A Study of the Natural Gas Industry’s Marketization Process – Models, Trajectory and Policy Instruments
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Since the mid-1980s, the structure of the natural gas industry has evolved dramatically. About a hundred years ago, the structure of the natural gas industry was less complex with few options for natural gas delivery. Natural gas has become increasingly fashionable in recent years. This paper analyzes the policy instruments in four typical countries in order to identify similar features among the reform trajectories and conclude them as two main reform models of natural gas: the “state-owned monopoly” and “private sector competition”.
Both reforms share certain characteristics (proprietorship diversification, de-monopolization, de-integration), and their final goal is to realize the “X+1+X” structure among the upstream, midstream and downstream market participants. In general, during reforms, governments usually employ three sorts of policy instruments at supply, environment and demand levels, through introducing capital investment, long-term contracts, exploration rights, and third-party access.
Natural gas, which has become an increasingly fashionable energy source in recent years, accounts for 24% of primary energy consumption worldwide. In the United States, the natural gas industry is an extremely vital segment of the economy. The natural gas industry provides valuable commerce to the economy in addition to proving the cleanest burning fuels to most segments of the economy.
The International Energy Agency(IEA) predicts that the consumption share of natural gas will surpass that of coal by 2030. As this market expands, the conflict between demand and supply extends. This paper explores how to solve these problems, how these countries are trying to develop market mechanisms and introduce market-based models into the natural gas industry. By comparing four typical trajectories of reform in four different countries, this paper focuses on the “State-owned monopoly” and “Private sector competition” models applied in these countries, as well as three efficient policy instruments.
According to the literature materials on the natural gas, three major topics have developed from natural gas. The first topic discusses how the upstream, midstream and downstream affect the reforms in the natural gas industry; the second topic recognizes the distinctions in reforms between different countries; and the third topic considers how natural gas reforms influence other fields, such as the infrastructures.
This paper develops as follows. Section 2 describes the “State-owned monopoly” and “Private sector competition” models, together with their similarities. Section 3 interprets four natural gas reform cases in the U.K., Australia, USA, and Germany. Section 4 evaluates the policy instruments applied in the reforms from three perspectives: supply, environment, and demand. Section 5 concludes the two basic models in the natural gas industry and how the market mechanism works in these models respectively.
Natural Gas Industry Reform Patterns
Market-based trajectories are closely related to these countries’ proprietorship right structures, which can be divided into two types: “state-owned monopoly” and “private sector competition”. In countries like the U.K. and Australia, the natural gas industry was monopolized by state-owned companies prior to the reform, while in countries such as the United States and Germany, the natural gas was owned by the private sector all along.
A country’s selection of reform pattern partly depends on its proprietorship right structure on the early stage. Despite their various starting points, these countries’ final goal is to achieve a “diversified” proprietorship rights structure, involving market de-monopolization industrial chain de-integration.
The “State-owned Monopoly” Model
In countries that follow the “state-owned monopoly” model, which represented by the U.K. and Australia, the natural gas industry’s upstream, midstream and downstream are fully monopolized before the reform. With abundant natural gas resources, these countries tend to consume more natural gas than they produce. First, they introduce competition in the upstream production, usually through attracting capital investment and building a national market.
Second, they eliminate the monopoly and introduce interventions into the natural gas market, then supervise the network of the gas pipeline under natural monopoly through market regulation, as well as abolishing long-term contracts, granting increased access to the third-party pipeline network, and separating midstream and downstream companies in order to achieve de-monopolization and de-integration.
With the de-integration among streams and the greater number of companies stepping into the market, eventually, the reforms in state-owned countries gradually completed. This kind of reform is essentially distinguished by “property rights privatization”, a pattern that can be summarized as the transformation from the “1+1+1” to the “X+1+X” pattern.
The “Private Sector Competition” Model
In countries that follow the “private sector competition” model, represented by the USA and Germany, competition in the natural gas industry was based on private sector intervention from an early stage. As the competition was limited, it was often insufficient due to the government’s supervision and industrial integration pattern. These countries didn’t have sufficient natural gas resources and to consume more than they produce.
In this model, the upstream of the industry becomes the most competitive sector. The reform usually begins with opening a wellhead market to allow the market mechanism to work, then abolish long-term pipeline network contracts in the midstream to attract new market participants. On the other hand, the government should mandate third-party access, and open up pipelines to other suppliers without regulation.
Simultaneously, the pipeline companies are required to separate their sales and transportation business. The “private sector competition” reform pattern is featured by “deregulation”, so this model can be summarized as a transformation from the “X+1+1” to the “X+1+X” pattern.
Similarity between the Two Reform Patterns
These two models have some features in common:
- they both start from the upstream, and then turn to the midstream and downstream;
- with policy instruments, they are designed to attract competition in the upstream market, such as granting pipeline network access to third-parties;
- the ultimate goal of both models is to realize de-integration in the upstream, midstream and downstream;
- grant pipeline network access to third-parties, as well as introduce competition to the whole industry except for the section limited on natural monopoly.
Natural Gas Industry Reform Trajectories in Various Countries
Among eight important industrial countries, the U.K., USA, Germany and Russia are labeled as grant success in their natural gas marketization reform. Although Brazil and Australia are not among these eight countries, they have been researched by scholars as special cases. This paper will focus on the U.K., Australia, USA and Germany to demonstrate the specific reform trajectories, which can be classified into the “state-owned monopoly” and “private sector competition” models.
The U.K. is a typical country following the “state-owned monopoly” pattern. After World War II, in order to promote energy security, this country enacted the Fuel Gas Act , which incorporated 1046 private-owned and municipal gas companies into the Fuel Gas Council. In 1964, the Continental Shelf Act was enacted, which granted domestic companies licenses to explore and produce natural gas in the North Sea.
From 1967 to 1978, the U.K. government invested in primary infrastructures to enlarge competition among the downstream market, as well as transforming the Fuel Gas Council into BG Corporation, and engaging in natural gas transportation, distribution and sales to monopolize the midstream and downstream markets . By the 1980s, the country’s natural gas run out in the mainland, so BG monopolized its exploitation, however the abundant North Sea natural gas was exploited by several transnational corporations, thereby leading to free competition between upstream companies. The midstream and downstream sections continued to be monopolized by BG, which was entitled to purchase the natural gas.
In 1982, the government initiated reform, enacting the Law of Petroleum and Natural Gas Enterprises (1982) and Energy Law (1983) successively, abolished BG’s special right to purchase natural gas, and allowed other enterprises to rent BG’s pipeline network to transmit gas, which to great extent weakened BG’s monopoly . In 1986, the Natural Gas Act 1986 was enacted to privatize BG, establish the Office of Gas Supply (Ofgas) to manage the natural gas industry, which gradually split the pipeline network business and push forward third-party access for its transportation capacity.
However, because BG controlled the U.K.’s pipeline network and long-term gas purchase contracts, it effectively retained its monopoly. To solve this trouble, in 1989, the 90:10 Regulation was enacted by Ofgas, which prohibited BG from entering into any trade whose gas purchase proves higher than 90% production of any gas field in the country, and required the production enterprises to sell the remaining 10% to independent suppliers/shippers and other competitors of BG.
This proportion was reduced to 80% in 1992. In 1995, the country enacted Natural Gas Law, which legally established competition system in the downstream of natural gas industry. In 1997, BG’s General Shareholder meeting resolved to incorporate its natural gas supply business into the newly-established Centrica PLC. In 2000, divided into two parts, BG combined its midstream business into the newly-established Lattiec Group, retaining only its downstream natural gas business, and finally finished its joint division.
The Australian gas industry has undergone major restructuring for the past few years. The restructuring strategies come in after the findings of the 1990 Common wealth’s National Gas Strategy and Industry Commission Report on Energy Generation and Distribution. The reform highlighted in these reports aimed at increasing competition and efficiency to decrease energy prices to both domestic users and industries. Having adopted the “state-owned monopoly” pattern, by 1994, all Australian states had constituted laws to ensure state-owned monopolies over natural gas production, distribution, and sales, although the vast national market did not yet exist.
Since 1994, Australia actively carried out pipeline network privatization reform to break the state-owned monopoly over natural gas wholesale and sales, and attract more individual and foreign investment in the national pipeline network construction. In 1997, Australia enacted the Agreement on Market Access of Natural Gas Pipeline, state governments agreed to abolish the restriction on the free access to and fair trade of natural gas, and push forward third-party access; natural gas could be traded among all states to widen downstream consumers’ choice, and so eliminate barriers between states and form a national market.
In 2001, Australia established the Ministerial Council on Energy (MCE), and set up the Central Federal Energy Regulatory Commission to manage interstate natural gas trading; the states authorized their public utility commissions to manage the natural gas industry in their states. Under this regulatory system, there was no administrative subordination relationship between the central and local regulators.
Australia’s natural gas industry started to adopt a national unified regulation pattern. On July 1, 2008, Australia enacted the State Natural Gas Law, which graded the natural gas pipelines, incorporating some into the national pipeline system, and further promoted the national natural gas market formation. Overall, a national natural gas market in Australia is required, as national competition relies on a unified market.
The United States has the largest natural gas market in the world. Natural gas consumers can now feel the positive impact of fifteen years of deregulation in form of lower prices and more services. Liberalizing gas the prices and bulk supply of natural gas have led to a health competition in the market. However, the regulators in the natural gas industry should concentrate on improving the regulation of transportation and minimize its distortive effect on the gas market.
The USA is typical of the countries that adopted the “private sector competition” pattern. During its initial natural gas development stage, the free competition principle led to many natural gas producers springing up in various states. Producers and distributors formed private holding transportation enterprises to build long distance interstate pipelines where required; numerous natural gas enterprises integrating upstream, midstream and downstream sections were founded, which held a monopoly in their own pipeline network district.
In 1938, the US Congress adopted the Natural Gas Act to authorize the Federal Power Commission (FPC) to regulate the interstate natural gas sales rate, which foreshadowed natural gas price regulation. In 1954, the US Congress adopted the Phillips Decision; which sparked federal government regulation of the natural gas price and resulted in the upstream market’s low competitiveness.
In 1978, the USA embarked on natural gas industry reform, and Congress adopted the Natural Gas Policy Act gradually to abolish wellhead price deregulation, which increasingly strengthened the upstream market’s competitiveness. In 1992, the USA adopted FERC Order 636 to mandate third-party pipeline network access, and require pipeline companies to abandon their sales business and provide a transportation business only, which broke the pipeline companies’ sales market monopoly, and gradually enabled users to purchase natural gas directly from producers and select pipeline companies for transportation, and enhanced the downstream market’s competitiveness.
Germany also adopted the “private sector competition” pattern. By 1998, natural gas there was monopolized by vertically integrated private enterprise in several regions of whom, Royal Dutch Shell PLC and BEB (a joint venture of Esso) controlled around half of Germany’s natural gas production.
In June 1998, the EU enacted the No.1 Order of Natural Gas Market, which required dealers to select suppliers independently. To meet this requirement, Germany started to promote natural gas market liberalization and declared contracts longer than 30 years illegal, to enhance new companies’ market access. In 2003, the EU enacted the No.2 Order of Natural Gas Market, which demanded that member countries split vertically integrated enterprises to separate pipeline network and supply businesses, although Germany suffered from a huge obstruction slowing down the implementation.
Meanwhile, Germany enacted the Treaty on Third-Party Access Amendment, which allowed new participants pipeline network access. In July 2009, the EU enacted the No.3 Order for Natural Gas Market Regulation, and Germany split its natural gas pipeline assets, separated pipeline network transportation, production and sales businesses, and finally abandoned the vertically integrated enterprise pattern.
Policy Instruments Analysis
This paper classifies these countries’ policy instruments into three types.
Policy Instruments: Supply level
The policy instruments at the supply level directly support the natural gas industry’s development through funding, technology, etc. Initially, the natural gas industry’s market suffered from a lack of investment, strength and market participants. To promote natural gas consumption, governments have facilitated exploration, production and pipeline construction and introduced upstream, midstream and downstream integrated enterprises through with direct investment or relevant policies to attract investment.
However, this market’s healthy development has been affected by poor efficiency due to the low integration within this industry. As the industry matures, more enterprises are participating and the incumbents are delivering business to newcomers in favor of cost reduction. Accordingly, the industry has developed non-vertical integration, and government policies have changed from focusing on the supply level to the environment and demand levels.
Policy Instruments: the Environment level
During the natural gas industry reform, the policy instruments at the environmental level included: proprietorship reform, a third-party access mechanism, the technical standards unification for pipeline network and lawmaking and regulation reform.
Initially, the natural gas enterprises’ proprietorship diversification was prominent in the de-monopolization, bringing in private capital, selling state-owned assets, loosening government regulations, abolishing legal barriers, and encouraging contracting-out. Third-party access is a main policy reform instrument in pipeline networks, targeting the midstream pipeline network and strengthening the competitive dynamics that is also widely used nowadays in England, the USA and elsewhere.
Technical standards unification is another significant policy for achieving natural gas industry de-integration and enabling more enterprises to enter this market technologically to shape national markets.
Efficient lawmaking and regulation can also reduce reform resistance and corporate rent-seeking, and reduce corruption. Various countries are implementing natural gas reform by perfecting regulation mechanisms and ensuring regulator independence.
Policy Instruments: Demand level
Policies at the demand level abate the market uncertainty, which benefits market stability and exploration. Demand policies include exploration right reform and long-term contract restriction or abolishment.
Natural gas exploration in the upstream is the foundation of natural gas industry and largely shapes the midstream and upstream natural gas markets as well as the whole industry’s market size. Therefore, countries generally work out relevant policies for natural gas reform and upstream exploration rights always come first.
The restriction or abolishment of long-term contracts is another policy instrument for industry reform. In countries where natural gas is privately-owned, producers and pipeline network owners have to start with a large amount of initial investment, so they prefer to sign long-term contracts with downstream consumers to decrease risks, thereby also consolidating the integrated business pattern and strengthening chain interaction. However, these long-term contracts increase the monopoly over the industrial chain, gradually reducing integration.
The following conclusions can be drawn from our examination of the four cases and three aspects of policy instruments.
First, natural gas industry reform can be divided into two models: “State-owned monopoly” and “private sector competition”. Governments tend to play an important role in introducing a free market through policy, and marketization trajectories are gradually promoting natural gas industry reform. State-owned monopoly reforms have developed from “1+1+1” to “X+1+X”, characterized by breaking down state-owned monopolies, achieving industry de-integration and introducing new competitors.
Moreover, private sector competition reform has transferred from “X+1+1” to “X+1+X”, characterized by loosening regulation, separating the midstream from downstream business and allowing more new followers to share pipeline networks. These two models have broken the natural gas industry’s integrated monopoly, promoted third-party access to the pipeline network and enhanced midstream competitiveness, using government policies as key tools for marketization reform.
Second, we examined natural gas marketization reform using four countries as examples: the USA and Germany’s natural gas marketization is characterized by private sector competition, while that in the U.K. and Australia by state-owned monopolies. The driving force for the development of natural gas marketization reform in these four countries was the contradiction between the demand and supply capability.
The power of the policies in the reform depends on the productivity, the capability, willingness of governments to intervene in the market, market size, etc. The government policy instruments are considered to be symbols of the key nodes of the natural gas reform path in various countries, reflecting the function and effect of government intervention in the market.
Third, the policy instruments used to promote natural gas industry marketization reform by the governments of various countries can be classified into three categories: policy instruments at the supply, environment and demand levels. The policy instruments at the supply level are concerned with attracting investment; that at the environment level include ownership diversification, the third-party access mechanism, the unification of technical standards for pipeline networks and the reinforcement of lawmaking and regulation; while, at the level of demand, they include the reform of exploration rights and abolishment or restriction of long-term contracts.
The common characteristics of these policy instruments are to increase the number of new followers, improve the extent of marketization competition and break the original monopoly over the upstream, midstream and downstream. Policy instruments generally appear in the form of government legislation, wherein the midstream and downstream enterprises break up or business separation is a policy which symbolizes that marketization reform has been achieved basically and indicates that market development has entered into the competition stage of “X+1+X” of the upstream and downstream markets.
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