ENERGY FORUM

A QUARTERLY JOURNAL FOR DEBATING ENERGY ISSUES AND POLICIES CONTENTS

Issue 81 May 2010 Energy Poverty Robert Bacon Suleiman J. Al-Herbish – page 3 In a world where some regions and in some countries many people are becoming wealthier by the year, if not by the day, poverty still The Credit Crunch and International Energy prevails. As our focus is on energy it is natural that our concern is Markets with energy poverty. Robert Bacon whose work at the World Bank Christopher Allsopp – relates to this important issue, and Suleiman Al-Herbish, the Di- page 9 rector General of the OPEC Fund for International Development Gas Matters (OFID), both contribute to a discussion on this theme. Stephen Bull Robert Bacon reminds us that effective attention in the interna- Armelle Lecarpentier – page 13 energy poverty affects a very large tional debate despite the recent number of people, not only in the King Abdullah Energy for the Poor Reforming UK Electricity third world. Recent estimates put the Initiative endorsed by the G20 and Markets number of people who lack access to the International Energy Forum. The John Rhys – page 20 electricity at 1.5 billion; and the num- fight against energy poverty does not ber of those who rely on biomass for have a champion on the world scene Letter – page 23 cooking and heating at 2.5 billion. as many other causes do. There is poverty, including in energy, Asinus Muses – page 24 in rich industrialised countries. In his contribution, Christopher Allsopp asks the important question More significantly, the size of the where do the world economy and the problem will not diminish in the international energy markets stand years to come unless a very ambitious after the credit crunch? Put differ- remedial programme is designed and ently: are we facing the possibility implemented. Energy poverty, which of a W-shaped recession or are we is about the lack of access to clean out of the woods? Allsopp reminds modern fuels, or inability to afford us of an ignored fact: the USA and them when technical or commercial other economies were slowing down access is available, is detrimental to before the onset of the financial crisis. health and education and more gener- The response of the central banks ally to human wellbeing. was to offset recessionary forces by Suleiman Al-Herbish believes pas- cuts in interest rates. Initially there sionately in the need to reduce the was confidence that policies will numbers of those who presently solve the recessionary problem. The suffer from energy poverty. Business failure of Lehman Brothers destroyed as usual policies will only condemn this confidence. Yet, the recession the energy poor to be deprived of although very deep was V-shaped. the use of cleaner and more efficient The recovery began in early 2009 fuels. The issue is not receiving thanks to the dynamics of the stock OXFORD ENERGY FORUM MAY 2010 cycle, monetary and fiscal policies adopted by major the recent deregulation, continue to dominate the countries and the cumulative effects of budget defi- gas supply structure in Europe. Looking ahead, cits that enabled de-leveraging by the private sector. the trend seems to lead to a situation where spot prices become the major, if not the unique refer- The recovery, however, will depend on the timing ence for the pricing of gas supplies. The current co- and scale of measures that governments may be existence of two gas price regimes may not survive minded to apply to solve the public debt problem. forever, but its demise is not imminent. We cannot dismiss entirely the possibility of fall- ing once more into recession. On this issue the Recent excitement about the new production of prospects for the UK are perhaps bleaker than for unconventional gas in the USA is an interesting the USA for example. Allsopp is fundamentally an story. It reveals that important phenomena in the optimist; I tend to be pessimistic. Nevertheless I energy world that are sometimes predictable are hope that events will prove him right. not predicted, and also reminds us that Malthusian Natural gas considered in the past as oil’s ‘little views about resources scarcity should be received brother’ can no longer be dismissed in this, or in with great caution. Over-pessimistic promoters any other way. Its importance has been continually of the peak oil theory are being reminded by the increasing over the past three decades not only gas example that both geology and technology can because of increases in its share of total energy spring major surprises. use but because of its dominant position in power Forum is interested in the complex problem of generation. Natural gas developments throw out electricity markets and their regulation. We are important issues for research and debate. lucky to have in this issue a contribution by John We have two contributions on aspects of these Rhys whose expertise acquired over a number of developments. Armelle Lecarpentier addresses the decades is remarkable. He addresses the problem complex problem of gas pricing in Europe, and of reforming the market structure in the UK, a Stephen Bull reflects on the emergence of new sup- problem that is concerning the regulator OFGEM. plies of what is labeled as ‘shale gas’. In a wide-ranging article Rhys examines critically, among other things, the benefits accrued in terms The gas pricing system in Europe involves two dif- of costs and prices under the liberalised regime, the ferent regimes: spot prices in market transactions problem of securing the investments necessary to and prices indexed on oil in transactions undertak- meet capacity objectives and low carbon sustain- en under long-term contracts. This co-existence is ability. Rhys has a proposal: a central purchasing obviously problematic; the system is coming under agency which will ensure the implementation of the pressure of competitive forces and oil-indexing objectives while maintaining valuable competitive is increasingly losing ground. market structures. Initially, in the 1950s and 1960s, the discovery of two major fields – Groningen in the Netherlands and West Sole in the UK – led the companies Contributors to this issue involved to seek security of supply in the new markets gas was penetrating and a continuous Christopher Allsopp is Director of OIES flow of returns to the huge capital invested. To achieve both objectives they entered into long-term Robert Bacon is a consultant at the World contracts with the buyers of gas and invented the Bank Take-or-Pay concept. In such contracts indexation Stephen Bull is Commercial Leader for Statoil’s to crude oil or petroleum product prices was gen- Marcellus Asset erally adopted. Suleiman J. Al-Herbish is Director General of The liberalisation of the UK gas market completed the OPEC Fund for International Development in 1998 had a significant impact on the market structure and the price regime. The UK national Armelle Lecarpentier is the Chief Economist hub (NBP) is used by producers for indexing gas at CEDIGAZ, IFP prices. Although several other hubs have emerged in Europe, the long-term contracts, agreed before John Rhys is a Senior Research Fellow, OIES

2 OXFORD ENERGY FORUM MAY 2010 Energy Poverty

Robert Bacon fuel poverty – a household is fuel heating, and this in turn is linked to a poor if it is unable to afford to number of adverse health effects. discusses definitions purchase sufficient energy (although The use of biomass or coal for of energy poverty and it has access). In the European Union cooking and heating is extremely considerable attention has been paid widespread and occurs over a very policies to reduce it to fuel poverty where low-income wide income range in developing households are too poor to purchase countries. The alternative fuels for sufficient fuel for heating during cold cooking include LPG, kerosene to a winters. For example, in 2006, it has What is Energy Poverty? small extent, and natural gas in a few been estimated that 12 percent of countries where there is an urban gas Globally, energy poverty is extremely households in England were fuel poor, network (such as Pakistan). Electricity widespread, and projections suggest with comparable levels in some other is used for cooking and heating only that, without aggressive policies to northern European countries. at the highest income levels outside of counter it, the level of energy poverty the industrialised countries. Biomass will remain high for many years to Why is Energy Poverty a Special includes charcoal, firewood, straw, and come. A commonly accepted and Concern? dung whose use depends on availabil- simple definition of energy poverty In developing countries the domi- ity and costs (direct and indirect). is that a household without access to nant use of electricity among poor electricity or clean modern fuels is households that are connected is for energy poor. However, even in this lighting, with television being the next definition the notion of access differs “currently about 1.5 billion commonest use. At higher incomes between users. Access to an energy other appliances using electricity people in developing source is generally understood to may be purchased (such as fans, or mean that the infrastructure to deliver countries lack access to refrigerators). However, it is rarely that source exists in the neighbour- electricity, and for cooking used for cooking or heating even at hood of the house (e.g. there are relatively high incomes. Without a or heating about 2.5 billion electricity connections in the village or connection to and use of electricity, neighbourhood). rely on biomass and 400 households are very limited in the million rely on coal” However, data related to this defini- amount of lighting they can use. tion are rarely available at a national Kerosene lamps, candles, or torches level and so a narrower definition is are then the principal lighting sources, The linking of energy poverty to the normally used. In this latter definition and all give weak illumination. Studies use of biomass comes through two access is understood to mean that have attributed a number of benefits aspects. First, the use of biomass for the household actually uses the fuel to having adequate lighting that cooking, and coal for heating in those in question (there is an electricity include education (the possibility of countries where there is a major heat- connection to the house, or there is more study time at home), extending ing need, is associated with high levels uptake of the fuel in question). On possibilities for home production, and of indoor air pollution. The inefficient this basis a recent study by the United improved health (through knowledge combustion of biomass results in Nations Development Program (The gained from watching television). the emissions of particulate matter, Energy Access Situation in Developing Generally, studies of the willingness carbon monoxide, hydrocarbons and Countries) reported that currently to pay for electricity suggest that, for other gases. Exposure to these causes about 1.5 billion people in developing small amounts of electricity consump- bronchitis, emphysema, and other countries lack access to electricity, tion, households value the benefits respiratory diseases. Worldwide, about and for cooking or heating about well above the cost of the energy 1.6 million deaths a year are attributed 2.5 billion rely on biomass and 400 used. In areas where there is no mains to the effects of indoor air pollution, million rely on coal. Forecasts have electricity supply, the community with women and children being most suggested that, largely due to popula- will also suffer from a lack of lighting at risk. Episodes of illness are cor- tion growth, absolute numbers relying in schools and hospitals, and lack of respondingly large. Recently, some on biomass are not expected to decline refrigeration in hospitals. Diesel or studies also indicate that incomplete over the next twenty years, while petrol generators are often used as combustion of biomass and coal only a small decrease in the numbers substitutes but are considerably more may be an important source of black without access to electricity can be expensive and inconvenient. Fuel carbon that makes a not insignificant expected. poverty, as seen in Europe, is mainly contribution to greenhouse gas A further distinction is made with linked to inability to pay for sufficient emissions. The relative emissions of

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subsidy element would need to be Table 1: Health Damaging Pollutants per unit Energy Delivered by Fuel: a large fraction of the incremental Ratio of Emissions to those of LPG cost. Where there are few existing high-income customers to help finance LPG Kerosene Wood Roots Crop Dung residues through a cross subsidy (paying above the cost of supply) then limita- Carbon monoxide 1.0 3.1 19 22 60 64 tions on the government budget will Hydrocarbons 1.0 4.2 17 18 32 115 restrict the rate at which access can be Particulate matter 1.0 1.3 26 30 124 63 increased. Source: Smith, Uma, Kishore, et al. 2000, US Environmental Protection Agency More recently, considerable attention has been given to off-grid sources of supply that may be better able to various sources of biomass compared Even when supply is brought to a vil- reach more remote communities. Suit- to those of LPG are shown in Table 1. lage, not all households will choose to able methods of generation are likely All forms of biomass are much more be connected. There are two reasons to be more environmentally friendly, polluting than LPG, or than kerosene. for this. First, the connection charge including small-scale hydro, solar, and Second, in rural areas biomass is usu- itself is large relative to the income of wind power. Costs will favour these ally collected, again mainly by women many households, and such house- off-grid solutions in certain circum- and children. Charcoal is a com- holds are often credit constrained and stances, and are increasingly likely mercial product, and firewood may unable to borrow to finance the lump to do so as the cost of small-scale also be sold. In urban areas biomass is sum required. Second, the cost of renewable declines. more often purchased, reflecting the electricity itself may be substantial, lack of freely available supply. The particularly in countries where the sector is inefficient or the costs of costs of the time and effort to collect “international aid the biomass place a burden on families generation are high (for example, by restricting time available for other landlocked countries without hydro or agencies and multilateral activities – particularly education for fossil fuel resources that have to rely development banks have on imports). For low-income house- children. Energy poverty therefore devoted a great deal of reflects not only a lack of income holds interested to consume only a to purchase modern and convenient few kilowatt hours a month, these two attention (if not financing) sources of energy, but is also as- factors present a barrier to uptake. to various schemes to sociated with adverse effects on the For this reason, many governments alleviate energy poverty” household’s health, and the education look to subsidise either the connection of children. charge (by a straight subsidy, or by spreading payments over time), or the electricity consumption of low-income Policies towards reducing the dam- Policies to Reduce Energy Poverty households through a rising block age from cooking with biomass do tariff or a volume differentiated tariff not limit themselves to encouraging Faced with the widescale incidence households to switch fuel. Increas- of energy poverty, predominantly in (where metering exists), in which small amounts of consumption are ingly it has been recognised that developing countries, international aid households will continue to use agencies and multilateral development subsidised either by larger users or through the government budget. biomass to cook even at income levels banks have devoted a great deal of when it might be expected that they attention (if not financing) to various For villages where there is no distri- would switch to a ‘superior’ fuel. In schemes to alleviate energy poverty. bution system, the total costs of lines particular, encouraging electrification With respect to providing electricity, and connections to bring electricity is not likely to make a substantial considerable efforts have been made may be so large, relative to the ability reduction in the use of biomass to increase the level of electrification and willingness to pay, that the total because many households that have in rural areas, where the majority of households without access live (in Table 2: Use of Biomass as Main Cooking Source and Connection to Sub-Saharan Africa only 12 percent Electricity Supply (%) of the rural population have access to electricity, while in India 47 percent Cambodia India Kenya Pakistan Thailand Uganda of the rural population are without access). Rural electrification tends Use of biomass to focus on larger communities that for cooking 93 70 82 73 37 96 are cheaper to supply, while remote Connected to electricity supply 18 64 18 83 99 11 and small communities tend to be neglected. Source: Bacon, Bhattacharya, and Kojima (forthcoming) World Bank

4 OXFORD ENERGY FORUM MAY 2010 access to electricity continue to use Encouraging the use of more efficient international debate focus on those biomass as their main cooking fuel. and cleaner biomass cooking stoves is hundreds of millions of people Table 2 shows the percentage of seen as potentially the most direct way without any access to modern energy. households for which biomass was of reducing the damage from the use Authoritative studies suggest that, the main cooking fuel in a number of of biomass. Many cheap and improved even in 2030, there will be 1.3 billion developing countries, as well as the stove designs have been tried, but as people without electricity: this figure percentage of households that were yet the cost of an effective and durable is only 200 million below today’s connected to electricity supply. Even stove is quite high relative to the estimate, meaning that increased in Thailand, whose per capita income incomes of poor households. power generation capacity worldwide was at least double that of the other Programmes of educating households is expected only to nearly offset countries in the sample, and that had (women especially) into the dangers the additional needs created by an almost universal access to electricity, of indoor air pollution and ways increasing population. Despite the one-third of the households continued to reduce the risks may lead to a genuine gains in development in many to rely on biomass for cooking. reduction in the exposure to the parts of the world, ‘business as usual’ pollutants from biomass combustion. policies will merely condemn many of Recommendations could include: not the poorest to life without clean and cooking in the house; keeping children efficient energy services. Such services “Unless women or children are essential to advance human devel- can make a direct financial out of the kitchen; ensuring that there is a chimney and adequate ventilation; opment and provide opportunities for contribution to household and knowledge of which forms of economic and social progress. We, the OPEC Fund for International Devel- biomass are the most harmful. For income instead of collecting opment (OFID), certainly believe that the free biomass, this is higher income households the benefits of improved stoves, or alternative the international community can do likely to be the preferred clean fuels can be explained. better than this. choice” The prevalence of energy poverty, and In the concluding statement of the its likely persistence in the absence of 12th International Energy Forum attended by Ministerial Delegations There are a number of reasons for this policies to intervene in the patterns of household energy use, indicates from 66 producer and consumer coun- pattern and policies need to address tries, we read that ‘The fight against all of them. First, in rural areas where that efforts to reduce its adverse side effects will be as important as efforts energy poverty has been unsuccessful biomass is free, there is a strong so far.’ We couldn’t agree more with incentive to use it. Unless women or to reduce the level of energy poverty itself. the general idea, as we know that 2.5 children can make a direct financial billion people are still lacking access contribution to household income to modern fuels to satisfy their basic instead of collecting the free biomass, needs. However, a closer look shows this is likely to be the preferred choice. us that we cannot qualify the ‘fight Second, cooking indoors with biomass against energy poverty’ as being is a demerit good. Women cooking ‘unsuccessful’, because what is called indoors are often unaware of the true ‘fight’ has hardly begun. Indeed, the health risks from the smoke and do topic of increasing energy access has not attempt to reduce it. Third, many been on the international agenda since households prefer to cook with bio- the World Summit in Johannesburg in mass – the traditional flavour of such 2002, but concern has rarely resulted cooking is important in many cultures, in concrete commitments and actions and households are unwilling to give it on the ground. In fact, energy poverty up either in part or totally. has received too little attention to say There are a number of policies Suleiman J. Al-Herbish that a real ‘fight’ was ongoing. designed to reduce the damage from rejects the gloom and The success of fighting energy cooking with biomass. poverty in the two coming decades Reducing the costs of LPG (as the doom surrounding will depend on partner countries’ clean fuel substitute for cooking) may energy poverty (i.e. developing countries benefit- encourage some switching towards the ing from international development use of LPG, but even where families assistance) political willingness to do use LPG they also continue to reform but mainly on the priority Introduction use substantial amounts of biomass. the international community would Indeed, at higher levels of income Energy security is always high like to attach to this issue. Energy households may use more of both on the agenda of both consumers poverty should not continue to be biomass and LPG. and producers but rarely does the considered the oldest orphan of the

5 OXFORD ENERGY FORUM MAY 2010 international development debate. kinds of income-generating activities, It is now recognised that modern Climate change issues are here to whether agricultural, commercial or energy is needed in all sectors and remind us that we live in a globalised manufacturing. Agriculture is by far for achieving all the Millennium world, tackling energy poverty the most important source of employ- Development Goals. Lower reliance worldwide is of importance for all ment and incomes in developing on harmful biomass will reduce illness developed and developing countries countries and access to affordable from serious respiratory disease. alike. Providing universal, clean, electricity can provide a significant Modern energy creates opportunities affordable and sustainable access to increase in productivity. Electricity for better medical care, education and energy will certainly be one of the key can power irrigation equipment and communications. Access to the world challenges of the twenty-first century. allow rural communities to add value of information will release human po- The Energy for the Poor Initiative to crops by drying, processing and tential, opening doors to science and launched by the King Abdullah of packaging. To face the challenge of culture. How many exceptional brains Saudi Arabia and supported by the food security, highlighted by the crisis able to make scientific breakthroughs G20 leaders and recently by the 12th of 2007 and 2008, world food supply may be found in the hundreds of International Energy Forum meeting will have to double by 2050 to nour- millions of people newly enabled to is providing a new momentum to the ish world population. This doubling play a fuller part in the life of global fight against energy poverty allowing of agricultural output on roughly society? us to envisage scenarios with universal the same available land can only be Energy investments require large-scale access to modern energy to all human achieved by a substantial increase in commitments of resources over long beings by 2030. productivity, by more water avail- periods of time. But once in place ability and consequently by enhanced they offer enormous benefits to every energy accessibility. businessman considering investment in Higher levels of mechanisation can manufacturing or process activity and “‘business as usual’ policies make a vital contribution to raising every farmer planning irrigation or will merely condemn growth rates by lowering costs and food processing projects. many of the poorest to life improving competitiveness, and without clean and efficient mechanisation relies on electricity. Better communications may open new energy services” markets to farmers and producers and “there are broadly provide up-to-date information on price trends and selling opportunities. two protagonists who could play key roles in Raising the income levels of rural Magnitude – The Many Benefits of communities can make a significant making energy accessible, Combating Energy Poverty contribution to social stability by affordable and sustainable: The excellent economic performance lessening the pressures to migrate to the international of some regions of the developing cities. Rapid growth of urban popula- world has improved energy access for tions exacerbates environmental and community and partner many communities since 2000. Good social tensions in developing countries countries” progress has been made in East Asia, as cities rarely have the resources to also in Latin America as electricity meet housing and other needs. networks have been extended. But Lack of access to electricity is not the access to modern energy in South only problem facing the energy poor. Why Are Many Countries Plagued Asia or Sub Saharan Africa continues Clean fuels for cooking and transport with Persistent Energy Poverty? to lag the rest of the world. In South are also in short supply. LPG and Asia 614 million people live without Like income poverty, energy poverty kerosene can provide efficient solu- access to electricity whilst in Sub has different causes in different coun- tions for cooking and lighting and Saharan Africa the number of people tries. However to alleviate this curse a reliable and affordable supply of living without electricity has risen there are broadly two protagonists vehicle fuels is essential if communi- to 587 million since 2000, despite a who could play key roles in making ties hope to move beyond subsistence slight increase in the rate of electri- energy accessible, affordable and agriculture and transport their fication. Generating capacity is far sustainable: the international commu- produce to market. Diesel generators below the needs of the population. nity and partner countries. can also provide useful energy in the Total installed generating capacity in village to drive workshop equipment Sub Saharan Africa (excluding South or power irrigation systems. Overall For the international community, en- Africa) is about 30 GW, less than that the consumption of modern energy ergy poverty is not receiving enough of Norway whilst the population of per capita in the poorest countries is attention in the international develop- the region is 150 times as large. less than one-sixth that of developing ment debate. The priority attached to Electricity is important to support all countries as a whole. energy poverty has still not reached a

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level commensurate with the dimen- However the results on the ground are energy-related CO2 emissions of sions of the problem. implemented slowly. One can observe just 1.3 percent by 2030. Even if one In the international arena, the issue that most low-income countries still allows for model uncertainties, this has just started to gain momentum. have not implemented an appropriate percentage remains very low. Interna- There are many international meetings economic and financial environment tional cooperation and assistance in taking place to address energy poverty to alleviate energy poverty. Besides the combating energy poverty should not but no international donors’ confer- UN and some countries, other players be preconditioned by stringent condi- ence has been organised to increase are not so powerful as to be able to tions regarding renewables. In fact, the assistance provided. Many non- raise the energy poverty flag high switching from traditional biomass binding statements are issued after enough. to sustainable modern biomass or a high-level meetings but with little From a financing point of view, the fossil fuel such as LPG would protect commitment on the ground. When oil international effort to assist poor the forest and have a beneficial impact prices reached levels higher than $140/ developing countries is increasingly on deforestation. Moreover, without bbl, there were many discussions at fragmented. This fragmentation of requiring fundamental technologi- OECD level concerning the resilience the development aid is not helping to cal breakthroughs, some scientists of economies and the potential impact implement the specific focus needed are devising development paths for on the poor; but when the oil prices for alleviating energy poverty. The Europe and North Africa to reach 100 declined the debate on this issue just fragmentation is characterised by the percent of electricity produced from vanished. welcome emergence of the private renewables by 2050. Consequently, sector in international cooperation but climate change issues should not be From a policy point of view, energy used as an argument to impede the also by the multiplicity of potential poverty has no ‘champion’, unlike fight against energy poverty. issues such as HIV-Aids, forest preser- donors; in fact this is in contradiction vation, water, desertification and so with the so-called Paris Declaration From the energy markets point of on. Even at the UN, energy is consid- where over 100 countries and institu- view, with a diversified energy mix ered as a cross-cutting issue. There are tions, among them OFID, called including both renewable energy and some laudable initiatives contributing for more effectiveness in dispensing fossil fuel, it is now recognised that to the international debate such as assistance. Fragmentation means the additional progressive demand for UN-Energy, which is an inter-agency that partner countries are dealing oil and gas generated by much wider mechanism to coordinate energy- with a high number of donors giving access to energy by poor countries related issues within the UN system; sometimes relatively small amounts of will not significantly disturb markets. also UN-CSD (UN Commission money – and requiring more bureauc- on Sustainable Development) under racy simply to keep track with them. The alleviation of energy poverty is UNDESA, which addressed energy “From a financing point issues at UNCSD-15 without reaching therefore ‘drowned’ in a myriad of a consensus on how to alleviate energy other development issues with little of view, the international poverty. Both UNDP and UNIDO effectiveness on the ground. effort to assist poor have developed real expertise in the Regarding climate change issues, for developing countries is field on how to tackle energy poverty the past decade many analysts con- but they work with relatively limited sidered that making energy accessible increasingly fragmented” resources. to the poor would drastically increase CO emissions. Although this opinion 2 later appeared to be an exaggeration, it was used as a reason not to trigger Regarding partner countries, they also “energy poverty has no a real fight against energy poverty, bear their share of responsibility in ‘champion’, unlike issues which would have been detrimental not providing energy access to a large to the planet. In fact, there appeared portion of their population. Energy such as HIV-Aids, forest to be a tacit international consensus access is not at the forefront of many preservation, water, to postpone the accessibility of governments’ preoccupations, espe- desertification and so on” energy for poor countries until cially in the poorest countries. There so-called green energy technologies are many impediments such as poor could be scaled-up technically and governance, a history of conflicts, UN meetings and results are necessary economically. mismanagement of utilities, lack of an as they shape the local, regional and We know today that many research enabling environment conducive to global policies. Indeed, Agenda 21, the centres among them the IEA have investment, corruption, inappropriate United Nations Millennium Develop- recognised that with the current and badly targeted policies as well as ment Goals, the Johannesburg Plan of trends of the fuel mix, if electricity a lack of regional vision in fostering Implementation, the Monterey con- access is generalised then there will trade in energy. sensus all provide development goals. be an additional increase in global Fortunately there are developing

7 OXFORD ENERGY FORUM MAY 2010 countries showing appreciable historical trends but they may under- poor countries even more difficult. progress in alleviating energy poverty. estimate the constraint of limited and Over the past ten years electric- Thanks to appropriate reforms and ageing generation capacity, especially ity consumption in the low-income targeted electrification programmes, in the low-income countries. Total countries has probably doubled but China, India, Vietnam and Brazil electricity consumption in these coun- total generating capacity has only do have success stories to tell in the tries increased by 60 percent from increased by about 50 percent. Most field of energy access. They have 2000 to 2006. Over the same period spare capacity in the generating improved the access for their citizens total generating capacity increased by industry has been absorbed over this substantially in the last two decades. only 27 percent. Updating the analysis period and economic growth in many However all across sub-Saharan to 2010 suggests that the low-income of these countries may be threatened Africa, and in parts of Asia, too many countries are facing severe pressures by aggravated power shortages unless people are still living without basic on generating capacity. investment in generation is stepped up energy services. Indeed if 2000–2006 growth rates of as a matter of urgency. demand and capacity had been main- Urgency of the Issue of Energy tained, by 2010 the average capacity A Key Lesson from the Financial Poverty for the Low Income utilisation required of these countries Crisis Countries would be 45 percent. IEA data for developing countries, which includes The recent financial crisis has taught The close links between economic countries with much more modern us a lesson: whenever an important growth and access to affordable generating equipment than most low- issue is given high priority on the supplies of modern energy have income countries, suggest that realised international agenda and a concerted, already been highlighted. This linkage capacity utilisation percentages in consensual, unified, resolute solution was well illustrated in recent years. 2007 clustered around 40–43 percent is provided by the international com- From 1990 to 2000, total primary for Latin America, Africa (exclud- munity, then success follows. Banks energy consumption in the developing ing South Africa), China and India. in the USA and Europe benefited countries rose at an annual rate of 3.6 Electricity utilities in the low-income from substantial bailout plans. Some percent: this growth rate increased to countries will only be able to meet US$ 1300 billion was injected into 5.6 percent from 2000 to 2007. The such projected demand for power if the banking systems of the advanced rates of growth of the network energy they achieve remarkable increases in economies, a policy that rapidly services were the highest of all the capacity utilisation. improved the banks’ liquidity and energy sources. This growth has accel- trading performance. In contrast, the erated sharply since 2000 particularly regulation of financial and commodity in Asia, in line with the fast growth markets aiming at reducing excessive of industrial and commercial activity. “Thanks to appropriate speculation received only lip service, The annual average growth rate of reforms and targeted as the issue was not considered to be both gas and electricity demand from of sufficient priority, particularly for 2000 to 2007 was over 6 percent for electrification programmes, the USA. the developing countries as a group. China, India, Vietnam and Building on this lesson, it is reason- Concentration on the electricity Brazil do have success able to assert that if combating energy sector can obscure the important stories to tell in the field of poverty in developing countries contribution of fossil fuels in reducing is given appropriate priority (and energy poverty. In 2007, electricity energy access” followed by concrete actions), it will only accounted for some 15 percent allow a departure from the ‘busi- of total final energy consumption ness as usual’ pattern and permit us in developing countries. Regarding More likely, as soon as pre-crisis to envision a world free of energy manufacturing and commercial opera- demand patterns are restored, the poverty by 2030. tions, however, there is usually no power market will tighten further lead- ing to higher costs, increased outages alternative to grid-sourced electricity The Way Forward – Solutions as a single source of flexible, scalable and brownouts. The high costs and and economic energy to satisfy me- unreliability of the electricity supply In order to face the challenges raised chanical, lighting and communications will act as a constraint on the growth by the scaling up of energy access, needs. This logic underlies the fast of GDP – moreover such a constraint the proposed solutions should ad- growth rates for electricity demand will operate over the medium term dress both partner countries and that are a feature of most medium- since investments in generating capac- the international community. For term assessments of the energy ity take years to come into operation. partner countries, on the basis that outlook for developing countries. In addition to the economic aspect, a one-size-fits-all solution does not constraints on the electricity generating exist, the barriers to energy access Such expectations may be consistent capacity will make adaptation measures mentioned previously should be with macroeconomic projections and to climate change extremes by energy addressed. In short, partner countries

8 OXFORD ENERGY FORUM MAY 2010 should develop or reinforce inclusive them the World Bank, a medium-term of energy poverty as well as to include policies, regulatory frameworks and programme of $5 billion to contribute it specifically in national development institutions that facilitate investment to alleviating energy poverty. OFID plans. I am pleased that this idea (both public and private) and encour- is coordinating its actions with the has received general acceptance and age trade to make energy accessible World Bank. that recently 66 Energy Ministerial and sustainable. They should also This important initiative has enabled delegations of producer and consumer implement pro-poor financing the prioritisation of energy access in countries at the 12th International mechanisms with the involvement of the international development debate, Energy Forum held in Cancun, local communities to make energy at a time when the oil barrel reached Mexico, in March, 2010, recognised affordable. There are success stories its highest price ever. Since then the advantage of defining such a goal in India, China and Vietnam that energy poverty alleviation has gained for the international community. could be emulated. However, in order new momentum. OFID is doing its Such a goal would, indeed, provide to develop the appropriate enabling utmost to support and increase this the needed coherent global vision to environment, poor countries need momentum within the international address energy poverty. specific support in human resources community. As in the case of climate change nego- and institutional capacity building. tiations, the ‘business as usual’ attitude Equally or more importantly, the in solving energy poverty should Conclusion energy poverty issue should be more not be an option. Leaving 1.3 billion visible on the international agenda. Three years ago, OFID proposed for people on the side of the road by 2030 Not a single financial institution no the first time at an international con- is just not acceptable. The Energy for matter how large it is, not a single ference that energy poverty alleviation the Poor Initiative is showing us that country no matter how rich it is can be designated as the ninth Millenium we can be bold and ambitious in our tackle the issue of energy poverty by Development Goal. The aim was to vision: universal access to affordable, itself. Energy poverty alleviation needs provide more international visibility in acceptable energy should become a collective international solutions. the development debate for the issue reality for all. This challenge has been recognised, notably by the leaders of OPEC at the Third OPEC Summit in Riyadh in The Credit Crunch and International Energy November 2007. The Riyadh Declara- Markets – What Now? tion mandated the OPEC Fund for International Development (OFID) Christopher Allsopp as well as the other OPEC Member Countries aid institutions to align their programmes to eradicate energy Two years ago, oil prices were on their way up to the peak of $144 on 3 July 2008 poverty in developing countries, a task – which was followed by a spectacular collapse to a low of $35.5 on 23 December. to be achieved in cooperation with At the time of writing, they are now up again to about $85 – having been trading in other financial institutions and the an implicit band of around $70–80 for several months. Clearly, the most important energy industry. Since the last OPEC driver of these extreme swings in the oil price has been the world economy – or summit, OFID alone has committed more accurately, perceptions about the financial crisis and anticipations about the close to $450 million in energy pov- likely course of the ‘great recession’ and the recovery. erty alleviation covering 22 operations This article takes stock of some of the lessons and, tentatively, tries to draw in 17 countries. out implications for the, still very uncertain, future. It starts with a brief recap of the history of the great recession, focusing on the policy response. The next In the spirit of the Riyadh Declara- section looks forward at the domestic and international policy problems and the tion, King Abdullah of Saudi Arabia final section concludes with some general remarks about the interactions between during an ad-hoc meeting of produc- global macroeconomic developments and the markets for oil and gas. ers and consumers launched what has become known as the Energy for the The Great Recession Poor Initiative, which underlined the prime importance of extending energy Before the financial crisis, the big question was why rising oil and other commodity access to the poorest countries. The prices – which delivered a shock comparable to (or larger than) the big oil crises Initiative embodies the political will of the 1970s – did not lead to world slowdown or recession, which would have expressed in the Riyadh Declaration moderated the demand for oil and checked or reversed the price rises. Essentially, in a plan of action to encourage the the reason for the difference was that the recent rise did not lead to general infla- wider participation of both public tion, especially in industrial countries. Second round effects, on inflation and on and private sectors and to leverage the nominal wage rises were almost entirely absent. With (flexible) inflation targeting effectiveness of the initial seed capital. policies in most OECD countries, any recessionary effects from rising oil prices Today OFID is contemplating to- (which act like an increase in indirect taxation in consumer countries) would be gether with other institutions, among offset as Central Banks sought to meet their mandates.

9 OXFORD ENERGY FORUM MAY 2010

The USA and some other countries were clearly slowing Kevin O’Rourke showed, early on, that the initial phases of before the credit crunch. With low inflation in the OECD the downturn were worse than interwar – though with the – despite soaring oil and other commodity prices – the important caveat that policy would be different this time prospective recession was a recession that central banks (see Figure 1). thought was neither necessary nor wanted. The response In fact the recession, though very deep, was V-shaped was predictable – offsetting cuts in interest rates (early and – with recovery setting in during the first quarter of 2009. aggressive in the USA) to head off the recessionary forces. Three features help to account for the V-shaped pattern. At the same time, the nature of the financial problems, which The first is the world stock-building cycle. Really large started in the summer of 2007 with the sub-prime crisis and rapid movements in the world economy are usually the in the USA, were becoming apparent; but it was widely result of the stock-building cycle. World trade, especially in assumed that the impacts on the real economy would be manufactures (and particularly autos) simply collapsed in the limited – i.e. that offsetting policies and bail outs would last quarter of 2008. To many observers’ surprise, the worst do the trick. This all changed in September 2008, with hit countries were not those that depended on financial serv- the bankruptcy of Lehman Brothers and rescue of the US ices, but those that depended on manufacturing – countries insurance giant, AIG. The decision not to bail out Lehman like Germany and Japan and also China. But a stock cycle Brothers was a huge shock to the system – and the world has a natural dynamic: when stocks have been off-loaded, economy seemed to ‘fall off a cliff’ in the last quarter of it naturally reverses. Moreover, the bigger and quicker the 2008 and into 2009. downturn, the more likely it is that there will be a rapid An interesting indicator of the robustness of confidence reversal. Essentially, this is what happened. Both the fall in the efficacy of offsetting policies is the behaviour of oil and the recovery have been bigger than expected and a large prices – which, despite the developing financial crisis and part of the explanation is the virulence of the international the stream of bad news during the first half of 2008, con- stock-building cycle. tinued to rise to their peak in July 2008, before beginning their rapid fall. The low point for spot prices, around the Policy beginning of 2009, coincided roughly with the maximum degree of pessimism about world prospects – and the upturn The second was, indeed, policy. The scale of the crisis, es- since correlates closely with developing confidence in global pecially after Lehman Brothers collapsed, was not generally recovery. foreseen. But the response, though muddled at times, was, in broad terms predictable. Interest rates were, in stages, The V-shaped Pattern of Recession and Recovery cut to the bone – to near zero in the USA and in many As noted, there was considerable confidence during the early other countries. As the zero bound for interest rates was stages of the financial crisis that policy responses would approached, fiscal packages were announced – spectacularly be sufficiently powerful to limit the downturn in global large in China, large in the USA and more minor but sig- output. After Lehman Brothers collapsed, confidence that nificant in Europe. At the same time, asset relief schemes, policy would, or could be, powerful enough evaporated. liquidity provision and quantitative easing added up to an Dire comparisons were made with the great depression of the extraordinary international policy package. And, eventu- interwar years. In an influential study, Barry Eichengreen and ally, it was large enough. Meltdown was avoided. Financial markets were stabilised – as indicated, for example, from Figure 1: World Industrial Production Interwar and data on interest rate spreads. And the perception that poli- 2008–2010 cies were actually working and that recovery would occur spread across financial and commodity markets. Major stock 100 markets recovered – by about 40 to 50 percent. Important April 2008 = 100 too, especially for oil and commodity markets, were the data coming out of China. Their offsetting policy, based on fiscal, 90 credit and administrative measures (and directed largely to infrastructure) resulted in average GDP growth for 2009 of about 8.7 percent – with the economy growing at over 10½ percent in the last quarter of the year and 11.9 percent per 80 June 1929 = 100 year in the first quarter of 2010. The conventional view is that policy put a floor under the contraction of the world economy and sparked recovery. 70 There is a worry that as stimulative policy measures fade (some are temporary and time limited) and as the boost from the stock-building cycle goes away, the world recovery will 60 falter – leading to very low growth or even to a double dip (or a W-shaped profile). This misses an important part of the 10 20 30 40 50 dynamics at work – namely, the influence of budget deficits Months since peak in major countries. Source: Eichengreen and O’Rourke

10 OXFORD ENERGY FORUM MAY 2010

The cumulative effects of budget deficits In fact, the typical pattern after financial crises is a very large swing to surplus by the private sector – which then In fact, the largest difference between the present cycle and comes back as private sector balance sheets adjust. For the great depression of the interwar years is the toleration example, in the UK, in the early 1990s, the private sector of rising budget deficits. In many countries these have risen swung from a deficit of about 4 percent of GDP to a surplus to extraordinary levels. The OECD estimate for the aver- of about 6 percent of GDP in a single year (a swing of about age (General Government) deficit in 2009 was 8.2 percent 10 percent of GDP). At the time, the public sector deficit rose of GDP – a deterioration from 2007 of 7 percent of GDP. to 8 percent of GDP. But as the private sector came back (as (The estimate for the USA is 10.7 percent of GDP, and for savings decreased and as private investment expenditure rose) the UK it is 13.3 percent of GDP). The swing to deficit the public deficit was eliminated, and actually moved to sur- far exceeds the discretionary fiscal stimulus applied by plus within five years. (Tax and expenditure programmes did industrial countries and reflects the ‘automatic stabilisers’ have to be adjusted to bring about this favourable outcome). (reduced taxes and increased expenditures) as the economy The Swedish banking crisis of the late 1980s produced an fell into recession. This is a powerfully stabilising force. even larger swing in the positions of the public and private This toleration contrasts with attempts by governments in sectors – which reversed as the private sector surplus came the interwar period to avoid budget deficits by raising taxes down and as the external current account improved. or cutting expenditures. The significance of the rise in budget deficits can be put a The Dynamics of Recovery different way. It is widely agreed that the financial crisis, the This brief account suggests that a number of factors account credit crunch and the swing to pessimism about economic for the pattern of recession and recovery: obviously policy prospects delivered a massive shock of a balance sheet kind (especially monetary policy but also fiscal offsets limiting the to the private sectors of most countries. Businesses and downturn); the natural dynamic of the stock-building cycle, households in the private sector needed to get out of debt: and the cumulative effects of fiscal deficits in allowing private they needed to invest less or to save more. In the jargon, sector balance sheet adjustment (deleveraging). As noted, they needed to ‘deleverage’. As a matter of accounting, there is a worry that, as the stock-building effect fades and however, this is only possible if some other sector moves as temporary fiscal measures (such as cash for clunkers) are into deficit. taken off, the recovery will falter – with, according to some In a closed economy (i.e. ignoring the external current analysts, the danger of a double dip (or W). The most power- account position) the mirroring would be exact – the im- ful force making for continuing recovery, however, is the one provement of the private sector balance would exactly match least discussed – the cumulative effects of the counterpart the deterioration in the budget deficit. For an open economy, budget deficits themselves. the public sector deterioration would equal the private sector But there is a serious downside to this optimism. This is improvement minus any swing toward surplus in the current that mounting concern over budget deficits and debt will balance of payments. lead to premature tax rises and expenditure cuts – before There are a number of implications for an assessment of private sector deleveraging has run its course. That would the current situation and macroeconomic prospects – some be a reversion to the kinds of policies that led to the Great optimistic and others more worrying, especially for the Depression. The timing of exit strategies is crucial. longer term. On the optimistic side, if public deficits are seen as Policy Problems Looking Forward offsetting (or allowing) ‘deleveraging’ by the private sectors of recession-hit economies, they provide a powerful and Prospects and Risks cumulative force for recovery. The reason is simple. The re- Consensus forecasts – such as those of the IMF – suggest quirement for ‘deleveraging’, though it may be large, is finite. that the recovery will proceed over the next few years at An indebted consumer, for example, who succeeds in saving, about the same rate of growth (in PPP terms) as before the does get out of debt – and is then likely to start spending crisis – that is at about 4 to 5 percent per annum. Though again. Similarly, a deleveraging firm or financial institution, if such a V-shaped pattern sounds good it involves a large step it succeeds in running a surplus, improves its balance sheet – down from the previous trend. The downward ‘level effect’ and is likely to return to more normal behaviour. Essentially, is probably about 6 to 10 percent of global GDP. there is a financial stock/flow cycle – which has analogies There are upside and downside risks compared with the with the stock-building cycle referred to above (though it is ‘consensus’. On the upside, ‘deleveraging’ may proceed likely to be slower). Also, the process of balancing private quickly and the perceived need for it will diminish as sector ‘deleveraging’ with public sector deficits is cumulative. confidence improves. This could lead to a period of above If the required amount of private sector deleveraging were average growth (there is plenty of capacity) and a move some (say) 10 percent of GDP, one year’s public deficit of a similar way back towards the previous trend. The downside risk is size would be sufficient. If the required deleveraging were that growth will be slower due, for example, to continuing 20 percent, then two years deficits would suffice, and so on. problems and restraints emanating from the financial sector. One can add that, once the recovery is seen to be underway, A double dip – a further shift down in the recovery path – the pressure for private sector deleveraging will abate – as is most likely to result from premature fiscal or monetary expectations turn more positive. tightening.

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would seem to require lower private savings or higher invest- Figure 2: Alternative Scenarios ment and a resolution of the payments imbalances between countries such as the USA and Asia.

What Kind of a Picture Looking Forward?

Previous trend Recovery An essential feature of the macroeconomic background is Step down uncertainty and the continuation of serious policy challenges.

Economic activity Conventional forecasts are not very useful when one of the few near certainties is that the ‘consensus’ is likely to move Slower growth about – driven by events. Financial and commodity markets will be driven by the same underlying set of forces. Given the many policy challenges, the key question is whether policy-makers will, in broad terms, succeed in doing what is necessary. The assumption that, with inevitable lags and hesitations, they would succeed in offsetting a potential financial collapse and a world downturn on the scale of the Time 1930s has proved right so far. But this was crisis management, which tends to concentrate the mind. Looking forward, the The Policy Challenge problems are more ‘normal’ but still very grave. Exit strate- As recovery proceeds, policy-makers would like to have gies will be hard to design – and the dilemmas referred to higher, more normal interest rates, substantially better and above will be hard to resolve. more sustainable fiscal positions and enough (internationally For example, the fear of protectionism has, so far, been coordinated) macro-prudential regulation of the economy unfounded. But the threat will continue – and perhaps to ensure that the problems of the recent past never recur. increase during the recovery period. The best guess, given But is it possible to get all these things right under current that the threat is so well understood, is still that it will be circumstances? It is certainly not going to be easy. largely avoided. The strong pressure is for the fiscal authorities to move A greater threat arises from the re-emergence of interna- first (but not too soon). But with fiscal tightening the implica- tional imbalances and the disparate positions of deficit and tion is that interest rates are likely to remain low – unless the surplus countries. For countries with serious medium-term recovery is considerably faster than the consensus expecta- fiscal and financial problems, exchange rate depreciation is an tion. The deflationary effects of fiscal restraint may mean attractive option, even if it arises from the pursuit of domestic policy interest rates have to remain low for quite a long time. policy choices (such as the continuation of low interest rates But policy-makers do not like low interest rates either. combined with fiscal consolidation). But such policies only If interest rates do remain low whilst there is a revival of add up if other countries – surplus countries as a group – are global growth, there is a danger of financial instability. Real prepared to tolerate revaluation. interest rates would be very low at the short end – and We have argued above that interest rates may well remain could be negative. (The relationship that matters is actually low – due to the imperative for fiscal consolidation in some between real interest rates and growth). Combined with high major countries, including the USA and due to the likelihood liquidity, this could set off asset price booms, and encourage that private savings will remain high in the aftermath of the high leverage – a repeat of the past, risking boom and bust. crisis. It should not set off general inflation if countries are mindful Paradoxically, this increases the pressure on regulatory of avoiding generalised excess demand, but asset price booms authorities to tighten up and to introduce countercyclical are increasingly seen as an additional threat to stability. ‘macro-prudential’ measures to stave off asset price rises This is where regulation, and particularly, macro pruden- and potential boom/bust scenarios. There are huge, and so tial regulation comes into the picture. The idea behind it is far unresolved, challenges here. But the bottom line may be to prevent the conditions that led to the recent crisis – by a situation of low real interest rates combined with tighter constraining finance. It is not at all easy to design – espe- regulation and credit restraints. cially as, to be effective, it would need to be internationally It is not just forecasters and oil market experts who coordinated. But it is probable that a combination of risk don’t know how all this will work out. Market operators aversion (resulting from the crisis) and regulation would at will closely watch every turn as policy issues come and go least postpone excessive risk-taking and asset price drifts and and as policy-makers appear likely to succeed or fail. These bubbles for a number of years. public signals may have exaggerated importance in a situa- The dilemmas appear acute. But is there any way of tion of large underlying uncertainty, leading to considerable squaring the various circles, or improving the trade-offs? volatility and swings in the ‘consensus’ – and hence in oil Essentially, the problems arise because of an incipient surplus and other energy prices. An overall picture of relatively of savings over investment in the world economy. This means rapid growth, firm but volatile oil prices, and low interest that policy-makers appear to face either continuing fiscal rates, with considerable downside risks if policy-makers lose deficits or uncomfortably low interest rates. A more normal their nerve or make mistakes as the world economy remains picture of fiscal prudence and reasonably high interest rates ‘fragile’. Interesting times!

12 OXFORD ENERGY FORUM MAY 2010 Gas Matters

Stephen Bull’s Fort Worth Basin where production twice that of the Barnett. The service started from shallow conventional sector has been a key driver in this reflections from the reservoirs in the 1950s. Geologists technology development. Shale gas scanning the basin noticed thick black production is more capital intensive frontline of US shale organic rich shale close to Barnett than drilling conventional vertical gas Spring Creek, named after John W. wells and growth in the horizontal Barnett who settled in the area in drilling and completions sectors has the 1870s. It was declining produc- led to increased industry consolidation The US shale gas phenomenon has tion from the Fort Worth Basin that from the E&P service industry, as captured the global energy audience pushed Mitchell energy to experiment seen in the Baker Hughes–BJ Services with a vigour that few would have with horizontal drilling and comple- merger and Schlumberger’s takeover predicted just five years ago. An tion techniques in the play. It was not of Smith International. abundance of clichés and tabloid-style until the mid–late 1990s with higher banners have been written by consult- gas prices and proven developments in ants, banks, journalists and companies fracture stimulation that the Barnett alike, with headlines ranging from was seen as an economic success. “The consequences and the climatic ‘Shale Gale’ to the Devon Energy Corp. initiated the first nationalistic ‘In Shale We Trust’ and of the big acquisitions in the US shale effects of shale gas are still the painfully ebullient ‘One Shale of a play by acquiring Mitchell Energy in the early stages and a Good Time’. Leaving headlines aside, for $3.5 billion in 2001. From this Klondike feeling is still there is indeed something significant point on new shale plays mushroomed occurring within the US energy including the Fayetteville (Arkansas), prevalent here in the USA” industry, which may have global Woodford (Oklahoma), Haynesville consequences. Is this a new paradigm? (Louisiana/Texas) and the Marcellus Absolutely. As Tony Hayward, BP’s (Appalachia). Five years ago these CEO, said recently at Davos ‘Un- names were more geological refer- The Billion Dollar Club conventional gas will transform the ences; today they are household names The money has certainly been flowing entire energy production landscape in the US gas industry. The list will in terms of acquisitions, divestments in the United States… and alters the expand over time including the Eagle and joint ventures within the US U.S. energy outlook for probably a Ford, Utica, Horn River, Niobrara, shale gas plays. As seen in Table 1 hundred years.’ The consequences Green River and many others plays. the deal count for USD +1 billion and effects of shale gas are still in the deals came in two phases. After the The shale gas experience is a classic early stages and a Klondike feeling is Devon–Mitchell deal, it was the US oil and gas story of tenacity, markets, still prevalent here in the USA. The Independents that dominated the first money and technology. The combina- spillover of the shale gas paradigm acquisition wave around 2005–2007, tion of these elements has created a goes further than just redrawing combining their normal appetite for supply picture completely overlooked supply and demand curves; it will acquisitions with fast and aggressive by almost all analysts as US shale gas also affect policy issues, the regula- organic land grabs. By 2008, a second production increased eightfold within tory and competitive environment wave of deals can be observed driven a decade. The aggressive advances and importantly climate issues with by the dual forces of the Majors made on the drilling and completion global consequences. In this article, seeking new growth platforms and US learning curves and the rapid applica- the author reports from the frontline Independents suffering from aggres- tion of latest technologies to new of the shale gas revolution, covering sive acquisitions and liquidity issues plays cannot fail to impress. For ex- a concise history of shale plays, the as gas prices fell and credit markets ample, it took 22 years for the Barnett competitor environment, the gas sup- dried up as the economy weakened. If to produce 1 billion cubic feet per day ply paradigm, the view from Capitol shale gas represents a new paradigm (bcf/day) gas production. To reach 1 Hill and offers some final thoughts on for natural gas supplies, the Majors bcf/day in the Fayetteville it took five the future direction of the industry. had to be part of this, acquiring not years and just three years in the Hay- just long-life resources and growth nesville. Average Initial Production potential, but also a must have skill set The Compact Shale Story (IP) rates have consistently moved for global applications. Shale gas experimentation started in higher in shale plays, lateral lengths the Texas Barnett Shale in the 1980s, drilled have increased and recovery The US shale gas business is highly with Mitchell Energy drilling the first rates are improving consistently. The attractive and distinctly unconsoli- well into the Barnett formation in average gas output per rig day in the dated; hence the entry choices are 1981. The Barnett Shale is part of the Haynesville and Fayetteville is now diverse. Statoil, BP and ExxonMobil

13 OXFORD ENERGY FORUM MAY 2010

non-US companies are using the Table 1: US Shale Gas Deals exceeding USD 1 billion US Independents as National Oil Year Buyer Seller Transaction Play Companies. By teaming up with these Value in ‘US NOCs’ through non-operated USD billion joint ventures – and not full out acquisitions – such deals pass with 2010 Reliance Atlas Energy Inc 1.7 Marcellus less nationalist scrutiny. One of the 2010 Mitsui Anadarko 1.4 Marcellus strongest cases of the US gas lobby in Washington DC is energy security 2009 Total Chesapeake Energy 2.2 Barnett hence participation from the Norwe- 2009 ExxonMobil XTO Energy 41.0 Haynesville, gians, French, Japanese and Indians Woodford, noticeably takes a different form than Marcellus, full out corporate acquisitions, as Fayetteville for example ExxonMobil’s USD 41 2009 BG EXCO Resources 1.05 Haynesville billion takeover of XTO. The failed Inc CNOOC acquisition of Unocal in 2005 still bears lessons for non-US 2009 Atlas Energy Inc Atlas Energy 1.01 Antrim, Resource LLC New Albany, energy companies pondering larger Marcellus corporate acquisitions. Joint ventures also reduce the human resource risk 2008 Statoil Chesapeake Energy 3.37 Marcellus apparent in making take-overs of 2008 BP Chesapeake Energy 1.9 Fayetteville companies possessing people with a desirable skill set and knowledge base 2008 BP Chesapeake Energy 1.75 Woodford who may simply leave the company. 2008 Quicksilver Collins & Young 1.30 Barnett Resources Holdings, L.P.; Hillwood Paradigm Supply Shift International The USA is the world’s largest and Energy; Chief most studied gas market, yet the Resources LLC rapid supply growth from US shale 2008 Plains Exploration Chesapeake Energy 3.15 Haynesville gas was never predicted. All supply & Production Co. analysts pointed towards two ‘facts’, 2007 BreitBurn Energy Quicksilver 1.45 Antrim falling domestic supply coupled Partners L.P. Resources with growing LNG imports and huge scale investments required to 2007 Atlas Energy DTE Energy 1.25 Antrim Resources, LLC Company develop Alaskan gas. Energy compa- nies expected the same, developing 2006 Devon Energy Chief Oil & Gas 2.20 Barnett strategies for US LNG imports from Corporation LLC Russia, West Africa, the Middle East 2006 TCW private CDX Gas LLC 1.17 Barnett, and South America. In the Energy equity (Citigroup, Fayetteville Information Agency (EIA) 2005 out- Credit Suisse First look US LNG imports were expected Boston, Societe to reach 6 trillion cubic feet (tcf) by Generale) 2025. In the 2010 forecast, the figure 2005 Chesapeake Energy Columbia Natural 2.2 Marcellus is around 1 tcf. Last year’s report Resources from the Potential Gas Committee 2005 XTO Antero Resources 1.04 Barnett (PGC) stated that the USA had a Corp technically recoverable resource base of 1836 (tcf) based on a reassessment 2001 Devon Energy Mitchell Energy 3.5 Barnett of shale gas. Total future supply, which includes the US Department have made the biggest bets so far in France in the Barnett (with Chesa- of Energy’s proved gas reserves, is terms of acquisitions and are seri- peake Energy), Mitsui of Japan (with estimated at 2074 tcf, a 35 percent ous about global applicability. BG Anadarko) and Reliance of India increase over the previous evaluation. and ENI for example have chosen (with Atlas) both in the Marcellus, The report captured the headlines smaller deals maintaining exposure to the largest and potentially most with the promise of 90 years of technology and gaining knowledge. prolific US shale gas play. What supply at current consumption rates The latest entrants include ‘national’ makes the current wave of acquisi- and another step in the direction energy companies including Total of tions particularly interesting is that of energy security. This kind of

14 OXFORD ENERGY FORUM MAY 2010 dramatic shift in supply forecasts is bill and the Kerry-Graham bill) the report was criticised for focusing rare in the oil and gas world. New although it is unlikely that Senators on fracking in coal bed methane and frontier basins challenge our exist- are going to vote for measures that justifying an amendment to the 2005 ing supply logic, for example the will increase energy prices ahead of Energy Policy Act that excluded North Sea, or the Brazilian sub salt, the November congressional elections fracking from coverage under the but what makes this different is the which generally makes Congress more Safe Drinking Water Act. Given the huge inventory of gas in the USA. partisan and less productive, particu- enormity of shale gas resources and Shale gas is cheaper to produce than larly after the bitter battle over health public concerns for water quality, the conventional onshore gas, it does care legislation. A climate legislation gas industry has to accept that clear- not demand immensely sophisticated vacuum in DC may actually help the ance from the EPA is required and, technology, it will continue to benefit natural gas industry as the lack of if accepted, would actually boost the from technological innovation, and a clear policy on the future cost of case for shale gas as a safe, domestic, supply is highly reflexive to market CO2 emissions means few electricity reliable and environmentally prefer- signals with low entry and exit generators are likely to bet on new able alternative to coal. barriers. About two-thirds of the US coal-fired plants. In fact the next wave gas production is expected to come of coal-fired plants (planned years from unconventional plays by 2018, before) could be the last. The State of the Gas Nation implying a different cost curve than So where are we today? At prices previously expected. What makes below USD 4/Btu at Henry Hub, the shale gas different is not limitations gas market is hung-over after the shale on productive capacity or resource “The USA is the world’s gas supply shock and weaker demand availability but the size of the market. largest and most studied caused by the recession. The market All of which represents a paradigm gas market, yet the rapid is clearly oversupplied and despite shift, but does DC get it? 42 percent less wells drilled in 2009 supply growth from than 2008, production remains robust. US shale gas was never The View from the Hill This has been driven by superior predicted” production rates from horizontal shale The effect of shale gas on future US wells vs. conventional verticals. Some gas supply has not gone unnoticed in commentators claim that the United Washington, but gas does not quite The short-term gas demand outlook States is in an unconventional gas capture the attention from Capitol is not bullish, but low gas prices bubble. Private drillers have already Hill it deserves. Despite natural gas certainly help make the US indus- exited accounting for just 9 percent supplying 22 percent of US electricity trial sector more competitive and of the unconventional gas rig count, and representing around 25 percent the growth in shale gas is providing but 49 percent for conventional oil of total energy use, natural gas has new jobs in areas of high unemploy- and gas drilling. Given the state of the generally been the poor relation in the ment, particularly in West Virginia, economy and little extra switching energy lobbying industry compared Pennsylvania and Louisiana. The capacity from coal to gas, the supply to oil and coal. At a recent confer- natural gas industry has never really side is likely to give before any signifi- ence organised by the Center for had a significant lobbying presence in cant demand growth strengthens gas Strategic and International Studies in DC previously, but this is changing prices. The main companies drilling Washington, DC Joseph Aldy, special and the industry is on the offensive for gas will be those exercising drilling assistant to President Obama for against coal. The gas industry is also carries (Chesapeake, Anadarko, Atlas) energy and the environment, said that on the defensive too. The regulatory and companies that are comfortably natural gas was indeed ‘neglected’ in environment is closely following hedged or flush with new owners energy policy. The main reason is that shale gas drilling, as legislators as- (XTO – supported by ExxonMobil). natural gas is not viewed as a strategic sess the environmental impacts. The Further consolidation is likely within fuel in terms of national security or biggest concern is the effect, if any, the unconventional gas sector imply- dependency. Aldy says that DC does of hydraulic fracturing (fracking) on ing a shift away from the smaller ‘get it’ when it comes to the national potable water supplies. New York private players to the mid-sized US gas inventory created by shale and the State has essentially stopped all shale E&Ps and their foreign joint venture environmental benefits of switching gas developments in the state pending partners. Larger, more financially from coal to gas for electricity gen- further investigations. The federal capable players in the gas sector may eration, but the industry should not Environmental Protection Agency reduce the supply volatility so preva- expect special treatment. The US ad- will begin a second research study to lent before in the US gas sector. This ministration though is very happy to investigate the impact of fracking on may encourage the conservative power see this technology exported to other water quality and public health. The industry to sign up to long-term countries. On the legislation front previous report in 2004 concluded stable supply contracts at the expense there are two climate bills doing the that that there was no evidence that of coal. The implication is a different rounds in DC (the Waxman-Markey fracking polluted water supplies, but business model for many existing

15 OXFORD ENERGY FORUM MAY 2010 players, providing more predictable But the current European and global buyer to take and in any case pay for returns, and the possibility of new economic context has put this system a minimum quantity corresponding entrants including utilities. The USA under pressure and the greater pric- to the ‘Take-or-Pay’ level, which is sitting on a phenomenal inventory ing spread between oil-indexed and is typically equal to approximately of hydrocarbons and the rest of the market prices has required substantial 80 percent of the Annual Contract world will feel its effect through rearrangements of the traditional con- Quantity (ACQ). The pricing formu- changes in supply patterns, new tractual and pricing structure of the lae negotiated in European long-term sources of demand and quite possibly European gas supply to limit drastic contracts are generally based on an an easier transition to a lower carbon market-share losses in an increasingly average of heavy fuel or home heating world. competitive environment. There have oil prices over the previous six to been recent signs that the European nine months, but in some cases (some market has been more prepared to Algerian contracts), gas prices can be abandon oil-price-linked formulae in directly linked to crude oil prices. long-term contracts and this evolu- The British gas market was the tion will grow in scale as long as the first in Europe to undertake gas current gas glut persists over the market deregulation, which was fully next few years. The pricing system in implemented in 1998. It is the only long-term contracts in Continental European market where the national Europe has already shown some hub (National Balancing Point, NBP) changes, and the declaration made by is used by producers as a reference Gazprom in March 2010 that it was index for gas supplies. UK spot gas willing to peg 10 to 15 percent of its trading volumes are currently about gas sales to its incumbent European 1000 bcm/year (compared to con- clients to spot market prices heralded sumption of 93 bcm in 2009). a major evolution in the European gas market’s structure in the coming Armelle Lecarpentier years. The international association CEDIGAZ has analysed the current considers the European pricing context and its “The European market is evolution of European future prospects. characterised by a ‘hybrid Gas Pricing pricing model’ with the co- The Growing Role of the Spot existence of market or spot Introduction Market prices … and oil-indexed The European market is characterised In order to monetise the huge gas re- prices” by a ‘hybrid pricing model’ with sources discovered at the birth of the the co-existence of market or spot European gas industry in the 1950s prices, determined on trading centres and 1960s, including finds such as the Although the NBP appeared as the by the supply-demand conditions, Groningen field in the Netherlands unrivalled leading gas hub in Europe and oil-indexed prices, established in in 1959 and the West Sole gas field in in terms of trade volume (which is long-term contracts between major the UK’s North Sea in 1965, natural commonly used to assess the liquid- gas suppliers and incumbent clients. gas suppliers decided to implement ity of a gas hub), some Continental As Howard Rogers noted in Oxford long-term take-or-pay gas supply European gas hubs have developed Energy Forum (November 2009), this contracts. These were considered strongly and the community of traders pricing pattern can be sustainable and as the most appropriate instrument has continued to grow in line with solid as long as the following ‘rules of to ensure the economic viability of the liberalisation process, which was engagement’ are in place: capital investments over time while securing outlets for the gas produced. stepped up by the provisions of the • Continental European pipeline gas Under these contracts, the natural gas second directive (2003/55/EC) that import contract prices adhere to price is based on the netback market took effect in July 2004. the contractual formulae based on approach, so that the maximum The Zeebrugge hub was the first a time-averaged relationship to gas purchase price that the gas purchaser short-term market created in Conti- oil and fuel oil, is willing to pay is calculated by nental Europe. In the years 2008 and • Continental buyers/midstream subtracting the transport and distribu- 2009, several all-time highs in its net players can engage in hub trading tion costs from the average price of traded volumes were recorded. In and LNG diversions as long as competing alternative non-gas fuels. 2009, traded quantities soared by 44 they honour their ‘Take-or-Pay’ These contracts have a traditional percent to a new record volume of 62 commitments under the long-term duration of 20 to 25 years and contain bcm, while the churn factor remained pipeline gas contracts. a ‘Take-or-Pay’ clause that obliges the unchanged at 5.0.

16 OXFORD ENERGY FORUM MAY 2010

Besides Zeebrugge, the Dutch gas transactions. In the fourth quarter of (1) The growing role of trading platform TTF (Title Transfer 2009, the NCG and Gaspool market unconventional gas production in the Facility) has become the largest gas centres emerged as two major hubs United States hub in Continental Europe, both in in Continental Europe. The trading In 2009, the marketing of US- terms of physically supplied volume rate recorded on the NCG Hub even produced gas continued to expand, (the quantity of gas supplied on this outstripped that of Zeebrugge in the despite poor economic conditions hub equates to around half of the total last few months of the year. Moreover, and a 45 percent reduction in the domestic consumption) and trading the Continental European gas hubs number of active rigs during the first volume, which amounted to 64 bcm have significant potential for improve- five months of the year. In the same in 2008. ment in their liquidity and efficiency year, LNG imports showed a modest in the future, partly due to the LNG absolute increase of almost 3 bcm. Other Continental European gas hubs surge in the Atlantic Basin. include the French PEG Nord, the The growth in US gas production was German GASPOOL and NetConnect mainly explained by a boost in the (NCG), Italy’s PSV and Austria’s Oil and Gas Price Decoupling: exploitation of unconventional gas Baumgarten. Causes and Consequences sources, whose productivity through horizontal drilling techniques has Recent gas developments and the Despite these developments, it should increased. In fact, the number of prevailing economic conditions since be noted that in 2009, the TTF vertical active rigs fell by 54 percent in 2008 have given rise to new price hub was trading roughly only 15 2009, while horizontal drilling activ- trends whose main consequences percent of NBP volumes. Indeed, the ity declined by only 16 percent. The have been a pronounced ‘disconnect’ long-term contractual relationships production of shale gas in particular between spot prices and oil-indexed established prior to the deregulation was least affected by the economic prices (see Figure 1). The greater between producing countries (Neth- crisis and enabled US production to imbalance between soaring supply and erlands, Norway, Russia and Algeria) keep growing, mainly for the follow- declining demand have created ‘a gas and traditional historic operators still ing reasons: largely dominate gas supply on the bubble’ on markets, which has led to Continental European gas scene, with a collapse in market prices dictated • Many shale gas reservoirs con- a market share of approximately 75 by fundamentals. From August 2008 tinued to obtain positive rates of percent in 2009. to March 2010, these prices remained return at prices of $3.5–5/MBtu. about 50 percent lower on average The production of shale gas on the Recent trends, however, have shown than oil-indexed gas prices set in Fayetteville Shale (Arkansas) and that the Continental European market long-term contracts in Continental the Haynesville Shale (Louisiana) in is in an improving position to make Europe and Asia. This new macroeco- particular, increased tremendously spot prices referential and reliable nomic pattern can be attributed to the in 2009, while the Barnett Shale signals for the efficient usage of gas combination of the following factors: (Texas), which shows relatively

Figure 1: The Decoupling of Oil-indexed and Spot Gas Prices

18

16 Continental Europe 14 Spot NBP 12

10

$/MMBtu 8

6 Henry Hub

4

2

0 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct

2008 2009 2010 Source: World Gas Intelligence, US DoE, CEDIGAZ

17 OXFORD ENERGY FORUM MAY 2010

higher production costs (evaluated Table 1: Evolution of the Natural Gas Supply Portfolio of GDF SUEZ at around $5/MBtu on average) saw more modest developments. 2008 2009 • Large-scale producers have selected Volumes in TWh In % Volumes in TWh In % the best and most productive wells to be drilled through high grading. Short-term purchases 309 25 393 33 E&P production 37 3 69 6 Long-term supply contracts 815 66 717 60 (2) The commissioning of plentiful Others 74 6 17 1 LNG supply capacity in 2009, Total 1235 100 1196 100 primarily from Qatar (+31bcm) but also from Indonesia (+10 bcm), Yemen Source: GDF SUEZ (+5 bcm) and Russia’s Sakalhin (+12.8 bcm). LNG contracts for European purchas- consumption in Europe (Central Russia and Yemen, which became new ers are for equity LNG that is taken Europe, Norway and Turkey in- LNG exporters in 2009, exported 6.61 by liquefaction project operators for cluded) dropped by 6.4 percent to 531 bcm and 0.42 bcm respectively in their marketing and branded LNG, such as bcm in 2009, with double-digit decline first year of operation according to ExxonMobil and Total in the Qatargas rates recorded in Spain (-11 percent), CEDIGAZ. The global LNG industry II and RasGas II projects. The volume Turkey (-11 percent), Hungary (-21 is now in a situation, in the short of ‘flexible’ LNG is expected to in- percent) and Romania (-14 percent), as term at least, of weak demand and an crease strongly from 38 Mt in 2008 up well as in Bulgaria, Greece, Slovakia, oversupply of LNG. to 120 Mt/y in 2015, adding increasing Finland and some Baltic countries. The economic and pricing context in pressure on prices arbitrages as LNG Only three markets (Belgium, Sweden 2009 gave LNG a competitive edge has recently become a price maker for and Latvia) actually raised their in the Atlantic Basin, where LNG North West Europe. This growth in gas consumption level. The largest demand increased 26 percent to 88.7 flexible and spot LNG supply would absolute decreases were recorded in bcm in 2009, under the impetus of the favour the growing importance of spot the United Kingdom (-7.4 bcm), Italy United Kingdom (+9.2 bcm) and Bel- price indexation in European supply (-6.9 bcm), Spain (-4.2 bcm), Turkey gium (+3.7 bcm), against a 2.4 percent contracts. (-4.1 bcm) and Hungary (-3.0 bcm). In drop in Asia-Pacific (CEDIGAZ esti- fact, these five markets account for 70 mates). Spot LNG purchases increased percent of the drop in European gas (3) The destruction of European strongly because of a rise in ‘flexible’ consumption in 2009. gas demand under the effect of the LNG that was sold in the Atlantic economic recession In contrast to LNG, European Basin under contracts linked to hub pipeline imports from Russia, the According to initial estimates market prices and with no restrictions Netherlands and Algeria fell by 12, by CEDIGAZ, real natural gas on sales destinations. Indeed, most 14 and 16 percent respectively in 2009 (CEDIGAZ estimates), attesting to Recent OIES Publications the fact that European purchasers were tempted to reduce their long- term contracted volumes as much as LNG Trade-flows in the Atlantic Basin: Trends and Discontinuities (NG 41) possible to exploit pricing arbitrages. by Howard Rogers, 2010

Natural Gas in the UK: An Industry in Search of a Policy? (NG 40) The Cases of France and Germany by John Elkins, 2010 Germany considerably cut its gas pur- chases from its three major long-term The Role of Natural Gas in the Dutch Energy Transition: Towards low- traditional sources, Russia, Norway carbon electricity supply (NG 39) and the Netherlands, by 18 percent by Floris van Foreest, 2010 from the first half to the second half of 2008. In the same period, the The Reformed Financial Mechanism of the UNFCCC Part II: The average European border price from Question of Oversight Post Copenhagen Synthesis Report (EV 52) these three sources soared 36 percent by Benito Müller, 2010 (E&E/F) and the average German border price increased only 22 percent, while The Reformed Financial Mechanism of the UNFCCC Promoting the three main supplier countries Transparency & Accountability (EV 51) continued to share 95 percent of the German gas supply. In 2009, by Luis Gomez-Echeverri, 2010 imports from other European sources

18 OXFORD ENERGY FORUM MAY 2010

(including main spot purchases from at least, keeping spot prices at much rally, and suggest a more bullish pric- the United Kingdom) increased by lower levels than oil-indexed prices. ing scenario from 2012 to 2013 than 21 percent, contrasting with a modest Recent data on forward prices indicate previously anticipated. growth in purchases from the three that the current large gap between In the High Demand Scenario of major traditional sources. In February Atlantic spot prices and oil-indexed CEDIGAZ, based on solid economic 2010, Gazprom and E.ON Ruhrgas prices in Continental European long- recovery, the global gas fundamentals reached an agreement on payment term contracts is set to prevail in 2010, will alter over the 2012–2015 period, arrangements for E.ON under the as shown in Figure 1. leading to a gradual re-coupling of Take-or-Pay clause and agreed on a spot and oil-indexed prices, as shown consensus to introduce a spot market in Figure 2. variable (10 to 15 percent) in existing supply contracts. “There have been recent Given the context of rising ‘flexible signs that the European LNG supply’ in the Atlantic Basin, it In France, the comparison between is predicted that spot indexation will the gas procurement portfolio of market has been more account for a fast-growing share of GDF SUEZ in 2008 and 2009 shows prepared to abandon oil- European gas imports in the next few that the company increased its spot price-linked formulae in years, resulting in downward pressure purchases by 27 percent in 2009. On on the average European border price. the contrary, long-term contracted long-term contracts” As shown in Figure 2, the long-term import gas volumes were reduced by contracted volume of Continental 12 percent in the same year. Imports Europe from extra-EU27 sources contracted with the Netherlands fell However, the opinions of analysts will start to drop dramatically after even more dramatically, by 38 percent, differ with regard to the degree by 2015 and new additional or extended following the transformation of a which supply will exceed demand – contracts will have to be signed to long-term contract (previously held the length of time that the gas bubble fill the soaring gap between supply by Distrigaz before the GDF SUEZ will last – and the future price of and demand in that period. And the merger) into a short-term deal. spot LNG supply. Many experts have possible reconnection of oil-indexed predicted a persistence of the global and gas prices post-2015 will not LNG glut until 2015 at the earliest. When is the End of the Oil and Gas ease increased questioning about the Price De-correlation Due to Occur? Recent information on the recovery of maintenance of a price indexation to gas-fired power generation in Asia and oil-products, whose role as alterna- It is commonly agreed that the global gas consumption in many European tive substitute in the netback market LNG industry will continue to face countries may be a signal of the first approach has become less and less an oversupply for the next two years signs of a quite rapid gas demand relevant.

Figure 2: Natural Gas Prices Outlook and European Gas Supply (High Demand Scenario)

400 14 Continental Europe's 12 contracted pipeline supply

300 10 European LNG imports

u Average Continental 8 European border price 200 Bcm 6

$/MMBt Spot Henry Hub (US)

4 Spot NBP (UK) 100

2

0 0 2008 2009 2012 2015 2020

Greater indexation to spot (flexible LNG) End of oil-indexation Coexistence with oil-indexed contracts in new contracts?

Source: CEDIGAZ

19 OXFORD ENERGY FORUM MAY 2010 Reforming UK Electricity Markets John Rhys

How Should OFGEM Approach the Issues of Security and • Elimination of high cost UK coal, which disappeared as Sustainability? initial vesting contracts were phased out in the 1990s. This reflected abandonment of the policies of successive The recent OFGEM consultation on gas and electricity UK governments in forcing the electricity industry, the markets has been seen as radical and controversial because, CEGB, to support the UK coal industry. Privatisation in a context of security and sustainability objectives, it ques- and competition may have provided a convenient cover tions the effectiveness of the current market structures for for this policy change, but this gain would have occurred the UK energy sector. In this it reaches a very similar set under any form of regulated or competitive industry. of conclusions to the October 2009 Committee on Climate • The simultaneous advent of relatively new technology in Change Progress Report to Parliament on Meeting Carbon the form of combined cycle gas turbines (CCGT); since Budgets. This article concentrates on electricity and argues this was and is an international technology, the innovation that, at least for the power sector, OFGEM’s concern is well and its development cannot be ascribed wholly or in part founded and should imply a radical reappraisal of market to UK market liberalisation. arrangements. This is especially important given the central • The combination of this factor – CCGTs – with a period role of the power sector in achieving targets for reduced of low energy commodity prices, and cheap and plentiful

CO2 emissions. gas. If anything the OFGEM arguments for more radical • Very substantial increases in efficiency, and cost reduction, reforms are understated. This paper seeks to: in natural monopoly elements of the sector, especially • examine more critically the sources of the benefits, in distribution costs; these however were driven by a com- lower costs and prices, that have accrued under the post bination of regulatory and private sector incentives, not 1990 market regimes; by market arrangements for generation and supply. • consider whether current trading and system operation • With CEGB assets sold off at below book value, and structures would be technically consistent with the gen- significant capacity surpluses through much of this period, eration technologies likely to form part of the new low both the need and ability to earn a full return on the capital carbon energy economy; value of historic investment were largely removed. • discuss the main market problems posed for securing the investment necessary to meet key objectives of adequate These factors should condition any assessment of the effec- capacity and low carbon sustainability; tiveness of competition per se as the prime driver of efficiency • argue that a central purchasing agency for the power sec- and cost reduction. tor could deliver the main policy objectives for the sector There is substantial evidence, especially post 1990, of sig- while retaining the most important features of competitive nificant improvements in generation efficiency, most notably market structures. in power station operation and availability, driven partly by competitive market pressures and partly by disciplines arising Post 1990 Experience. Assessing the Gains from Regula- from private ownership of the facilities. This was reinforced tion, Competition and Other Factors by reductions in concentration within the industry in the late 1990s, driven by post-1990 competition policy concerns. It is the attribution of the efficiency gains and substantial cost However it is very hard to argue convincingly that these and price reductions following the major market reforms and gains resulted from particular characteristics of the competi- privatisations in 1990 that largely drives argument over the tive market structure and rules since 1990 or 2000, and cer- advantages of current market arrangements, and especially tainly not from the particular feature of supply competition over particular features such as the forms of electricity trad- per se, the component of the competitive framework most ing or supply competition. OFGEM implicitly attributes directly affected by more radical reforms such as a supplier a substantial part of past gains to the current structure of obligation or a central buyer. Indeed Richard Green argued trading arrangements rather than to the body of 1990 re- in 2003 that retail competition can raise wholesale prices, forms as a whole; this conditions its assessment of the risks corresponding to reduced efficiency and ultimately higher associated with more radical changes to current trading and consumer prices, in comparison with a market based on market structures. long-term contracts and a regulated supply business. However, a very high proportion of historical efficiency One further factor deserves mention – the 2001 NETA gains and falls in consumer prices post 1990 derived directly changes. Inter alia this removed the element of capacity from factors which cannot legitimately be ascribed either payment, with an inevitable short-term downward effect to particular features of the market structure or even to the on prices. However failure to provide an alternative means existence of a competitive market per se. In particular, and to reward capacity contradicts the fundamental economics taking the whole period since 1990, the most important fac- of the power sector, especially the link between market tors promoting lower costs and prices included: driven prices and investment. It is now widely held to be a

20 OXFORD ENERGY FORUM MAY 2010 significant part of the security of supply issue. We cannot assume therefore that a market built around We should not therefore assume that established advan- the notions of daily or half-hourly optimisation and pricing tages and benefits, accruing from a structure built around will remain ‘fit for purpose’, or that the current structure is competition and private investment, would necessarily be capable of incremental evolution to a new and more complex compromised even in quite major modifications to the cur- system of market ‘auctions’, let alone any bilateral trading rent structure. equivalents, that will still deliver short-term operational efficiency. Technical Requirements for Trading and System Opera- This emphasises the central importance of having market tions in a Low Carbon Non-fossil Future arrangements that are compatible with the predominant technologies of the day. If we are seeing an evolution towards One of the great technical achievements of the radical market a set of technologies with very different operating character- design for the 1990 privatisation was that it successfully rep- istics, both on the supply and demand side, then we shall need licated the operational optimisation embodied in the CEGB very different market structures. We cannot assume a natural merit order structure into a market bidding arrangement. incremental evolution from the rules that exist today, or even Without this feature the market would have been substan- that a similar market structure will be possible or optimal. tially and visibly less efficient at its inception, undermining claims for the virtues of competition in promoting efficiency. Problems in Securing Low Carbon Investment and Ad- It was a pre-condition imposed on the market design. equate Capacity under Current Market Structures It also demonstrates the link between the technology of power generation and market structure. Pre-1990, system op- OFGEM correctly focuses on the primary issue for market eration was based on deployment of flexible fossil fuel plant arrangements as being how to ensure high and unprecedented that could respond to meet continuously changing demand levels of investment, to meet both security and low carbon for a non-storable commodity. Central control scheduled and targets, all against a background of an aging plant stock. dispatched the lowest marginal cost plant in ascending order Several difficulties exist and are apparent in current market of merit. Post-1990 this worked through a bidding process structures. which, conceptually at least, encouraged players to bid at marginal cost, and corresponded exactly to the merit order Perverse treatment of financial risks. OFGEM correctly ob- ranking employed within the command and control system serves that ‘investments with stable operating and fuel costs of the CEGB. Notwithstanding the NETA modifications to (such as nuclear and wind) could be viewed by … suppliers trading arrangements, this close connection remains. as more risky than investments whose costs vary with volatile However a future low carbon world is likely to have very global fuel costs.’ Fossil fuel plant will continue to be at the different plant operating characteristics, dominated by rela- margin for some time and hence to set price. So fossil plant tively inflexible plant (nuclear), plant with intermittent and/ gets a degree of protection (varying by type of fuel and ef- or stochastic characteristics (renewables), and in the medium ficiency) equivalent to partial pass through of fossil fuel price term much greater opportunities for positive/negative storage volatility. This intrinsically discriminates against non-fossil through different types of more flexible demand (e.g. to serve plant; a pass through of fuel costs for incumbent forms of the transport sector). Faced with very different technical generation creates a barrier to entry of new technologies. and economic characteristics, where a high proportion of plant may have zero marginal cost but technology specific Asymmetry in treatment of capacity risk. Another unsatis- limitations on flexible response to load changes, electricity factory feature of current arrangements is the fundamental markets and system operations will need to be defined very asymmetry between the risks of under- and over-provision, differently. Efficient system operation for example may and in particular the conflict this creates between market and depend on more complex forms of optimisation defined over social objectives for the power sector. weeks or months rather than hours or days. From a societal perspective, the net costs of over-provision Some issues associated with current arrangements have may be relatively small. There is a significant resource cost in already been highlighted in the 2009 Pöyry report on wind over-investment, but it is partially offset by earlier retirement variability, paradoxically the problems for viability of fossil- of less efficient plant. Under-provision on the other hand is fired generation dependent on price spikes and infrequent op- commonly seen as near catastrophic. Inelastic demand is not eration, resulting from intermittent wind power. We should choked off by prices, and the outcome is load disconnection expect new problems as both the number of new non-fossil and potentially widespread loss of output across all sectors technologies and their contribution increase. of the economy. It is a ‘market failure’ that cannot be ignored Optimising the operation of generation based largely on by governments. a variety of non-fossil or non-thermal technologies is inevi- However, from an individual investor perspective, and tably a much more complex task than simply stacking the in the absence of long-term contracts, it is over-provision short-run marginal costs of generating plant in a one stage, that presents worse outcomes, through a collapse of prices. one price, auction process. If it is amenable to an auction Restoring equilibrium by closing capacity invites regulatory process at all, it would probably be to a multi-stage auction intervention on competition grounds. Under-provision, by with complex structures and no very clearly defined output contrast, implies higher prices and better returns. of a single ‘price’ for each period. This asymmetry was balanced in the 1990 arrangements

21 OXFORD ENERGY FORUM MAY 2010 through market mechanisms established specifically to Coordination issues also include incorporation of decen- provide continuity in security of supply – a penal incentive tralised options, along with their associated infrastructure requirement on public suppliers to buy in the market up to requirements, choice of sites for wind power, to maximise a price intended to reflect the value placed by consumers on diversity, and for CCS, to minimise new infrastructure costs secure supply – the Value of Lost Load (VOLL). This feature for pumping and storage of captured CO2. This suggests was discontinued under NETA, abandoning a fundamental a possible need for an overall investment framework, in link between setting a security standard and explicit assump- the form of additional powers and responsibilities for the tions about the costs of system failure. National Grid, or for a new power-purchasing agency with In the context of low carbon investment, this asym- responsibility for ensuring adequate capacity and meeting metry is even more pronounced. Over-investment implies sectoral emission targets. over-achievement of sector carbon targets, and hence more carbon-efficient operation of the sector. Within a rationally Finding the Right Path to Effective Reform administered framework of national targets this would in principle allow more carbon allowances to be ‘spent’ in The main problems identified in achieving essential invest- sectors such as aviation where consumers implicitly attach ment relate therefore to carbon prices, contractual or revenue a much higher value to their use of fossil fuel and resulting certainty for investors, potential inadequacies in system emissions. Given that current carbon emissions are typically operation and trading linkages as the sector moves away from valued or priced at well below most estimates of their social conventional fossil technologies, the coordination and timing cost, according to the Stern Review and other sources, this of investments in capacity and infrastructure, and adequate would be a large offsetting social gain, albeit one whose incentives to ensure security of supply. incidence may be very diffuse. OFGEM (and the Committee on Climate Change) pro- pose alternative approaches to reform, on a spectrum from Background of uncertainty. OFGEM suggests one problem incremental changes to existing trading arrangements, includ- is a heightened perception of risk and hence high costs of ing very significant measures such as a carbon floor price, to capital. However nominal interest rates are at an all time more radical institutional changes, such as additional supplier low, and according to most of the canons of modern finance obligations or a central agency. The essential strategic choice theory, investment in well regulated utility industries, with is between reliance on a series of possible ‘fixes’ to correct risks that are not heavily market correlated, should be low deficiencies in existing market structures, or introduction of risk and low beta. Anything else implies lack of confidence formal obligations to provide adequate security and meet in the regulatory framework. The real difficulty therefore is emissions targets. in attracting high levels of investment against a backdrop of The analysis above suggests that the first approach has contractual or regulatory uncertainty. several deficiencies: the general problem of trying to sec- The most obvious historical parallel for a high investment ond guess markets, the potential proliferation of complex transformation of the power sector in a modern economy is additional rules, schemes and instruments, and failure to the highly successful decarbonisation of the French power address the implications for market structure of fundamental sector in the 1980s and 1990s, the scale of which was certainly technology-driven change in the sector, all of which will add comparable to the challenge facing the UK today, and which to investor uncertainty and carry significantly higher risks of was accomplished primarily through the state sector (EdF). not delivering on the objectives. A more convincing statement of the problem, therefore, The more radical options, for a supplier obligation or is to consider how the necessary and very high levels of central agency, are similar, in that the first might naturally investment can be achieved through private investment and evolve into the second with suppliers creating a jointly owned an appropriate balance of regulation and competition in agency to meet obligations, and in that both tend to imply electricity markets. limitations on supply competition. Such an agency offers the most certain prospect not only of securing an adequate Carbon prices. Markets, essentially through the EU Emis- quantum of low carbon investment, as well as supply security, sions Trading Scheme (ETS) have so far failed to deliver but also of securing a balance of different types of capacity carbon prices that are sufficiently high and stable to support and load management options compatible with secure and necessary investments in low carbon generation technology. efficient system operation, and of coordinating that with the This may reflect unwillingness by governments to coun- necessary infrastructure investments. tenance adequately tight emission limits, and this has led The agency would in effect become the major purchaser OFGEM, among others, to consider carbon price fixes as and wholesaler for the sector, inviting tenders for new capac- one possible solution. ity, and coordinating its programme with associated infra- structure investment by the National Grid. With properly Coordination. Finally, in parallel with the system opera- designed and implemented tenders and contracts, this would tion issues posed by new technologies, there are analogous retain both competitive pressures in building new plant and questions of coordination, not considered by OFGEM, in incentives for efficiency in operation. Its obligations would the choice of investment: to determine what combinations encourage a diverse balance of capacity types technically and proportions of technologies in the generation capacity compatible with maintaining supplies, and higher reserve mix are technically feasible in meeting future load patterns. margins to ensure adequate security.

22 OXFORD ENERGY FORUM MAY 2010

Competition in retail supply could continue but would in the sector, including economically viable decentralised have to focus on competition in the true supply functions of generation capacity. It would also be able to contract for providing a billing service, rather than exploiting consumer existing capacity, and this would help to encourage a natural inertia or lack of information as to the true wholesale price transition from existing commercial arrangements. of electricity as a commodity. As a purchaser and wholesaler the agency would also This paper is based on the author’s recent submission to provide a natural channel for support to innovative solutions OFGEM Consultation Document ‘Project Discovery’

LETTER

On Oil Peak or Peaks have ‘suddenly appeared! Why were Finally, demand, a central factor in we not able to model or predict any the Peak Oil debate continues to Dear Editor, of these developments and discoveries surprise us and to transform this or why could the industry not see 10 debate. Following the recent re-rating I read with interest your article on trillion barrels of oil in place in 1900? of the oil price, global oil demand Peak Oil in the most recent Energy History shows that there has never has been flat for the last three years. Forum, and would like to provide been a shortage of resources, only a Prior to which, oil demand growth some additional reflections on this temporary shortage of human creativ- had been strong, driven by China and subject. Primarily, the trends in oil ity and plenty of inadequate models developing countries, but today the (and gas) continue to surprise the and predictions. world consumes 12–13 mbp/d less majority of experts in the energy oil than what the top modellers were sector. Our industry is still unable to Oil and gas production capacity has predicting some ten years ago. In fact, design a model that can explain what continued to expand at varying rates in the last decade major downward has actually occurred during the many and to hold even as some countries revisions have been made to long-term years in which the Peak Oil debate and NOCs lost control of their demand prospects with profound has intensified, but failed to materi- operations – global oil capacity is implications (no one expects OECD alise. There are at least two reasons now above 91 mbp/d and gas capac- demand to ever recover), but the Peak for this, one being we simply can’t ity above 50 mboep/d. Some major Oil alarmists have cared to not notice model human creativity and that we oil-producing countries which had this trend. We are now told that global are unable to predict major events and experienced historical peaks in the oil demand in 2025–2030 is expected their consequences; just two major past, such as the USA, Russia, Saudi to be around 100 mbp/d, but this is 40 examples that most modellers did not Arabia, Iraq, Canada and Colombia, mbp/d less than expectations a decade see coming – the fall of the wall and are now once again expanding and ago. The story for gas demand is the attendant collapse of supply from in some cases exceeding or about to similar, particularly in the USA, where Russia (and its rise) and the rise of exceed their historical peaks. Curi- major downward revisions have been China. ously, decline rates, one of the most made over the years, and the world The Peak Oil debate needs to be important parameters in the Peak Oil is now facing a major glut. One can discussed considering the dynamics equation also seem to be the least only concur that the impact of price, of resources, supply, demand, and understood phenomena. Analysts technology (especially), consumer pat- oil prices. It is no secret that since and CEOs have ‘simplified’ relevant terns, and substitution (to name a few) modern exploration of hydrocarbons factors such as geology, wells drilled, has also proven difficult to model. began in the early 1900s, the estimates recovery methods, marginal econom- for global resources and reserves ics, investment trends, politics, and have been increasing – at present economics (to name a few) of some Ivan Sandrea economically available resources 80 countries and 800 companies in exceeded 10 trillion barrels of oil in the globally accepted 5 percent factor place and 25,000 trillion cubic feet for decline rate. But when one looks Ivan Sandrea is Vice President of of gas in place. Recoverable reserves, at how much liquids capacity has Strategy for International Exploration currently estimated at 10 percent of expanded in the last ten years and & Production, StatoilHydro. the resources in place, have also been how much new capacity has come increasing. In the last three years, we on-stream, the 5 percent simply is not have had major upward revisions as a comprehendible; it has been much result of the US shale gas boom, the lower. Growing supply has always Australian coal bed methane boom, been a long-term challenge, not only the discovery of oil and gas in Brazil’s since 2000. All Peak Oil models have sub-salt formations in ultra deepwater been, undoubtedly, far too simplistic and access to Iraq. And all of these on the supply side.

23 OXFORD ENERGY FORUM MAY 2010 Asinus Muses

Lovelock’s Second Principle percentage error of its predictions for too many before giving a speech titled production and consumption has been ‘After Copenhagen, What?’ His answer Science makes progress by unifying very respectably below 10 percent. But is four-pronged: ‘pour money like wa- apparently disparate phenomena. When the error in their price predictions has ter’ into research on carbon-reducing Newton discovered the principle of averaged more than 50 percent for both research; beg the rulers of China and gravity he simultaneously explained oil and gas, and more than 40 percent India to get on board, on the basis of the motion of the stars, the descent for coal. While Lovelock’s new prin- their long-term interests; nationalise of an apple from its tree, and the path ciple is surely part of the explanation, the US energy industry; and restrict of an arrow through the air. Darwin’s Asinus reminds the reader that it must future climate negotiations to seven theory of evolution explained the di- be applied with care. The real question large ‘countries’ (one of them the EU), verse forms of life on this planet on remains: are the dumbos in the EIA, presenting the rest of the world with the basis of one simple principle. James or are they the buyers and sellers of painful trade sanctions if they don’t Lovelock’s infamous Gaia hypothesis hydrocarbons? sign up. Asinus can’t help feeling that has not yet reached the status of these in number three, at least, the profes- great theories, but Lovelock appears Demanding the impossible sor’s usually keen sense of real politik to have stumbled across another prin- has deserted him. Obama didn’t even ciple whose explanatory potential is A suggested answer comes in a paper nationalise healthcare and Republicans breathtaking. We refer to the principle by Dermot Gately and Joyce Dargay declared him a communist (in addition of human stupidity, invoked by the en- on the future of oil demand, towards to a Muslim, baby-killer, Satanist and vironmental thinker as the explanation which Asinus has ambivalent feelings. terrorist). That energy nationalisation for our collective failure to understand It’s always a pleasure to see a consensus may be the optimal policy does not and to tackle climate change. ‘We’re of officialdom punctured, but unnerv- imply that the US political system will not that bright an animal… I don’t ing when the message is that the EIA, allow it happen. DeLong forgets Mark think we’re yet evolved to the point IEA and OPEC have all underestimated Twain’s famous precursor to the Love- where we’re clever enough to handle as future oil demand out to 2030 by about lock principle: ‘Suppose you were an complex a situation as climate change,’ a quarter. Official estimates assume, idiot. And suppose you were a member he states, citing, in addition, the pres- apparently without justification, that of Congress. But I repeat myself.’ ence of a great number of ‘dumbos’ the income elasticity of demand will even in the scientific community. Yet be substantially lower in the future It’s an ill wind just as Newton’s other great discovery, than it has been so far. Dargay and that of the differential calculus, led to a Gately argue that the efficiency savings The Icelandic ash cloud, having ground- universe of applications undreamt of by that took place after the oil shocks of ed flights over much of Europe for sev- its originator, Asinus is confident that the 1970s are unrepeatable, and that eral days, has thereby exposed its silver this first use of the Lovelock principle it was the collapse of the constituent lining: carbon emissions due to trans- is just the tip of the iceberg. Those economies of the Soviet Union that portation have probably been reduced diplomatic exchanges on which Asinus kept oil demand in check through the by several million tons, outweighing the is so fond of reporting; sub-prime mort- 1990s – presumably, or at least one approximately 200 thousand tons a day gages and the banking crisis; the more hopes, another unrepeatable experience. emitted by the volcano itself. Australian extreme reaches of postmodernism; At the newly predicted rate of demand climate change sceptic Ian Plimer has English plumbing; all these mysteries growth, supply, of course, will not be claimed that, ‘Over the past 250 years, and more instantly become explicable able to keep up. The oil price, after a humans have added just one part of once we accept Lovelock’s new insight. year of sobriety around the $65–$80 CO2 in 10,000 to the atmosphere. One range, made a drunken lurch to $87 in volcanic cough can do this in a day.’ US EIA: SNAFU early April. If Dargay and Gately are Given that the largest volcanic erup- right, it looks like the oil price may be tion of recent years, Mount Pinatubo The application of the principle does, heading for a long-term binge. in the Philippines in 1991, contributed however, require judgement. Take the the equivalent of about one-700th of US Energy Information Administa- DeLong’s long shot the carbon produced by humans in tion’s recent report on its historical pre- the single year 2006, Asinus finds him- dictions for energy demand, supply and Berkeley Professor of Economics J. self again reaching for Lovelock’s new price, going back to 1982. The average Bradford DeLong may have had a jar principle.

Oxford Energy Forum. ISSN 0959-7727. Published by Oxford Institute for Energy Studies, 57 Woodstock Road, Oxford OX2 6FA, United Kingdom. Registered Charity 286084. Tel: (0)1865 311377. Fax: (0)1865 310527. E-Mail: [email protected] EDITOR: Robert Mabro. Annual Subscription (four issues) £45/$85/a65. © Oxford Institute for Energy Studies, 2010. Indexing/Abstracting: The Oxford Energy Forum is indexed and/or abstracted in PAIS International, ABI/IN- FORM, Fuel and Energy Abstracts, Environment Abstracts, ETDE and CSA Human Population and the Environment 24