Natural Gas in Europe – Preparing for the Next Challenge

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Alex Barnes, EAGC Advisory Board Member, Alex Barnes & Associates Ltd.
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After two decades, the EU now has a liberalised gas market. Trading determines wholesale prices based on supply and demand and gas-to-gas competition. Prices are converging across Europe and have fallen to ten-year lows, as LNG competes with pipeline gas in Europe’s large and liquid market. Storage levels are at record highs as the market has absorbed higher volumes. All this shows that the market is working exactly as one would expect. Policymakers, regulators and the industry can all congratulate themselves.

However, there is a new challenge. The way we use natural gas must change if Europe is to decarbonise by 2050. Faster switching from coal to gas in power generation in the short term will help buy us time to make the changes needed, but this is not enough. Natural gas will have to be decarbonised at the point of combustion, or the point of conversion to hydrogen. Methane emissions during production and transportation need to be reduced further. If natural gas cannot do this, it faces an existential threat to its role in the European economy.

Hydrogen from natural gas can help meet Europe’s decarbonisation targets, at lower cost and with less implementation risk than renewable electricity alone. It can supply energy to the parts of the economy that electricity cannot reach, such as homes that cannot easily be converted to heat pumps; industry, which requires high-temperature process heat; or heavy trucks, which cannot use batteries. Hydrogen can be produced from natural gas using steam methane reforming with CO2 captured and stored, or via pyrolysis where solid carbon is the by-product.

How can the gas industry make this fundamental change? How long will it take? It took many years and numerous Directives, Regulations, and Network Codes to liberalise the market. Yet, compared to the challenge of establishing a role for natural gas-based hydrogen, the task was relatively simple. There were clear examples of how to liberalise gas markets using the principles of regulated third party access and unbundling of vertically integrated monopolies, the US and UK experiences in the 1980s and 1990s. Producers supplied the same gas, which was transported by the same pipelines, and used in the same appliances by the same customers. Stable or growing demand enabled regulators to promise networks guaranteed revenues in return for low regulated returns. The way gas was bought and sold changed but the fundamentals of the industry remained the same.

None of these conditions applies to hydrogen from natural gas, thereby making the development of an appropriate framework even more challenging. Previous attempts at decarbonising the economy show the risks of poorly designed regulation. Market liberalisation in electricity, with generation determined by marginal costs, coupled with subsidies for renewables and too low a carbon price, led to the perverse outcome that renewables squeezed lower polluting gas out of the generation mix rather than higher polluting coal. Germany is failing to meet its climate change targets despite spending millions on renewables.

Any regulatory framework needs to coordinate consumers, producers and networks. Consumers need to be encouraged or compelled to switch to low carbon energy. Nearly two-fifths of gas consumption is for residential and commercial use, mainly space heating. These customers will need to choose between electric or hydrogen-based heating. However, changing one’s heating system is a lot more complicated than changing supplier, as it includes upfront capital costs and assumptions about future supply costs.

Consumers will be reluctant to choose hydrogen unless they know there will be economic supply. However, producers of hydrogen from natural gas will only invest if they have some hope of a market. Hydrogen from electrolysis depends on cheap renewables to be viable, but this is limited to areas with surplus capacity.

Both consumers and producers are reliant on the decisions by networks and their regulators. Unless regulators allow distribution networks to convert to transporting hydrogen, there can be no supply or demand for hydrogen. However, it is unclear who will pay for the conversion without a sufficiently large customer base. Transmission networks can continue to transport natural gas for conversion to hydrogen at the city-gate, enabling continued competition between gas suppliers.

The conversion of networks needs to be synchronized with the development of supply and demand since once the distribution network is converted to carry hydrogen, all the consumers on the network have to convert their appliances at the same time; there needs to be sufficient hydrogen supply for them to do so.

Regulators also need to ensure competition between renewables and hydrogen from natural gas to maximise consumer welfare. In the absence of a suitable framework to address the issues outlined above, the likely outcome is that countries will simply build more renewables generation and expensive electricity networks even if this makes decarbonisation more costly and less likely.

We can meet these challenges, but we must start developing the answers now for hydrogen from natural gas to succeed.