7/25/2019 TUD 2010 - SECURE_D5-2-5 http://slidepdf.com/reader/full/tud-2010-secured5-2-5 1/18 Project No 213744 SECURE Security of Energy Considering its Uncertainty, Risk and Economic implications SP1 – Cooperation Collaborative project Small or medium-scale focused research project DELIVERABLE No 5.2.5 Vertical Integration Index and Market Structure – Natural Gas Vertical Integration in Liquefied Natural Gas Due date of deliverable: End September 2009 Actual submission date: September 2010 Start date of project: 1/1/2008 Duration: 36 months Organisation name of lead contractor for this deliverable: Chair of Energy Economics and Public Sector Management, Dresden University of Technology, (TUD) Revision: Project co-funded by the European Commission within the Seventh Framework Programme Dissemination level PU Public X PP Restricted to other programme participants (including the Commission Services) RE Restricted to a group specified by the consortium (including the Commission Services) CO Confidential, only for members of the consortium (including the Commission Services
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SECURESecurity of Energy Considering its Uncertainty, Risk and Economic
implications
SP1 – CooperationCollaborative projectSmall or medium-scale focused research project
DELIVERABLE No 5.2.5
Vertical Integration Index and Market Structure – Natural GasVertical Integration in Liquefied Natural Gas
Due date of deliverable: End September 2009
Actual submission date: September 2010
Start date of project: 1/1/2008 Duration: 36 months
Organisation name of lead contractor for this deliverable: Chair of EnergyEconomics and Public Sector Management, Dresden University of Technology,(TUD)
Revision:
Project co-funded by the European Commission within the Seventh Framework ProgrammeDissemination level
PU Public XPP Restricted to other programme participants (including the Commission Services)
RE Restricted to a group specified by the consortium (including the Commission Services)
CO Confidential, only for members of the consortium (including the Commission Services
SECURE – SECURITY OF ENERGY CONSIDERING ITS UNCERTAINTY,
RISK AND ECONOMIC IMPLICATIONS
PROJECT NO 213744 DELIVERABLE NO. 5.2.5
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1. Introduction
Vertical integration along energy value chains is a topic intensively discussed from bothan economic and (geo-) political perspective, and thus highly relevant for energy
security. The ongoing liberalization of European natural gas and electricity markets
focused on an unbundling of transmission infrastructures and restrictions in long-term
contracting in order to support competitive market patterns and the development of a
functioning internal market. Incumbents as well as new entrants responded to energy
political changes by adapting their corporate strategies, including vertical and horizontal
structures, too. Amongst others, convergence between natural gas and electricity
markets (i.e. vertical integration along the extended value chain including natural gas
supply and power production) is an increasing post-restructuring phenomenon.
It is difficult, if not impossible, to study the vertical integration in the natural gas sector
at such a level of detail that a vertical integration index could be constructed. Indeed,
the data limitations are substantial, both on the European and on the global level. They
do not allow to define precisely some of the critical variables (e.g. ownership of ships,
joint ownership of pipelines) that would assure the uniqueness of such an index.However, we have been able to carry out an extensive literature survey on the topic of
vertical integration and we have studied the phenomenon of vertical integration in the
liquefied natural gas (LNG) value chain.
Liquefied natural gas plays an increasing role in the natural gas supplies of many
European countries, with many new-built LNG import (regasification) terminals in the
last decade. This is a truly global market, where the European importers are competing
with American and especially Asian importers. The players in the LNG value chain areglobal, multi-national companies and it is essential to understand their supply and
integration strategies in order to understand the security of European supplies with
LNG.
Whereas vertical structures in the natural gas industry within the European Union are
mainly determined based on regulations, contracting patterns with external suppliers are
predominantly determined by geopolitical considerations of exporting and importing
countries as well as corporate-specific strategic considerations. Thereby, the increasing
dynamics of the liquefied natural gas (LNG) market are of central interest and have an
impact on regional natural gas markets which increasingly become linked.
SECURE – SECURITY OF ENERGY CONSIDERING ITS UNCERTAINTY,
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2. Vertical Structures in the LNG Industry
The development of the global LNG market from an infant towards a mature industryhas been accompanied by far-reaching dynamics in vertical structures within the
industry. We focus on the changing role of traditional long-term contracts and the
increasing relevance of short-term and spot trade. A number of oil and gas majors
follows a strategy of vertical and horizontal integration investing in a portfolio of
export, shipping, and import capacities at the same time that other companies choose a
strategy of non-integration operating LNG terminals as ‘tolling facilities’.
2.1 The changing role of long-term contracts
Investments in LNG infrastructure, especially in upstream exploration, production, and
liquefaction, are very capital-intensive. Therefore, financing traditionally required the
conclusion of long-term sales and purchase contracts before the construction process
was initiated (Jensen, 2009a). Sellers typically have been state-owned oil and gas
majors (e.g., Algerian Sonatrach) and for a minor share joint ventures of private
companies (i.e., US’ Philipps and Marathon) or of private and state companies (e.g.,
Brunei Coldgas, a partnership between the state of Brunei, Shell, and Mitsubishi).
Buyers typically have been downstream state-controlled utilities (e.g., Gaz de France,
Japanese Tokyo Gas).
The traditional contract was a rigid take-or-pay contract in which the buyer accepted to
take-off a certain minimum level in the range of 90% of the nominal contracted
quantities. The seller in turn accepted a price escalator related to some measure of
competing energy prices. Hence, the buyer took the volume risk whereas the price risk
was transferred to the seller. Restrictions in destination limited arbitrage trades.
Within the three importing regions, alternative contracting patterns and pricing
structures established. Prices for LNG thereby are set either by price competition with
domestic gas (mainly US, UK) or by the operation of pricing formulas. When the first
LNG contracts were negotiated with Japanese buyers in the 1960s, Japanese power
generation was heavily dependent on fuel oil. Pricing clauses therefore tied the price
escalation to the Japanese Customs Clearing price. This pricing scheme later was
adopted for other Asian contracts, too. In the mid-1990s, the oil-linkage of LNG prices
in Asian contracts was softened. So-called ‘S-curve’ formulas guarantee the interest of
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3. Empirical Evidence Based on Transaction Cost Economics
As discussed above, various governance forms co-exist in the LNG industry, includingthe poles of spot market transactions and vertical integration as well as numerous hybrid
forms such as long- and short-term contracts, joint ventures and strategic partnerships.
Frequently, the same company chooses different governance modes along alternative
value chains. Furthermore, different companies follow varying strategies even though
they traditionally operate in similar stages of the value chain. This chapter summarizes
findings from empirical studies investigating firms’ motivations to integrate vertically
in the global LNG market.
3.1 Theoretical background
Transaction cost economics (see e.g. Williamson, 1975, 1985) hypothesizes that the
optimal choice of governance depends on the relative costs of alternative institutional
arrangements which in turn depend on the characteristics of the transaction at stake.
Economic actors are assumed to be characterized by bounded rationality and may
behave opportunistically. In a world in which uncertainty about the future state of nature
is present, contracts will remain incomplete and do not account for all possible
contingencies. This distinguishes transaction cost economics from neoclassical
economics, where contracts are assumed to be complete, probability distributions of all
possible future events are known and all relevant future external conditions can be
considered ex-ante in the contracting stage. As long as there is functioning competition
among trading partners, incomplete contracts are unproblematic. However, ex-post
bilateral dependencies, as do result from investments in relationship-specific assets, will
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RISK AND ECONOMIC IMPLICATIONS
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4. Conclusions
The vertical integration of the LNG supply chain is an important issue for energysecurity, in particular for Europe where own natural gas resources are declining. While
it may be argued that energy security is enhanced by vertical integration and long-term
contracts, the opposite may also be true, since the degree of diversification may be
higher in non-integrated supply chains. We have analyzed the structures of LNG-chains
internationally, and find that less integration, directly or via contract duration, occurs in
liberalized markets. This result also holds for Europe. We do not conclude, however,
that this is a major supply risk: the market entry barriers are relatively low, diversified
supply is (still) available, and some healthy competition within European importers also