With adversity comes opportunity. The global gas crunch has hurt countries around the world but has also made them appreciate their common concerns. That has provoked policy-makers to take a serious look at current and future energy security policies. In the EU the competitive gas markets, enabled by short-term spot markets, has reminded us of the value of long-term contracts when prices are volatile and rising. Meanwhile, China’s state-controlled prices have protected households from the most painful price increases, but continues to work against the introduction of renewables when they can undercut fossil prices. Caspian Conran at Baringa explains how the two regions can learn lessons from each other to come up with optimal energy security policies for when the gas supplies get back to matching demand, probably around 2025. Growth in U.S. shale gas exports will meet most of that global demand growth, though whoever is president then (gulp!) will need to enforce the emissions transparency rules currently on the table to prevent the serious problem of methane leakage. Conran goes into the similarities and differences between the EU and China’s energy security concerns, noting that the fundamentals are here to stay: global trade in gas, and the growth of renewables.
Recent years have demonstrated the interconnectedness of the global economy and the symmetry of shocks faced by both the EU and China. The challenge posed by the global pandemic has presented both regions with both medical and economic crises. More recently, both parties have faced a natural gas supply crunch, underlining what they have in common when it comes to their energy goals.
The shortage of natural gas globally has driven unprecedented increases in wholesale gas prices, bringing into focus not just the increasing integration of gas markets globally but also the commonality in national risks, and by extension policy goals, in the EU and China.
The issue of energy security is of central importance to both China and the EU. Both are increasingly dependent on imports of natural gas to secure their energy needs. EU gas imports stood at 80% of consumption in 2020 as domestic production declined, most notably in onshore Dutch production. Similarly, China’s import exposure, whilst slightly lower at 40%, continues to rise in line with increasing energy demand which is powered by strong economic growth and the switch from coal to gas. This is expected to continue as China looks to meet its NDC for coal use to peak by 2030.
Common areas: 3 categories
In response to this common challenge, both China and the EU can point to common areas where cooperation and dialogue could prove mutually advantageous.
These fall into three categories:
- Global LNG capacity and gas transparency.
- Price resilience – contract design and procurement.
- Renewable energy deployment and market design.
Global LNG capacity and gas transparency
Demand is expected to continue to outstrip the annual capacity of LNG growth for many years to come. This will contribute to a tight market up until 2025. However, anticipated capacity increases will exceed annual demand increases post 2025, when the gas market will loosen.
Baringa’s analysis of future LNG projects shows that around 70% of additional capacity post-2025 will come from the US. Biden’s target for a zero carbon power generation sector by 2035 is expected to create a huge surplus of domestically-produced gas. Much of this capacity resides within crucial swing states in the US, where previous Republican presidential candidates have made political traction from weaponising Democrat incumbents’ decarbonisation agendas, which they describe as ‘a war on jobs’. To manage this political risk from the decarbonisation of power generation, a policy pivot to export offers a natural solution. This additional US capacity would provide extra liquidity to global markets, providing both depth and alternative supply sources for both EU and China LNG consumers.
…U.S. Shale emissions
A common challenge raised by US shale has been the lifecycle emissions of the gas. The gas extraction process, as well as gasification, transport, and liquefaction steps, significantly increase the emissions impact of US shale gas. This is driven primarily by methane leakage at each stage which is 80 times more potent than CO2. This has undermined the willingness of consumers to use US gas, given the potential environmental implications. Notably, the Irish government has banned imports of fracked gas due to these emissions concerns.
In order to allay these concerns, cooperation between China and the EU to develop transparency requirements for global gas could raise consumer confidence over the lifecycle impact of shale gas emissions. In addition, greater transparency is likely to create competitive incentives for shale producers to work to reduce emissions.
Political players have also started to act to legitimise the role of shale gas. Recent commitments on methane emissions from Biden at COP26, most notably a target to reduce methane emissions by 30% by 2030, has the capacity to improve the image of US shale gas. After a series of rollbacks of regulations on methane venting, flaring and leakage from the Trump administration, Biden era targets provide the opportunity to incorporate US LNG into the global LNG market.
Recent deals between China and US LNG exporter Venture Global LNG for 4 million tonnes of LNG per year underline the potential for US LNG to deliver additional supply to a tight market.
Price resilience – contract design and procurement
The balance between the security of supply and cost is borne out in the design of contracts for natural gas imports. Here, recent events have highlighted the potential volatility of a liberalised spot market-based design, relative to a market dominated by long-term contracts. Finding the right balance is an area of common interest.
European markets have predominantly embraced decentralised and liberalised markets, with prices being set by gas on gas competition in spot and futures markets. As a consequence, European consumers have benefited in recent years when wholesale prices are low, acting as a swing market for excess global supply. However, exposure to spot prices when they are high has a corresponding negative outcome; making Europe much more vulnerable to the price shock of recent months.
In contrast, China’s preference for long-dated contracts has insulated Chinese consumers from the price shock to a greater extent than consumers in Europe. For example, around 80% of Chinese contracts were long-dated as of 2018. With European capitals such as Madrid calling for changes in European procurement, this may represent a valuable knowledge sharing opportunity for the two parties, allowing them to review and discuss the impact of their different models and perspectives.
Alternatives such as fixed volume but flexible price contracts could provide a ‘third way’ between the two market designs.
Renewable energy deployment and market design
The renewable energy revolution offers the opportunity to harness national renewable resources without relying on imports. Indeed, the development of the post-fossil economy redefines not just the domestic energy system but also national external relations and the geopolitical environment more generally.
However, as renewable production increases to take a greater share of the energy mix, additional flexibility in grid management is required in order to manage the variability in renewable output. In addition, the prospect of significantly reduced marginal costs from renewables increases the efficiency advantages of market-based dispatch, with lower price sources being prioritised in merit order.
The current market design of the Chinese power market limits the deployment of renewables at scale. Supply and demand are managed by means of state dispatch, with industries being offered set supply requirements at a standardised price. These terms favour base-load power technologies which can provide predictable capacity, as opposed to more volatile generation from renewables. Flexibility is provided by some ancillary markets, with power companies paid to provide usable ramp-up capacity to meet changes in demand.
As renewable energy production increases, greater flexibility is required in order to match supply and demand. China is currently trialling eight spot markets which allow for market-based dispatch. Leveraging price signals allows for a market-based allocation of supply to meet power demand, incentivising flexible dispatch from generators and rewarding the lowest cost technologies.
Embracing a liberalised market approach does come with some disadvantages for China. Specifically, liberalising prices removes certain levers which Chinese authorities have traditionally used to achieve specific economic and social goals. Namely, price setting has allowed authorities to subsidise commercial activities and to encourage social stability through energy bill management for households. Nevertheless, the gains from liberalisation are expected to outweigh these disadvantages.
The European experience offers opportunities for valuable dialogue. Power markets in the EU are liberalised, with most countries offering long term capacity markets, day ahead markets and balancing intraday markets to manage supply and demand based on price signals. In addition, the depth of liquidity has been increased by means of an active policy of developing interconnectors between the national power grids of member states.
China’s authorities have also signalled the existence of these twin goals, both to develop market-based dispatch through price liberalisation and greater liquidity in markets by integrating regional power markets through transnational power exchanges. The integration of renewable resources into the energy mix offers the palpable benefit of bolstering energy security by reducing national exposure to fossil fuel imports. However, these goals demand challenging market reforms. The opportunity to learn from the European experience may provide opportunities to smooth China’s transition to a liberalised power market.
2021 highlighted the challenge of energy security in both China and the EU, as global shortages of natural gas drove wholesale prices to record highs. This common challenge creates shared opportunities for dialogue and cooperation.
Increasing the global capacity of LNG can be aided by supporting efforts to incorporate fracked gas into the global energy system through the use of emissions disclosures. With China and the EU taking differing approaches to gas procurement, the right balance between long-dated contracts, which prioritise supply security, and spot market exposure, which prioritises price advantages, is a natural area of dialogue after this year’s price shock. Finally, energy security incentivises renewable energy deployment. However, this will require market design changes in China, where valuable insights could be garnered from the European experience.
This article was first published in the EU-China Energy Magazine – 2021 Christmas Double Issue, available in English and Chinese, and is published here with permission