Security of supply is the big thing right now, and as governments consider rationing, it seems that the definition is straightforward - it’s the ability to get access to enough of the requisite resource.
But how do you define “enough”?
it can be “enough” to fulfill demand as it has been to date, or as one expects it to be (“one” to be defined…)
it can be enough to fulfill demand at a market-clearing price (in which case, you will always have “enough” if the price is allowed to rise to the level where markets balance, as by definition, this is the price where all demand willing to pay that price is satisfied)
it can be enough to fulfill demand at a price that keeps certain internationally-traded activities competitive. Any activity that requires that supply as a material input will care above all that it has access to that good at a price similar to competitors. Supply issues that affect price only some areas (for contractual or infrastructure reasons) are a problem for such industries in these areas
it can be enough to fulfill demand at a price that is cheap enough not to be a political issue.
Well designed markets should at least deliver the second. The issue is that markets are marketed (pun intended) as delivering the fourth, at all times. So any price increase, especially for a vital commodity like energy, immediately becomes a bigger issue than simply “security of supply”, and gets caught in domestic politics, where cheap shots are a normal way of business, as well as international politics, especially when the supply of the goods is controlled by State actors that manage them implicitly or explicitly as geopolitical tools of influence and power.
Let’s be clear: ideal markets will always deliver price outcomes that lead to “enough” of a resource, whatever the behavior of suppliers. Famine and mass death-by-freezing are possible outcomes to balance markets and as such are “efficient”. Obviously, they are not desirable solutions. So, clearly, at some point, markets are not seen as the only tool, and political interventions are required. The when and the how of such interventions are the fundamental questions of any polity. All markets are politically constrained - there is no solution which is “purer” than any other, they simply reflect different political choices. What kind of security of supply is embedded in a market design is one of these choices, whether explicitly or not.
With energy, and oil and natural gas in particular, a large number of forces apply, the main ones being (i) energy is a vital commodity that is indispensable to life, so literally a matter of life and death (so: politically highly sensitive); (ii) energy is a critical input to most economic activity, and a key driver of the state of the economy (so: sensitive to a lot of vested interests and lobbying); (iii) the supply of energy commodities is significantly uncorrelated from overall economic activity and located in parts of the world that are often autocratic and/or hostile (so: a subject of interest to the national security apparatus of government). Inertia should also be taken into account - people tend to expect things to remain as they are, and react negatively (and potentially explosively) to changes, in particular, negative change like price increases; and in the case of energy, infrastructure matters and demand is largely driven by existing infrastructure and activity, so is not very elastic in the short term.
Oil is too wide a topic here, so we’ll focus on natural gas, but one policy to note in Europe as regards oil has been to increase taxes massively over the past 40 years (well, mostly the first half of that period) to (i) reduce demand, and (ii) make retail prices significantly less volatile than wholesale prices. This has helped to dampen price variations to generally (but not always) politically tolerable numbers, and make retail demand for oil products even less sensitive than other kinds that pay less taxes (like industry, or other parts of the world), and put the market balancing efforts somewhere else, while maintaining otherwise market-driven prices.
Natural gas is interesting because it is an industry that is fundamentally dependent on available transport infrastructure like pipelines or LNG plants and vessels, and large infrastructure investment is always a political choice (either directly, by planning it, or indirectly, by allowing it). This makes both demand and supply even less elastic.
It is also an sector where Europe has long been a large importer, notwithstanding the North sea resources concentrated in a handful of countries. So at the beginning, gas consumption in countries like France, Germany and Italy has been driven by supply, organized around large import contracts, and security of supply was of paramount importance in structuring and negotiating the imports. Supply was based on bilateral long term contracts between public or quasi-public entities, and organised around dedicated infrastructure that tied the supplier as exclusively to the buyer as the reverse. I have often noted that an international pipeline is like a child in a couple - an irreversible connection that will require long term coordination, if not love and cooperation. The same was true, initially, of LNG infrastructure, which was organized around dedicated liquefaction plants, tankers and import terminals with very little flexibility to be used for any other purpose. Contracts further cemented this inflexibility, with very long term durations, “take or pay” clauses and rigid price formulas. These were de facto state-to-state arrangements with some mechanisms to acknowledge market forces (for instance, prices were indexed to oil, ensuring that any gap between the price of a usable unit of energy and its broad competitors remained moderate).
Governments like France that took strategic issues seriously went further and ensured that gas contracts were diversified amongst multiple suppliers, with none taking a dominant position: with contracts with Algeria, the Netherlands, Norway, Egypt, Qatar and later others, France was able to ensure, for instance, that Russia never made up more than 25% or so of its overall supply, and it further built up gas storage capacity to cover several months of use in case of unexpected events.
Such policies effectively covered all 4 of the above definitions of “enough”, allowing some market forces to play while ensuring as predictable a supply as possible.
Within Europe, the UK had a different approach, made possible by the availability of North Sea oil & gas, and triggered by the Reagan-Thatcher deregulatory policies that, among others, pushed for energy markets to be liberalized. In particular, the power market moved towards a design focused on short term prices as a tool to balance supply and demand on a ongoing basis (an important physical requirement of the sector) and to bring efficiency to power generation. In the context of plentiful natural gas and technological progress in gas turbine technology, which provided competitive and flexible power, this helped create IPPs (independent power producers) which invested in new gas-fired plants and made gas plants the marginal producer in such liberalized markets. This created a durable link between gas and power prices while, at the same time, increasing demand for gas cut the link between oil & gas prices.
In that context, with gas plentiful and widely available on increasingly liquid and sophisticated markets, gas users focused on competitiveness rather than security of supply. Long term contracts and storage became cost items, or were seen by regulators such as the EU Commission as anti-competitive instruments used by some countries (like France) to block liberalization and protect incumbents and local industry. LNG cargoes slowly became marketable outside of long term contracts, creating opportunities for arbitrage between the (until then largely de-correlated) markets of Europe, Asia and the US.
EU policy focused on the third item of my list - security of supply meant having access to gas at a competitive price. Infrastructure investment prioritized interconnectors and other items meant to reduce physical bottlenecks, while regulatory policy tried to eliminate other bottlenecks (such as exclusive access to infrastructure by some players; “no resale” clause in long term contracts) that hampered a level playing field.
Security of supply thus was increasingly understood to mean that anybody could buy gas at the then prevailing price - and since prices were most of the time quite low, this was seen (wrongly) as an effective price reduction policy as well.
It is important to note that old fashioned security of supply rules (such as imposing minimum storage requirements, and limiting dependency on a single external supplier) could have been imposed in the context of liberalized markets via regulatory constraints applying consistently to all players across the market, but this was fought by gas users as making gas more expensive (and them less competitive against non-European competition in energy-intensive sectors like metal manufacturing or chemicals). More Russian gas - but only under spot contracts! - meant cheaper prices for industry.
In that context, the arguments against the Nordstream pipelines could reasonably be seen as self-interested lobbying by competing gas suppliers (like US LNG) as nothing else was done in the name of "strategic” security of supply by those advocating against the pipeline.
It is worth noting that Russia has consistently pushed for long term gas contracts, and has, at least until the most recent period, always fulfilled its obligations under such contracts. This is because, symmetrically, security of demand matters when building the relevant production and transport infrastructure, and stable relationships were also seen as valuable - and State to State relationships as '“normal” for Russia. From their perspective, they are heavily dependent on European consumers and long term contracts protect them. The long running EU-driven liberalization of energy markets has been a source of frustration for them, in promoting a more volatile and uncertain environment for gas, but also an incredible opportunity as they were allowed to build up positions in the demand and even infrastructure side of the business on the European side, allowing them to create a partial de-risking of their upstream investments - gas storage in Germany, gas distribution business in the UK, and (on the oil side) refineries.
In that last respect, Europe was incredibly naive - expecting Russia to follow market rules at all times. Pipelines like Nordstream 2 are a risk in so far as they embed Russia as a dominant supplier through the additional capacity they provide (something that could have been avoided via simple EU-wide regulations limiting the absolute volume of gas from any non-OECD country, or even non-EU/EEA country, to, say, 25% of all demand) but at least they provide strategic mitigation via the two-way dependency they create. But allowing Gazprom to own storage capacity and retail distribution companies was insane and irresponsible. Combined with the policies against longterm contracts, that allowed Russia to get away last year with a curtailment of spot deliveries, and non-refilling of empty storage, putting Europe as a whole in a much weaker short term position on the energy front when they invaded.
Russia is still making a strategic mistake in the long term, because Europe will now regroup and update policies on the assumption that Russia is no longer a reliable supplier, and will adapt both demand and supply to avoid Russian gas. This cannot be done easily in the short term (thus the perceived weakness under item 4 of my initial list of what is “enough”) but it can definitely be done in the medium term - and probably faster than everybody imagines if it actually becomes a strategic policy priority (which it still, amazingly, does not seem to be) in addition to the choices that commercial players will make when faced with expensive and unreliable supplies. This requires new infrastructure, but this will in turn drive commercial behavior when available.
There is also the strategic choice to focus on new supply infrastructure (LNG terminals and gas supplies (via contracts, long term or otherwise, with new suppliers) rather than on reducing demand in heating via energy efficiency, in power generation via a increased focus on making renewables energy expansion easier, and in industry by promoting different technologies (green hydrogen, carbon-free cement and steel, etc.) - it is entirely logical in the short term to focus on supply substitution, but it will be essential that long term focused on demand substitution, and preferably not to gas from elsewhere or other fossil fuels, as this will only perpetuate the long term dependency on imports.
“Security of supply” is now conveniently used by coal lobbyists, LNG suppliers and nuclear energy supporters to promote their wares, but it is fundamentally about market design. Net importers of energy in particular should consider carefully how to incorporate security of supply requirements in market designs. The obvious short term fixes involve reforms that build buffers and resiliency at the least cost without destroying the value of price as a signal to organize economic activity, such as minimal storage requirements, ownership rules for key infrastructure, and a continued focus on interconnecting infrastructure. But regulators should also consider how some market rules embed behavior that is fundamentally hostile to “security of supply” - the use of short term/marginal pricing in capital intensive industries, the focus on pure price criteria for investment in life-critical goods and the natural tendency of market players (including domestic, commercial ones) to get bigger and capture both markets and regulators via oligopolistic practices, and then defend market rules that favor them against all rational arguments. More generally, the inability of markets to take into account externalities (and security of supply is a form of externality) should become a broader topic of discussion.
This is urgent for energy markets today, including if we move to new forms of energy production and use like renewables and electric cars that require new commodities, but it will similarly apply to many other markets, especially if we enter a period of increased conflict with China and suddenly realize that the vulnerability of supply chains extends across the board…
Security of supply
This is the best critique that I have read anywhere of how and why liberalised market design & marginal pricing undermine security of supply, and the many missed opportunities to improve the system with simple regulation at minimal or zero cost to consumers. Another excellent post Jerome thank you.