Rationale – The need for new UK gas storage

“Gas has a vital role to play in delivering energy security – only just a couple of years ago we were within hours of exhausting our gas storage supplies. The solution I think is more import routes and more storage” Charles Hendry – Minister of Energy 2010-12

WHY DO WE NEED MORE GAS STORAGE ?

WHY THE GOVERNMENT NEEDS TO SUPPORT NEW INVESTMENT IN GAS STORAGE?

The briefing paper below was researched and written by Stag Energy in consultation with the British Ceramic Confederation (BCC), the Major Energy Users Council (MEUC) and NATIXIS (leading provider of project finance for major energy infrastructure projects)

February 2017

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In July 2016, Centrica reported that it would have to shut down its Rough gas storage facility. This highlighted the urgent need for Government to review the decision (September 2013) to rule out any form of support for new investment in UK gas storage. The Rough facility accounts for ~75% of all UK storage capacity. Even with Rough operational the UK’s gas storage capacity was very low relative to the demand for gas i.e. less than 15 days of average Winter demand compared to >100 days in Germany and France. With Rough out of action the UK will have gas storage equal to less than 5 days of average Winter demand to compensate for any sudden surge in demand and/or shortfall in pipeline or LNG shipments. This will lead to greater gas price volatility and higher consumer energy costs. Major new storage facilities take years in design and construction so action is required now to support new investment in this essential energy infrastructure.

How much gas storage do we have now?

The UK’s consumption of gas relative to total energy consumption is one of the highest in the EU – nearly 40% - but the level of gas storage relative to demand (5bcm of operational capacity) is one of the lowest – less than 15 days based of average Winter demand. However, in September 2013 the Government concluded that “the UK gas supply was resilient with supplies outstripping demand” and this was cited as the main reason why no regulatory framework was needed to support investment.

The UK does have ample import capacity viz Norwegian pipelines, EU interconnection and LNG terminals and a strong price rise can pull more gas into the UK, but markets take time to react to price signals and that results in a cost to consumers. The recent announcement that the Rough facility will need to close until Spring 2017 highlights the vulnerability of the UK to sudden and unexpected increases in demand or shortfalls in supply.

This risk of price spikes from unexpected and unpredictable shortages will become more severe in the future and while no policy can deliver absolute security the best type of security is provided by maintaining a minimum level of flexible domestic gas storage connected to the national grid.

So, what are the risks and why do we need more storage?

A cursory analysis of the global gas market indicates a plentiful supply of gas relative to demand. But this general picture disguises two fundamental structural changes in the UK market.

First, the UK’s dependency on imports is rising rapidly – UK domestic gas production has declined from >100% in 2005 to almost 60% in 2015 and National Grid expects imports to rise to around 80% of demand by 2030. Second, short term fluctuations in UK power demand for gas is increasing as intermittent renewable capacity rises – National Grid estimate that between 30-40GW of gas fired generation will be required by 2030 to support both regular and peak demand for electricity, and this capacity will be required to operate extremely flexibly. Both factors are driving the need for more flexible gas storage.

The UK’s growing import dependency is aggravated by a number of characteristics in the wholesale gas market namely (a) the lack of a long term price signal for seasonal gas price differentials, (b) price volatility that is a result of external, often international, factors, (c) reliance on a small number of dominant suppliers and short term LNG contracts to underpin security of supply, and (d) the very low level of UK based flexible storage relative to demand. (see above)

The planned expansion in both wind and solar generation will increase gas demand volatility and the need to provide gas supply price security. Without a meaningful volume of flexible gas storage, consumers will be exposed to a greater frequency of pressure on supply and an increase in gas and power price volatility. For example, National Grid estimate that the daily variation in power generation gas demand due to loss of wind could exceed 100mcm/pd compared with a daily average of 153mcm/pd.

The vulnerability of the UK is to these short term swings in demand, infrastructure outages and supply chain response delays. Evidence of this short term requirement for deliverability and the longer term effectiveness of the wholesale price rises in attracting higher imports can be seen across the last three Winter periods. For example, the gas price spikes of March 2013 reflected a period of deliverability scarcity over 4-6 weeks with consumers and the economy being burdened with additional costs approaching £350m due to the lack of a coherent gas storage policy.

Why the need to underpin the demand for additional storage?

In October 2011, the ECC Select Committee report on UK Energy Security concluded that:

“ 77. The UK needs more gas storage capacity capable of delivering gas at a high rate. The Department of Energy and Climate Change should be concerned about the lack of gas storage used to manage seasonal demand fluctuations. It should aim to double the UK’s current gas storage from current levels by 2020 in order to avoid exposure to gas supply interruptions and price spikes, and, in the longer term, to ensure a resilient gas supply to flexible gas plants acting as “backup” to intermittent electricity generated from wind.

88. The UK needs to significantly increase its gas storage capacity. The Government must develop a strategy for achieving this. Doing nothing—or continuing to give inconsistent signals to the market about which approach it will choose—could result in no storage being built. This would diminish energy security. “

These recommendations were not followed and in recent years, market prices signals have not been strong enough to stimulate new storage investment.

Storage projects are long term, capital intensive projects requiring consistent and stable price signals to attract the necessary private sector financing. Current seasonal price differentials are not sufficiently liquid and the period of time over which they are visible is too brief to support long term funding. Planning, so often a hurdle for major infrastructure projects, is not an issue in the gas storage sector. Some 10bcm of new projects have received planning consent in recent years, although a number of these prospects are being abandoned due to market fundamentals. The problem centres on the lack of demand certainty over the longer term. For example, in 2005 DECC listed 5bcm of additional storage capacity (10 projects) expected to come on line by 2010 but only 0.35bcm was actually delivered by 2015, and no further capacity has been committed to construction. The chart below highlights the potential decrease in UK storage capacity as ageing assets close.

If no action is taken to underpin the long term demand for storage, then the risk of price volatility and supply shortages will increase significantly as import dependency and the volume of intermittent renewable power generation increases. The introduction of a regulatory framework to underpin a minimum level of gas storage capacity appears to be the most cost-effective method for underpinning the demand for storage and unlocking private sector investment and is widely used in Continental Europe.

What is the most cost effective method of supporting new investment?

There have been two primary mechanisms that have been considered by Government to support a minimum level of domestic gas storage for the UK market. A Public Supplier Obligation (PSO) on suppliers or a Government managed intervention to underpin minimum revenues for selected storage facilities.

A PSO provides a structure requiring suppliers to hold a certain amount of gas in storage at the start of each Winter, this would be the simplest and most cost-effective solution because it does not require direct Government intervention or support in the market. It sets down a long term security standard and then leaves it to suppliers and storage operators to devise a contractual framework that delivers the most cost effective security from gas storage that the market requires and is prepared to pay for. The PSO approach does not require central procurement with the Government and/or Ofgem picking winners and losers and underpinning the revenue of storage operators.

The alternative, interventionist approach has a number of disadvantages compared with the light-touch approach of a PSO mechanism, namely (a) it would be more costly and complex to establish and would probably require new primary legislation, (b) it would require the Government to organise some form of auction to allocate existing and new storage capacity, (c) it would potentially result in a windfall gain for existing capacity, and (d) it would commit Government and consumers to the delivery of new capacity but it would not guarantee that gas would be stored to provide the necessary market security.

What would be the impact on industrial and residential consumers?

UK energy intensive users support the case for greater UK gas storage and the PSO. According to Dr Laura Cohen, Chief Executive of the British Ceramic Confederation, and member of the EIUG:

“More UK gas storage, maintained through a PSO on suppliers, is likely to provide the highest level of supply security against price spikes and disruptions in international gas markets since gas is held close to the point of consumption, and holding a larger volume provides a greater level of price insurance. Furthermore, supplier PSOs are already the market norm in many European countries. We accept that this will result in an increased cost for all consumers and we need to understand the implications here more fully on annual bills including costs to support the storage assets - but over the long terms the cost of this insurance will underpin energy price certainty for British business and consumers.”

If the Select Committee recommendations were implemented in full, the total cost of 5bcm of new storage would be in the region of £4bn. This, it should be noted, is a fraction of the total required infrastructure cost estimated by National Grid for the next decade. Calculations by the BCC allowing for a 30 year life, cost of capital, finance and gas indicate an overall additional cost to all consumers of 1p/therm.

What should the Government do now?

The Government has recognised the need for a regulatory framework to support security of electricity supply. The recent Electricity Market Reform established a Capacity Auction to ensure adequate electricity generating capacity was available to provide consumers with an appropriate level of “insurance” against electricity supply disruption.

While a less interventionist approach is recommended to support security of gas price and supply, no new investment in UK gas storage will take place until clear regulatory principles are established and investors can proceed with confidence. These new assets will take time to build and it is already highly likely that Rough close before new capacity can be completed.

All National Grid Future Energy Scenarios show increased gas storage capacity, and deliverability in 2040, by which time the UK will almost certainly have closed at least lost over 80% of current UK gas storage capacity.

Action is required now to review again the current state of gas security and devise the necessary measures to manage the risks associated with increases in both the level of import dependency and the volume of intermittent renewable energy generation.

In the interests of the wider UK economy, it is also important to note that the Government’s desire for private sector investment to underpin economic recovery will be significantly enhanced by this new infrastructure investment. With a suitable regulatory framework, job creation and investment will flow into the economy for over a decade before costs of gas price security insurance began to feed through into consumer energy prices.

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