Overcoming Monopoly Power with Buyer Alliances for Natural Gas

With a few exceptions, Central and Eastern European states are highly dependent on imports of natural gas from Gazprom, the Russian state monopolist. The gas markets in the region are essentially fragmented along national lines, both commercially and physically, thus making them vulnerable to monopoly power. As a result, import prices for Russian gas have been found to be higher in the Baltic States than for example in Germany which benefits from supply source diversification while the Baltic States do not. As is well known, supply source diversification is a crucial mechanism for security of supply – enabling both price competition and lower vulnerability to supply disruptions. However the high fixed costs of the necessary infrastructure and the small size of many Central and Eastern European gas markets makes it uneconomical to organise diversification for each of them separately. The most commonly discussed solution to this problem is to invest in interconnector pipelines so as to transform a set of separate national gas transmission systems into a larger regional system. Arbitrage could then occur throughout this interconnected system, thus helping to overcome price discrimination on the part of a monopoly supplier. If, in addition, one of the countries in such a network were to acquire a new source of supplies – for instance an LNG terminal – then the benefits of diversification could be transmitted throughout the entire group of countries thanks to the possibility of physical arbitrage.

Another solution which has received far less attention is to create a virtual transmission mechanism through the imposition of a single import price. This concept is based on the idea of having a ‘single buyer’ (or single importer) for natural gas – or a (single) gas purchasing agency. The general idea is that a single gas purchasing agency enables the consolidation of the bargaining power of small buyers and should, intuitively, lead to more favourable outcomes when negotiating with a large supplier. In a recently published report, Vulnerability and Bargaining Power in EU-Russia Gas Relations, I carry out simple numerical simulations to illustrate this principle. I analyse the effects of forcing two buyers to negotiate jointly with a monopoly supplier under the assumption of a common price as compared to having these same two buyers negotiate separately.

The results suggest that buyer alliances typically lead to falls in the average price of imports, but not necessarily to a fall of the import price for all buyers. In addition, the profit margins of some of the buyers (in some cases of all of them) may fall. Contrary to intuition, it is not necessarily the case that the supplier suffers a fall in profits. These basic results give an economic grounding for why European natural gas companies continue to negotiate their supply contracts separately and show little interest in joint supply contracts. In effect, buyer alliances may often be win-lose solutions for their potential members, or even lose-lose solutions if one looks at profit functions alone. The results are however quite different if one focuses only on the price effects and if, in addition, one assumes that diversification occurs as well for at least one member of a buyer alliance. When compared to an initial situation with two separate markets with no diversification, a buyer alliance accompanied by supply source diversification for one of the two markets leads to a fall in the price of imported gas for both buyers. This is because the benefits of diversification are de facto transmitted from one buyer to the other through the fact that there is a self-imposed single price for relations with the monopoly supplier. The intuition for this result is that the buyer alliance presents a joint demand function to the monopoly supplier. When one of the members of the alliance gains access to a new source his demand falls, and therefore joint demand falls as well, thus opening the way to a lower price from the monopoly supplier.

This result has simple yet powerful implications. In particular, it means that every country in a given group can benefit from diversification provided that one of them diversifies sources and that they form a buyer alliance. Moreover it is not even theoretically necessary for these countries to be interconnected physically. The transmission mechanism in this case is the common import price. All that is required (again in theory) is for the national gas companies to form a joint negotiation team in order to sign a single supply contract with a single per unit price for the deliveries. Looking now to Central and Eastern Europe, it is easy to see which groups of countries could consider forming buyer alliances. One such group would naturally be in the Baltic region, encompassing the three Baltic States plus Poland and/or Finland. Another such group could be in Southeast Europe, for example encompassing Greece and Bulgaria (plus perhaps others). Another group encompassing Croatia, Slovenia, Hungary and Slovakia could also be imagined. The basic rule of thumb would be that each buyer alliance needs only one shared LNG terminal.

This type of arrangement would of course be considerably more likely to succeed in practice if the countries involved are also interconnected physically. This would yield the additional benefits of price arbitrage within the alliance (between gas from the monopoly supplier and gas from the new source), as well as higher resilience to possible physical supply disruptions for each individual member of a buyer alliance. In sum, the ideal solution would be to combine both mechanisms, thus leading to regionally integrated markets with diversified import portfolios, lower import prices from the monopoly supplier and higher resilience to both price shocks and supply disruptions. The benefits from such arrangements would be in the national interest of each alliance member – preferable to the status quo for final consumers, and hence for the economy as a whole, in addition to being more secure.