CHAPTER 20 GAS TRADING AND DERIVATIVES - THE UK EXPERIENCE

• Jurisdiction: Derecho Internacional

Mining and Oil and Gas Law, Development, and Investment - Book 2
(Apr 2007)
CHAPTER 20
GAS TRADING AND DERIVATIVES - THE UK EXPERIENCE
Kirsti Massie
Attorney, McGriggors LLP
London, UK
Ed Blackmore
Group Vice President
Sempra Energy Europe Limited
London, UK

ED BLACKMORE

Ed Blackmore is Head of the European Gas desk with Sempra Energy, whom he joined in 1999. Prior to this he worked in gas trading and marketing with ARCO British Limited. He has also worked for PriceWaterhouseCoopers in their oil and gas consultancy, Eastern Natural Gas, a UK retailer and British Gas Plc.

KIRSTI MASSIE

Kirsti Massie studied law at Cambridge University, England before progressing to the College of Law, Guildford to take her Law Society Finals which she passed with first class honours. Kirsti has spent the majority of her career working in-house in the legal department of two major multi-national energy companies, namely National Power plc and International Power plc. Whilst at National Power plc Kirsti's responsibilities included providing legal support for the company's UK gas business. At International Power Kirsti was responsible for providing legal support to enable the company to establish and maintain its UK and European energy trading business. As a result Kirsti is familiar with the master trading documentation typically used in the UK as well as netting arrangements and credit/collateral support arrangements covering a wide range of energy commodities including power, gas, carbon and renewable obligation certificates. Kirsti joined McGrigors' Energy Projects team in July 2005 where she specialises in energy projects with a particular focus on energy trading. Kirsti recently spoke at a Carbon Trading seminar in London on the subject of current legal issues in carbon trading.

Introduction

This paper will discuss the development of gas trading and trading of gas derivatives in the United Kingdom ("UK") and will:

(i) briefly track the development of the gas market in the UK looking at key changes in the commercial, physically-traded market, legislative and regulatory framework and contractual documentation;

(ii) provide a brief overview of the Uniform Network Code (the " Network Code") and consider the standard terms and conditions most typically used in the trading of gas in the UK and how such terms and conditions work in conjunction with the Network Code;

(iii) consider some of the "highs and lows" experienced in the UK as the traded gas market has developed; and

(iv) reflect on the success or otherwise of the UK experience and consider whether there are lessons to be learnt by other markets, including those in Latin America, considering undertaking a similar liberalisation exercise.

Key Facts

In 2005 the UK gas market accounted for approximately 39% of the total UK energy consumption.¹

The total size of the UK gas market, in volume terms, amounted to approximately 80bcm, of which:

• 43% was used for electricity generation;

• 18% was used for industrial and commercial purposes; and

• 39% was used for domestic purposes.²

As can be seen from the above figures, the UK is heavily reliant on gas particularly for the purposes of power generation. Gas is also widely used as a domestic fuel. It is therefore of little surprise that, given the importance of gas in the UK, security of supply issues remain a focus of the "energy debate" generally in the UK and are a key consideration in any discussion of the UK gas market and wider European energy market.

Market Snapshot

Any consideration of the UK gas market must be undertaken with an acknowledgement of the physical structure and constraints of that market and the legislative, regulatory and contractual provisions and arrangements that have come into being to accommodate the physical nature of the market. All are inherently interlinked and influence and are influenced by each other. The gas market is a complex and fascinating matrix of competing and complimentary issues.

[Page 20-2]

Set out below are the issues which we see as key to the UK gas market and its operation.

Legislative / Regulatory Position

The legislative / regulatory regime in the UK is largely shaped by European policy on the liberalisation of energy markets in Europe, although it is worth noting that the UK embarked on its "liberalisation journey" well in advance of any European policy to that effect. Various pieces of legislation are relevant to the gas market, in particular the Gas Act 1986, the Utilities Act 2000 and the Energy Act 2004.

The Network Code sets out the terms and conditions for the input, transportation and offtake of gas from the national gas transmission system ("NTS").

The diagram below is a simplified illustration of the "gas chain" in the UK, showing the physical gas flow and also the contractual gas flow position.

The Regulator

The liberalisation of any market with the removal of monopolies and an increase in the number of market participants gives rise to a requirement for a regulatory authority and rules to be established to govern, in the case of the gas market, access to and use of pipeline infrastructure, to permit fair competition amongst suppliers and to ensure conformity of supply to the commercial, retail and domestic end-users. In the UK the onshore regulator is the Gas and Electricity Markets Authority, supported by Ofgem. Ofgem's function has developed over the

[Page 20-3]

years to include responsibility for monitoring competition and tackling anti-competitive behaviour within the UK energy market.

Licensed Activities

Certain gas activities in the UK are licensed, meaning that a person is prohibited from undertaking such activities without obtaining the required licences from the Secretary of State.³ The transportation, interconnector operation, shipping and supply of gas are all licensed activities. A licence sets out the terms and conditions with which the licence holder is required to comply in order to continue to hold the licence e.g. transporters of gas are required to publish a document detailing the terms and conditions (in particular conditions relating to gas quality) on which they will permit gas to flow through the system.

An exemption from the requirement to hold a licence may be granted by the Secretary of State in certain limited circumstances.

Uniform Network Code

The Network Code sets out the rules and regulations that apply to the transportation of gas through the NTS, including the arrangements for the input and offtake of gas from the NTS, the charges payable for the transportation of gas through the system and the calculation of imbalance and scheduling charges. The Network Code is made binding as between the NTS operator (Transco (now part of National Grid)) and any shipper by way of a Shipper Framework Agreement. Every shipper is required to enter into a Shipper Framework Agreement before it is permitted to ship gas through the NTS. Additional agreements, referred to generically as Ancillary Agreements, may also be required to cover issues or arrangements not dealt with in sufficient detail in the Network Code e.g. Advanced Reservation of Capacity Agreements which set out the arrangements for the long term reservation of capacity in the NTS. Credit support is also required to be provided by a shipper to Transco to provide appropriate support for a shipper's obligations under the Network Code.

[Page 20-4]

Gas: The Legal Matrix

The Balancing Regime

The regulatory framework is largely shaped by the physical reality and constraints of the gas market and gas infrastructure. This physical reality is reflected in the provisions of the Network Code particularly in a key element of the Network Code, the daily balancing regime. Transco must physically balance the NTS by ensuring that the quantities of gas input into the system match the quantities of gas offtaken to ensure that gas continues to flow through the system as a whole and preserve system security. The Network Code contains provisions to incentivise gas shippers to balance their inputs and offtakes and to provide Transco with the necessary information to enable Transco to manage the system. Details of the balancing regime are dealt with later in this paper.

[Page 20-5]

Balancing is carried out at a national level, in other words, from a commercial balancing perspective, it does not matter where in the system the gas is physically input into the NTS. The effect of this is that from a commercial perspective the NTS is not divided into separate areas and shippers have a great deal of flexibility in terms of where they actually put gas into the system which in turn enhances competition throughout the market as a whole.

However, one consequence of carrying out commercial balancing at a national level is that a point has to be created at which balancing is assessed. Under the Network Code this point is the National Balancing Point ("NBP"), a notional point on the transportation system through which all gas is deemed to flow. The NBP is also the point at which onshore gas trading in the UK takes place.

Transco is itself prohibited from buying or selling gas other than for the limited purposes of physically balancing the NTS. This physical balancing of the system is undertaken through the OCM System pursuant to which shippers bid the prices at which they would be prepared to put less or more gas into the NTS. Transco then accepts the best priced bids according to the physical needs of the system.

NBP / Beach Trading

Onshore gas trading most commonly takes place at the NBP. However, gas may also be traded at the beach, i.e. prior to its entry into the NTS. Different terms and conditions are used for the trading of gas at the beach, reflecting the physical difference of the situation and the different risks and potential liabilities to be taken by the parties to the trade. Trading at the beach is...