A Top-Down Approach to Evaluating Cross-Border Natural Gas Infrastructure Projects in Europe.

• Author: Kiss, Andras
• Position: Report

1. INTRODUCTION

   Cross-border investments in electricity and natural gas transmission networks raise unusual challenges for cost-benefit analysis. Trading on a new interconnector narrows price differences across markets, making consumers better off on one side, but worse off on the other. Producer surplus moves in the opposite direction, while storage units (in case of gas) can either gain or lose profits, depending on seasonal demand-supply patterns. Market participants in directly and indirectly connected third countries are also affected. Moreover, the new infrastructure element might only be needed in case of a serious (but rare) supply disruption. These nuanced complications can forestall neighboring transmission system operators (TSOs) and governments from investing into projects that would otherwise be beneficial for the region as a whole.

   Europe, with over 30 interconnected national electricity and gas markets, is ripe for divergent bilateral and regional interests over cross-border transmission investment. Aware of the threat of underinvestment in market interconnection, the European Union (EU) established a system for supporting energy infrastructure projects deemed essential for a fully integrated European market and for security of supply. These projects of common interest (PCIs) may benefit from accelerated planning, permitting and environmental process, and they can access financial support provided by the EU. (1) Yet there is no clear consensus about how PCIs should be chosen and evaluated.

   In this paper, we contribute to the policy debate by providing a model-based project evaluation method for the natural gas sector and demonstrate its use on a set of currently shortlisted PCIs in Central and South Eastern Europe (CSEE). Our main tool is the European Gas Market Model (EGMM), a competitive short-run equilibrium model for the natural gas market in Europe. (2)

   The current method for identifying projects for PCI status has been developed by the European Network of Transmission System Operators for Gas (ENTSOG), tested in two PCI selection rounds in 2013 and 2015, and is subject to continuous fine tuning (ENTSOG, 2013). Frontier Economics (2014) and ACER (2014) have, however, pointed out shortcomings of the ENTSOG methodology by--among others--(1) not providing impact estimates on stakeholders other than consumers and producers; (2) not breaking down benefits by EU member states; (3) not including non-EU members; (4) failing to adequately identify complementary and competing projects; and (5) over-simplifying transportation costs. The market-based evaluation method we propose in this paper addresses all of the above issues.

   Our project evaluation mechanism unfolds in three steps. First, we establish baseline scenarios that account for expected demand, supply, and long-term contractual positions, as well as infrastructure elements (pipelines, storage units, LNG terminals) that are likely to be operational by 2020 (the year of analysis). The model is detailed enough to provide equilibrium surplus estimates for all market participants in each EU and non-EU country included. Second, we simulate market outcomes by adding all possible combinations of shortlisted PCIs in our sample to the baseline case. Third, we compare the gain in regional welfare for each pipeline combination against the joint investment costs, and provide a ranking of project sets based on our annual net social benefit measure. By considering every feasible PCI configuration, rather than single projects in a selected order, our ranking method allows for an endogenous determination of which projects are competing and which ones are complementary.

   The final outcome is an illustrative set of proposed PCIs under each baseline scenario. Even though the analysis presented in this paper is not exhaustive, we can still draw some general lessons from the exercise. All baseline scenarios suggest that the central region of South Eastern Europe (roughly around the core of Serbia) is most in need of pipeline investments. In the reference case, connecting Serbia and Greece through Bulgaria (southern supply direction) brings the highest net benefits for the region. The construction of a long-planned LNG terminal on the coast of Croatia would, however, make it more beneficial to build pipelines from Croatia to Serbia and to Hungary (western supply direction). Regardless of which baseline is considered, it is never optimal to build all, or even a majority of the proposed projects. This conclusion has important policy implications: supporting too many proposals would lead to underutilized infrastructure that would have to be ultimately financed by consumers through higher regulated tariffs.

   Somewhat contrary to our expectations, we also find that most of the welfare gains from new investment tend to accrue to the countries building the pipelines, in some cases even making third countries slight net losers. This reflects the limited number of scenarios considered, but it also raises questions about the exact mechanism through which the PCI scheme improves welfare for the EU itself. (3)

   As a secondary application, we also demonstrate the advantages of the EGMM's treatment of long-term supply contracts in conjunction with the proposed PCI evaluation mechanism. We explore a hypothetical baseline scenario in which the contract delivery points of gas arriving from Russia are moved to the member state border where the gas enters the EU, and all transit routes from the east avoid crossing Ukranian territory. (4) Although this is a large shift from the current mode of operation, we find that its negative welfare consequences for the CSEE region are modest. However, this result significantly depends on assumptions about a (not-yet-existing) southern route becoming available for Russian transit. (5) The new baseline also shuffles the project combination rankings, moving a north-to-south supply route from Poland at the top of the list. Implementation of the proposed PCIs has the potential to neutralize around 30 percent of the welfare decline in the region. We also discuss other potential benefits, such as the improvement of buyer bargaining position, after modeling results are presented.

2. LITERATURE

   This paper adds to an extensive literature on the numerical modeling of natural gas markets. Prominent modeling tools and applications focusing on the European consumer market include GASTALE (Boots et al., 2004; Egging and Gabriel, 2006), NATGAS (Zwart and Mulder, 2006; Zwart, 2009), TIGER (Lochner and Bothe, 2007; Lochner, 2011; Dieckhoner et al., 2013), GASMOD (Holz et al., 2008), the World Gas Model (Egging et al., 2010), the Global Gas Model (Holz et al., 2016; Richter and Holz, 2015), GaMMES (Abada et al., 2013), and the EPRG-Gas Market Model (Chyong and Hobbs, 2014). Smeers (2008) provides an in-depth discussion of the models existing before 2010.

   Our approach is different from most models (except for TIGER) that allow for strategic behavior by upstream firms, and in some cases also in the downstream market, in that we assume all market participants are price takers. (6) Working with a perfectly competitive equilibrium has drawbacks, as the presence of market power is an important issue in the upstream market. We remedy this shortcoming with the inclusion of a detailed representation of long-term take-or-pay supply contracts in the model. Our assumption is that most of the upstream market power is exercised through the pricing of these contracts with the market working more like the competitive benchmark in the short run. Accordingly, a single simulation run of our model encompasses one calendar year. (7)

   The price-taking assumption allows us to go into finer detail both geographically and in the temporal dimension. We aggregate demand at the country level, but not across countries. The modeling literature often lumps small neighboring markets (e.g. in South Eastern Europe) together for computational convenience, which rules out the analysis of interconnection between these markets. We also break the modeled time frame into monthly periods, whereas the cited models typically include only 1-3 seasons per year. The monthly output is especially helpful when examining market disturbances, which are typically short-lived, and the extent to which storage units can mitigate them depends on short-run gas withdrawal capacities. In terms of geographical and temporal granularity, our model is close to--but still less detailed than--the TIGER model. (8) However, we do allow for price responsive demand functions and can therefore carry out a more informative welfare analysis. The detailed take-or-pay contracting structure in the EGMM also allows us to examine the effect of virtual reverse flows on market integration with limited physical connectivity.

   We use a comparative static framework for our project evaluations, contrasting equilibrium outcomes with and without the investments, which could--in theory--also be carried out with other cited models that are sufficiently detailed. Some models even go beyond the static approach and allow for infrastructure changes within the time frame of the simulations. Lise and Hobbs (2008) extend the GAS TALE model to automatically include new pipelines and storage units whenever the forecasted congestion rents exceed a specified threshold value. (9) In the Global Gas Model, transmission and storage system operators decide about new investments based on a private cost-benefit analysis.

   Making the investments of profit-oriented yet geographically limited entities in interconnected markets endogenous is not straightforward. It is not clear, for example, how the substitutability or complementarity of new pipelines can be modeled if the investment decisions are taken project-by-project by non-overlapping (or partially overlapping) sets of TSOs. In reality, policy makers with their own objectives also need to consent to the...