The Emergence of Markets in the Natural Gas Industry

Abstract

Deregulation and restructuring of the natural gas industry in many countries has led to the development of new markets that have changed how the industry operates. A growing number of countries - including the United States, the United Kingdom, and Argentina - are reforming their gas sectors to increase competition and develop new models of interaction among participants. A number of models and lessons of reform are available to other countries interested in reforming their natural gas industry.

As countries have deregulated prices and lowered entry barriers in the natural gas industry, many new participants have emerged, promoting competition in the newly created markets. The increased competition has benefited everyone through more efficient pricing and greater choice among natural gas contracts.

Four distinct structural models have emerged in the industry's restructuring. The traditional model (a vertically integrated industry) has been increasingly replaced by models that decentralize the industry along horizontal and vertical lines. With increasing decentralization, regulation of the industry focuses on pipeline transportation and distribution, the industry segments with natural monopoly characteristics. Regulation aims to protect both end users and participants in the deregulated segments from the market power of companies operating in the monopolistic segments.

As a result of deregulation, two major markets emerge: The natural gas market (which facilitates the trading of natural gas as a commodity) and the transportation market (which enables market participants to trade the services needed to ship natural gas through pipelines). Competition and open entry are crucial for these two markets to function efficiently. The transportation market is affected by the market power of pipeline companies, but resale of transportation contracts brings competition to this market and facilitates the efficient allocation of contracts. Intermediaries and spot markets promote efficient pricing and minimize transactions costs.

Markets have become more complex with deregulation, and trading mechanisms are needed to ensure the simultaneous clearing of natural gas and transportation markets at minimum cost to the industry. Two main trading models guide transactions: The bilateral trading model (which relies on decentralized bilateral negotiations between market participants) and the poolco model (which relies on a centralized entity to coordinate transactions). Properly applied, both models lead to the same outcome. The bilateral trading model has dominated because of its simplicity of implementation, but the poolco model has great potential once problems of sharing and processing information are addressed.

This paper - a product of the Private Participation in Infrastructure Group, Private Sector Development Department - is part of a larger effort in the department to analyze issues arising from private participation in infrastructure.