Policy Pulse – 9 March 2022 – Veritas Global
Photo by KWON JUNHO on Unsplash
Key messages:
The EU is right to be concerned about dependence on Russian natural gas
Enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification
Expected benefits to the European energy system include sustainability, security, stability, and competitiveness
On 8 March 2022 the European Commission proposed a series of measures for addressing the EU’s energy insecurity. The proposal includes both immediate and longer-term measures for addressing dependence on Russian natural gas. Crucially, the proposal identifies diversification of supply as one of the key levers for addressing EU energy security for the medium and long-term. In this context, there is an opportunity to build on the European Commission proposal and take decisive actions to diversify supply though enhancing access to Caspian and Central Asian natural gas.
Enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification
According to the European Commission, domestic supply of natural gas meets about 10% of total EU consumption and has limited scope to boost production. The EU is highly reliant on imports and has limited alternatives for diversifying away from Russian natural gas. North Sea production is at capacity and reserves have been significantly depleted, making it very difficult to maintain and grow supply. Algeria is already doing its part to supply the EU, with market share of natural gas imports increasing significantly in recent years. Suppliers of liquefied natural gas (LNG) are expected to boost production, but it is uncertain whether they can be a reliable source for meeting EU demand in the medium-to-long term. Qatar can significantly boost LNG production but is better positioned to serve markets in Asia. The US may continue to supply modest quantities of LNG to Europe, but it is unlikely to become a large-scale supplier. Fracking practices, which have been a key driver for increasing US natural gas production, are increasingly coming under pressure, including due to local environmental and health impacts. These developments raise questions about the viability of the US to sustain volumes needed to meet expected local natural gas demand while at the same time supporting large-scale exports.
The EU’s best option to diversify supply is to tap into resources in non-Russian countries of the Caspian basin and Central Asia, which are home to about one quarter of all proven natural gas reserves globally. Diagram 1 shows the largest proven natural gas reserves that exist in proximity to Europe with the size of white circles drawn in proportion to proven reserves.
Diagram 1:
Caspian and Central Asia region has the largest proven natural gas reserves in proximity to EU
Source: Veritas Global using graphics from mapchart.net and data from BP Statistical Review of World Energy July 2021
The benefits for Europe to access the vast energy pool in the Caspian and Central Asia is partially being realized through the Southern Gas Corridor, a project that was operationalized at the end of 2020 and continues to increase deliveries. However, the scope for scale-up is far greater than what is currently planned to be implemented. One of the best options for enhancing diversification of natural gas supply to Europe is to develop additional capacity that brings Caspian gas to European markets through transit routes that do not pass through Russia or other members of the Eurasian Economic Union.
The option that offers the best supply diversification benefits (known as White Stream) would bring natural gas from the Caspian to the EU. For example, natural gas could originate in Turkmenistan or in the shallow water offshore fields of the Caspian and be transported by pipeline through Azerbaijan and Georgia to the Black Sea. From the Georgian Black Sea coast, the gas could be transported by an underwater pipeline directly to Romania, where it would plug into the EU gas network (an alternative but more costly and technically complex option is to ship the natural gas across the Black Sea after converting it to LNG). The technical aspects of this project have been assessed in detail with feasibility studies supported through EU funding for common projects of interest. However, a lack of political will combined with misplaced concerns over the project’s climate change impacts has meant that the project has not received a green light despite being nearly shovel ready. The slow progress of developing this corridor has given Russia a dominant position across European gas markets and in practice has increased EU’s reliance on coal for electricity generation.
The EU has prioritized development of hydrogen-based energy obtained by using renewable energy as one of the main responses to addressing supply side dependence in natural gas markets. The EU’s hydrogen strategy, if fully implemented, targets production of up to 10 million metric tons of renewable hydrogen in the EU by 2030, which is the energy equivalent of about 5% of current natural gas demand in Europe. The European Commission proposal from 8 March 2022 sets 2030 targets that go beyond the hydrogen strategy, but these additions will have limited impact on overall natural gas demand. Between 2030 and 2050, the EU hopes that renewable hydrogen technologies reach maturity and start being deployed at a large scale. While this strategy offers an ambitious program for long-term decarbonization, it does little to address the EU’s short- and medium-term energy security needs. Even if all goes to plan, the EU hydrogen strategy implies that renewable hydrogen will not be effective at containing Russian’s dominant position in natural gas markets for at least the next two or possibly even three decades.
Expected benefits to the European energy system from improving access to Caspian and Central Asian natural gas include sustainability, security, stability, and competitiveness
Sustainability: A key feature of the EU’s climate change mitigation strategy is to increase electrification in the economy while decarbonizing electricity generation. In significant part the EU plans to achieve this objective by deploying greater renewable energy. Natural gas plays an important role in enabling greater renewable energy deployment by offering a viable solution for addressing supply intermittency. Except for nuclear power, electricity generated through natural gas currently offers the most viable and low-carbon alternative to coal-based power as a solution for intermittency. In Europe, limiting supply of natural gas and making it more expensive in practice incentivizes the use of coal. In 2021, as natural gas prices rose, electricity generators across the EU switched from gas-to-coal leading to higher greenhouse gas emissions. For example, in Q4 of 2021 in northwest Europe, in response to record-high natural gas prices, coal fired power plants increased their output by 20% year on year. Natural gas plays an essential role in supporting a more sustainable energy system in Europe.
Security: The crisis in Ukraine has also revealed that Europe is not immune from large scale military confrontation. The heightened risk environment exposes critical natural gas transmission infrastructure to the possibility of subversive actions which could include cyber or even direct attacks. Increasing the geographic scope for both the source of natural gas and transmission infrastructure helps improve system reliance and security. Access to a diversified pool of suppliers could also help limit the exposure to spillovers from broader supply disruptions in linked markets.
Stability: LNG is the marginal source of gas for Europe, this means that non-LNG suppliers sell pipeline gas at the competitive equilibrium price with LNG. (The exceptions to this are the gas deliveries made against long-term contracts). However, pipeline suppliers may also influence market outcomes when LNG market condition are tight (demand exceeds supply). If a large enough pipeline supplier withholds natural gas sales it could drive up the LNG price. A key development in gas markets in 2021 has been an increase in the correlation between the European and Asian gas benchmarks to 0.93 (from below 0.8 in 2019). Given how tight natural gas markets have become across Europe and Asia, we think that a withholding in pipeline deliveries (or reduction in production) in one market could lead to upward price pressure in the LNG price in both markets. This in effect increases incentives for collusion across natural gas suppliers and encourages development of an OPEC equivalent for natural gas (it could also create incentives for collusion between OPEC and major natural gas producers that also produce oil). Broadening the pool of suppliers offers the best means through which to limit incentives for supplier collusion.
Competitiveness: As highlighted by the European Commission, Russia has a large market share in natural gas markets across Europe. In addition, the combination of excess production and transmission capacity to Europe in our view magnifies Russia’s market dominance. Existence of excess capacity in transmission and production discourages new investments by other participants especially new entrants. The IEA estimates that in 2021, Gazprom production was about 7% below capacity despite strong domestic and external demand with historically high gas prices. In addition, domestic storage injections in Russia rose to new records while deliveries to the European Union fell by 3%. Furthermore, at the end of 2021, Gazprom while continuing to meet long-term contracts, nearly stopped making new sales on the spot market and did not fully use existing reserved capacity. While some of the disparities may be explained by technical disruptions, weather variance, and maintenance, the overall picture suggests strategic and anti-competitive behavior. Some observers have suggested the withholding of deliveries was part of Gazprom’s effort to drive up the gas price to increase incentives for the German regulator to approve certification of NordStream2 whereas others have linked the behavior to escalating tensions in Ukraine. In either case, the behavior would be considered strategic and is likely to have had a material impact on the entire gas market through creating upward price pressure. The observed dynamic further supports the notion that Russia has not only acquired monopoly power but has already abused it to intentionally influence market outcomes. Improving Europe’s access to Caspian and Central Asian natural gas could help, at least in part, to limit strategic behavior and improve the competitiveness of the natural gas market.
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