Making gas network regulation fit for decarbonization

To meet our global climate targets, the use of gas distribution networks will likely decline over the coming decades in Europe. Current gas price hikes and shifts away from Russian supplies will accelerate this transition. Under current regulation, however, lower network usage leads to increasing network tariffs, and to customers paying for potentially redundant infrastructure. Therefore, we need an honest debate about the future of gas networks, and who will carry the costs if pipelines are decommissioned prematurely.

Use of gas distribution grids will likely decline substantially

To reach net-zero, the role of natural gas as an energy carrier in Europe must decrease considerably over the coming decades. Recent gas price rallies and the EU’s new ambition to reduce Russian imports will only exacerbate this development. For gas networks, this means a substantially lower usage of existing infrastructure. In the case of the larger, cross-regional transmission networks, this development might be mitigated by retrofitting networks to hydrogen, and building new gas power plants as a bridge technology. However, this way out is limited for smaller and meshed distribution grids, which primarily deliver natural gas for heating buildings. In the medium term, the green hydrogen and biogas supplies for heating buildings will be limited because domestic potentials are insufficient and for hydrogen, potential export countries face high financing costs and currently lack the required infrastructure. Therefore, the available green gases must be used for processes where decarbonization alternatives are still not available, e.g. in refineries or the chemical industry. In contrast, heating buildings can be decarbonized via heat pumps and district heating, which are often cheaper as well. As a result, the official exit strategy of gas distribution networks, namely switching to 100% green gases, will not warrant the current size of distribution networks – which in Switzerland alone have a value of almost CHF 5bn.

Lower demand increases network tariffs and poses stranding risks

In a competitive market, a declining network demand would lead to reduced network tariffs. However, gas distribution networks are monopolies and hence subject to strict regulation in virtually all European countries. Regulatory agencies therefore determine how much network operators can earn for their services. Simply put, regulation allows operators to cover their network costs, i.e. operating expenditures and annual depreciation, and earn a pre-defined return on the remaining asset value (see Figure 1). If demand drops, the allowed revenues remain the same such that the network tariff per transported unit of gas increases. This directly raises end-user gas prices of which network tariffs account for about a quarter in Germany and Switzerland. In extreme cases, a network-wide demand collapse leads to a so-called “death spiral” where higher network tariffs reduce demand even further. Furthermore, demand reductions can render some network assets redundant, particularly if overly optimistic expectations led to unwarranted investments in the past. This poses the question if and how such “stranded” assets should still be recouped via network tariffs, and how a regulatory framework that was designed for constant or growing demand can be made fit for the challenges ahead.