Stages of big way

Russia needs a national model of the gas market

May 16, 2012, prepared by Nikolai Khrenkov
and published in corporate Gazprom Magazine Issue 4

In November 2011 and April 2012 federal authorities adopted several regulatory documents that gave the green light for gas trade at commodity exchanges and trading systems, though leaving undecided some issues concerning its rational organization. At the same time, adopting a clear-cut strategy on the government level, that would envisage a whole range of measures for the staged implementation of market relations in the gas sector, remains a problem to be solved.

Today, taking steps in this direction are the experts from Gazprom’s Gas and Liquid Hydrocarbons Marketing and Processing Department and the Directorate for Electronic Forms of Gas Trading of Gazprom Mezhregiongaz. Their task is to form a model of the future Russian gas market considering both the foreign experience and specific features of our country and to ready proposals for improving laws and regulations and introducing the means to facilitate the implementation of this model. Though even now, despite the existing differences in opinions, the Russian Government, Gazprom and the expert community have an approximate understanding of what the stages of the big way towards a gas market should be.

Drivers of commerce

The first stage is to launch electronic and exchange trading in gas. It should be implemented with regard to the two regulatory documents already adopted: the Federal Law on Organized Trades and the Russian Federation Government Decree On Natural Gas Trading at Commodity Exchanges <...> No.323 of April 16, which allowed Gazprom to sell up to 15 billion cubic meters of gas in 2012 and up to 17.5 billion cubic meters starting with 2013.

Producers and consumers of the blue fuel have waited for such documents for more than expected hoping these would enable to resume spot sales through the Gazprom Mezhregiongaz Electronic Trading Platform (ETP). As is known, it is the only trading system in our country that has the experience of physical gas sales at free market prices. For more than two years of the ETP operation, trade there strictly followed the market logic: prices were fixed by sellers and purchasers: when demand was low they dropped, and when it was high – they increased.

Unfortunately, the adopted Decree has left the platform (which has no commodity exchange license) out of the bounds of market gas trade, which will take commodity exchanges additional time and efforts to acquire a unique ETP experience. As the foreign experience shows, specific features of gas trade presuppose not only the existence of commodity exchanges in the market structure, but also specific trading platforms technologically connected with a gas transmission system operator. It provides the trading participants with the information on free gas resources and their pegging to pipe inlets. Meanwhile, the trading itself is coordinated with gas transmission facilities (see corporate Gazprom Magazine Issue 11, 2011). Thus, the model of exchange trading in gas, being created at the moment, will demand additional amendments from the Government.

Russian price

The second milestone should be abandoning of the government regulation of prices on gas produced by Gazprom and its affiliated companies (preserving the government-regulated reduced charges for the population). This milestone has been fixed in the Russian Federation Government Decree No.1205 adopted in late 2010. In accordance with this Decree, the period between 2011 and 2014 is regarded as a transition period when Gazprom gas wholesale price is adjusted according to the price formula, which envisages gradual arrival at equal profitability from gas supplies to both the foreign and domestic markets and considers alternative fuel prices. In addition, until January 1, 2015 the price formula will include decreasing coefficients, that is, Gazprom will sell gas on the discount determined by the Federal Antimonopoly Service.

One of the main aims of creating the market is deregulated pricing, not the gas price increase to a certain level.

Another important section of this document stipulates that by July 1, 2014 the Government should be provided with proposals on transition (starting with January 1, 2015) from government regulation of wholesale gas prices to government regulation of gas transmission through gas trunklines in Russia. In other words, by the above mentioned date the government will have introduced deregulated gas pricing in the gas market. However, there are certain apprehensions that Decree No.1205 (with the scheme stated in it to take effect only in 2013) may be amended, especially the part concerning the arrival at equal profitability by 2015. In particular, in autumn 2011, Sergey Novikov, Head of the Federal Tariff Service said that this event might take place between 2015 and 2018.

Be it this way or another, in any case, it is not the reason for refusing another section of the Decree and preserving wholesale government regulation after 2015. One of the main aims of creating the market is deregulated pricing, not the gas price increase to a certain level. The thing is that the price formula aimed at equal profitability is the only market benchmark for the natural gas price in Russia today. But gradually, with the elaboration of market regulation means, coupled with efficient methods of government regulation, they will enable to set up an advanced system of price indication. In future, this will lead to forming a domestic gas price that will depend not so much on foreign oil prices, as on the Russian market operators. It will be based on national interfuel competition, when a consumer estimating his fuel costs will look up to prices of different energy sources specifically in his region.

Thus, after deregulation, domestic gas pricing will depend on Russian consumers’ purchasing power. This aspect is probably the most important one for the Russian national gas market creation. It should be kept in mind that natural gas consumption volume in our country alone is comparable to that of all the countries of the European Union together. That is why it is only logical and reasonable that market prices for gas inside Russia should be formed on the basis of domestic supply and demand, as the case is in the USA at the moment.

Entrance – exit

But to arrive at such a result, the third milestone should be completed, namely the creation of a gas capacity market. It should be mentioned at once that unlike the first two milestones, for which the regulatory base is under formation already, in regard to the gas capacity market all rulemaking for now is limited to providing independent gas producers with access to Gazprom’s gas transmission system capacities. In other words, the situation is treated in a very simplified way, that is, the more non-Gazprom gas there is in a pipe, the higher competition is, which is better both for the market as a whole and for every consumer in particular. But in reality, it is better only for independent producers themselves, since it makes it possible for them to increase profit, and with the access to the pipe their current situation is not bad at all – their gas volumes allowed for transmission annually grow. Moreover, 2010 saw the Russian Federation Government Decree No.872, which stipulates that Gazprom should provide independent producers with full and detailed information on the availability of free capacities in the gas transmission system.

But for all that, about a half of the gas sold by independent producers account only for four regions located not far from main production sites. As for southern and western regions of Russia, independent producers don’t supply them with gas due to the existing system of cross-subsidization, when the wholesale gas price in a certain Russian Federation constituent doesn’t match the actual price of gas supply to this region via the gas trunkline system.

That is why it would be logical to start the creation of the capacity market with stopping regional cross-subsidization and switching from government regulation of gas prices to gas transmission tariffs regulation as a kind of a monopoly activity. At present, this tariff is prescribed only for independent producers, but it should also be extended to Gazprom. Such measures will make it possible to create equal competitive positions for Gazprom and independent gas producers within the UGSS.

The next important step is the legislative change of Gazprom’s status. In accordance with the Law on Gas Supplies, Gazprom is responsible for uninterrupted and failsafe gas supply to Russian consumers. It gives additional preferences to independent producers, because whatever may threaten their gas supplies, Gazprom will always cover the shortfall from its own resources. But such a situation is not acceptable for market relations – gas sellers should be responsible for gas supplies in the frame of contract relations. Gazprom, being the owner of the gas transmission system, should only act as a guarantor of uninterrupted and failsafe delivery of gas volumes stated in the contract to the ultimate consumer.

Another important aspect consists in modifying the system of tariffs for gas transmission via gas trunklines. The existing system suggests the application of two tariffs – ‘for use’ and ‘for delivery’. The tariff ‘for use’ is determined on the basis of the tariff table for the ‘entrance area – exit area’ pair. The calculation of the tariff ‘for delivery’ demands determining the route for gas transmission starting with the given entry point up to the exit point, which serves as a basis for calculating the length of the transmission route and the price of the product delivery service.

Natural gas consumption volume in Russia alone is comparable to that of all the countries of the European Union together. That is why it is only logical and reasonable that market prices for gas inside Russia should be formed on the basis of domestic supply and demand, as the case is in the USA at the moment.

International experience has proven that in market conditions this scheme should operate in a different way, namely through the application of separate tariffs for entry and exit points. Such a model reflects the essence of gas transmission via the gas transmission system in the most reasonable way, because in reality it is impossible to trace the way of gas from a certain supplier to a certain consumer.

Capacity trade

Then, the pool of members should be formed: it will include gas producers, large industrial consumers, traders and regional suppliers, which will conclude a contract with the gas transmission system owner for purchasing the capacity at the gas transmission system ‘entrance’ and ‘exit’. Capacity purchase means acquiring the right to inject or withdraw gas into/from the gas transmission system. Moreover, these members may purchase the capacity both at the ‘entrance’ and ‘exit’ points if desired.

After that, they conclude gas purchase/sale contracts among themselves. Exchanges or brokerage offices which find partners themselves and guarantee their economic diligence, may serve as floors for contracts conclusion. As for the trade itself, that is gas purchasing/selling, or to be even more specific, the title to gas is transferred within the gas transmission system at a virtual gas balancing point which has no geographical reference to any physical point of the gas transmission system. In other words, gas trade is traded ‘within the system’.

Therefore, any prospective purchaser may see the gas price ‘within the system’ at the moment in the on-line mode. He purchases the needed gas volumes either by himself or through a broker, having purchased the capacity at its exit point beforehand, or in other words having a prepaid opportunity of receiving this gas volume at his own gas distribution station with a gas distribution pipeline laid directly to his facilities. However, the customer may purchase gas at a lower price at a wellsite, but in this case to receive gas at his gas distribution station he has to purchase beforehand not only the capacity at the exit point, but also at the entry point. The customer may also purchase gas outside the gas transmission system, that is, at the gas distribution station. In this case, the issue of capacity purchase is handled by the producer or trader who includes its price into the gas price for consumers.

There is another crucial issue – as large regional consumers may purchase gas from different suppliers, at some point the issue of balance closing presents itself, that is determining the actual volume of fuel consumed with the account of all suppliers and consumers of the given region. To fulfill this function it would be reasonable to establish the institute of regional suppliers which provide gas supplies within this or that territory. Moreover, they will also be tasked to supply gas to small-scale consumers and population who do not have an opportunity to buy capacities and gas directly from the gas transmission system owner and the gas producer. As this kind of activity is apparently monopolistic, the price for regional suppliers’ services should be regulated by the government in about the same way as it is now with regional gas selling companies, for which the regulatory authorities fix payments for distribution and logistical support services.

The regional supplier in this case plays two roles – it purchases gas for small-scale consumers in the wholesale market and acts as agent of large-scale suppliers that purchase gas in the wholesale market by themselves.

Finally, one more element is necessary, that is the functioning of a commercial gas balancing system, which will enable to avoid the risks connected with incomplete or, vice versa, excessive volumes of gas offtaken by a consumer under the relevant contract and in cases when the supplier for some reason cannot provide the consumer with the volume of gas stated in the contract. We have already written about this system, which is currently being elaborated by Gazprom, in Issue 3, 2011. We’ll just note that its key element will be the operation of physical gas trading systems, which in the conditions of a sound gas market will serve as means of spot trade, price indication and commercial balancing. That is why commissioning of these platforms as soon as possible is currently the gas sector’s top-priority goal, which will enable to implement the first stage of its large-scale transition to market trade.

Meanwhile, steps should be taken concerning the transition from government regulation of wholesale gas prices to the regulation of gas transmission tariffs and, finally, developing a necessary regulatory base for the capacity market formation. Gradual and staged implementation of these steps will allow Russia to form its own gas market model to satisfy consumer needs and provide sufficient investments into the gas industry development.