services by al- Participants in the physical gas market trade lowing resale of firm transportation contracts contracts for the physical delivery of natural in a secondary market. Under way for more gas—physical gas contracts (sometimes referred than ten years, the deregulation process has to as cash gas contracts). These contracts differ now shifted its attention to the retail gas market. in two main dimensions, the purpose of the The World Bank Group 3 MARKETS IN THE NATURAL GAS INDUSTRY FIGURE 1 VERTICALLY INTEGRATED NATURAL GAS INDUSTRY Production Pipeline transportation Distribution End users Gas transportation Gas supply transactions FIGURE 2 OPEN ACCESS AND WHOLESALE COMPETITION End users Residential Commercial Producers Pipeline company Distribution utility Industrial Wholesale market Traders and suppliers Electric utilities Gas transportation Gas supply transactions FIGURE 3 UNBUNDLED INDUSTRY AND RETAIL COMPETITION End users Residential Commercial Producers Pipeline company Distribution company Industrial Spot market Traders and suppliers Electric utilities Gas transportation Gas supply transactions 4 Competition in the Natural Gas Industry transaction and the duration of supply, and thus ceed supply, and gas shortages may occur. In divide the physical gas market into several seg- such a situation demand must be rationed by ments. A purchase of gas for resale takes place administrative rules—an interruption of supply in the wholesale gas market, and a purchase —rather than prices. for end use in the retail gas market. Wholesale transactions are concluded among producers, Deregulation of the gas industry and greater traders, suppliers, pipeline companies, and dis- flexibility in natural gas supply change the im- tribution firms, while retail transactions occur portance of long-term supply contracts. Par- between suppliers and industrial or residential ticipants in deregulated gas markets need to consumers. balance their supply and demand in both the long and the short term so they can react to Differences in the duration of gas supply di- changing market conditions. Short-term balanc- vide gas contracts into three classes: ing can be achieved by trading in the short- ▪ Short-term gas contracts, for supply of up to term (spot) market, where producers, traders, one calendar month. suppliers, distribution utilities, and large end ▪ Medium-term gas contracts, for supply of one users enter into daily trades. Spot market par- to twelve months. ticipants can acquire natural gas supplies rela- ▪ Long-term gas contracts, for supply of more tively quickly and choose the time and quantity than one year. of supply based on needs and price. That flex- ibility allows them to form a portfolio of long- Natural gas transactions were traditionally based and short-term contracts that minimizes sup- on long-term supply contracts between inte- ply and price risks in both the long and the grated gas companies and their customers. Be- short run. cause these contracts fixed the price and volume of gas to be supplied over a specified Spot markets typically develop where buyers period, they reduced supply and price risks. and sellers are concentrated, such as at a pipe- But they provided little flexibility to reflect the line interconnection near a large metropolitan economic value of natural gas under changing area or at a major terminal in a gas-producing region. The Henry Hub in Louisiana and the Bacton terminal in the United Kingdom, for Participants in spot markets, unable example, are both located at the entry point to a major pipeline network in a large producing to predict the future prices of natural region. By aggregating supply and demand, spot markets offer industry participants the gas, are exposed to price risk. Their benefits of intensive competition among buy- ers and sellers, high liquidity, and greater effi- demand for tools to minimize this price ciency in the pricing of natural gas. risk leads to the development of a In a well-functioning spot market short-term (spot) prices reflect the economic value of natu- financial gas market. ral gas. Gas industry participants use spot prices to value supply contract portfolios and make market conditions. For example, the economic decisions about the size and timing of con- value of natural gas tends to be high during sumption. Thus spot markets in natural gas extremely cold weather, when gas supply and serve the same function as other commodity transportation capacity are generally con- or stock exchanges—they reveal the market strained. If the contract price of natural gas is value of the commodity traded. In the United fixed, supply and demand do not adjust in re- States spot prices of natural gas at Henry Hub sponse to the higher value. Demand may ex- are a common indicator of market value. The World Bank Group 5 Spot prices tend to be volatile, however, re- certain level of maturity and a large share of sponding to changes in underlying factors of natural gas is traded under short-term contracts. supply and demand such as the weather, avail- Since only a few countries have a mature spot able pipeline capacity, or consumption patterns. market, the financial gas market is a relatively Participants in spot markets, unable to predict new concept. Only the United States and the the future prices of natural gas, are exposed to price risk. Their demand for tools to minimize this price risk leads to the development of a financial gas market. Transactions in the financial gas The financial gas market market involve the transfer of risks The contracts traded in the financial gas mar- between market participants with ket serve two main purposes: they minimize the price risk in the natural gas spot market, different risk characteristics and risk and they minimize the basis risk resulting from the changing price differential between physi- management skills. cal and financial gas contracts. Financial gas contracts also serve as an instrument for specu- United Kingdom have active financial gas mar- lation and price arbitrage in the gas market. kets today. Nymex, in the United States, devel- They are seldom used for physical delivery of oped and actively trades three natural gas futures natural gas. and options contracts for delivery in three ma- jor spot markets in the United States and Canada. The most common financial gas contracts are The International Petroleum Exchange, in Lon- forward contracts, swaps, futures, and options. don, trades a natural gas futures contract for Forward contracts and swaps are typically delivery at the National Balancing Point, a no- custom-tailored, with every aspect negotiated tional balancing point in the pipeline system of by the parties to the contract. Futures and op- BG (the pipeline transportation spin-off of British tions are standardized contracts typically traded Gas). Financial gas markets are likely to emerge in established commodity exchanges such as in other countries as deregulation continues. the New York Mercantile Exchange (Nymex) in the United States. The transportation market Transactions in the financial gas market involve Contracts traded in the transportation market the transfer of risks between market participants cover transportation services, the supply of with different risk characteristics and risk man- pipeline capacity and movement of natural gas agement skills. For example, a distribution com- needed to deliver gas to a desired location. pany with an obligation to serve final customers Pipeline companies sell transportation contracts tends to be exposed to price risk because it can- to shippers—any industry participants that want not adjust its demand in response to changes in to move natural gas—in the primary transpor- spot prices. Intermediaries such as traders or tation market. In some instances holders of firm brokers tend to be experts in managing risk and transportation contracts may resell them to can therefore better absorb the price risk. A trans- other market participants in the secondary fer of price risk from the distribution utility to transportation market. intermediaries minimizes the overall exposure to price risk and the costs of risk management. The primary transportation market A financial gas market will emerge in countries The contracts purchased by shippers in the pri- where the physical gas market has reached a mary transportation market give them the right 6 Competition in the Natural Gas Industry to transport natural gas under specified condi- with a corresponding portfolio of transporta- tions. The most important distinctions among tion contracts. Thus pipeline companies need transportation contracts are the duration and to offer medium- and short-term transportation the reliability of the services provided. Con- contracts and flexibility in the choice of injec- tracts can be long, medium, or short term. And tion and delivery points. Such services are typi- they can provide firm or interruptible service, cally preceded by the development of a more a distinction that determines the priority given flexible regulatory environment for pipeline to a shipper during capacity shortages. Trans- companies and the creation of a secondary portation contracts also specify the location, transportation market. timing, and volume of natural gas shipments. The secondary transportation market The natural monopoly characteristics of pipe- line transportation require that the primary trans- Holders of unused firm transportation contracts portation market be regulated to limit the market can resell these contracts in the secondary power of pipeline companies and promote effi- transportation market. Buyers and sellers in this cient allocation of resources. A pipeline com- market may be almost any participant in the pany must incur substantial fixed costs to primary transportation market, though pipeline companies are excluded because of their mar- ket power. Secondary transportation markets If transportation contracts establish came into existence in the United States in 1992, when the Federal Energy Regulatory Commis- transferable property rights to pipeline sion introduced a capacity release program requiring interstate pipelines to allow holders capacity, contract holders can trade the of firm transportation contracts to release, or sell, any unused portions of their reserved pipe- contracts freely and the secondary line capacity to other network users. The United Kingdom introduced a similar program of pipe- market can flourish. line capacity resale in 1996 under the Network Code of British Gas. construct the pipeline system before it can pro- The resale of transportation contracts promotes vide transportation services. And these fixed efficient allocation of transportation capacity. As costs dominate the company’s cost structure a result of short-term changes in supply and because the variable costs of shipping natural demand, some pipeline users will not utilize all gas through the system tend to be relatively low. their contracted capacity, while others will lack Pipeline transportation exhibits economies of capacity to ship their gas. In the absence of a scope as well as scale. Once the pipeline is con- secondary market holders of unused capacity structed, a company typically uses the same fa- cannot sell it to those who need it and pipeline cilities to offer different transportation services. capacity may go unused. A pipeline company can use spare capacity for interruptible services, Deregulation of natural gas markets creates a but efficiency may be compromised because in- need for flexible transportation services. Mar- terruptible tariffs tend to undervalue available ket participants need to be able to match their capacity. By contrast, the resale of firm trans- gas supplies with transportation services. And portation contracts allows contract holders to they often require short-term balancing of natu- realize market value for unused pipeline capac- ral gas supply and demand to optimize the cost ity. Thus it can lead to optimal allocation of trans- and reliability of natural gas deliveries. They portation capacity among market participants, can achieve such balancing only if they can based on their willingness to sell or pay. The match their portfolio of gas supply contracts efficiency of capacity allocation is sometimes The World Bank Group 7 constrained, however, by regulation of the re- tracts. Spot markets in transportation contracts sale price, which tends to be capped to reduce are developing in the United States, where elec- the potential for exercise of market power. tronic systems for trading natural gas and trans- portation contracts link large numbers of buyers To promote efficiency in the secondary trans- and sellers. portation market, it is important to assign prop- erty rights to transportation capacity to a large Market prospects number of shippers. If transportation contracts establish transferable property rights to pipe- Having achieved considerable success in whole- line capacity, contract holders can trade the sale market competition, the United Kingdom contracts freely and the secondary market can and the United States are moving toward com- flourish. But if transportation contracts estab- petition in retail gas supply to small consumers, lish property rights that are not transferable, under arrangements that will allow consumers the resale of contracts is impossible unless it is to choose among gas suppliers and reap effi- intermediated by the pipeline company. Con- ciency gains like those in the competitive whole- tract holders may still engage in side-dealing sale gas market. The services needed to support by using their spare capacity for delivery of retail competition, such as metering and billing, third-party gas, but these deals often involve are also targets for the introduction of competi- high transaction costs. Firm capacity contracts tive provision. The unbundling of pipeline trans- that give their holders the right to reserved pipe- portation has led to marketlike operation of Viewpoint is an open line capacity typically establish property rights. natural gas storage facilities, with storage op- forum intended to But the transferability of such contracts depends erators taking advantage of seasonal and daily encourage dissemina- tion of and debate on on prevailing regulation. price variations in nearby spot markets. Active ideas, innovations, and trading of short-term transportation contracts will best practices for ex- The resale of transportation contracts can take eventually give rise to a financial transportation panding the private sector. The views pub- several forms. Auctions in which shippers bid market where participants can minimize the lished are those of the by price can be used for trading both long- price risks in the physical transportation mar- authors and should not and short-term transportation contracts, al- ket. And with continued advances in technol- be attributed to the World Bank or any of its though they may be too time-consuming for ogy and in the understanding of how the natural affiliated organizations. resale of short-term contracts. Transactions in gas industry operates, more opportunities for Nor do any of the con- which shippers mutually agree on the condi- competitive provision of goods and services will clusions represent official policy of the tions for contract resale give the parties a great surely emerge. World Bank or of its deal of flexibility and so are well suited for all Executive Directors types of transportation contracts. But this form Andrej Juris (andrej_juris@nera.com), NERA, or the countries they represent. of trading may be too costly for smaller and Washington, D.C. less informed participants that have to shop To order additional around for the best deal. copies please call 202-458-1111 or contact Suzanne Smith, editor, Short-term transportation contracts may be Room F6P-188, traded in a transportation spot market. To pro- The World Bank, 1818 H Street, NW, mote liquidity and efficient pricing in this Washington, D.C. 20433, market, transportation contracts need to be or Internet address standardized in all important dimensions. The ssmith7@worldbank.org. The series is also resale of short-term transportation contracts not available on-line only promotes efficient allocation of contracts. (www.worldbank.org/ It also facilitates the simultaneous clearing of html/fpd/notes/ notelist.html). gas and transportation markets by enabling market participants to match their spot gas Printed on recycled transactions with short-term transportation con- paper.