Sept. 2001 Vol. 222 No. 9  International Politics

Øystein Noreng,  Contributing Editor

Big changes are inevitable for European natural gas

Major changes are underway in Europe’s natural gas market. Although French and German officials continue to drag their feet on energy market reform, it is only a matter of time (probably a short time) before markets and infrastructure are opened to competition in these countries. The European Union’s (EU) objective, to establish integrated markets for electricity and natural gas, appears realistic within the next few years. Responding to institutional changes that will profoundly affect operations, large mergers and acquisitions are taking place. Finally, while the European market’s trading pattern is changing quickly, the major supplier, Russia’s Gazprom, seems blocked for the short term.

Opening electricity and gas markets to competition on the UK model is the result of laborious, methodical effort by the EU Commission. Forcing Norway to abandon its gas sales monopoly (GFU) this spring was a major victory. The commission is now using this victory as a model to force France and Germany to open their gas markets to real competition. For the EU, bringing Norway to order was essential in view of the restructuring of Europe’s gas industry, as well as Russia’s serious problems.

Market "openings" bring competition to Continental gas companies that hitherto enjoyed a protected life and high profits as more or less institutionalized monopolies. Exposure to competition makes old positions no longer tenable – incumbents can either restructure or disappear. Italian and Spanish gas firms have quickly adapted to new realities, helped by expanding demand.

French and German difficulties. Company restructuring is more difficult in the French and German gas industries. In France, the government has refused to implement the EU’s natural gas directive – although it has accepted it on principle – out of fear of union unrest before 2002 parliamentary elections. In Germany, the negotiated access to pipelines maintains transporters’ control of the gas market, representing, in many ways, a mock deregulation. The Economy Minister appears ideologically opposed to imposing regulatory authority for electricity and gas transmission. As in France, German officials seem unwilling to implement any more measures before 2002 elections. Thus, no serious action seems likely in either nation before late next year, with open access to pipelines perhaps in 2003.

Meanwhile, the French government has pulled back from privatizing state-owned gas trader, Gaz de France. This has prevented Gaz de France from entering partnerships that have cross-ownership with foreign companies, such as Norway’s Statoil. In Germany, however, the gas industry’s structure is changing quickly. The current wave of power industry mergers and acquisitions can be seen largely as defensive moves in light of a more competitive, riskier future.

It is telling that local and regional governments, especially in Germany, are selling their stakes in energy monopolies. BP also sold its shares in Ruhrgas to E. On, which has become the major Ruhrgas shareholder. BP’s strategy is, perhaps, to pull out of gas transportation, where tariffs and profits are likely to be regulated and low. Instead, BP will opt for trading in a more open market. Electricity giant EdF shows a keen appetite for entering gas trading, indirectly taking positions in German regional firm GVS. This could point to closer integration of Europe’s gas and electricity industries.

A crucial time in Russia. The most spectacular change is apparently occurring in Russia. This summer, Russia’s natural gas transporter / seller announced a moratorium on new export deals, arguing that domestic customers would have priority. Gazprom’s problems are, however, more critical. Contrary to the oil sector, Russia’s gas industry has remained under state control, subject to political manipulation and exploitation. It is also Russia’s largest taxpayer, essentially financed by gas export sales to Europe. By providing smaller consumers, households and small businesses with gas at low or no cost, Gazprom acted during the 1990s and beyond as the "glue" that keeps Russia together. The state provides gas for heating and cooking in return for loyalty, on the implicit presumption that charging prices to cover costs would compromise political stability.

Concurrently, low transfer prices paid to regional suppliers have compromised upstream investment in maintenance and expansion of productive capacity. Gazprom also has neglected to invest in its own decaying network that threatens supply security. Gazprom has ceded some of the more valuable assets to Itera, a private firm specializing in exports. Not surprisingly, the relationship between Gazprom and Itera is under investigation, compromising the ability of the former to raise money in international markets.

In spite of huge reserves, Russia’s gas industry is in serious trouble. Pressure is falling fast in the major West Siberian fields that account for most output, compromising future production, and gas is leaking steadily from rusty pipelines. For Russia to maintain and enhance its role as Europe’s leading supplier, the gas industry has to undergo drastic changes. It needs investment, better management and more business-like, less-politicized operating conditions. There are signs that the Putin administration acknowledges these issues. In late 2000, Gazprom was forced to open 15% of pipeline capacity to outsiders, representing Russia’s first go at opening the gas market. Indeed, Russia seems to follow the EU in this process, encountering many of the same obstacles and vested interests.

This summer, Russian officials changed Gazprom’s management, and said they would separate gas production, transportation and marketing. Curbing Gazprom’s power will open opportunities for oil companies, regional firms and, eventually, foreign investors to make money on Russian gas. The effort will require capital, but the potential is huge. More Russian gas will ultimately enter the market at a lower cost. This will only be after a difficult transition period, when legislation will be crucial. In the meantime, Algeria and Norway can consolidate their positions in Europe’s gas market.

Øystein Noreng is Professor, Norwegian School of Management, and he holds the TotalFinaElf chair in petroleum economics and management. He is a regular contributor to this column.