Throughout the world, natural gas is gaining prominence in national energy systems. In many economies its share of the energy mix is growing. Major factors behind this global growth include market liberalisation, a switch from other fuel sources and improved access to unconventional natural gas reserves. Environmental and energy security considerations have added impetus to the trend.

In this chapter, we examine developments in natural gas supply and demand globally. We look at developments and trends in international natural gas markets in terms of supply, demand and prices. We also consider the experiences of many developed economies of liberalising the natural gas value chain. Given the increasing importance of natural gas as an energy source, we examine the effect of natural gas on national energy security. Finally, we consider the environmental benefits of a shift to natural gas, in terms of boosting local air quality, improving health outcomes and increasing the overall productivity of the economy.

1 Global Natural Gas Markets

As global energy demand has grown, so has the importance of natural gas in the energy system, both in absolute terms and as a share of the global energy mix. In 1980, natural gas accounted for 19% of global energy consumption, and by 2010 that figure had risen to 23%. During these two decades, natural gas consumption rose on average by 2.6% per year, compared to 2% for overall energy consumption, and is expected to sustain a 2% annual increase until 2030. While much of the current demand for natural gas comes from developed markets, demand in coming years is expected to be driven by increased consumption in emerging markets, particularly for power generation. Indeed, the bulk of this new demand is expected to come from Asia, and particularly China.

Demand for natural gas is driven primarily by switching from other fuel sources, such as oil and coal. In addition, increased economic intensity—which is pushing demand for all fuels—is contributing to growing consumption of natural gas. Reduced energy intensity (the amount of energy needed for a given output) is mitigating these growth pressures slightly. Perhaps surprisingly, our research finds that price differentials between natural gas and other fuels have a relatively small effect on fuel switching and demand growth.

The development of unconventional natural gas has further stimulated natural gas demand growth. In the wake of recent success in the United States in exploiting shale natural gas, a larger portion of the world’s natural gas supply is expected to come from unconventional natural gas reserves. In 2030, shale natural gas and coalbed methane are expected to account for more than half of North America’s natural gas production. Further, the US Department of Energy has estimated that China holds the world’s largest reserves of technically recoverable shale natural gas, almost twice as much as found in the United States. However, cost, the geographic distribution of the natural gas fields, and the need for the appropriate capabilities could be obstacles to exploiting these reserves.

The global natural gas trade, and especially the flourishing LNG trade, has supported the continued growth in natural gas demand. Global trade in LNG doubled between 2003 and 2013. The increase in global LNG trade is expected to continue, leading to an increasingly linked and integrated global natural gas market. Partly as a result of the increased production of unconventional reserves in the United States and elsewhere, countries exporting LNG are likely to become more diversified in coming years, creating a supply network with links to a broader range of demand centres. LNG shipping is also more flexible, adding further momentum to global LNG trade. Because they do not rely on immovable pipeline networks, uncommitted LNG shipments can respond to price and be quickly directed to the best markets, based on price. Energy security advantages and arbitrage opportunities also help LNG shipments to compete with natural gas delivered over pipelines.

Pricing systems for natural gas are gradually shifting away from oil-indexed contracts, especially outside Asia. While natural gas contracts have traditionally been linked to the price of oil, the underlying economic fundamentals for these two fuels have diverged. Oil-based fuels are primarily used for transportation, with power and heat generation becoming a much smaller contributor to demand, while the use of natural gas in power and heat generation is increasing. In addition, the creation of natural gas hubs—notably in Europe and the United States—has enabled natural gas contracts to be linked to transparent and readily available natural gas price benchmarks, such as Henry Hub in the US and the British National Balancing Point (NBP).

As part of this study, we examined the impact of different Chinese natural gas demand scenarios on global energy markets. The analysis suggests that an increase in China’s natural gas demand is not likely to have a significant impact on global natural gas prices, as global supply is able to respond to increased Chinese demand. However, Chinese coal demand displaced by the increase in natural gas demand is likely to have a significant impact on global coal prices. China currently accounts for a large share of global coal demand, and the decline in demand, combined with global coal supply being slow to respond to the new market conditions, is likely to depress global coal prices. In the absence of any policies to restrict coal use, regional economies such as India and Indonesia are likely to be the main beneficiaries of lower coal prices.

2 International Experiences of Liberalising the Natural Gas Value Chain

As part of our study, we examined the liberalisation experience of natural gas systems in five markets that have witnessed significant increases in consumption in recent years. In all of these markets—the United States, the European Union, the United Kingdom, Japan and South Korea—market liberalisation and increased competition played a significant role in increasing domestic demand for natural gas. The market development in each of these cases was unique, but there are nonetheless positive and negative lessons that China can learn from.

When it comes to increasing the share of natural gas in the energy mix, three key energy-related concerns for policy-makers are:

  • providing affordable natural gas for business, residential and industrial end users;

  • enhancing national energy security by diversifying supply networks and improving the country’s negotiating position in international natural gas markets; and

  • delivering ancillary benefits, such as improving air quality or supplying energy to poor households and regions.

Liberalising the natural gas value chain can help to balance and support these objectives. For example, increased competition in the extraction and sale of natural gas can drive down costs, and therefore reduce the price paid by consumers and end users. It can also help to diversify sources of supply, increasing energy security.

The countries we studied followed similar paths to liberalisation, although they differed in the details and the level of success. The process of liberalisation helps to deliver competitive market outcomes—to provide end users with the greatest choice at the lowest price. This can be achieved by opening markets to competition or through regulatory measures to limit or cap prices where natural monopolies exist.

The natural gas value chain can be divided into three segments: the upstream exploration and production segment; midstream infrastructure, including transmission and distribution pipelines and LNG terminals; and the downstream wholesale and retail markets for natural gas that bring the fuel to consumers and end users. Competitive markets can exist at many points in this value chain.

Competition in the upstream segment can drive greater efficiency and innovation in the exploration and production of natural gas, as a way to drive down costs and develop greater volumes of domestic supply. For example, before the liberalisation of natural gas markets in the European Union, state-owned, vertically integrated natural gas companies had little incentive to improve the efficiency of their operations, leading to increases in the price of natural gas. Similarly, greater competition in the downstream segment can increase choice and reduce the price paid by the end users of natural gas, for example by increasing competition in the shipping and sale of natural gas. These segments can be opened to competition, within a regulatory oversight framework that ensures and supports competitive markets and without the need for further regulatory interventions.

However, opening the midstream segment to market competition is typically not desirable, and is likely to fail. Midstream infrastructure, such as pipelines, is highly capital-intensive. For example, in 2013, onshore oil and natural gas pipeline construction in the United States cost $4.1 million per mile, while offshore pipelines cost $7.6 million per mile. High fixed costs and relatively low operation and maintenance costs point to large economies of scale: the costs of delivery decline rapidly with volume. This fits the definition of a natural monopoly, where the lowest long-run average costs are realised when production and ownership are concentrated in a single firm. Countries have dealt with the natural monopoly characteristics of midstream infrastructure in a number of ways: by mandating third-party access to pipeline infrastructure; by regulating the tariffs that pipeline infrastructure owners can charge for access; and/or by separating transport services from upstream and downstream businesses (a process known as unbundling).

To be more specific, countries that have successfully liberalised the natural gas value chain began by creating the necessary institutions, particularly a strong and independent natural gas regulator. They then moved to ensure open access to the natural gas network by, for instance, requiring large integrated companies to unbundle their holdings, regulating network charges and overseeing third-party access to transmission and distribution networks. These countries also deregulated prices where appropriate, especially in the upstream and downstream segments of the value chain. They set market standards and mandated transparency, for example by standardising trading agreements and supporting the development of natural gas hubs. And finally, they strived to protect end users by overseeing competition and managing adverse market impact.

3 Liberalisation of Different Segments of the Natural Gas Value Chain

In addition to examining the evolution of natural gas systems in selected markets, our study also looks at international experiences of liberalising specific parts of the natural gas value chain.

In the upstream segment, liberalisation has focused on encouraging new entrants and increasing competition through appropriate fiscal and licensing regimes. International experience suggests that these measures are necessary to meet national objectives, as well as to ensure the quality and quantity of natural gas production.

In the midstream segment, the natural monopoly characteristics of natural gas transmission and distribution infrastructure have meant that liberalisation efforts have focused on providing third-party access and unbundling. In setting the framework and terms for third-party access, governments need to balance the need for fair and open access with incentives for further investment in midstream infrastructure. This balance varies by country and circumstance. For example, regulators in Japan have favoured midstream investment over access. Thus, while provisions for third-party access exist in law, enforcement has tended to be lax.

In addition to third-party access, unbundling is an important consideration with regard to midstream assets. Often, as a country begins the process of liberalisation, the national market is dominated by one or a few companies that own assets throughout the value chain. These companies have a strong incentive to restrict access to midstream infrastructure in order to benefit their own upstream or downstream businesses. Because of this natural tendency, countries seeking to liberalise their natural gas markets often require these vertically integrated companies to separate—or unbundle—midstream assets into autonomous businesses. Unbundling has taken various forms. While countries like the United Kingdom and The Netherlands have achieved full ownership unbundling, others like the United States, Germany and France have chosen to stop one step short, at structural unbundling. The experience of these latter countries indicates that full ownership unbundling is not required, and that structural unbundling under a strong regulator can capture many of the benefits of full ownership unbundling.

Finally, with respect to the downstream segment, our study examines the development of competitive natural gas wholesale markets and the establishment of natural gas hubs. Wholesale markets connect upstream sellers and retail buyers and establish a basic price point for natural gas in a country or region. Regulatory efforts here have often strived to encourage the development of natural gas hubs, national or regional centres that ease transactions between buyers and sellers. Hubs can push natural gas pricing away from oil-indexed contracts, creating a more competitive pricing mechanism that is based on the value of natural gas and is more responsive to changes in market conditions.

Successful hubs enable competitive pricing of natural gas, more efficient market co-ordination and increased market transparency, with consumers and end users benefiting from the more efficient pricing of gas. By reflecting the true cost and value of natural gas in the economy, hub pricing also ensures that trade and investment decisions are made on the basis of economic benefits and efficiency. Hubs also create powerful and self-reinforcing network effects, which help to lower transaction costs and increase competition in wholesale gas markets. Finally, a hub also supports energy security objectives by supporting the diversification of sources of supply. Diversified and liquid hubs are better able to respond to changes in demand compared to the inflexibility of long-term contracts, for example by procuring LNG cargoes on the spot market during peak demand periods.

4 Natural Gas Energy Security and Social Influence

As global energy demand has grown, so has policy-maker interest in the security of energy supply. Until recently, concerns about energy security centred mostly on safeguarding oil supplies, but as the global energy mix has diversified, the scope of energy security has broadened as well. Our study finds that while there are a wide range of approaches that a country can use to achieve energy security, they can be distilled down to three critical aspects of the supply chain: sources, infrastructure and institutions. Combining imports, domestic supplies and access to alternative fuels results in a diversified supply with readily available fuel substitutes. Ensuring the quantity and quality of physical assets such as storage facilities, pipelines and LNG terminals means that sources of supply can be accessed reliably. Finally, proper market and political organisations, as well as underlying incentives, are necessary along the supply chain in order to develop these sources and infrastructure.

Assessing China against this framework, our study finds that the country is in a good position with respect to natural gas energy security. In terms of sources, rising LNG trade, future pipeline imports and significant availability of alternative fuels provide a diversified source of supply compared to other large natural gas-consuming countries and regions such as Japan, South Korea and the European Union. Rapid infrastructure development has meant that China has capacity (especially storage) to match the levels of other major gas-consuming countries.

Since China became a net importer of natural gas in 2007, import sources have rapidly diversified. Figure 16.1 shows, compared to the EU, Japan, and Korea, China’s rapid increase in the diversification of its natural gas imports, thereby increasing its energy security. In 2007, China’s only import source was Turkmenistan. The Herfindahl Index was 1. Following the development of LNG trade, China’s import sources have diversified rapidly, and its Herfindahl Index has correspondingly dropped. Today, China’s natural gas import diversification is comparable to that of the EU. In 2010, it was even comparable to nations with the most diversified sources of natural gas—Japan and Korea.

Fig. 16.1
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China’s natural gas import diversification. Source Vivid Economics, based on EIA data

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Compared to nations with high natural gas energy ratios that rely more on natural gas imports, China’s imports are more diversified. China, the EU, Japan, Korea, and Turkey are the top five importers of natural gas. These five nations have very diversified sources for their imports, and their Herfindahl Indexes are all very low. However, as shown in Fig. 16.2, compared to other countries, China’s natural gas energy ratio is lower, and its reliance on natural gas imports is lower. In fact, other nations do not have the import diversification that China enjoys, and their reliance on imports and on natural gas is significant. However, these nations rarely face major natural gas security issues, which indicates that China could safely raise the proportion of natural gas in its energy mix as well as its proportion of natural gas imports.

Fig. 16.2
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China’s import security as compared to major nations. Source Vivid Economics, based on IEA and EIA data; natural gas proportions are from 2011, with remaining data from 2013

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LNG enables not only China but also the entire world to achieve greater supply diversification. From 2003 to 2013, global LNG trade doubled, with a huge influx of new buyers and sellers. Figure 16.3 shows Japan’s LNG trade network. Japan’s LNG sources are in the inner circle, while the outer circle shows other countries that Japan’s import sources supply. The arrows show LNG trade direction. The coloured arrows indicate how reliant each exporting nation is on Japan. Red arrows show relatively high reliance on Japan and yellow arrows show low reliance. In 2003, there were relatively few nations supplying LNG to Japan, and Japan was one of the few consuming nations. By 2013, Japan had added more nations from which it imported LNG, diversifying its import sources. Moreover, these exporting nations had grown their client base since 2003, though many still relied heavily on Japan for their LNG sales.

Fig. 16.3
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Japan’s LNG supply sources are diversified. Source Vivid Economics, based on IEA data

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Figure 16.4 shows China’s natural gas trading network in 2013. In addition to LNG trade during this period, there was also one Turkmenistan natural gas pipeline. Compared to other nations, China’s imports of LNG were more diversified. However, compared to Japan in 2013, there is a marked difference. For exporting nations, Japan is a more important export destination.

Fig. 16.4
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Sources of China’s natural gas. Source Vivid Economics, based on IEA data

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In the future, new pipeline natural gas will improve the security of natural gas for China. Figure 16.4 shows that currently China’s pipeline trading has negotiating power. Turkmenistan has only Kazakhstan and Iran as its other export options. China, on the other hand, also plans to engage in pipeline trade with Uzbekistan, Kazakhstan and Myanmar (the options for these countries are limited as regards pipeline destinations) as well as Russia (East-West Siberian oil and gas field natural gas export destinations are limited). Therefore, even though Japan’s LNG supply is more diversified, China (leaving LNG to one side) still has the option to use pipeline natural gas and can also engage in domestic production. This means that China does not need to have a strong relationship with natural gas-exporting nations as Japan does, but can instead use natural gas hubs to make exporting nations compete with one another.

Domestic natural gas production can greatly improve China’s natural gas security. Domestic production is a reliable option to replace imports, and can improve negotiating power. China’s domestic production has great potential, and features some of the world’s major unconventional natural gas reserves. However, current production levels are low, and future production remains uncertain. This uncertainty is a key factor in China’s natural gas security, since international experience shows that natural gas security of producing nations is entirely different.

There is a close relationship between natural gas market liberalisation and whether a nation has domestic production. Nations without domestic production such as Japan and Germany and nations with large volumes of domestic production such as the United Kingdom and United Sates prove this point. For example, Japan’s market is more co-ordinated and there are large companies with bargaining power with exporting nations. However, the United States and United Kingdom have more open markets and their competitive pressures stimulate more domestic production. Another factor is that domestic production improves bargaining power with exporting nations, since when import supply is cut off, the nation has a reliable substitute source. Figure 16.5 illustrates the consistent relationship between domestic production and market liberalisation.

Fig. 16.5
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Time points when major nations promoted market liberalisation reforms

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Currently, China’s natural gas market is a co-ordinated one. However, there is still major potential to develop domestic production. International experience has shown that further deepening of market liberalisation will increase domestic production, which then improves natural gas supply security. This would compensate for any reduction in bargaining power that might arise from moving away from the current co-ordinated market system. Therefore, out of consideration for energy security, China could strive to increase domestic production, and market liberalisation is one means to stimulate domestic production.

China has another abundant substitute for natural gas that can further improve source security. Natural gas can be used for power generation and supply of heating—and these are energy services that China’s abundant coal or renewable energies can provide. To a lesser extent, natural gas is also used for transport, where oil products can potentially be substituted. if the natural gas supply were disrupted, switching over to other fuels could limit the negative repercussions. However, using other fuels requires a variety of technologies, not all of which are available to consumers, such as being able to switch smoothly from natural gas to fuel oil or other sources for heating. Moreover, using coal and petroleum as substitutes will have a greater impact on the environment and climate. For these two reasons, the priority should be to improve energy security through domestic production and diversification of imports.

China has the world’s sixth-largest natural gas import capacity, and through the West-East pipeline it also has major pipeline import capabilities. This infrastructure was developed after 2005, and China is continuing to develop its infrastructure, with plans for major expansions in the future. Current plans indicate that by 2020, China will have increased its pipeline import capacity by 114 billion m3 over 2012, with 40 billion m3 of LNG import capacity, which is forecast to satisfy planned natural gas import demand.

In terms of reserves, China’s reserve volume is on par with other major natural gas-consuming nations. For example, in 2014 storage facility construction brought consumption reserve volume on a par with Japan, as shown in Fig. 16.6. In 2020 it is planned that reserve capacity will increase, even if demand grows as expected, to the highest level worldwide, the level currently held by Europe.

Fig. 16.6
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Gas reserve volume as a proportion of consumption, showing planned increase for China. Note 2013 China data includes the 10.7 billion m3 of China National Petroleum Corporation Hutubi. Source Vivid Economics, based on IEA data

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Based on international experience, a lack of infrastructure, maintenance and prompt post-incident repairs are the main reasons for natural gas supply cut-offs. Moreover, in many nations, these problems are often overlooked, viewed as operational issues rather than policy issues. As China’s natural gas industry develops, continued investment in infrastructure and the establishment of sufficient and reliable accompanying technologies and incentive measures will be especially important.