The Quo Vadis Study on the EU Gas Regulatory Framework – What does it tell us? (and what not?)

By Gijs Kreeft, PhD Researcher on the Regulation of Power-to-Gas at the Groningen Centre of Energy Law

The absence of a legislative proposal on the gas sector under the Clean Energy for All Europeans Package could be interpreted as a regulatory standstill in the EU gas market. Nothing, however, is less true. During the past 12 months, a deal has been struck between the European Commission and Gazprom through which the Russian gas giant committed itself to tune down its dominant behavior in Central and Eastern Europe, an information exchange mechanism has been established with regard to agreements in the field of energy by Member States with third countries (Decision (EU) 2017/684), a new Security of Supply Regulation (Regulation (EU) 2017/1938) has been adopted, and amendments to the 2009 Gas Directive have been proposed in light of North Stream 2. Earlier, in 2016, the Commission already decided on revised exemption conditions for the OPAL pipeline, capping the exemption for third party access at 50% of the pipeline’s capacity. Besides these recent measures, the Commission is in a process of looking beyond 2020 by exploring what long-term regulatory reforms are required to improve the functioning of EU gas markets. Part of this forward-looking process was the commissioning of a so called “Quo Vadis Study” on the EU Gas Regulatory Framework. After a long period of consultations and stakeholder evaluations, this report, drafted by EY and REKK, has now been made available to the public.

The Latin term “Quo Vadis” translates into “where are you going”? A Quo Vadis study with the regulatory framework of the EU gas market as its focus is thus intended to shine light on the regulatory path ahead. According to the report itself, the objective thereof is to analyse whether the current regulatory framework in the EU gas sector, assuming the full implementation of the Third Energy Package and related gas Network Codes, is efficient in maximising overall EU welfare, and to make regulatory recommendations. The strength of the report lies in the first part, the analysis of the current EU gas market. The proposed regulatory pathways are, however, characterised by stakeholders as somewhat incomplete and unrealistic.[2] Admittedly, the issue of incompletion is caused by the commissioned scope of the study, which is limited to an assessment of welfare maximisation and lacks any reference to the future role of gas in an increasingly electrified and decarbonised EU energy system.

What it tells us
First, what does the report tell us? The report starts with an enquiry into the inefficiencies in the EU gas market. As starting benchmark, it is stated that high-level price convergence is an important sign of an integrated and well-functioning gas market, as this illustrates that there are no serious trade barriers for transporting gas to where it is valued the most. The provided analysis of the gas wholesale prices of 2016 shows, however, that a significant price spread exists between countries in the North-Western part of the EU, which can be regarded as one single market, and those on the Eastern border of the Union. Several inefficiencies are identified in the study as causing this spread: 

         i.            Lack of competition in the (extra-EU) upstream sector, leading to higher wholesale prices than in the US. Exposure to pressure from extra-EU suppliers differs per EU Member State;
       ii.            Lack of (bidirectional) interconnectors. For example between France and Italy or Poland and Lithuania;
      iii.            Current level and structure of cross-border tariffs which leads to “pancaking”, i.e. the accumulation of tariffs when gas flows via multiple intra-EU interconnection points;
     iv.            Physical and contractual congestion and market foreclosure (caused by long-term contracts). Capacity hoarding and unused bookings by dominant suppliers may block access to crucial interconnection points for competitors. As proof of such capacity hoarding, the report refers to the PRISMA capacity auction in May 2017 where Gazprom was the only party acquiring long-term capacity rights for the period beyond 2019 (notably, all this capacity was booked at the entry point of North Stream 2 and downstream pipelines such as the Gazelle);
       v.            Local regulation and limited transparency. This category points to a collection of inefficiencies due to administrative costs, technical standards (such as gas quality) which may hamper interoperability, and retail price regulation;
     vi.            Network operation inefficiencies due to the fragmentation between TSOs. According to the report, this fragmentation results in cost-inefficient infrastructure investment decisions.
Notably, the analysis in the study on the effectiveness and potential of current regulation to remedy these inefficiencies is rather positive. It is expected that most inefficiencies can be addressed through Regulation 347/2013 on the guidelines for trans-European energy infrastructure, the new gas security of supply Regulation ((EU) 2017/1938), the network code on rules regarding harmonised transmission tariff structures for gas (the TAR NC), the amended network code on capacity allocation mechanisms (CAM NC), and the guidelines for congestion management procedures (SWD (2014) 250).

Nevertheless, the modelling of the EU gas market in 2020 in which the Third Energy Package and Network codes are fully implemented (the “2020 Reference” scenario) reveals that an increase in imports due to lower domestic production and a growing reliance on spot contracts results in more congestion. The authors of the report expect that, unless regulatory reforms are undertaken, the shift from long-term to spot contracts will lead to increased price spreads among EU Member States.
Four different pathways for regulatory reform are present in the study:

         i.            Tariff Reform Scenario: the pancaking of tariffs is considered to be a barrier for the flow of gas from low-priced countries to high-priced countries as it cancels-out the potential profit from spatial arbitrage. Under this first scenario, the authors propose to abolish intra-EU cross-border tariffs and replace these with higher tariffs at the EU entry-points where gas is imported from outside the Union. The revenues then need to be re-allocated among the different TSOs through a new TSO compensation fund which would also pay for intra-EU infrastructure investments. As this scenario is intended to level-out current price spreads, wholesale price levels in current low-price levels (e.g. Germany and the Netherlands) will likely increase;

      ii.             Trading Zone Merger Scenario: this involves the merging of multiple markets into a single market with one entry/exit zone, wholesale price, and the abolishment of intra-zone tariffs. Voluntary and bottom-up market mergers, in combination with the full implementation of third energy package, were also considered the right way forward under the ACER European Gas Target Model. Notably, the Quo Vadis study, at multiple occasions, states that voluntary mergers have until now been slow and few. However, according to ACER, voluntary market mergers have already led to a 50 per cent reduction in the number of markets between 2006 and 2017 (54 versus 28)[2];

    iii.            Combined Capacity-Commodity Release Scenario: long-term capacity bookings on intra-EU pipelines may lead to strategic capacity hoarding by dominant extra-EU suppliers (read: Gazprom) to the detriment of their competitors. As a result, only limited pipeline capacity remains accessible for short-term trading, which negatively affects the flexibility of the gas markets. This scenario proposes a so-called “50-50-50” reform. It simultaneously proposes an increase up to 50% in the share of short-term transmission capacity for both existing and new infrastructure (50-50) and an obligation for gas producers/importers to sell at least 50% of their gas at the nearest Virtual Trading Point when entering the EU (50);

     iv.            Extra-EU Upstream – EU Downstream Strategic Partnership Concept: this scenario is, at least for the moment, the most challenging from the political point of view. I entails a cooperative concept in which the producing country (Russia) agrees to liberalise its upstream sector in favor of increased foreign investment and allows to apply the provisions under the Third Energy Package to its export pipelines (e.g. North Stream 1 and 2). In return, the EU will not set a cap on the share of Russian gas and will introduce a benefit sharing agreement which allows Russia to share in the downstream welfare benefits caused by the partnership compared to the 2020 reference scenario.

The stakeholder responses to the report have been, for the most part, critical of the proposed scenarios.[2] The main point of criticism is that the proposed reforms will bring about high transitional and institutional costs, while the benefits presented in the study of implementing the different scenarios compared to the 2020 reference scenario are considered to be rather modest. Notably, the scenario which is expected to bring about the largest increase in overall welfare is the Russia-EU partnership under the fourth scenario. This scenario assumes, however, a political goodwill which is clearly absent under the current EU-Russia relationship. Furthermore, the costs related to the implementation of the different scenarios are for the most part neglected.
The general sentiment among stakeholders is that the focus for the short- to mid-term should rather be on the full and coherent implementation of the third energy package and network codes. Also, the stakeholders are more optimistic about the future occurrence of voluntary market mergers under the current regulatory scheme than the authors of the Quo Vadis Study.

As said, the strength of this report lies in its analysis of the current EU gas market. It rightfully points to the dominant position of extra-EU gas suppliers such as Gazprom and the lack of (bi-directional) interconnection between certain market areas. These efficiencies have, however, already led to the wide range of measures covered under the introductory paragraph of this blog. In addition, the Commission has presented an EU strategy for liquefied natural gas and gas storage which should mitigate the current dependency on only a few supply routes. Together with a full implementation of the Third Energy package and subsequent Network Codes, these measures should already for a large part be capable of addressing the identified efficiencies by the Quo Vadis study.  

What it doesn’t tell us
As the scope of report is limited to welfare maximisation, and thus price, the study only covers a part of the story which will define the future EU gas market. The report states: “[t]he issue of inland gas production is beyond the scope of this study, but institutional support of EU energy production, especially from renewable resources (e.g. biomethane, power-to-gas) can be one of available mitigation actions aimed at reduction of the EU imports needed” (p.98). The role of renewable gas as alternative source of supply is, hence, not accounted for. A recent report by ECOFYS illustrates, however, that alternative, sustainable, and decentralised gas production options may play an important role in the Union’s future gas supply by annually producing 122 billion cubic meters of gas by 2050.[3]
A positive development is, therefore, the European Commission's intention to carry out a study analysing the interactions and possible synergies between inter alia the gas and electricity sectors, as well as the prospects of renewable gases and decarbonised gas.[4] This study will thereby assess what role gas and the gas infrastructure can play in the decarbonisation process. With these insights, a clear strategy can be developed on where the EU gas sector should be going.

[1] Stakeholder responses are accessible via link.
[2] Comments by ACER to the draft Quo Vadis Study, available via link.
[3] ECOFYS (2018), ‘Gas for Climate’, available via link.
[4] Conclusions of the 30th Madrid Forum of 19-20 October 2017, available via link


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