Privatesector P U B L I C P O L I C Y F O R T H E Note No. 138 March 1998 Natural Gas Markets in the U.K. Competition, industry structure, and market power of the incumbent Andrej Juris The deregulation of the U.K. natural gas industry has facilitated new entry and competition in almost all segments of the industry except pipeline transportation. The new regulatory framework, developed largely by the Office of Gas Regulation (Ofgas), has allowed market forces to stimulate a variety of specialized services and market transactions to meet customer needs. But the entire process has been difficult because of a flaw in the initial industry structure: the government privatized British Gas as a vertically integrated company. The U.K. experience shows that leaving gas supply integrated with pipeline transportation and tying up gas in long-term contracts impede competition. This Note reviews the U.K. reform and the development of new spot, on-system, and “Flexibility Mechanism” markets. The U.K. experience The government opened the wholesale and con- tract gas markets to promote efficiency and Before 1986 British Gas operated as the publicly lessen the traditional dominance of British Gas. owned, vertically integrated transporter and sup- It permitted large consumers to contract for natu- plier of natural gas in the United Kingdom. Only ral gas directly with producers. And it allowed gas production was open to competition, and independent gas shippers, traders, and suppli- this segment was dominated by multinational ers to arrange gas supplies for large consumers oil companies. In 1986 the government priva- in order to create competition in wholesale sup- tized British Gas, choosing to leave it a single, ply.1 The tariff market remained closed to com- vertically integrated company in order to speed petition, and British Gas continued to be the the transaction and maximize the sale proceeds. sole supplier of natural gas to small consumers. At the same time it separated the gas market The government believed, rightly at the time, into three major segments: that competition in gas supply to small consum- ▪ The wholesale market, where gas is traded ers was not economically feasible. Wholesale between producers, traders, British Gas, and and contract gas prices were liberalized, while independent suppliers. Ofgas regulated retail tariffs to protect consum- ▪ The contract market, where gas is supplied to ers from the market power of British Gas. large consumers (initially those consuming more than 25,000 therms a year, now those Structural lessons consuming more than 2,500 therms a year) by British Gas or independent suppliers. The initial decision not to unbundle British Gas ▪ The tariff market, where gas is supplied to in 1986 hindered development of a competitive small consumers (those with annual con- gas market. Because British Gas controlled the sumption below the threshold for large con- entire pipeline system and held long-term gas sumers) by British Gas. supply contracts with producers, it was able to The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 Natural Gas Markets in the U.K. retain a de facto monopoly in the wholesale business, and BG plc, a transportation and stor- and contract gas markets and control entry by age business. This separation, or “demerger,” of independent gas suppliers. In an attempt to British Gas was completed in 1997. improve access to gas supplies and transporta- tion, Ofgas introduced the 90:10 rule in 1989, The demerger finally corrected the gov- which prohibited British Gas from contracting ernment’s failure to restructure the industry at more than 90 percent of gas deliveries from the time of the privatization. The costs of the any field on the U.K. continental shelf. The failure had been significant. The industry’s 90:10 rule effectively forced producers to mar- flawed structure resulted in frequent regula- ket their gas to independent suppliers, promot- tory interventions in the markets and disputes ing the development of wholesale gas trading between Ofgas and British Gas. This increased at the “beach,” the entry terminals of the Brit- the regulatory risk and cost of capital for Brit- ish Gas pipeline system. ish Gas, which saw a big drop in the market value of its assets. Between the fall of 1993 The 90:10 rule did not, however, remove the and mid-1996, when the disputes were par- main source of the problem: the ability of ticularly intense, the market value of the assets British Gas to control access to its pipeline net- fell by half—from £15.5 billion to £7.7 billion. work. Complaints about the company’s mar- And the demerger itself was a costly exercise, ket power prompted another set of regulatory with the company paying millions of pounds in accounting and legal fees. It is important to introduce structural The U.K. experience shows that if a single company controls access to gas supplies and changes at the beginning of the reform to transportation capacity, as British Gas did, com- petition may be inhibited. Simply removing ad- set the stage for developing markets and ministrative barriers to entry in gas supply and deregulating gas prices are not enough to en- competition later in the reform. sure competitive gas markets. A move from mo- nopolized to truly competitive gas markets measures in the early 1990s, when Ofgas asked requires structural and regulatory changes that British Gas to release more natural gas to in- protect new entrants from the market power of dependent suppliers and to build “Chinese the incumbent. It took almost a decade to rem- walls” separating its gas supply and pipeline edy the failure to unbundle British Gas before transportation businesses. The intention was its privatization. Only after U.K. regulatory au- to increase independent suppliers’ access to thorities intervened in the acquisition of natural natural gas from producers and to level the gas from producers and the incumbent’s opera- playing field for suppliers contracting for pipe- tion of the pipeline network could real compe- line transportation. tition emerge in natural gas supply. British Gas complied by selling about 5 billion New markets cubic meters of natural gas (roughly 3 percent of the total gas supply) to independent suppli- Competition has fostered new ways of trading ers and by creating two divisions, British Gas natural gas, reflecting market participants’ need Energy and British Gas TransCo. But the prospect for more flexible gas supply arrangements. Spot of further regulatory intervention on liberaliza- markets have formed at major terminals, al- tion of the retail gas market led the company to lowing market participants to balance their seek more permanent structural change. In 1996 short-term supply and demand by trading natu- it decided to split its assets into two companies: ral gas. As a result of new pipeline operating Centrica, a gas production, sales, and supply rules, a flourishing spot market has developed The World Bank Group 3 within the pipeline system. The pipeline op- number of participants in the wholesale and erator also uses market pricing to determine contract gas markets. Independent suppliers and the costs of balancing supply and demand over large consumers demanded contractual and sup- the pipeline network. ply flexibility to allow them to efficiently balance their short-term supply and demand. Indepen- While the natural gas markets are substantially dent suppliers also sought a trading location that deregulated, gas transportation remains heavily would give them unrestricted access to gas de- regulated because of the natural monopoly liveries, outside the control of British Gas. characteristics of pipeline transportation. Brit- ish Gas—followed by its transportation spin-off, Aided by regulatory measures, the market BG—has remained the single operator of the response to the demand for greater flexibility U.K. pipeline system, and transportation and better location was the development of charges are regulated. The secondary transpor- spot markets. First, wholesale gas trading tation market is just beginning to emerge, with moved to the “beach.” Here natural gas supply resale of pipeline capacity among shippers al- from more than forty producers promised suf- lowed only since 1996. ficient availability of natural gas and flexibility in delivery conditions. Second, the concentra- As markets for wholesale (and, increasingly, re- tion of trading at entry terminals promoted the tail) gas supply have become more and more development of spot markets, where natural competitive, the quantity and quality of services available to market participants have improved, and consumers have benefited from declining The on-system market has become real prices for natural gas even as consumption has been increasing. Residential prices fell by increasingly popular among shippers 24 percent in real terms between 1986 and 1995, and industrial prices by 47 percent. During the because of its central location, same period consumption increased by 38 per- cent.2 The deregulation of wholesale and con- accessibility, and low transaction costs. tract markets has attracted more than forty suppliers, all competing fiercely. The increased gas is continuously traded. More trading op- competition in the contract market is reflected portunities were created when British Gas sepa- in the diminishing market share of British Gas, rated its gas supply and pipeline transportation which fell from 80 percent in 1992 to 33 per- operations. The introduction of the British Gas cent by the end of 1996. The industry operates Network Code in 1996, which set out the rights much more efficiently than it did before 1986, and responsibilities of users of BG’s pipeline and consumers have been able to benefit. network, created two additional gas markets within the pipeline system of British Gas. Market dynamics Participants in the U.K. gas market now use four The trading and contracting of natural gas in mechanisms for trading natural gas (figure 1): the United Kingdom have changed dramatically ▪ Bilateral contracts. since the privatization of British Gas in 1986. ▪ Spot markets. Traditionally, most natural gas was sold under ▪ The on-system market. long- and medium-term contracts between pro- ▪ The Flexibility Mechanism. ducers and British Gas at the wholesale level and between British Gas and consumers at the Bilateral contracts retail level. After the contract market was liber- alized in 1986, long-term contracting became Bilateral contracts represent the traditional form insufficient to meet the needs of the growing of trading natural gas in the United Kingdom. 4 Natural Gas Markets in the U.K. FIGURE 1 MECHANISMS FOR NATURAL GAS TRADING IN THE UNITED KINGDOM Producer 1 Producer 2 Gas trader Spot market Shipper 1 Shipper 2 BG On-system market BG Flexibility Mechanism Key: Bilateral contracts between producers and shippers Spot market trading between producers, traders, and shippers On-system trading of gas and imbalances between shippers; requires prior notification of BG Flexibility Mechanism, for trading between shippers and BG Producers and British Gas typically concluded demand and supply characteristics of contract- long-term take-or-pay, or “depletion,” contracts ing parties. under which British Gas covered a share of the financing of a producer’s field development But the opening of the gas market to competi- cost in exchange for assured future gas tion also exposed British Gas to transition costs, deliveries. net liabilities resulting from overcontracting. In 1996 it held take-or-pay obligations to purchase The opening of natural gas supply to competi- about 4.6 billion cubic feet of gas a day (bcfd) tion has introduced new contractual relations from producers over the next five years, while in the gas market as producers and indepen- gas sales were projected at 4.35 bcfd, on the dent suppliers have looked for ways to achieve assumption that BG would maintain a 90 per- greater supply and price flexibility. This has cent share in the tariff market in 1998. That initiated the development of a wide range of resulted in an estimated surplus of 0.25 bcfd, long-, medium-, and short-term supply con- or 5 percent of take-or-pay obligations, with a tracts with delivery provisions to meet specific value of £528 million.3 Although this surplus is The World Bank Group 5 not a significant volume, it still represented al- ducers’ gas supply was contracted by British most 30 percent of spot market sales in 1996. Gas. Over time there has been a large increase Thus if BG delivered its surplus gas to spot in volume and in the number of traders. markets, it would drive down spot market prices and potentially harm its position in the The most active spot markets are at the Bacton retail gas market. In the event, the losses have and St. Fergus terminals, which are well con- probably been mitigated by delays in the in- nected with large producer and consumer ar- troduction of retail competition. eas. The most common contracts traded in these Spot markets The strong prospects of the on-system Spot market trading has developed with the opening of natural gas supply to competition. market and its potential for efficient As the large number of contractual relations between producers and suppliers made it in- pricing of physical gas contracts have led feasible to always negotiate all aspects of supply contracts, demand arose for the standardized the International Petroleum Exchange in contracts suited for spot market trading. An- other factor in the development of spot mar- London to develop its first natural gas ket trading has been the gradual shift in natural gas transactions to locations where producers futures contract based on delivery at the and suppliers can rely on standardized deliv- ery conditions and have the best access to the National Balancing Point. pipeline system. markets are day-ahead and monthly gas con- Natural gas spot markets have developed at six tracts, specifying delivery on the next day and onshore terminals of the British Gas pipeline in the coming month. Other contracts traded network, where the concentration of producers’ in spot markets include: gathering pipelines and the transportation pipe- ▪ Balance gas contracts, for delivery in the rest lines of British Gas promised good availability of the current month. of both gas supplies and transportation capac- ▪ Quarterly and annual gas contracts, for de- ity. The spot markets enable participants to bal- livery in a specific quarter and year. ance their supply and demand in the short term ▪ Time spread contracts, for the exchange of by buying or selling natural gas in one or more contracts with different delivery periods. central delivery locations. The high volume of natural gas trading in the spot market has led to Despite the increasing volume of gas traded in greater standardization in supply conditions, spot markets, trading remains relatively thin such as in the duration of delivery, and thus in and illiquid. Trading volumes at Bacton in 1996 gas supply contracts. This standardization of con- ranged from 2 million to 8 million therms a tracts promotes market liquidity and efficiency day, only 5 to 10 percent of the total daily sup- in spot gas prices. ply. Prices at the terminal varied accordingly— from 9 pence to 14 pence a therm. The U.K. Spot market gas trading in the United Kingdom gas market appears to be relatively small to is bilateral, involving producers and shippers, support efficient functioning of five to six spot or on a brokerage basis, with traders often act- markets. Perhaps a more central location is ing as intermediaries. Spot trading started in needed where most of the country’s natural 1989–90 as a bilateral telephone market be- gas supplies could be traded. British Gas, in- tween producers and independent suppliers, spired by the growing use of natural gas spot but trade volumes were low because most pro- trading, introduced a central location within 6 Natural Gas Markets in the U.K. its pipeline system when it launched its on- gas contracts have led the International Petro- system market in 1996. leum Exchange (IPE) in London to develop its first natural gas futures contract based on deliv- The on-system market ery at the National Balancing Point. The intro- duction of the IPE Natural Gas NBP contract on The on-system market is basically a natural gas January 31, 1997, marked the beginning of fi- spot market with the delivery point at the Na- nancial gas trading in the United Kingdom and tional Balancing Point (NBP), a notional point in Europe. The contract has found broad ac- in BG’s pipeline network at which BG balances ceptance among gas traders because of its cen- its high-pressure pipeline system. In effect, all tral delivery location and smooth administration. gas supplies transported through BG’s high- By July 31, 1997, the volume traded under such pressure pipelines can be traded at the NBP. contracts had reached almost 30 million therms, equal to about 40 percent of the United A transaction in the on-system market typically Kingdom’s daily production of natural gas. involves shippers that own transportation contracts and are willing to sell or purchase natural gas. The BG’s Network Code requires all shippers Selling shippers use their reserved pipeline capacity to balance their gas shipments through the pipe- to deliver natural gas to the NBP, where they sell line system—that is, to maintain their injections it to interested buyers. Buying shippers then use and withdrawals of natural gas below a speci- fied tolerance level—on both a daily and a monthly basis. Shippers can balance their ship- The Flexibility Mechanism allows market- ments by buying or selling natural gas in the highly liquid on-system market, where the price based determination of the value of the of natural gas determines the cost of maintain- ing their balance. But shippers do not always natural gas needed to restore the balance maintain their daily balance, and the whole pipe- line system may become unbalanced if the sum in BG’s pipeline system. of individual imbalances exceeds a certain tol- erance level. The pipeline operator must then their pipeline capacity to transport the gas from inject or withdraw natural gas to restore the the NBP to the desired location. Transactions are balance in the pipeline system. The value of facilitated by BG, which keeps track of traded the natural gas in these transactions is not re- volumes and provides transportation services. flected in the on-system price, because BG can- not participate in on-system trading. To facilitate The on-system market has become increasingly the pricing of this gas, British Gas introduced popular among shippers because of its central the Flexibility Mechanism in 1996. location, accessibility, and low transaction costs. The whole range of natural gas contracts, much The Flexibility Mechanism the same as those traded in a spot market, are traded daily in the on-system market. Traded The Flexibility Mechanism allows market-based volumes in the on-system market, and possibly determination of the value of the natural gas in other spot markets, are likely to increase as needed to restore the balance in BG’s pipeline the share of Centrica, the British Gas supply and system. BG trades this natural gas in an auc- trading spin-off, in the liberalized retail market tion. Interested shippers post their bids, speci- diminishes and more gas becomes available from fying volumes and the prices at which they producers as a result. want to buy or sell, on an electronic network. BG buys natural gas if it expects that injections The strong prospects of the on-system market into the system will be less than withdrawals, and its potential for efficient pricing of physical and sells natural gas if it expects the reverse. The World Bank Group 7 BG accepts the bids that cover the expected accompanied by open access to gas supplies system imbalance and that either minimize the from producers and to transportation capacity cost of buying natural gas or maximize the rev- for delivering natural gas to consumers. The enue from selling it. The price of the last practices of tying up natural gas in long-term accepted bid determines the system marginal supply contracts and integrating gas supply with price at which transactions between BG and pipeline transportation must be eliminated to shippers are concluded. BG solicits bids from enable independent suppliers to acquire natural shippers daily, so that they are always available. gas in the wholesale market, gain equal access to pipelines, and start to compete on equal foot- As in any auction, competition among ship- ing with the incumbent gas company. pers promotes efficient pricing of natural gas traded under the Flexibility Mechanism. If ship- Developing competitive natural gas markets can pers want to ensure that BG accepts their bids, require frequent regulatory changes and inter- they will reveal their true willingness to buy or ventions, as it did in the United Kingdom. But sell natural gas. BG can construct a market (sup- these interventions can lead to many controver- ply and demand) from shippers’ bids, and de- sies and disputes among industry participants cide which ones minimize the cost of restoring and between the industry and the regulator, of- the system balance. Since the last accepted bid ten with harmful effects for both companies and determines the price for all transactions, the consumers. The cost of increased regulatory risk system marginal price reflects the economic value of natural gas needed to restore the bal- ance in BG’s pipeline system. The practices of tying up natural gas The cost of restoring the system balance under in long-term supply contracts and the Flexibility Mechanism is recovered from the shippers that cause the imbalance. Undisci- integrating gas supply with pipeline plined shippers must either pay the system marginal price for the natural gas below the transportation must be eliminated to tolerance level of their shipments or accept the system marginal price for natural gas that is enable independent suppliers to acquire above the tolerance level. Since the system marginal price is typically higher than the price natural gas in the wholesale market, gain of natural gas sold or lower than the price of natural gas purchased in the spot market, un- equal access to pipelines, and start to disciplined shippers experience losses on their imbalances in addition to any imbalance pen- compete on equal footing with the alties imposed by BG. These potential losses deter shippers from violating the balancing incumbent gas company. rules of the Network Code. and the risk of political intervention discourage Conclusion investment in the gas sector. So it is important to introduce structural changes at the beginning The U.K. experience shows that the develop- of the reform to set the stage for developing ment of competitive natural gas markets must markets and competition later in the reform. be supported by an appropriate industry structure and regulation to protect new entrants Market forces have proved to be vital and from the market power of the incumbent. To effective in the gas industry, once appropriate promote competition, the liberalization of en- structural and regulatory measures establish try to gas supply and of gas prices must be some breathing room. New entrants in gas 8 Natural Gas Markets in the U.K. trading, shipping, and supply can emerge over- night and introduce new methods of transacting business, such as spot market trading. By con- centrating trading in one location, spot markets like the U.K. on-system market can serve a vital function for market participants that require flex- ibility in gas supply and efficient pricing of natu- ral gas. And spot market pricing of natural gas can be used for valuation of system balancing, as it is in the Flexibility Mechanism of BG. 1 Categories of market participants are defined in the Network Code of BG plc, the pipeline transportation spin-off of British Gas. Ship- pers are firms with shipper licenses that buy gas from producers, sell it to suppliers, and contract with BG to transport the gas to consumers. Suppliers are firms with supplier licenses that buy gas from shippers and then sell it to consumers. They do not deal directly with producers or BG. Since many companies in the United Kingdom have both supplier and shipper licenses, these terms are used interchangeably here. Traders are firms that buy and sell natural gas in a spot market and do not deal directly with con- sumers or BG. Viewpoint is an open 2 Based on data from the U.K. Department of Trade and Industry. forum intended to 3 Gundi Royle, “British Gas: Light at the End of a Long Tunnel,” encourage dissemina- (Morgan Stanley International, Investment Research U.K. and Europe, tion of and debate on London, 1996). ideas, innovations, and best practices for ex- panding the private Andrej Juris (andrej_juris@nera.com), NERA, sector. The views pub- Washington, D.C. lished are those of the authors and should not be attributed to the World Bank or any of its affiliated organiza- tions. Nor do any of the conclusions represent official policy of the World Bank or of its Executive Directors or the countries they represent. 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