Measuring the energy security implications of fossil fuel resource concentration

ARTICLE IN PRESS Energy Policy 38 (2010) 1635–1644

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Measuring the energy security implications of fossil fuel resource concentration$ Nicolas Lefe`vre Woodrow Wilson School of Public and International Affairs, Princeton University, New Jersey, USA

a r t i c l e in fo

abstract

Article history: Received 3 February 2009 Accepted 3 February 2009 Available online 19 March 2009

Economic assessments of the welfare effects of energy insecurity are typically uncertain and fail to provide clear guidance to policy makers. As a result, governments have had little analytical support to complement expert judgment in the assessment of energy security. This is likely to be inadequate when considering multiple policy goals, and in particular the intersections between energy security and climate change mitigation policies. This paper presents an alternative approach which focuses on gauging the causes of energy insecurity as a way to assist policy making. The paper focuses on the energy security implications of fossil fuel resource concentration and distinguishes between the price and physical availability components of energy insecurity. It defines two separate indexes: the energy security price index (ESPI), based on the measure of market concentration in competitive fossil fuel markets, and the energy security physical availability index (ESPAI), based on the measure of supply flexibility in regulated markets. The paper illustrates the application of ESPI and ESPAI with two case studies—France and the United Kingdom—looking at the evolution of both indexes to 2030. & 2009 Elsevier Ltd. All rights reserved.

Keywords: Energy security Resource concentration Indicators

1. Energy insecurity and fossil fuel resource concentration 1.1. An impractical definition of energy insecurity Energy insecurity can be defined as the loss of welfare that may occur as a result of a change in the price or availability of energy (Bohi and Toman, 1996). While comprehensive from an economics perspective, this definition raises a number of important practical concerns for policy makers. Most importantly, due to the ubiquity of energy production and use and the complexity of many of the underlying processes, measuring such welfare losses has proved to be a difficult task. In addition to the multitude of direct impacts on energy using activities, a change in the price or availability of energy may also have complex macroeconomic implications. This, combined with a broad diversity of evaluative perspectives, renders economic assessments of energy insecurity highly uncertain. In the case of oil for example, by far the fuel most extensively studied in the context of energy security, Huntington (2005) highlights the inherent difficulty in assessing and predicting the far reaching economic effects of price shocks. Efforts to measure overall welfare effects associated with energy insecurity therefore typically rely on highly stylized models which, whilst they may

$ This paper builds on work undertaken by the author while at the International Energy Agency (IEA) and published in 2007 (IEA, 2007a). E-mail address: [email protected]

0301-4215/$ - see front matter & 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2009.02.003

be instructive from a broad planning perspective, are of only limited guidance to the design of policy. The definition of energy insecurity also gives no indication of the likely causes of such welfare losses. Usual suspects on energy policy makers’ mind include extreme weather events as observed with hurricane Katrina, which hit the Gulf of Mexico in 2005 and caused extensive damage to US oil and gas infrastructures. They also include the difficult task of short-term balancing of supply and demand in electricity markets, as demonstrated by the blackouts and brownouts that struck North America and Europe in 2003 (IEA, 2005). Yet none is as pervasive and politicized as fossil fuel resource concentration. The geological facts are simple: the Middle East accounts for 62% of global proven oil reserves. Taken together, members of the Organization of the Petroleum Exporting Countries (OPEC) hold 75% of the total. In contrast OECD countries hold only 7% yet account for 58% of world consumption. Similarly, 56% of global proven reserves of gas are found in three countries: the Russian Federation (26%), Iran (16%) and Qatar (14%). OECD countries hold only 9% of this total while accounting for 50% of global consumption.1 The resulting concentration of fossil fuel supplies combined with the sensitive political climate in many exporting countries has fuelled much political concern in OECD countries and in other resource poor countries. Experience has tended to

1

All statistics are for end of 2006 (BP, 2007).

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reinforce these concerns. Not only have important supply shortfalls occurred in the past, most were politically charged.2 1.2. A need for alternative assessment tools Due to the complex and uncertain nature of energy security, policy makers have relied strongly on expert judgment to define whether government action is indeed necessary to reduce energy insecurity associated with resource concentration and, if so, the course of action to follow. With decades of extensive government experience at both the technical and political level such an approach may very well have been suitable. Looking into the future, however, it may no longer suffice. Indeed with the emergence of anthropogenic climate change as an increasingly important energy policy concern, energy security will no longer be the main driver of energy policy. As the cost of action to reduce energy related greenhouse gas emissions rise more attention will be placed on the effectiveness of energy policy in achieving multiple goals. This is likely to particularly concern interactions between policies to mitigate climate change and those designed to address energy insecurity linked to resource concentration as in both cases policies are likely to directly affect the size and composition of the fuel mix. In the case of resource concentration, government efforts typically aim to minimise exposure to from risk-prone fuels or suppliers while in the case of climate change mitigation they aim to reduce greenhouse gas emissions from the burning of fossil fuels. The policy overlap may therefore be significant.3 This paper puts forth new tools to help policy makers assess energy insecurity associated with fossil fuel resource concentration. Section 2 discusses the basis of this alternative approach while Sections 3 and 4 introduce two new measures of energy insecurity. Section 5 illustrates how these can be applied with two country case studies and Section 6 provides some additional comments on the approach.4

2. What to measure: balancing uncertainty and policy relevance The dilemma in accounting for energy security is in finding a suitable middle ground between uncertain aggregate welfare estimates on the one hand and unstructured expert judgment on the other. Interestingly, much can be learned from climate change mitigation, where a similar dilemma has been addressed by policy makers. 2.1. Insights from climate change mitigation Fig. 1 schematizes the causal links of anthropogenic climate change. Human activity (stage I) produces greenhouse gases (stage II) which lead to a rise in atmospheric concentrations (stage 2 Almost all supply shortfalls have concerned oil (IEA, 2007c). Historically there have not been equivalent supply shortfalls of natural gas. However, the growing importance of long distance gas trade is of increasing concern to policy makers. The Russia–Ukraine gas dispute of January 2006 is one indication of this sensitivity. 3 In contrast, interactions between government efforts to address other causes of energy insecurity and climate mitigation efforts are likely to be of secondary importance. The level of resilience of the energy system to extreme weather events or the ability to balance electricity supply and demand on the short-term, for example, have no clear link to climate change mitigation and vice versa (IEA, 2007a). 4 The analysis presented in this paper focuses on fossil fuels. In reality, uranium, used in nuclear power generation, is also characterized by a certain level of resource concentration. Similarly, if biofuels become more broadly traded, resource concentration may also become an issue.

Stage III GHG concentrations

Stage IV Average temperature; thermodynamic response Stage V Impacts on human, natural systems

Stage II Emissions of GHGs Stage I Human activities: Energy production and consumption, industrial processes, land use

Fig. 1. Causal links of anthropogenic climate change. Source: adapted from Pershing and Tudela (2003).

III). This enhances the natural greenhouse effect leading to rising average temperatures (stage IV) which impacts human and natural systems (stage V). Each of these stages presents new uncertainties. For example, while emissions of greenhouse gases (stage II) from human activity can be measured with relatively high confidence based on energy consumption data and carbon emission factors, measuring the impact on atmospheric concentrations (stage III) requires understanding and gauging carbon exchanges between land, oceans and the atmosphere as well as the evolution of greenhouse gases in the atmosphere (including gas life-times and subsequent reactions with other gases). Measuring resulting temperature increases (stage IV) is characterized by further uncertainty. Ultimately, measuring precise effects (stage V) on human and natural systems and their welfare implications is a daunting task. So while defining a measure based on effects (stage V) might be a more accurate reflection of actual climate change mitigation, due to the accumulated uncertainty it is difficult to link with any accuracy to human activity (stage I), and therefore loses policy relevance. For this reason policy makers have adopted a policy assessment approach which emphasizes the need for certainty: climate change mitigation policies are, simply, assessed based on their impacts on greenhouse gas emissions (stage II) and in particular CO2. 2.2. Application to fossil fuel resource concentration A similar approach can be sought for the energy security implications of resource concentration. In doing so it is first useful to revisit the definition of energy security mentioned at the beginning of this paper and in particular the relationship between the price and physical availability components of energy security. 2.2.1. A price or physical availability concern? The importance of these two components depends to a large extent on the characteristics and effectiveness of the energy market in question. On one hand, in a competitive market setting, a supply shortfall leads to a rise in price which in turn triggers a number of responses. These include more expensive suppliers coming to the market as well as a reduction in demand from consumers unwilling to pay the higher price. The price mechanism therefore minimizes the risks of physical unavailability. The dominant energy security concern in this case is that the energy price is being set at an uncompetitive level by the market participants. On the other hand, in a regulated market setting, prices do not reflect changes in demand and supply. A supply shortfall is not accompanied by a price signal as in the case of competitive markets. Supply and demand cannot adjust appropriately and

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imbalance in the market may lead to physical unavailability. While regulation may bring price security in this case, the dominant energy security concern is likely to be physical availability. In reality no market is either perfectly competitive or regulated and to varying degrees both the price and physical availability components of energy security are always present. Nevertheless, some simplifications can be made in the context of this paper. In particular, the international oil and coal markets are sufficiently mature to assume that the price component is the dominant energy security concern. The assessment in these two cases will therefore focus exclusively on this price component of energy security. With respect to gas, the situation is more complex. Gas markets around the world can be open to competition (e.g. the United States) or more tightly regulated (e.g. most European countries). In the case of gas, therefore, the assessment of energy security considers both price and physical availability. 2.2.2. Causal links of the price implications of resource concentration With this distinction in mind it is possible to identify the basic causal links for the energy security implications of resource concentration. Fig. 2 schematizes the price implications of resource concentration in a competitive market setting. Fossil fuel demand (stage I) is met through transactions on an international market characterized by resource and ultimately supply concentration (stage II). This can lead to market power and uncompetitive behavior on the supply side. Prices may be set above the competitive level and may experience excessive volatility (stage III). This affects domestic welfare as it raises the cost of energy for businesses and households and may lead to macroeconomic disruptions (stage IV). As we have seen, a direct assessment of welfare impacts (stage IV), while the more accurate measure of energy security in theory, is complex and highly uncertain in practice and provides only limited guidance to policy makers. Assessing the contribution of resource concentration to energy price movements (stage III) is also a difficult task. Fossil fuel markets, whether oil, natural gas, or coal, are international in scope and price fluctuations may encapsulate a wide variety of events, whether technical, economic or political. Distinguishing the effect of resource concentration is therefore complex and highly uncertain. In contrast, though far from simple, measuring actual market concentration (stage II) is workable. While this may not reflect energy insecurity as well as changes in welfare (stage IV), an assessment focusing on a measure of concentration is likely to be of greater practical guidance to policy makers. 2.2.3. Causal links of the physical availability implications of resource concentration Fig. 3 considers the causal links of the physical availability implications of fossil fuel resource concentration in a regulated market setting. Domestic fossil fuel demand (stage I) must be met by supplies from a market characterized by a certain degree of resource concentration (stage II). Bilateral contracts are established with suppliers at a regulated price (stage III). The likelihood of physical unavailability in the domestic market then depends on the rigidity of the actual fuel supply infrastructure (stage IV).5 For example, in the hypothetical case where a country relies solely on imports from one country through one pipeline, if a supply shortfall occurs it will certainly lead to physical unavailability in the importing country. In contrast, if a country imports from a variety of countries and through a variety of transport means (namely by pipeline and tanker), a supply shortfall from one of its 5 This includes rigidity of import infrastructures, contractual arrangements, and the availability of domestic production capacity.

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Stage III Uncompetitive price and/or excessive price volatility Stage II International fuel market characterized by resource/supply concentration

Stage IV Welfare loss due to change in price of energy Stage I Domestic fossil fuel demand

Fig. 2. Causal links: price implications of resource concentration.

Stage III Contractual supply arrangements at fixed price Stage II Market characterized by resource concentration

Stage IV Rigidity of supply infrastructures

Stage V Welfare loss due to change in physical availability of energy Stage I Domestic fossil fuel demand

Fig. 3. Causal links: physical availability implications of resource concentration.

trade partners may more readily be covered by increased exports from others and physical unavailability in the importing country may be avoided. In any event, if physical unavailability does occur in the importing country this will entail some welfare losses (stage V). Again a direct assessment of welfare losses due to a change in the physical availability of energy (stage V) is difficult and uncertain. In contrast, an assessment of the rigidity of supply infrastructures (stage IV) and of contractual supply arrangements (stage III) seems less prone to uncertainty and as such may provide greater clarity to policy makers. In the next sections two new measures of the energy security implications of resource concentration are presented. The first measures the price implications of resource concentration in competitive markets and focuses on market concentration in international fossil fuel markets. The second measures the physical availability implication of resource concentration in regulated markets and focuses on the rigidity of supply systems. 3. Measuring the price implications of fossil fuel resource concentration in competitive markets The measure of the price implications of resource concentration consists of two components. First, a measure of market concentration in each international fossil fuel market—referred to here as energy security market concentration (ESMC)—aims to represents the ‘price risk’ resulting from fossil fuel resource concentration. Second, for a given country, exposure to these price risks is incorporated into an energy security price index (ESPI).6 3.1. Energy security market concentration (ESMC) ESMC is based on the Herfindhal-Hirschman index (HHI), equal to the sum of the square of the individual market shares of all the 6

ESPI is named Energy Security Indexprice in IEA (2007a).

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participants. HHI is a well established measure of market concentration commonly used by governments as a tool to assist them in determining market power in the scope of competition law.7,8 The international oil, coal, and gas markets are considered independently9 and market participants are assumed to be countries. Arguably, private companies, which play an essential role in fossil fuel markets, could be considered as the market participants. However, governments ultimately have control over the exploitation of their natural resources.10 From a security perspective, therefore, a country level approach seems best suited.11 While the uneven distribution of energy resources is the cause of the energy security concern we are interested in, it is only through the physical development of the international market that this concern materializes. Basing the measure of market shares on resources is therefore inappropriate. Whether production or exports should be used depends on prices and physical export capacity. Assuming the hypothetical case of unlimited trade capacity, if no price distinction is made between energy for domestic consumption and exports, then one should measure market shares based on total production. If, on the contrary, a distinction is made between the price for domestic use and exports, then not all domestic production is made available on the international market, and exports should be used as the basis to measure market shares.12 In reality trade capacity is limited by infrastructures and market shares should also reflect each country’s real export potential. Using a measure of net export potential as the basis for the definition of market shares therefore seems well suited as it encompasses physical limitations and whether countries price domestic consumption differently from exports or not. For each fossil fuel f, therefore, ESMC is defined by X 2 Sif (1) ESMC ¼ i

where Sif is the percentage share of each supplier i in the international market for fuel f defined by its net export potential (Sif varies from 0 to 100). Values of ESMC vary between 0, which suggests a highly competitive market, and 10,000 for a pure monopoly. A higher ESMC value therefore implies higher insecurity. In the case of oil and coal, net exports from all countries are included in the measure of ESMC. In the case of natural gas, a distinction needs to be made between suppliers selling gas on competitive terms and suppliers selling gas through long-term regulated contracts. Only exports sold on competitive terms should be considered in ESMC. A key question from an energy security perspective is whether a country’s own share affects risk. In other words, whether ESMC should vary from country to country depending on the country’s 7 HHI is notably used to assist the US Federal Trade Commission in the assessment of horizontal mergers (FTC, 1992). 8 HHI is also known as the Simpson diversity index in ecology. It is one of the dualproperty measures identified by Stirling (1998) in his assessment of diversity measures. 9 See IEA (2007a) for a discussion of market boundaries when assessing fossil fuel resource concentration. 10 In fact, in the case of oil and gas, approximately 80% of reserves are operated by state-owned companies. 11 Due to the unique level of integration of Canada and the US in the field of Energy through the North American Free Trade Agreement (chapter 6) these countries are considered jointly in this analysis. 12 While the liberalization of fossil fuel markets in OECD countries has led to the alignment of pricing policies in OECD countries, this is not necessarily the case in other countries. In fact most resource rich countries have different pricing policies for domestic use and exports. Russia, for example, which holds the largest natural gas resources in the world, has historically maintained a very significant price differential between gas used for domestic consumption and for exports. Similarly, according to the World Bank, Iran, which holds the third largest proven oil reserves, and the second largest natural gas reserves, maintains the highest energy subsidies in the world (World Bank, 2003).

own market share or whether all countries face the same ‘price risk’. The answer to this question is not straightforward. If a country is a large net exporter then prices set above the competitive level would lead to an enhanced revenue stream. From the consumer’s perspective, however, much depends on the magnitude of this revenue stream and redistribution policies. In a case where there are no, or only limited redistribution policies associated with export revenues, a price increase would not benefit consumers and therefore the price risk should be considered the same as any other country. If, on the contrary, a country has effective wealth redistribution policies then the price risk on the market should be considered less than that of a country with a smaller share of the market. For simplicity and as a precautionary stance a single price risk is assumed irrespective of a country’s own position on the market. In other words, all countries are considered to face the same price risk associated with resource concentration. 3.2. Accounting for political stability While further modifications to Eq. (1) may be appealing to better account for the specificities of energy security concerns, the downside is that it necessarily adds complexity to the analysis. Nevertheless, accounting for political stability seems particularly important in the scope of fossil fuel resource concentration. As mentioned earlier, in addition to being geographically concentrated, energy resources are also often located in politically sensitive areas of the world. This may affect the reliability of countries as trade partners.13 To account for political stability, the measure of ESMC defined in Eq. (1) can be modified as follows: X ESMCpol ¼ ðr i  S2if Þ (2) i

where ri is a political risk rating for country i. The inclusion of this parameter should scale up market concentration risks when participants are politically unstable. The approach proposed in Eq. (2) assumes linearity in the scaling of market share by political risk but other approaches may be considered. The extent of the scale-up should reflect the importance given to political stability. Here an illustrative case is considered where r ranges from 1 to 3. In other words the worst possible level of political risk rating leads to a tripling of the country’s contribution to ESMC and the best does not affect the country’s contribution. ESMCpol therefore ranges from 0 for perfect competition amongst countries with the highest level of political stability to 30,000 for a pure monopoly of a country with the worst level of political stability. A number of political stability ratings can be used. In the scope of this study the World Bank’s Worldwide Governance Indicators were adopted. These are based on a methodology first developed in the late 1990s and consist of a statistical aggregation of a large number of survey responses on the quality of governance in OECD and developing countries compiled by survey institutes, think tanks, non-governmental organizations and international organizations (World Bank, 2006). The Worldwide Governance Indicators target six dimensions of governance through separate indicators. Two of these are of particular relevance for energy security.14 13 Energy sector operations may notably be affected by civil unrest. For example, over recent years strikes have affected output in a number of oil producing countries, including Nigeria and Venezuela, with sometimes significant adverse effects on oil production. The political stability of a country may also reflect the likelihood that its government abuses the country’s position in the market. 14 See Kaufmann et al. (2006). More information on the World Bank Governance Indicators at: www.govindicators.org.

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 The ‘Political Stability and Absence of Violence’ indicator



measures perceptions of the likelihood that the government in power will be destabilized or overthrown by possibly unconstitutional and/or violent means, including domestic violence and terrorism. The ‘Regulatory Quality’ indicator measures the incidence of market-unfriendly policies such as price controls, as well as perceptions of the burdens imposed by excessive regulation in areas such as foreign trade and business development.

These indicators are defined on an annual basis and range from about 2.5 to +2.5 with high values indicating better governance performance. A percentile ranking is also available. A composite indicator is used here, based on the average of the two scaled to the chosen range for r (i.e. 1–3).15 With this approach, the composite governance indicator ranges from 2.99 in the case of Somalia to 1.02 in the case of Finland and Luxembourg. The OECD average is 1.38 while OPEC countries average 2.31. In the case studies presented in Section 5 the composite governance indicator are assumed to remain constant over the 2004–2030 timeframe. This assumption is obviously inaccurate and a more in-depth analysis should incorporate scenarios on how changes in the political risk in various regions may affect outcomes. For the purpose of this paper, however, this simple assumption is sufficient.

3.3. Energy security price index (ESPI) To capture the exposure of a given country to the price risks associated with resource concentration the share of the country’s total final primary energy supply exposed to each ESMCpol value needs to be identified. The ESPI is then the sum of the products of ESMCpol and the corresponding share of the fuel mix exposed: X ESPI ¼ ½ESMCpol-f  Ef =TPES (3) f

where ESMCpol-f is the ESMCpol value for fuel f, Ef is the country’s supply exposed to the ‘price risk’ of fuel f, and TPES is the country’s total primary energy supply.16 As schematized in Fig. 4 (right hand side), E-coal is simply total coal supply. In the case of oil and gas, however, the value of E-f depends on the country’s gas market organization. Natural gas prices are either set competitively or regulated. In the first case, the approach is as simple as in the case of coal. E-oil and E-gas are, respectively, total oil and total natural gas supply. In the case where gas prices are regulated, however, much depends on the nature of the price regulation. If the price of gas is simply fixed then there is no price concern for gas and E-gas is equal to zero. In the vast majority of cases, however, the gas price is indexed to oil in one way or another. As such, gas is also exposed to the resource concentration price risk of the oil market. In this case therefore E-oil is equal to total oil supply plus the gas supplied through oilindexed contracts and E-gas equals zero. In some cases, such as the UK discussed in section 5, natural gas supply is partly priced competitively and partly based on such oil-indexed contracts. In such cases E-oil is equal to total oil supply plus gas supplied through the oil-indexed contracts and E-gas is equal to gas supplied through purchases in the competitive segment of the gas market.

15 To avoid giving too much importance to events in a specific year the average of the 2002–2005 years is used. 16 E-f and TPES should be both measured in energy units so E-f/TPES is in percentage points.

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4. Measuring the physical availability implications of fossil fuel resource concentration in regulated markets When the gas market is regulated, gas prices do not reflect changes in supply and demand conditions and physical availability is therefore an important security concern. This is notably the case of most European countries as well as Japan and Korea. In such cases, the flexibility of gas supply infrastructures determines the country’s physical unavailability risk. In particular, due the difference in the inherent flexibility of liquefied natural gas (LNG) and pipe-based trade a distinction should be made between these modes of gas transport. In the case of pipe-based contracts between two countries a supply shortfall cannot be easily compensated for by other supplies. Generally, the importing country cannot use the same infrastructure to import from other sources, as a pipeline tends to tie a customer to a given supplier. If the country has access to other import pipes then it may be able to compensate for some of the lost supply though this is uncertain. Spare capacity availability generally depends on the time of year with no or very limited spare capacity during periods of strong demand (e.g. winter peak). Also, much depends on domestic infrastructures and available capacity to transport the gas from one import pipe network to another. If the importing country has access to spot cargoes thanks to LNG infrastructures, much depends again on physical availability constraints. It will only be able to increase LNG imports to compensate for a supply shortfall from pipe-based imports if there is available capacity at the regasification terminals and throughout the gas network linking the LNG terminal and the import pipe. In the case of an LNG-based contract, in the event of a supply shortfall, the country to which the LNG cargo was destined has the opportunity to use the freed capacity to import LNG from elsewhere. The country would most likely look at LNG spot cargoes to replace lost volumes. Unlike the case of pipe-based contracts, there should be no capacity constraint and physical unavailability risks are limited.17 Due to the relative inflexibility of pipelines, therefore, physical unavailability concerns are predominantly linked to pipe-based imports. The approach proposed here is therefore to consider the share of a country’s total energy demand met by pipe-based gas imports purchased through long-term regulated contracts as the measure of the physical availability component of resource concentration. An energy security physical availability index (ESPAI), expressed in percentage, can therefore be defined as follows18: ESPAI ¼ Gasimp-pipe-regulated =TPES

(4)

where Gasimp-pipe-regulated is the supply of gas that is imported by pipeline based on regulated contracts and TPES is total primary energy supply. ESPAI ranges from 0 when either all gas supply is purchased on competitive terms, there are no pipe-based imports (i.e. imports are entirely based on LNG), or the country is self sufficiency in gas (i.e. no imports), to 100 in the hypothetical case where the country’s TPES only consists of natural gas and supply is entirely imported through pipelines and based on regulated longterm contracts. With the inclusion of ESPAI our overall approach to measure the energy security implications of resource concentration can be summarized as shown in Fig. 4.19 17 In reality tanker availability may be an issue, yet as LNG trade volumes increase this should become less of a problem. 18 ESPAI is named Energy Security Indexvolume in IEA (2007a). 19 For the regulated gas segment of the fuel mix, only the case of oil-indexed contracts are shown in this figure as these represent the majority of contractual arrangements today.

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Measuring the Physical availability component of resource concentration (ESPAI)

Measuring the price component of resource concentration (ESPI)

Country fuel mix

Market concentration in intl. gas market

Non fossil fuels

(ESMCpol-gas)

Pipe-based import dependence Gas – Competitive Gas Regulated- Oil indexed Oil

Market concentration in intl. oil market (ESMCpol-oil)

Coal Market concentration in intl. coal market (ESMCpol-coal)

Fig. 4. Measuring the energy security implications of resource concentration.

5. Case studies: France and the United Kingdom In this section the approach detailed above is applied in two case study countries, France and the United Kingdom, to assess the evolution of ESPI and ESPAI over time. The analysis uses country level data from the IEA (2007a) and projections from the 2006 World Energy Outlook reference scenario (IEA, 2006b). In most cases, regional trends from the Outlook were applied to country data and adjusted accordingly to provide as coherent a dataset as possible. While certainly an inaccurate projection of the future, the objective of this section is to demonstrate how the approach defined in the previous section may work. The adoption of this approach in a formal policy analysis context would require a more accurate dataset as well as undertaking sensitivity analysis not included here. The next subsections present how ESPI, its components, and ESPAI may evolve over the 2004–2030 period following a set of assumptions, both embodied in the Outlook’s reference scenario, and detailed below. 5.1. Energy security price index (ESPI) 5.1.1. ESMC in the international oil market A difficult issue when measuring market power in the international oil market is the treatment of OPEC’s member countries. On the one hand, OPEC has set production quotas for each of its members in a coordinated manner since the early 1960s. On the other, the effectiveness of this process is uncertain. Quotas have not always been respected, particularly in times of low oil prices. In addition, negotiations to define production quotas among OPEC members have proven difficult, in part because oil revenues typically represent such a large share of the economy (Adelman, 2001). Nevertheless, while clumsy,20 OPEC remains a cartel-like organization. Here OPEC is considered as a single supplier to the international oil market. This is certainly an overly 20

A term first used to describe OPEC by Adelman (1980).

stringent assumption and a more in-depth assessment should include alternative assumptions. Nevertheless this assumption stands from a precautionary perspective of energy security and is suitable to demonstrate the approach presented here. Predictably, the net export potential21 of OPEC is by far the most important, representing in 2004 close to four times the level of Russia, the second largest participant in the international oil market (Fig. 522). Over the 2004–2030 period the net export potential of OPEC is also projected to grow at a faster pace than most other market participants. It notably grows by close to 74% between 2004 and 2030 while that of Russia grows by only 20%. The combined export potential of the five most important participants in the market in 2004 represents 86% of the total and OPEC alone accounts for 56%. By 2030, this share increases to 88% of which 67% is accounted for by OPEC. In 2004, ESMC is about 3700 (Fig. 6). When looking at the 2004–2030 period, ESMC first drops between 2004 and 2010 before a significant and sustained rise, reaching approximately 4800 by 2030. This represents an increase of 30% between 2004 and 2030. ESMCpol is at about 8700 in 2004, 136% more that ESMC. ESMCpol increases to about 11,400 by 2030, 138% more than ESMC. 5.1.2. ESMC in the international coal market The same five countries remain the largest participants in the market throughout the 2004–2030 timeframe, namely Australia, China, Colombia, Indonesia, and South Africa (Fig. 7). Australia is the largest net exporter in the market throughout the 2004–2030 timeframe. Its net export potential grows by 74% between 2004 and 2030. Indonesia and Colombia see their export potential 21 ESMC is based on a measure of the net export potential of countries and therefore requires information on total available export capacity. Due to the difficulty of projecting such data we assume that the export potential of a country is equal to its net exports as defined by: net exports ¼ total productiontotal consumption. 22 Figs. 5–13 are based on country level data from the IEA (2007a) and extrapolations from the 2006 World Energy Outlook reference scenario (IEA, 2006b).

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Fig. 8. Coal market ESMC and ESMCpol, 2004–2030.

Fig. 5. Export potential of five largest participants in the oil market, 2004–2030.

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Fig. 7. Export potential of five largest participants the coal market, 2004–2030.

almost double in the same time, while South Africa’s grows by some 44% and China’s drops slightly. The gap between the first and second position in the market grows slightly. Taken together, these five countries represent 83% of the global market in 2004 and this share increases to 88% in 2030. ESMC is about 1900 in 2004 and grows by 22% to 2030 to reach close to 2300 (Fig. 8). ESMCpol is at approximately 3000 in 2004, some 64% greater than ESMC. ESMCpol then increases to reach about 3700 in 2030, 62% higher than ESMC.

5.1.3. ESMC in the competitive segment of the international gas market Assessing market concentration in the gas market is complicated for two reasons. First, unlike the coal and oil market, there has not been a world gas market but rather several regional markets. As LNG trade between regions continues to grow these regional markets are being rapidly integrated into a world market structure, yet the pace at which this takes place is difficult to determine (IEA, 2006a, 2007b). Second, the size and concentration of the competitive segment of the international gas market depends to a large extent on developments in regulated segments of the market as this binds suppliers to bilateral contracts. A large share of world gas supplies can therefore not be accounted for in the competitive segment of the market. To address these issues, a number of simplifications are made. First it is assumed that by 2010 price changes in one region will be reflected in other regions. In other words, that regional dynamics will continue only until 2010, after which a global market structure can be considered. For 2004 there are therefore two separate markets: the Americas on one hand and the rest of the world on the other (Europe, Africa, Middle East and Asia).23 Starting from 2010 these are considered as one. Assuming a world market by 2010 may be too short a time frame yet an increasing number of projects tend to indicate that such global linkages are already underway and will intensify in the near future.24 Second, existing contractual arrangements based on oil-indexed prices are assumed to remain the norm throughout the 2004–2030 timeframe in Europe25 and Asia. This is unlikely to be the case in reality. Gas market liberalization efforts in Europe are likely to lead to a greater share of gas purchased on competitive price terms. Yet due to the complexity of this issue and the vital role of existing long-term contracts, the transition is uncertain and at best likely to be slow. This assumption, much like others in this paper, should be considered as a working basis to assess ESMC. Based on these assumptions, Figs. 9 and 10 depict the evolution of concentration in the competitive segment of the international gas market. In 2004, the market serving the two case study countries (i.e. the combination of Europe, Middle East, Africa and Asia suppliers) is dominated by LNG exporters as these play a key role in the emerging spot market while pipe-based trade in Europe is predominantly bound by oil-indexed contracts (Fig. 9).

23 While African suppliers may not physically export to Asia, the Middle East exports to both Europe and Asia creating price linkages between these different regions. 24 See IEA (2007b) for a project by project review. 25 With the exception of the UK where the competitive segment of the market represents approximately 50% of total demand.

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1642

30

France

Regional market World market structure structure

350

oil

gas

coal

Nuclear

Renewables

300 20

Mtoe

Mtoe

250

10

200 150 100

2004

2010

2020

0

Malaysia

Algeria

Nigeria

Qatar

Norway

Malaysia

Algeria

Nigeria

Qatar

Norway

Malaysia

Indonesia

Qatar

Algeria

Nigeria

Norway

Malaysia

Qatar

Oman

Algeria

50 0

2010

2004

2030

300

Fig. 9. Export potential of five largest participants in competitive segment of the gas market, 2004–2030

2020

2030

United Kindgom oil

gas

coal

Nuclear

Renewables

250

Mtoe

200 5000 Transition from regional to world market structure

150 100

4000

50 3000

0 2004

2010

2020

2030

2000 Fig. 11. Fuel mix composition of France and the United Kingdom, 2004–2030.

1000 ESMCpol

ESMC

9000

0 2004

2010

2020

8000

2030

7000 Fig. 10. Gas market ESMC and ESMCpol, 2004–2030.

5.1.4. Energy security price index (ESPI) Fig. 11 shows the evolution of the fuel mix of both France and the United Kingdom between 2004 and 2030. As noted above, in this analysis the current gas market organization in Europe is assumed to remain unchanged throughout the 2004–2030 period.

ESPI

Algeria is the largest participant representing 35% of the total. It is followed by Qatar and Oman who represent respectively 23% and 17%, of the market. In 2010, Norway, the only pipe-based exporter among the top five in the market, is the most important participant in the competitive segment of the world market. Norway then moves to second position from 2020 following Qatar. In 2004, the five largest participants represent 90% of the market. This value drops to 60% in 2010 as the market is diluted based on the assumed shift to a global market structure. By 2030, the five largest market participants account for 54% of the total. In the regionally constrained market of 2004, ESMC is of 2200 (Fig. 10). The shift to a global market structure leads to a drop in ESMC to a value of near 1000 in 2010. ESMC subsequently increases to a little under 1100 in 2020 before reducing again to about 900 in 2030. ESMCpol is 4800 in 2004, 118% higher than the ESMC value. Between 2004 and 2010, ESMCpol drops to 1700, some 73% higher than ESMC. This represents a much lower increase that in 2004, as countries with better political stability ratings now play a more important role. Between 2010 and 2030, ESMCpol follows the same trend as ESMC, reaching a little under 1600 by 2030.

6000 5000 4000 3000 2000 1000 France

United Kingdom

0 2004

2010

2020

2030

Fig. 12. Energy security price index, 2004–2030.

In the case of the United Kingdom it is assumed that approximately half of gas demand is met by supply purchased on the competitive market while the other half is met by long-term oilindexed contracts. In the case of France, only a fraction of gas demand is met by supplies purchased on the competitive market segment. For simplicity 100% of demand is assumed to be met through oil-indexed long-term contracts. In the case of the UK, therefore, total oil supply as well half of gas supply is exposed to oil market ESMCpol while the other half of gas supply is exposed to gas market ESMCpol. In the case of France, total oil supply plus total gas supply is exposed to oil market ESMCpol while none of its fuel mix is exposed to gas market ESMCpol. Fig. 12 shows the evolution of ESPI in our two case study countries. In 2004, the ESPI value of the UK is approximately 6100 while that of France is 4300. Though to varying degrees, ESPI drops in both countries between 2004 and 2010 before increasing to 2030. ESPI reaches close to 6200 in 2030 in the case of France, a

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5.2. Energy security physical availability index (ESPAI) While the reliance on LNG and pipe-based trade is known for 2004 in both France and the UK, defining future prospects depends on a number of uncertain parameters, including the evolution of gas prices and infrastructure costs. For simplicity, the growth in LNG trade projected to take place at the global level over the 2004–2030 timeframe in the World Energy Outlook reference scenario is assumed to take place in the two case study countries. Again, this is an overly simplistic assumption but provides the necessary information for assessing the impact of LNG investments on ESPAI. The resulting evolution in projected gas trade by import means is shown in Table 1. France has very limited domestic production in 2004 and becomes 100% import dependent starting from 2010. In 2004 LNG already accounts for 20% of total imports and this share is assumed to grow to 25% in 2030. While the UK has been an important producer of gas, in 2004 it became a net importer, importing approximately 1% of total consumption—all of which was via pipelines. As production continues to decline, import dependence rises reaching 88% by 2020 and 96% by 2030. By that date, 24% of imports are expected to be LNG-based. Fig. 13 shows the evolution of ESPAI for France and the UK. ESPAI in France grows from 11% in 2004 to 15% in 2030. In the case Table 1 Gas import dependence, 2004–2030.a France (%)

United Kingdom (%)

2004 Total Pipe LNG

97 77 20

1 1 0

2010 Total Pipe LNG

100 78 22

35 32 3

2020 Total Pipe LNG

100 77 23

88 71 17

2030 Total Pipe LNG

100 75 25

96 76 20

a Based on country level data from the IEA (2007a) and extrapolations from the 2006 World Energy Outlook reference scenario (IEA, 2006b).

30 France

United Kingdom

20 ESPAI

42% increase compared to the 2004 value, and about 8000 in the case of the United Kingdom, a 30% increase compared to 2004. France’s ESPI is 29% lower than the UK value in 2004 and 22% lower in 2030 primarily a result of a greater share of non-fossil fuels in France’s fuel mix. The common trend over the 2004–2030 period reflects the relative importance of oil market risk which bears a similar rising profile (see Fig. 6). Looking at 2004–2010, in the case of the UK, the drop in ESPI is much more pronounced than in the case of France. This can be explained by the role gas plays in the UK fuel mix combined with the country’s gas market arrangements. As the UK purchases half of its gas supplies on the competitive segment of the market, it is exposed to gas market ESMCpol which drops significantly between 2004 and 2010. In contrast, not only does France have a comparatively smaller share of gas in its fuel mix, its reliance on oil-indexed contracts means its ESPI is unaffected by ESMCgas trends.

1643

10

0 2004

2010

2020

2030

Fig. 13. Energy security physical availability index, 2004–2030.

of the UK, ESPAI grows from approximately 0 in 2004 to 16% by 2020 and 18% in 2030. The UK’s zero value in 2004 is associated to its very low import dependence. Similarly, the rising trend to 2020 follows the country’s increasing imports of gas. The UK’s ESPAI value surpasses that of France by 2020. While only half of the UK gas supply is assumed to be at risk of physical unavailability compared to all of France’s supply, the higher UK value from 2020 is due to a comparatively larger gas share of the fuel mix. The slower rise in the UK’s ESPAI between 2020 and 2030, parallel to France’s trend, reflects shift to near total import dependence and a relatively stable LNG shares.

6. Conclusion The approach introduced in this paper provides new tools to assess the energy security implications of fossil fuel resource concentration. Its objective is to complement economic assessments of welfare effects and expert judgment with an alternative which gauges the causes of energy insecurity in a systematic manner. Much like any quantitative effort to assess energy security the indexes presented in this paper are imperfect and based on important simplifications. Yet the approach is sufficiently transparent for alternatives to be easily tested. This is true of structural parameters, such as the decision to use net exports as the basis to measure market concentration in ESMC, as it is for assumptions made in the case studies, such as considering OPEC as a single supplier to the oil market. The assumptions embodied in the case studies of France and the UK presented in Section 5 therefore undoubtedly have important effects on results obtained. In a formal policy analysis setting, these assumptions should be challenged by considering different scenarios and undertaking a variety of sensitivity analyses. Nevertheless, the case studies illustrate how the approach may be used and highlight some of the insights it provides. For example, before being aggregated into ESPI, ESMC results for individual fuel markets are interesting in their own right. Based on the assumptions adopted in this paper oil market resource concentration is the main driver of the rise in the price component of energy insecurity for both France and the UK over the 2004–2030 period. In 2004, oil market ESMC is close to 200% that of the coal market and 168% that of the natural gas market. By 2030 oil market ESMC is 212% that of the coal value and 540% that of the natural gas market. Yet different assumptions would certainly lead to very different results and these can readily be explored through ESMC and ESPI. This may include assessing the effect of considering OPEC as a less than perfect cartel like organization or of a progressive shift towards greater competition in the European gas market.

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Similarly, a comparison of ESMC and ESMCpol highlights the relative political stability of the main participants of each market. In the case of the oil market, ESMCpol is about 140% more than the ESMC value. In contrast, in the coal market ESMCpol is only about 60% greater than ESMC. In the case of the competitive segment of the natural gas market, starting from 2010, ESMCpol is about 75% greater than ESMC. When comparing the three fossil fuel markets, the oil market is therefore characterized by greater political instability then both the coal and gas markets. In the case of gas, the transition from regional to world market structure between 2004 and 2010 leads to a significant improvement in political stability of the main market participants. The case studies also highlight the role of natural gas in linking the price and the physical availability components of energy security. Importantly, gas market concentration is significantly lower than that of the oil market, particularly due to the increasing globalization of gas trade. Oil-indexed gas pricing, therefore, exposes countries to a market characterized by higher concentration than if gas were purchased on the competitive segment of the market. This effect is most significant for France which purchases almost all of its gas supplies through oil-indexed contracts. In contrast, only about half of UK supplies are purchased through such long-term oil contracts. Oil-indexed pricing also creates important physical availability concerns, as reflected in the evolution of ESPAI. This is most striking in the case of the UK, where ESPAI emerges as a new and important energy security concern as the country grows increasingly import dependent, surpassing France’s ESPAI level by 2020. This approach may also be used to gauge the impact of various policy options.26 Increasing the rate of penetration of renewable and nuclear energy sources in the fuel mix, for example, will have a positive effect on both ESPI and ESPAI yet the magnitude of the energy security benefits depends on the energy security profile of the fuel displaced. Similarly, due to the importance of oil market concentration in driving the rise in ESPI an effective way to improve energy security is by reducing exposure to oil market ESMCpol. Considering the characteristics of oil consumption in most OECD countries, this means improving energy efficiency in vehicles and, on the longer-term, switching to other fuels such as electricity, biofuels or natural gas. On the other hand, increasing domestic oil production is unlikely to improve ESPI. Whether produced domestically or purchased from abroad, oil prices are determined on the international market and considering the weight of OPEC and Russia in determining oil market ESMCpol (see Fig. 5), ESPI is unlikely to be affected. Governments may also seek

26 From a methodological point of view, policy assessments need to be made in comparison to a baseline scenario. For example, if a policy affects the share of the fuel mix exposed to a given fuel market concentration the assessment should be made relative to the baseline fuel mix. Specifically, when undertaking policy analysis, TPES in Eq. (3) and (4) should remain that of the reference case.

to improve ESPI by providing assistance to resource rich countries to help enhance political stability. With respect to natural gas, a transition from oil-indexed contracts to trade based on competitive pricing will contribute to lower both ESPAI and ESPI, particularly considering the positive effect on gas market ESMC from the globalization of gas market structures. Finally, ESPI and ESPAI may readily be associated to a measure of CO2 emissions to provide a simple means to assess energy security and climate change mitigation jointly. Acknowledgments The author would like to thank William Blyth and two anonymous reviewers for their insightful comments on earlier drafts. References Adelman, M.A., 2001. The clumsy cartel: OPEC’s uncertain future. Harvard International Review 23 (1) Spring 2001. Adelman, M.A., 1980. The clumsy cartel. Energy Journal 1 (1). Bohi, D.R., Toman, M.A., 1996. The Economics of Energy Security. Kluwer Academic Publishers, Norwell, Massachusetts. British Petroleum (BP), 2007. BP Statistical Review of World Energy, London. Federal Trade Commission (FTC), 1992. Horizontal Merger Guidelines, issued jointly by the Department of Justice and the Federal Trade Commission, Washington, DC. Huntington, 2005. The economic consequences of higher crude oil prices. Final Report EMF SR 9, Energy Modeling Forum, Stanford, California. International Energy Agency (IEA), 2007a. Energy Security and Climate Policy: Assessing Interactions. IEA/OECD, Paris. IEA, 2007b. Natural Gas Market Review: Security in a Globalising Market to 2015. IEA/OECD, Paris. IEA, 2007c. Oil Supply Security: Emergency Response of IEA Countries 2007. IEA/ OECD, Paris. IEA, 2006a. Natural Gas Market Review 2006: Towards a Global Gas Market. IEA/ OECD, Paris. IEA, 2006b. World Energy Outlook 2006. IEA/OECD, Paris. IEA, 2005. Learning from the Blackouts: Transmission System Security in Competitive Electricity Markets. IEA/OECD, Paris. Kaufmann, D., Kraay, A., Mastruzzi, M., 2006. Governance Matters V: Aggregate and Individual Governance Indicators for 1996–2005. World Bank, Washington, DC. Pershing, J., Tudela, F., 2003. A Long-term Target: Framing the Climate Effort, Beyond Kyoto: Advancing the International Effort against Climate Change. Pew Center on Global Climate Change, Washington, DC. Stirling, A., 1998. On the Economics and Analysis of Diversity, SPRU Electronic Working Papers Series, No. 28, Brighton, UK. World Bank, 2006. A Decade of Measuring the Quality of Governance: Governance Matters 2006, Worldwide Governance Indicators, The International Bank for Reconstruction and Development. The World Bank, Washington, DC. World Bank, 2003. Iran medium-term framework for transition. Economic Report No. 25848, The World Bank, Washington, DC.