[GGP] Beware Regulators Even when Bearing Gifts

When the Trojan priest Laocoon warned his fellow citizens about “Greeks bearing gifts”, he was ignored by them and then killed by the gods for his efforts. Now I feel I must warn the Greeks – along with others – about gifts being borne by the European Union Commission (EC). In the following article, I argue that promises of derogations or exemptions from the unnecessary proposed Gas Directive amendment give a false sense of security to pipelines affected by it. I hope that I will not suffer the same fate as Laocoön.

The EC’s flawed proposed Gas Directive amendment[1] aims to regulate import pipelines from third (i.e. non-EU) countries. The benefits of this proposal are far from clear. Many industry and trade bodies have criticised the amendment and the way the EC has tried to rush it through, including Confindustria, BusinessEurope, European Federation of Energy Traders, the Czech Gas Association, Eurogas and others.[2] (For my own view, see The Gas Directive amendment – a solution in search of a problem.) The European Parliament Research Service says that the EC has claimed economic benefits without citing specific evidence.[3] There are very clear situations where regulation of gas markets is necessary and has brought benefits to consumers, but this is not one of them.

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The proposed amendment will affect both existing and future import pipelines to Europe, making them subject to EU gas market rules for the first time. The existing pipelines affected include the following:

• TransMed from Algeria to Italy via Tunisia, commissioned in 1983
• Maghreb from Algeria to Spain via Morocco, commissioned in 1996
• Greenstream from Libya to Italy, commissioned in 2004
• Medgaz from Algeria to Spain, commissioned in 2010
• Nord Stream from Russia to Germany, commissioned 2011/2012

The proposed amendment will also affect Nord Stream 2, currently under construction and due for completion in 2019; TransAdriatic Pipeline which will connect Greece and Italy via Albania; the proposed East Med pipeline connecting Israel, Cyprus, Greece and Italy; and GALSI between Algeria and Sardinia.

Arthur D Little (ADL) has written a report[4] that shows how the amendment will require changes to existing agreements, including those between governments (IGAs). As any seasoned negotiator knows, the risk of reopening one aspect of an agreement is that your counterparty may want to reopen other aspects, which you would rather not change. The ADL report highlights the complicated nature of the existing IGAs and the difficulties faced by the projects when developing them. New pipelines may need IGAs to solve the “conflict of laws” between the EU and third countries.[5] Currently no such conflict exists, so the proposed amendment needlessly complicates matters.[6] The EU Council Legal Service[7] says the proposed amendment is contrary to the UN Convention on the Law of the Sea, which governs the laying of pipelines in the exclusive economic zones of maritime countries.

However, the EC has proposed that existing pipelines could receive derogations, and new projects could receive exemptions, from the legislation. Apparently, the EC has been using this to reassure those countries affected that they have nothing to fear from the amendment. I am more sceptical, based on over 20 years working in energy market regulation. I have never met a regulator that does not use its power in one way or another. Which makes sense, because what is the point of having power if you do not use it, even if only sparingly?

Benefits must outweigh costs of regulation

There are very legitimate reasons why governments should regulate markets, so I am not arguing for no regulation at all. Rather it is generally accepted that you should only regulate where there are clear benefits. As the EC itself says, EU actions should be based on “evidence and understanding of the impacts” and regulatory burdens should be “kept to a minimum.”[8] The proposed amendment fails this test, as another report[9] by Arthur D Little shows. Moreover, the EC itself has failed to conduct a proper impact assessment.

Are derogations or exemptions the answer? This raises the question of why you need to regulate at all, if most projects are going to receive derogations or exemptions.[10] This will hardly create the level playing field claimed by the EC. There is also an optimistic assumption that the projects will receive the assurances they need.

This is where the Trojan reference comes in. Derogations and exemptions are a gift from regulators. The regulator decides what type of derogation or exemption you may receive, if any; its duration; its scope and any additional conditions. It is very difficult to challenge a regulator’s decision and even if you can, this may be time consuming and expensive. This leaves projects with very limited room for manoeuvre. It is therefore far better to keep regulatory burdens to a minimum in the first place.

Exemptions can fail

Even an exemption is no guarantee of safety. An example of this is Interconnector UK (IUK) which operates a gas pipeline between Belgium and Great Britain. In 1995 the project received permission from the EU for the shareholders to also hold the capacity rights for 20 years to enable financing.[11]  The pipeline entered service in 1998. Under the Second Gas Directive of 2003, IUK became subject to regulated third party access but regulation remained relatively light touch.

However, the Third Gas Directive of 2009 imposed the requirement of ownership unbundling, which prohibits companies from being gas producers or suppliers and also owning pipelines. This caused problems for IUK shareholders, who also owned capacity rights. Despite the 1995 decision, IUK shareholders had to divest their capacity rights or their shares. Other European pipeline companies did not have to apply ownership unbundling because they were part of “vertically integrated” companies.[12] IUK did not qualify as a “vertically integrated” company.

The enforcement was counter-productive because IUK was not the intended target of the unbundling rules whereas the European vertically integrated companies were. The 1995 decision had taken account of the same factors that led EU policy makers to impose ownership unbundling and decided it was acceptable to grant IUK an “exemption.”

Furthermore, pipelines, which had been built since 2003, had been able to gain an exemption under Second Gas Directive rules, which continued to give them protection under the Third Gas Directive. IUK did not have such an exemption as it predated the Second Gas Directive. Arguments that its 1995 “exemption” gave it equivalent protection failed, despite a sympathetic hearing from the authorities.

The IUK case is arguably one of “collateral damage.” IUK’s problems trace back to the decision to classify it as an interconnector under the Second Gas Directive. This paved the way for the tighter regulation of the Third Gas Directive and the unfortunate loopholes in the drafting which meant that IUK could neither rely on its original exemption – which it should have been able to do – or use the exemptions available to “vertically integrated” companies.

National regulators undermined

The proposed Gas Directive amendment ensures that projects cannot rely on their friendly national governments giving them the “right” derogation or exemption. It entails a competence shift away from member states and towards the EC, which will be the ultimate arbiter of any derogations or exemptions. Even if the national regulator grants an acceptable exemption, the EC may overrule it.

One example is the Ostsee-Pipeline-Anbindungsleitung (Opal), the pipeline in Germany that connects Greifswald in Germany with the Czech Republic, enabling Gazprom to deliver gas from Nord Stream to customers in Europe.[13]

Under the Second Gas Directive[14] Opal applied for an exemption in 2008. The German regulator, the Bundesnetzagentur (BNetzA), initially granted a partial exemption for 22 years. The EC reviewed the BNetzA decision in 2009 and imposed extra restrictions, limiting Gazprom’s use to 50% unless Gazprom agreed to gas and capacity release programmes of 3bn m³. The BNetzA granted an exemption on this amended basis in July 2009.

Gazprom disputed the EC decision but could not utilise fully its booked capacity in Opal, and hence Nord Stream, between 2011 and 2017. After much discussion, the EC revised its decision in October 2016, giving Gazprom full access to Opal.

The Polish gas company, PGNiG, complicated matters by challenging that decision in the courts, even though Opal does not connect to or go through Poland. A final decision by the EU Court of Justice is expected in 2019.

Opal was clearly subject to regulation under EU rules. However, the EU decision to limit Gazprom’s access was open to question from a regulatory perspective. Katja Yafimava says[15] the EC’s October 2016 decision shows a “(belated and not openly acknowledged) recognition on the part of the EC that there was no rationale, either in the energy or competition acquis, for not allowing Gazprom to utilise more than 50% of Opal’s capacity.” The World Trade Organisation also ruled that the Opal restriction was against WTO rules in 2018 following a case brought by Gazprom.[16]

The case is a very clear illustration that exemptions are not a free gift from regulators (even the original BNetzA exemption was only partial), and that the process can be uncertain, time consuming and costly. Nor should project developers rely on political goodwill as a guarantor of a favourable outcome. The EC decided to restrict Gazprom’s use of Opal despite EU support for Nord Stream as a Project of European Interest. Relations between countries and the EC can change quickly depending on circumstances, as both the travails of Greece during the financial crisis, and the situation of Britain after the Brexit referendum show.

Unintended consequences

Finally a personal recollection. With others I led the team that successfully applied for an exemption for the Dragon LNG terminal in the UK, one of the first projects to receive an exemption under the Second Gas Directive in 2004/5.[17] The UK regulator (Ofgem), the UK government and the EU Commission were all very supportive of the project. However, this did not mean that we received a “free ride”, despite my original (and naive) belief that it was obvious we should receive an exemption.

Much time and effort was spent justifying the exemption request and meeting the conditions proposed by the regulator, for example the design of a ‘Use it or Lose it’ mechanism. A couple of times the process nearly came unstuck because of genuine misunderstandings between the project and Ofgem. There had to be alignment between the project’s original sponsors (Petroplus, BG Group and Petronas) which was sometimes complicated by the commercial implications of the exemption. It was also necessary to factor in the different objectives of Ofgem, UK Government and the EC, and allow for this when estimating the time it would take to gain the exemption needed before the final investment decision could be taken in 2004.

In the end, the request was successful and Dragon has now been in operation for nearly ten years. However, the key lesson I learned is that an exemption request is not a simple undertaking, and a proposed amendment so reliant on exemptions and derogations could cause more problems than it solves. It would be far better if EU member states rejected the amendment as unnecessary and unfit for purpose.