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Economics of Natural Gas Supply Diversification for EU

Policy Pulse – 28 March 2022 – Veritas Global

Photo by Darya Jum on Unsplash


Key messages

  • Expanding Caspian natural gas pipeline supply will greatly benefit EU’s energy security in the 2030-time horizon and beyond

  • Had the White Stream project been realized, it would have brought more Caspian gas to EU, generating savings of between €24 bn to €48 bn in 2021 for natural gas users in EU

  • Increasing capacity of natural gas supply to EU will improve price stability

  • Support for receiving more LNG and development of new pipelines are mutually reinforcing policy measures that advance consumer interest

  • EU can continue to use natural gas indefinitely while cost-effectively meeting its 2050 net carbon neutrality target

Background and context


On 8 March 2022 the European Commission proposed measures for addressing EU’s energy insecurity. The proposal identified diversification of supply as one of the key levers for addressing EU energy security. Specifically, the proposal looks to increase supply of non-Russian natural gas by sourcing more Liquefied Natural Gas (LNG) and increasing imports of pipeline natural gas. Other measures covered by the proposal include reducing demand for natural gas through developing renewable substitutes, including hydrogen produced from renewable energy sources.


The European Commission proposal outlines in detail immediate measures that can be taken to reduce EU’s dependence on Russian natural gas. However, for the 2030-time horizon the proposal simply extrapolates the current measures. In our view, there is an opportunity to improve EU’s energy security over the 2030-time horizon and beyond through focusing on increasing the capacity of new pipelines.


Our previously published analysis “Caspian Gas Is Key to EU Supply Diversification” highlighted that enhancing access to Caspian and Central Asian natural gas is the best option for EU supply diversification. Caspian gas is a critically needed supplement to EU’s hydrogen strategy. The hydrogen strategy is an ambitious program for long-term decarbonization, but it does little to address EU’s energy security needs over the next two to three decades.


This policy brief explains how the full operationalization of the White Stream project, which would bring natural gas from the Caspian to EU, can contribute to price stability for European consumers. Furthermore, this brief explains how development of new natural gas pipelines and support for new LNG supply are mutually reinforcing policies. The brief also highlights that continued use of natural gas can be fully compatible with EU’s 2050 net carbon neutrality target.


Increasing capacity of natural gas supply to EU will improve price stability


As shown in Table 1, if the White Stream project had been implemented, there would have been an increase in supply of 5.8% in the European market which would have resulted in a 24% decrease in the wholesale price of natural gas. On aggregate, this would have generated savings for users in the European Union of between €24 bn to €48 bn in 2021.


Table 1: Savings to EU consumers in 2021 if White Stream had been implemented


The White Stream project, if fully operationalized, would bring 32 billion cubic meters (bcm) of natural gas from the Caspian to the European Union, which is the equivalent of about 5.8% of total natural gas consumption across Europe in 2021.


On aggregate, demand for natural gas is inelastic, meaning a large change in price is needed to produce a small change in quantity consumed. Short-term price elasticity of demand is estimated at - 0.24, which means that a 10% increase in price reduces demand by about 2.4%. In the absence of an estimate for short-term price elasticity of supply, this value for price elasticity of demand is assumed to be a reasonable proxy.


Using this short-term price elasticity, would mean that a 5.8% increase in supply would translate to a 24% decrease in the price, which if applied to the total natural gas spending by consumers would translate to savings to natural gas users in EU of about €48 billion in 2021. A more conservative approach for estimating the potential savings would be to calculate impacts only against the price increase since 2019, which we estimate at about €100 billion in the wholesale market. Using this more conservative approach would imply savings to natural gas users in EU of about €24 billion in 2021. While each approach has its merits, the range offers the most relevant reference point for policy makers.


A crucial point to realize is that the benefits of lower gas prices accumulate downstream and eventually are passed on to consumers. Given the structure of the gas market, these benefits are not captured by natural gas suppliers. In effect, the benefits of lower prices are transferred from current suppliers to consumers. This characteristic of the gas market means that existing suppliers of natural gas are incentivized to discourage entry of new suppliers. Given these features, there is a strong case for public sector intervention in facilitating new entry and development of diversified supply infrastructure.


Support for new LNG and development of new pipelines are mutually reinforcing policy measures that advance consumer interest


In our view, there is an opportunity to improve EU’s energy security over the 2030-time horizon and beyond by focusing more on increasing the capacity of new pipelines bringing gas from the Caspian. According to the European Commission, about 80% (or 50 bcm per year) of the natural gas supply diversification is planned to come from increasing LNG supply. The remaining 20% (10 bcm per year), is planned to come from new gas transported by pipelines. While this approach may be appropriate for the short-term, it is not appropriate for the medium term. Priority should be given to developing new natural gas pipelines.


Natural gas production cost modeling for the European market, commissioned by the UK Department for Business, Energy & Industrial Strategy, identified a cost advantage of new pipeline gas projects over new LNG supply (See Figure 1). The production cost curve presented in Figure 1, identifies different sources of natural gas that could be supplied to the European market. The height of each bar corresponds to the cost of supplying the natural gas from a particular source to the European market whereas the width of the bar corresponds to the estimated volume that could be delivered per year from the identified source. Caspian gas offers a cost competitive option for supplying the European market and could deliver over 50 bcm per year.


Figure 1:

Base Case Gas Supply Cost Curve – 2035 (2015 prices)

Source: Fossil Fuel Supply Curves, Report of the UK Department for Business, Energy & Industrial Strategy, May 2016, prepared by Wood Mackenzie Ltd.


The impact of increasing access to new LNG compared to increasing new sources of piped gas has different consequences for the natural gas supply curve. The impacts from these mutually reinforcing measures would further European consumer interests.


Policy support that is targeted at increasing access to future LNG projects will flatten the slope on the tip (right-hand side) of the natural gas supply curve (see image I in Figure 2 below). The reason is because the vast majority of future LNG potential is on the right-hand side of the production cost curve, therefore, the supply response will largely impact this segment.


However, increasing support for gas from new (future) pipelines will shift the entire supply curve to the right. The shift will be less pronounced on the left-hand side of the supply curve and more pronounced in the middle (see image II in Figure 2 below). The scale and segment of the shift in the supply curve is presented in proportion to opportunities identified in the production cost curve from future piped gas.


If the two measures are pursued in parallel, the cumulative impact will be both a flattening of the slope of the tip of the supply curve and a shift in the supply curve. Basically, the sum of the two effects (see image III in Figure 2 below).


Figure 2:

Impact of policy support for new LNG and new pipes on natural gas supply curve


Box 1: The Geographic Market – Is it Just Europe or Europe and Asia?

A relevant technical point to note, is that this analysis is done using the assumption that the geographic market for natural gas is Europe. However, some analysts consider that the relevant geographic market is broader and should encompass both Europe and Asia, as the two regions are linked indirectly through LNG trade. In fact, the price correlation across leading European and Asian benchmarks increased to 0.93 in 2021 compared to below 0.8 in 2019. Nevertheless, a correlation in spot prices across LNG products should not necessarily be interpreted as the existence of a single geographic market.


However, even if a broader geographic market definition is applied, that encompasses both Europe and Asia, the scale of the benefits estimated in the analysis from adding additional capacity would not change. Although, the benefits would be distributed more widely, accruing to both European and Asian consumers in the broader Europe-Asia natural gas geographic market. The addition of 32 bcm in 2021 would have increased supply in the broader Europe-Asia geographic market by about 2.2%. If the same price elasticity assumptions are used, this increase of supply would correspond to a decrease in prices by 9.2%. The benefits to consumers in 2021 would still have been in the range of €24 bn to €48 bn but these saving would be distributed more widely across the broader Europe-Asia geographic market.


Even under the broader geographic market definition, there are compelling reasons why Europe would find it in its interest to secure higher volumes of natural gas supply from the Caspian. The lower production cost of Caspian gas makes it possible for Europe to potentially lock in supply at a lower rate than offered through new LNG projects. Piped Caspian gas also offers the possibility to have certainty of supply and reduce over reliance on new LNG capacity, access to which depends on continuously outbidding Asia. Furthermore, enhanced access to piped gas from the Caspian will help reduce exposure of Europe against supply disruptions in natural gas markets.

EU can continue to use natural gas indefinitely while cost-effectively meeting its 2050 carbon neutrality target


Carbon capture and storage technology offers a technically viable solution for capturing nearly all carbon dioxide emissions that result from the combustion of natural gas. Currently, this method is not economically attractive as it is cost prohibitive. However, with research, development, learning, and accommodative polices, carbon capture and storage technology has the potential to become commercially viable.


In the meantime, there are vast pools of cost-effective emission reduction opportunities in developing countries. The newly agreed rules at UNFCCC COP 26 for international collaboration under the Paris Agreement (also known as Article 6 of the Paris Agreement) offer an unparalleled opportunity for delivering the best greenhouse gas emission reductions, which can be used to offset emissions from using natural gas.


But capturing “tailpipe” emissions and offsetting are not the only options. The rapid progress in recent years in direct air carbon capture processes and technology has the potential to be truly transformational. Based on our forthcoming assessment, which is in the process of being peer reviewed, our estimate is that certain companies, through leveraging existing mature technology and process innovation, have achieved the ability to capture carbon directly from the air at a cost of between US$90 to US$130 per metric ton of carbon dioxide. While this is much more expensive than the abatement opportunities available in developing countries, it is comparable to the current price point of carbon emission permits in EU. The significance of this development is that direct air carbon capture conceptually offers endless opportunities for emission reductions at the same carbon price. In effect, this technology puts a price ceiling on reducing carbon emissions.


Whether it is through carbon capture and storage, carbon offsets, or direct air carbon capture processes, there are many options available for neutralizing greenhouse gas emissions. EU can continue to use natural gas indefinitely and still meet its 2050 carbon neutrality target without incurring huge costs. Natural gas plays an important role in enabling greater renewable energy deployment by offering a viable solution for balancing capacity to manage fluctuations in renewable energy supply. Except for nuclear power, electricity generated through natural gas currently offers the most viable and low-carbon alternative to coal-based power as a solution for intermittency.


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