Introduction – V4 as a regional integrator
Traditional structure of V4 (and Central European in general) gas markets is changing rapidly in past decade. There are two main drivers of that: Russian diversification policy, concentrated on bypassing Ukraine and accessing Western European markets directly, and, partially motivated by Russian pressure, market dominance and conflicts with Ukraine, CEE market integration basing on North-South gas corridor.
Considering this two factors is seems that at least two additional players should be included in V4 integration analysis to understand why V4 members interests differ too much to use it as a base for gas market integration, and that players are Austria and Ukraine. Additionally, historical gas grid framework, namely Brotherhood/Progress transmission system should be included as a natural base for any further development and market integration as it offers the largest capacity already in place.
V4 members division is based on interpretation of Russian diversification policy and profit sharing from its realisation.
- Slovakia, historically the most important part of Russian natural gas transit system, is threaten to lose this status as a result of Nord Stream II construction and deepen cooperation between Czechia and Austria, that could deprive its TSO from most of transit revenues, leaving it only with local consumption and part of Ukrainian imports.
- Czechia benefited largely from Nord Stream I, OPAL and Gazelle construction that added transit capacity to Net4Gas system and allowed to bypass Ukraine and Slovakia on the way to NCG market and southern Europe. Nord Stream II could bring even more profits, as it would make Czechia one most important transit countries for Russian natural gas – position currently held by Slovakia. As Nord Stream II targets rather south direction, if supplemented with construction of one of Czechia-Austria interconnectors, could completely deprive Slovakia’s TSO of transit revenues (1).
- Hungarian policy balances between regional diversification in form of increasing interconnectivity with its neighbours, limited trust in single gas market reliability and willingness to take part in one of Southern Corridor projects – Nabucco and South Stream in past, Turkish Stream recently, to supply Hungarian market in future.
- Poland strongly supported greater North-South interconnectivity, supplemented with regional supply diversification in the form of LNG market access through the Świnoujście LNG terminal and Baltic Pipe – Norwegian Continental Shelf connector, with capacity sufficient to secure most of Polish, Czech and Slovak import demand, or Polish and Ukrainian in different scenario, but basing its policy rather on security dimension rather than commercial.
- Ukraine shares Polish views on Russian energy policy, being threaten mostly by its outcomes since Naftohaz, state-owned gas market incumbent, and state budget profits significantly from natural gas transit. At the same time, Ukraine used existing transmission system reverse flow with large success to diversify and limit Gazprom’s market power.
- Austria continues its efforts to strengthen cooperation and market integration around Baumgarten gas hub and supports Nord Stream I and II development as it supports its TSO’s role in Russian gas transit further south, having Czechia as a main regional partner.
This divides them into three groups – Poland and Ukraine (Nord Stream opponents) in first, Czechia and Austria (Nord Stream beneficiaries) in second and Slovakia with Hungary (waiting for outcomes) in latter. All but Poland and Hungary use Brotherhood/Progress transmission system as a base for any integration model, whether it would or not include new Nord Stream II gas flows. With most of infrastructure already in place and large import capacity from EU hubs it is Poland that needs to invest and risk most to reach V4 markets with its projects and market vision.
V4 Gas Target Model in regional reality
Gas Target Model, introduced in 2011 and modified in 2015 assumes that any hub, to serve its purposes, should have five dimensions:
- Sufficient demand – at least 20 bcm per year (220 TWh) per single market,
- At least 3 sources of imported gas,
- Market concentration below 2000 points of HHI,
- At least 8 exchange traded gas (excluding OTC) to consumption ratio (churn rate),
- At least 110% of Residual Supply Index value.
It is clear that, at least at this point of time, none of V4 countries can achieve 20 bcm / 220 TWh threshold and churn ration of 8, and it could take years before it happens. Polish market, biggest in the region, could reach consumption level only by massive investment in gas-fired power plants combined with fast coal replacement in households heating segment and that is definitely not a scenario that Polish government promotes. That leaves region with many different market integration scenarios described below.
Chart 1. Natural gas consumption in V4 countries and Austria.
Source: Eurostat, own calculations.
In terms of natural gas import sourcing, physically all V4 countries are mainly supplied from Russia, with some LNG imported to Poland and possibly some Norwegian gas delivered to Czechia through Gaspool balancing zone. V4 is connected to Russian gas deposits through Ukraine, Belarus and Germany (Gaspool), to Norwegian and Dutch through Germany (Gaspool and NCG) and, to some extent, to Romanian via Hungary and Italian market through Austria. Only Poland is able to connect its transmission system directly to natural gas deposits (namely – Norway) and global LNG market and that is a driver of diversification policy. For the rest of V4 group, dependence on transit through neighbouring countries is an inevitable part of energy policy and that is reflected in their energy policy as those markets, direct access to Norwegian deposits through Poland is practically the same option as having it today through Gaspool or NCG, in commercial terms both having lower entry-exit fees than Polish TSO. The further east and south, the more attractive Polish offer could be, as Slovakia and Ukraine have to pay more for transit to supply its needs from European market.Market concentration(2)
Chart 2. Herfindel-Hirschmann Index values in V4 countries and Austria.
Sources: URE, E-Control, MEKH, ERU, URSO.
All V4 markets, as well as Ukrainian and Austrian, are far from reaching required liquidity. Currently, the most liquid are Austrian (reaching 3,0 churn ratio, including OTC trading) and Polish (reaching 0,87 on exchange and OTC market). Rest of markets are illiquid or non-active at all, dominated by spot trading.
Sergio Ascari’s V4 market integration scenario published by Warsaw’s Ośrodek Studiów Wschodnich (4) identifies six V4 gas market main problems:
- dominance of Russian supplies under long term, oil linked contracts;
- limited interconnection (except between Czech Republic and Slovakia);
- overwhelming East-West flows;
- limited, though growing, internal competition and, as a consequence, poor market liquidity;
- expected increasing demand due to the gradual loss of competitiveness of more polluting fuels, as well as of more gas penetration in the residential market;
- low security of supply standards.
Ukraine faces the same problems, apart from e) as drastically increased prices forced gas consumption savings, especially in households market segment.
But after four years since publication, structural changes can be noticed:
- Russian long-term contracts still dominates the market, but the largest are about to expire: Ukrainian by the end of 2019, Polish by the end of 2022. Still, none of traders on each of V4 markets is not able to pass cost of out-of-cash oil-indexed contracts on final customers as competition grows.
- Interconnection is in some cases limited (especially Poland) and several projects are delayed, but by 2021/2022 most of planned projects should be completed.
- East-West flows still dominates, but most of strategic pipelines can be revered if needed and creates a base for internal competition development.
- Markets liquidity is still low and slowly improving, with notable CEGH growth.
- Demand growth is curbed by energy efficiency growth even including fuel-switching in households segment. Gas-fired power plants are generally still out-of-money in current market reality.
- With development of new infrastructure and reverse flows as well as new legislative framework (SoS directive) security increased greatly, allowing most of CEE countries import significant volumes from EU hubs and particularly Ukraine.
Fundamental question is how to create a market (or markets) for CEE region that will be at the same time large enough, liquid, diversified and competitive and will be commercially viable for TSO’s involved. Clearly, today’s battle between Nord Stream II and North-South Corridor concepts as well as between different market integrators has different beneficiaries.
Current infrastructure framework
Basing the integration model on two factors:
- Combined consumption of integrated markets and
- Views on Russian energy and foreign policy,
Two integration blocks could be created:
- Poland, Ukraine and possibly Slovakia,
- Czechia, Austria and possibly Slovakia,
Slovakia’s position will depend on its TSO’s tariff policy and, partially resulting from it, BACI link construction. Hungary, as its policy is rather concentrated on internal market integration around several state owned entities, securing new long-term supplies from Russia and at the same time increasing regional interconnectivity, is not expected to join any initiative that could decrease its control over internal market. In any case, its position in region places it closer to Austrian CEGH hub and deeper integration requires debottlenecking existing interconnector from Austria.
Main integration framework is already in place – Brotherhood/Progress transmission system needs some upgrades, mainly to increase reverse flow capacity, but main cost – if needed – will be covered by gas flow from Russia, whether it would be transferred through Ukraine or Germany. That gives strong commercial support to place center for CEE gas trading in Baumgarten area, in Austria, Czechia and Slovakia, where existing (even without Nord Stream II) capacities exceed demand multiple times.
To compete with already existing framework, Poland, pursuing its export goals in V4 region, has to offer at least competitive prices in medium term perspective, whether it would be achieved by LNG terminal expansion or Baltic Pipe construction, as Gaspool and CEGH linked contracts are already offered by local suppliers. With growing number of pure trading companies – that have no other assets than wholesale and retail operations and therefore are not able to offset trading loses with profits generated in other market segments, any investments and related contracts that has no commercial incentive even in short term will limit regional cooperation. Any flows from Poland southwards will have to compete with Gaspool-CEGH linked prices and in current situation it is Polish market that is traded with premium to Gaspool, hence there is no incentive for Czech and Slovak traders to support exit capacity development from Poland as would have no chance to cover the Gaspool-TGE spread and transmission costs selling gas on own market. Situation may change with Norwegian link development in 2022, but as PL-SK interconnector is expected to be online by the end of 2020, Polish export plans have to be based on LNG market. Today, any connection constructed should work in exit-to-Poland mode as Gaspool-TGE spread reaches 1,5-2,0 EUR/MWh (reflecting yearly firm capacity cost from Gaspool to Poland plus premium), while Czech market trades with very thin spread thanks to low-cost entry fee to Czech market from any directions.
Situation is different when Ukraine is considered, as it seems that gas exported to Ukraine is generally priced against German hubs (Gaspool and NCG) or CEGH and that cost plus transmission through V4 gives practically the same price, as exported from Poland. Basing on currently valid tariffs, gas transfer to Ukraine costs around 2,6-2,9 EUR/MWh (assuming there are free yearly firm capacities) and Polish transit route is not overpriced significantly.
That places Poland in at least competitive position to export gas to Ukraine, while its concept of export to V4 is rather out-of-money if Czech and Slovak customers are concerned. Second group – Czechia and Austria, possibly with Slovak support, could concentrate on commercially tempting Nord Stream II project and base its own market integration on existing infrastructure or, without Nord Stream II, work together to strengthen CEGH as a regional hub.
Apart of that, liquidity on CEGH, although still on non-satisfactory level, started to grow dynamically since beginning of 2017. In first half of this year more gas was traded on both spot and futures markets than in whole 2016. At the same time, TGE stagnated as a result of obligatory stocks regulation amendments in 2016 and 2017, being fueled only by gas release program PGNiG obligation to sell up to 55% of imported volume. Both developments clearly indicates which market is more attractive for trades. As Polish policy is based on market diversification and it was announced that market would be opened wider after this goal is achieved, market creation is rather secondary target for Polish government.
Additional game-changer could arise with Ukrainian upstream development as falling domestic demand can be meet increasingly by local production. It may though take several years before Ukraine becomes net exporter as it requires stable legislative framework, which in current political situation could be difficult to achieve. With large cross-border capacity, possibly limited Russian flows, Ukraine may seek to market its gas in whole region, but preferably basing pricing policy on well-established markets.
Considering this two dimensions – commercial and technical – and division inside V4 and its neighbors, it would be optimal to increase integration of Poland and Ukraine, sharing similar interest, and Czechia and Austria. Place of Slovakia in this model is based practically on eustream’s tariff policy and physical integration of Net4Gas and Gas Connect Austria grids through BACI or Oberkappel link.
Realisation of optimal model
There are two main dimensions of integration – infrastructure and consumption threshold. Practically all necessary infrastructure projects – optimal for different market players – are already in progress:
- Northern Gate projects (Baltic Pipe, Świnoujście LNG terminal expansion and/or FSRU),
- PL-UA interconnector,
- PL-SK interconnector,
- Possibly Stork II interconnector,
- Nord Stream II-EUGAL,
- BACI or Oberkappel Net4Gas-Gas Connect Austria link,
- Czech grid reverse flow (DE-CZ-SK/AT),
- Slovak grid reverse flow (CZ-SK-AT/UA),
As most of them are scheduled to be completed by 2020/2021 (with exception of Northern Gate, expected to be finished by the end of 2022), the basis for further integration would be laid. With this infrastructure the first V4 problem will be solved – lack of North-South connections. Second step requires trading-friendly legislative.
In case Nord Stream II and Eugal delay or termination, Slovakia will maintain its traditional role and Czech-Austrian market integration will be significantly less attractive commercially. CEGH pricing would still be based on balancing between German hubs, Ukrainian imports and Italian PSV. With Nord Stream II and BACI/Oberkappel link operational, CEGH have a chance to reduce spreads against German hubs and become even more attractive trading place for regional players. Integrated Czech, Austrian and Slovak markets can reach 20 bcm per annum consumption threshold required by GTM and they are practically ready to integrate at infrastructure level, requiring only minor grid upgrades. The main barrier is TSO’s revenue-sharing arrangements. But with BACI link and continued support of competitive market development in Austria and Czechia (illustrated with reduction of HHI value), CEGH could become main regional integration centre.
Polish hub idea could materialize as long as Baltic Pipe and Polish TSO’s capacity would be available for different market players, including domestic PGNiG’s competitors and large consumers and Norwegian Continental Shelf upstream companies, allowing them to arbitrage between NCS connected markets. Assuming changes in legislative framework, including obligatory stock, licencing and reporting regime etc., and more active development of TGE (i.e. lower transaction costs, wider range of products including external markets and introduction of financial products) resulting in Polish market pricing being closer to other EU markets, reducing Gaspool-TGE spread to level that could make it more attractive for V4 and Ukrainian importers. Still, competitive market will be crucial to achieve this goal and that should become a priority. LNG inflow, at least until world market become saturated enough to treat European hubs as something more than a place of last resort and considering its physical characteristic (especially cargo sizes), making this market available rather for large players, could be limited even if spot pricing currently – and possibly for a number of years – is attractive comparing to EU hubs. Still, any of scenarios above requires massive, costly and time-consuming investments and market integration will not stop until they materialize. Polish TSO’s cooperation with regional TSOs – Danish Energinet, Slovak Eustream and Ukrainian UTG may result construction all necessary infrastructure. Main weakness of this concept expectation that main (and possibly only) gas marketer will be Polish incumbent as it may strengthen its influence on Polish market and, at the same time, leave it overcontracted as it is today.
Although Polish market is the largest of all V4 and, contrary to them, consumption grows steadily in slow pace, to reach 20 bcm per annum limit Poland would have to invest heavily in gas-fired power plants adding up to 8 GW to the system. As that is hardly possible, not only due to coal-friendly energy policy, but also because marginal profitability of them. Enhanced connection to Ukraine could at least partially solve that problem, granting access to largest regional market that may need a partner sharing its political views and aims.
Ukrainian market has three important features: large consumption, developed infrastructure and upstream potential. With proper and stable legislative framework it could play a role of Netherlands in region, being a base for trading hub creation if exploration and deposits development result in large extraction growth, sustained for decades. Obviously, Ukraine does not have potential – or at least at current exploration stage – to dominate regional market as the Netherlands did with Groningen field development or as Russia in past decades, but considering surrounding markets demand it still could play a significant role, supplementing imports from other directions. But that legal and policy requirements are not simple to realize as Ukraine faces fundamental security threats and needs strong external – political, financial, advisory – support to defend itself and introduce even basic reforms, fight corruption and reduce oligarch’s influence on state politics, at the same time maintaining fiscal stability.
Ukrainian market – in import and export scenario – with its demand could give strong support to both integration centres. But as CEGH-centered integration aims at transit revenues capturing directly threating Ukrainian interests, it seems that Polish idea is more attractive in long term, granting access to new sources of gas for Ukraine at competitive prices (comparing to today’s import model), in exchange increasing utilization of new infrastructure in Poland, reducing its cost. Still, challenges are enormous, as nearly one fifth of Polish transmission infrastructure has to be upgraded, not including Baltic Pipe and/or LNG terminal expansion and development. Clearly, Poland needs a long-term partner (or partners) to reduce cost and create market for imported gas.
(1) For CZ-DE market spreads it does not really matter whether Nord Stream II is constructed or not. Czech market is strongly influenced by Gaspool and NCG pricing, and thanks to large crossborder capacity and competitive market, spreads are rather thin.
(2) Data for HHI calculation: Poland – 2016, rest of markets – 2015. Sources: URE, E-Control, ERU, URSO, MEKH.
(3) Basing on assumption that HHI value under 1000 is considered highly competitive, between 1 000 and 2 000 – competitive and above 2 000 – concentrated, with maximum level of 10 000, meaning full monopoly. Assumption made on EC guidelines: Guidelines on the assessment of horizontal mergers under the Council Regulation on the control of concentrations between undertakings, Official Journal C 031 , 05/02/2004 P. 0005 – 0018, http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:52004XC0205(02).
(4) Segio Ascari, The Gas Target Model for The Visegrad 4 Region, Ośrodek Studiów Wschodnich, Warsaw, May 2013, https://www.osw.waw.pl/pl/publikacje/raport-osw/2013-06-19/gas-target-model-visegrad-4-region.